FINANCIAL RATIOS
Making sense of
Revenue Statements
And
Balance Sheets
Introduction
• Financial ratios are calculations that help
managers examine the performance of the
business.
• They also assist in determining whether the
business is meeting its financial objectives.
• Ratios allow comparison over time, with
industry averages and with their competitors,
they allow for the prediction of trends and
assist in planning.
•IT IS NOT ENOUGH TO
SIMPLY CALCULATE
RATIOS YOU MUST
INTERPRET THEM....
To begin...
• You must be familiar with The Accounting
Equation
• Assets = Liabilities + Owners equity
• This equation is the one that ensures that the
Balance Sheet actually balances.
The types of ratios
• There are several categories of ratios that
businesses use and you need to know which
ratio falls under which category
TYPE/CATEGORY
OUTLINE
LIQUIDITY
SHORT TERM STABILITY
SOLVENCY
LONG TERM STABILITY
PROFITABILITY
FINANCIAL RETURN
EFFICIENCY
RETURN ON COSTS
Liquidity
• Liquidity measures how easily a business can
meet its current liabilities or short term debts.
• It is the relationship between current assets
and current liabilities.
• Ideally the business should have more current
assets than current liabilities to pay their short
term debts as they fall due.
How is liquidity measured
• By using the Current Ratio
• Current Ratio =
current assets
current liabilities
Generally the industry standard for liquidity is
2:1. This means that for every dollar of liability
the business has 2 dollars of assets to pay for
it
Worked Example
• Using the Coco’s Coastal Cafe Balance Sheet:
• A) Determine the level of current assets and
current liabilities
• B) Substitute these numbers into the ratio
• C) Write a short statement that describes the
current ratio of Coco’s Coastal Cafe ( is it
good?)
Solvency
• Refers to the long term stability of the
business and whether it can meet its total
financial obligations as they fall due.
• The term used to describe the relationship
between debt and equity is gearing. If the
business has accumulated more debt than
equity it is termed highly geared.
How solvency is measured
• By using the gearing ratio
• Gearing Ratio =
Total liabilities X 100
Owners Equity
Generally the industry standard for small business is
50% and for larger business 100% This means for a
small business that for every dollar of equity
invested the business has generated 50c of debt.
Worked Example
• Using the Coco’s Coastal Cafe Balance Sheet:
• A) Determine the level of total liabilities and
owners equity
• B) Substitute these numbers into the ratio
• C) Write a short statement that describes the
gearing ratio of Coco’s Coastal Cafe ( is it
good?)
Profitability
• Profitability refers to the businesses ability to
make a financial return from their activities.
• Profitability can be determined in 3 ways by
calculating:
* Gross Profit Ratio (GPR)
* Net Profit Ratio
(NPR)
* Return on Owners Equity (ROOE)
Gross Profit Ratio
• This ratio indicates the percentage of each
dollar of sales, this is gross profit. It indicates
the mark up placed on goods sold.
• Generally the higher this percentage the
better as this gives the business better
opportunities to account for their expenses
GPR
• Gross Profit Ratio = Gross Profit
GPR
Sales
X 100
Worked Example
• Using the Coco’s Coastal Cafe Revenue
Statement:
• A) Determine the level of Gross Profit and
Sales
• B) Substitute these numbers into the ratio
• C) Write a short statement that describes the
GPR of Coco’s Coastal Cafe ( is it good?)
Net Profit Ratio
• Net Profit Ratio takes into account the
expenses of a business and this is how it
differs from the GPR.
• The Net Profit Ratio (NPR) will be less than the
GPR and if expenses were increasing then the
NPR would be decreasing.
• This ratio measures what percentage of each
dollar of sales is net profit. 13-20% is good for
retail businesses.
NPR
• Net Profit Ratio =
NPR
Net Profit X 100
Sales
Worked Examples
• Using the Coco’s Coastal Cafe Revenue
Statement:
• A) Determine the level of Net Profit and Sales
• B) Substitute these numbers into the ratio
• C) Write a short statement that describes the
NPR of Coco’s Coastal Cafe ( is it good?)
Return on Owners Equity
• This is one of the most important indicators as
it shows how much the owners investment
and risk in the business is earning.
• A high figure is desirable but the trend over
time is more significant
• A figure below 10% would be a concern as the
owner could invest in much less risky areas for
a similar return. E.g. bank and property
investments
ROOE
• Return on Owners Equity =
ROOE
Net Profit X100
Owners Equity
Worked Example
• Using Coco’s Coastal Cafe Revenue Statement
and Balance Sheet:
• A) Determine the level of Net Profit and
Owners Equity
• B) Substitute these numbers into the ratio
• C) Write a short statement that describes the
ROOE of Coco’s Coastal Cafe ( is it good?)
Efficiency
• Efficiency means that a business is the
maximum returns for the minimum costs.
• Efficiency ratios provide a tool to determine
how efficiently the business is using its assets
and spending to create sales and profits.
• There are 2 main efficiency ratios
– Expense Ratio
– Accounts Receivable Turnover Ratio
Expense Ratio
• This ratio shows the relationship between
sales and expenses used to make those sales.
• The Expense Ratio needs to be as low as
possible so that the business can generate a
better NPR.
• Strategies are often used to lower the Expense
Ratio once it has been determined.
Expense Ratio
• Expense ratio =
expenses X 100
sales
•
•
•
•
Using Coco’s Coastal Cafe Revenue Statement:
A) Determine the level of Sales and Expenses
B) Substitute these numbers into the ratio
C) Write a short statement that describes the
expense ratio of Coco’s Coastal Cafe ( is it
good?)
Accounts Receivable Turnover Ratio
• This ratio shows how long it takes for the
business to collect money that is owed to
them
• A long period is a concern as it means the
business’s cash flow could be jeopardised.
• If a business can collect its debts within 14
days that is excellent but anything up to 60
days is acceptable. The lower the number of
days the better.
Accounts Receivable Turnover Ratio
• Accounts Receivable = Accounts Receivable
Turnover Ratio
Sales /day
(sales /day is calculated by dividing the value of
sales by 365)
• Using Coco’s Coastal Cafe Revenue Statement
and Balance Sheet:
• A) Determine the level of Sales and Accounts
Receivable
• B) Substitute these numbers into the ratio
remember to divide the sales by 365!!!
• C) Write a short statement that describes the
Acc/Rec Turnover Ratio of Coco’s Coastal Cafe
( is it good?)