Section 8 Ratios
UFP Accounting and Finance
Financial Ratios
1. What is accounting
2. Balance Sheet
3. Income Statement
4. Accounting equation
5. Double Entry Book-keeping
6. Adjustment to the income statement and balance sheet
7. Sources of finance
8. Financial ratios
At the end of this topic you need to know:
a) How to calculate and comment on Profitability Ratios
b) How to calculate and comment on Liquidity Ratios
c) How to calculate and comment on Gearing Ratios
d) How to calculate and comment on Stock/Inventory Ratios
e) How to calculate and comment on Payables and Receivables
Ratios
f) Advantages and disadvantages of using ratios
UFP Accounting & Finance
Section 8 Ratios
UFP Accounting and Finance FORMULA TABLE
Formulae
PROFITABILITY RATIOS
Gross profit percentage
Gross profit x 100
Revenue
Requirements
Net profit percentage
Net Profit x 100
Revenue
Return on Net assets employed
Profit before tax
x 100
Net assets*
Return on capital employed
Profit from operations
x 100
Capital employed**
SOLVENCY/LIQUIDITY RATIOs
Current ratio
Current assets
Current liabilities
Acid test (liquid) ratio
Current assets –inventory
Current liabilities
Capital gearing percentage
Non-current liabilities
Capital Employed**
x 100
ASSET UTILISATION RATIOS
Trade Receivables collection period in
days
Trade Payables payment period in
days
Trade Receivables
Revenue
Trade Payables
Inventory turnover in days
Average inventory
Cost of Sales
Inventory turnover (times per year)
Cost of sales
Average inventory
Net Asset ratio
Revenue
Net Assets*
x 365 days
x 365 days
Credit Purchases or cost of sales
x 365 days
*net assets are calculated (for ratio analysis purposes only) as: Non-current assets + current assets –
current liabilities.
** capital employed is calculated as: (Issued share capital +Reserves +Non current liabilities)
Please note: We advise that students use the formulae above, however students will not be penalised for
using an alternative formula as long as it is correct.
UFP Accounting & Finance
Section 8 Ratios
Worksheet
Profitability Ratios
1) Gross Profit Margin examines the % of profit made on each pound
of sales after the cost of sales (variable costs/materials) have been
deducted. The higher the % the better.
2) Net Profit Margin examines the % of profit made on each pound of
sales when all costs (variable and fixed) are deducted. The higher
the % the better.
For some industries the margin may be low, e.g., supermarkets
have around a 3% margin. It doesn’t mean low total profits, it
means the amount made on each sale is low. For electronic items
the margins may be 15-30% or more.
3) Return on Capital Employed examines the percentage of
operating profit generated from Total Capital Employed (Equity
finance and long-term loans). It looks at how much is invested in
the company compared with the profit. The higher the % the better.
Shareholders are particularly interested in this ratio.
4) Return on Net Assets examines the income/profit produced by
total/net assets (all assets minus current liabilities) during a period measures how efficiently a company can manage its assets to
produce profits during a period. The higher the % the better.
UFP Accounting & Finance
Section 8 Ratios
Total capital employed is Shareholders funds plus creditors falling due AFTER one year (ie long term loans)
Question: Calculate the profitability ratios for each year and comment
Ratio
ROCE
Formula
Net profit
x100
Total Capital employed
Gross
profit
Margin
Gross Profit x 100
Sales
Net
Profit
Margin
Net profit x 100
Sales
Net
assets
Profit before tax x 100
Net assets
2010
2009
1. Comment on the GP Margin
Gross profit margin is a way to check a company’s profitability. The % of profit
made on each pound of sales in 2010 (8.1), appears to be higher than the
percentage in 2009 (7.6). It can be noticed that the sales for the year 2010 is
higher than the sale for 2009. The higher the percentage the better. It would
appear the business improved it’s sales and also the cost of production
compared to it’s sales.
2. Comment on the ROCE
UFP Accounting & Finance
Section 8 Ratios
Question: Calculate the profitability ratios for each year and comment
Ratio
ROCE
Formula
Net profit
x100
Total Capital employed
Gross
profit
Margin
Gross Profit x 100
Sales
Net
Profit
Margin
Net profit x 100
Sales
Net
assets
Profit before tax x 100
Net assets
2010
1. Comment on the Net Profit margin
UFP Accounting & Finance
2009
Section 8 Ratios
2. Comment on the ROCE
Worksheet -Liquidity Ratios
These ratios assess the firm’s ability to pay its short-term liabilities
1) Current Ratio looks at the ability to pay short term debts from
current assets. Ideally the assets should be sufficient to cover the
liabilities (1:1 is ideal)
2) Quick or Acid Test Ratio looks at the ability to pay short term debts
but does not include stock as this is viewed at the least liquid
current asset
Calculate the liquidity for Tesco for both years.
Ratio
Formula
2010
2009
Comment on the short-term liquidity position for Tesco
UFP Accounting & Finance
Section 8 Ratios
Ratio
Formula
2010
Current
Ratio
Acid Test /
Quick Ratio
Comment on the short-term liquidity position for Ryanair
UFP Accounting & Finance
2009
Section 8 Ratios
Worksheet
Gearing Ratios
This ratio examines the level of long-term debt in the company. It calculates
how much of the total capital used in the business is generated from longterm loans.
Most firms will have long-term loans but are considered highly geared if more
than 50% of total capital used in the business is generated from loans.
Highly geared firms may be considered risky due to uncertainty in interest rate
changes.
a) Calculate and Evaluate Wetherspoon’s Gearing Ratio for 2009 and
2010
b) Is a high gearing ratio always a negative indicator?
UFP Accounting & Finance
Section 8 Ratios
Sales
Operating Profit
TN Ltd
£
600,000
265,000
OP Ltd
£
980,000
440,000
Net Profit
245,000
380,000
Cash
Inventory
Trade receivables
Current liabilities
Long-term loan
Share capital and reserves
15,000
11,000
14,000
30,000
82,000
343,000
10,000
12,000
28,000
60,000
88,000
522,000
Calculate:
Gross profit margin
Net profit margin
Current ratio
Gearing ratio
Compare and comment on the performance of the 2 companies
UFP Accounting & Finance
Section 8 Ratios
Worksheet
Inventory / Payables and Receivables Ratios
Two Inventory Ratios – Inventory turnover and inventory days
Let’s remember that firms do not want to hold high levels of stock. They want
a quick TURNAROUND of stock and only want to hold the same stock for as
FEW DAYS AS POSSIBLE.
Example Subway (sandwich store) will use their stock up daily. So, they will
probably have a turnaround of stock 360 times a year (inventory turnaround)
and will only keep stock for 1 day (inventory days). So, firms want a HIGH
TURNOVER and a LOW INVENTORY DAYS figure
Formulas
Inventory turnover days: Average inventory / cost of goods sold x 365
Inventory turnover ratio: cost of goods sold / Average inventory
Subway
Jewelers
Debenhams
Average
inventory
£1m
£50m
£10m
British
Aerospace
£400m
COGS
£300m
£200m
£60m
£600m
Inventory days
Inventory
turnover
UFP Accounting & Finance
Section 8 Ratios
Receivables collection period in days (receivable or debtor
days)
Accounts receivable days is the number of days that customer invoices
(typically) are outstanding before being collected. Obviously, a firm wants to
collect from debtors as quickly as possible (so the lower the number of days
the better)
Formula: Receivables / sales x 365
Receivables
Sales
Receivable Days
Firm A
£10m
£60m
Firm B
£1m
£10m
Firm C
£1m
£8m
Comment on the above ratios
UFP Accounting & Finance
Firm D
£7m
£100m
Section 8 Ratios
Payables payment period in days (payables or creditor days)
Accounts payables days is the number of days that firm’s (typically) take
before paying their outstanding bills. Obviously, a firm wants to wait as long
as possible to pay its debts. However, there are obvious risks associated with
taking more time than is permitted by the terms of trade with the supplier. One
is the loss of supplier goodwill; another is the potential threat of legal action or
late-payment charges.
Formula: Payables / purchases x 365 (purchases are the same as CoGS)
Payables
Purchases
Payable days
Firm A
£1m
£6m
Firm B
£1m
£10m
Firm C
£2m
£8m
Comment on the above ratios
UFP Accounting & Finance
Firm D
£80m
£900m
Section 8 Ratios
Worksheet
Compare the ratios
Gross Profit Margin
(profit after material
deducted)
ROCE (how well it uses
capital)
Trade payables
(How long the firm takes
to pay its bills)
Trade receivables
(how long firm takes to
collect money from
debtors)
Inventory turnover
days
Company A
30%
Company B
38%
12%
15%
2 days
20 days
5 days
45 days
82 days
35 days
The 2 companies sell the same products, their cost of sales and operating expenses
are similar
Use profitability ratios to find out which firm might be more attractive to
investors:
Compare and comment on the trade receivable ratio (positive and negative
point)
Calculate the inventory turnover for firm A and B
UFP Accounting & Finance
Section 8 Ratios
Notes
Advantages and disadvantages of using ratios
Advantages:

