Ratio Analysis of Accounts
Lesson Objectives for Today:
• Differentiate between profitability &
liquidity ratios.
• Calculate the main financial Ratios.
• Analyze the main financial ratios.
Why do businesses use Financial ratios?
• We can monitor the performance of the
company
• We can measure the financial strength
of the company
Liquidity
• The degree to which an asset or security can be
bought or sold in the market without affecting
the asset's price. Liquidity is characterized by a
high level of trading activity. Assets that can be
easily bought or sold are known as liquid assets.
• The ability to convert an asset to cash quickly.
Also known as "marketability.“
• There is no specific liquidity formula; however,
liquidity is often calculated by using liquidity
ratios.
http://www.investopedia.com/video/play/liquidity/
Ratios you need to know how to
calculate:
• ROCE (Return on Capital Employed)
• Gross Profit Margin
• Net Profit Margin
• Current Ratio
• Acid Test Ratio
Return On Capital Employed
(ROCE)
ROCE (%) = Operating Profit x 100
Capital Employed
What does it show?
• The ROCE is considered to be the best measure of
profitability. The ROCE indicates how much money
is made by the business, compared to how much
money has been ‘put into’ the business.
• A decent ROCE would range from 20 – 30%,
however, again this ratio is industry specific.
Gross Profit Margin
Gross Profit Margin (%) = Gross Profit x 100
Sales Turnover
What does it show?
• The GPM tells us the profit a business makes on
its cost of sales, or cost of goods sold.
• Gross profit is the profit we earn before we take
off any administration costs, selling costs and so
on.
• The ratio can be improved by increasing prices or
reducing the direct cost of sales.
Net Profit Margin
Net Profit Margin (%) = Net profit before tax x 100
Sales Turnover
What does it show?
• The net profit margin ratio tells us the amount of net
profit per £1 of turnover a business has earned. That is,
after taking account of the cost of sales, the
administration costs, the selling and distributions costs
and all other costs, the net profit is the profit that is
left, out of which they will pay interest, tax, dividends and
so on.
• NPM can be improved by raising prices or lowering cost of
sales or expenses.
Current Ratio
Current Ratio = Current Assets
Current Liabilities
What does it show?
• The current ratio should be higher than 1:1;
however, 1.5:1 – 2:1 is considered as ideal. This
represents £1.50 or £2 of current assets to every
£1 of current liabilities.
• A value of below 1.5:1 suggests a liquidity/solvency
problem.
• A current ratio in excess of 2:1 may indicate poor
management of resources with capital tied up in
stocks, debtors or lying idle in the bank.
Acid Test Ratio
Acid Test Ratio = Current assets – stocks
Current Liabilities
What does it show?
• Stock is the least liquid of current assets. It has to be
sold first, turned into debtors and then eventually into
cash.
• A ratio of 1:1 is generally considered as satisfactory. This
represents £1 of liquid assets to every £1 of current
liabilities – showing both amounts are the same.
• A value of below 1:1 suggests a liquidity/solvency problem.
The business does not have enough current assets to meet
short term liabilities, for example, creditors.
Individual Activity
Calculate the following ratios:
• ROCE (Return on Capital Employed)
• Gross Profit Margin
• Net Profit Margin
• Current Ratio
• Acid Test Ratio
Extension
Comment on what each result shows and how might they act
on the result.
Profit and Loss
2005 ($000)
Sales Turnover
1,250
Cost of Sales
900
Gross Profit
350
Operating Expenses
105
Operating Profit
245
Interest Payable
50
Profit before Tax (Net
Profit)
195
Corporation Tax
35
Profit after Tax
160
Dividends
120
Retained Profit for the year
40
Review
ROCE =
=
245 x 100
1,160
21 .1%
The higher the result the more successful
are the managers in earning profit from
capital used in the business.
Review
Gross Profit Margin = 350 x 100
1,250
= 28%
This means that on every $ worth of
goods sold, the company made on average
28 cents gross profit.
Review
Net Profit Margin = 195x 100
1,250
= 15.6%
The higher this result, the more
successful the managers are in making
profit from sales.
Review
Current Ratio = 140
130
= 1.1:1
This result is low. It means the business
could only just pay off its short term debts
from current assets. A safer ratio would be
between 1.5 - 2
Review
Acid Test Ratio = 140 – 80
130
= 0.46:1
This is low. A result of 1 would mean the
company could just pay off its debts. This
result means that the company cannot
afford to do this.