Ratios help compare current performance with previous records.

Ratios help compare a firm’s performance with similar competitors.

Ratios help monitor and identify issues that can be highlighted and resolved.
Disadvantages:

Ratio analysis information (Income Statement and Balance Sheet) is historic –
it is not current and does not reflect the current performance of the firm.

Ratio analysis does not consider external factors such as a worldwide
recession.

Ratio analysis does not measure the human element of a firm / it just looks at
the quantitative element
UFP Accounting & Finance
Section 8 Ratios
UFP Accounting & Finance Assignment
Ratios
UFP Accounting & Finance: Main Ratios
The following information is extracted from the financial statements of two
public limited companies
ABC Plc (£)
XYZ Plc (£)
Sales
25,000
16,000
Cost of goods sold
(9,000)
(4.000)
Gross profit
Expenses
(5,000)
(7,000)
Net Profit
Current Assets
Current liabilities
Long-term loan
Preference share capital
Ordinary share capital
Reserves
500
400
2,000
1,000
2,000
1,000
1000
600
2,000
2,000
9,000
4,000
For each of the companies, calculate: (2 marks for each correct answer in
each company)
a. Gross profit margin
b. Net profit margin
c.
ROCE
d. Current ratio
e. Gearing ratio
UFP Accounting & Finance
Section 8 Ratios
The following information is extracted from the financial statements of two
public limited companies
CDE Plc (£) LMN Plc (£)
Sales
7,000
3,000
Cost of goods sold
(500)
(200)
Gross profit
Expenses
(2,000)
(1,400)
Net Profit
Current Assets
Current liabilities
Long-term loan
Preference share capital
Ordinary share capital
Reserves
800
900
5,000
1,000
1,000
500
700
600
5,000
5,000
1,200
200
For each of the companies, calculate: (2 marks for each correct answer in
each company)
a. Gross profit margin
b. Return on capital employed (ROCE)
c. Current ratio
d. Gearing ratio
e. Which company is performing better?
UFP Accounting & Finance