Unit 3
Accounts & Finance
Ratio Analysis
Learning Objectives
To be able to calculate ratios
To be able to use ratios to interpret and
analyse financial statements from the
perspective of various stakeholders
HL – To evaluate the possible financial and
other strategies to improve the values of
ratios
Five main groups of ratios
• Profitability ratios
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–
–
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Gross Profit Margin
Net Profit Margin
ROCE
Mark-up
• Liquidity ratios
Accounting
Ratios
– Current Ratio
– Acid Test Ratio
• Financial efficiency ratios
– Stock (inventory) Turnover Ratio
– Debtor Days Ratio
– Creditor Days Ratio
• Shareholder or investment ratios
– Dividend Yield Ratio
– Earnings per share ratio
• Gearing ratios
– Gearing Ratio
Key word – Efficiency
How well a firm is using
its resources
Financial Efficiency Ratios
• Many different ratios
• Two most frequently used are
– Stock turnover ratio
– Debtor days ratio
Financial
Efficiency Ratio
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•
•
•
Cost of goods sold
STR
Value of stock (average)
1. Stock (Inventory) Turnover Ratio
In principle, the lower the amount of capital used
in holding stocks, the better
Modern stock control theory focuses on
minimising investment in inventories (JIT)
This ratio records the number of times the stock
of a business is bought in and resold in a period
of time
Generally, the higher the ratio, the lower the
investment in stocks will be
Financial
Efficiency Ratio
Cost of goods sold
STR
Value of stock (average)
1. Stock (Inventory) Turnover Ratio
• This ratio uses average stock holding
• The average value of inventories at the start of
the year and at the end
• Alternative formula is
Stock turnover ratio (days) =
value of stocks
cost of sales / 365
Financial
Efficiency Ratio
•
•
•
•
Cost of goods sold
STR
Value of stock (average)
1. Stock (Inventory) Turnover Ratio
Result is not a % but the number of times stock
turns over in the time period (usually a year)
The higher the number the more efficient the
managers are in selling stock rapidly
Very efficient stock management will give a high
inventory turnover ratio
Normal result for a business depends on the
industry it operates in (fresh food higher ratio
than car shop)
Debtor Days Ratio
• The debtor days ratio, also know as the debt
collection period measure the number of days it
takes a firm, on average, to collect money from
its debtors, the shorter the time the better the
management
• Debtors are the customers who have purchased
items on credit from the business and therefore
owe money to the firm
Trade debtors (accounts receivable)
Sales turnover
x 365 (days)
Debtor Days Ratio
• Can also be calculated using total credit sales,
thus excluding sales for cash from the
calculation – more accurate, as cash sales
never lead to debtors
• Results show how long a company gives its
customers time to pay debts
• No right o wrong result
Debtor Days Ratio
• For example, if a firm’s debtors totals $1M whilst its turnover
is $5M, then the ratio is 73 days
• This means that on average, it takes the business 73 days to
collect debts from its customers who have bought items on
credit
• Why is the lesser the time the better?
• A business who has a low figure may have to be careful they
are not losing out to other businesses who may be offering
better credit terms
• It is common for a business to allow customers 30-60 days
credit so a ratio of between 30-60 would be acceptable
• The period depends on the context of the business
Improving debt collection period
• Impose surcharges on late payments, e.g.
banks utility companies
• Give debtors incentives to pay earlier, such as
a discount before the due date
• Direct debit
• Refuse any further business with a client until
payment is made
• Threaten legal action
Creditor Days Ratio
• Measures the number of days it takes, on average, for
a business to pay its creditors (suppliers)
Trade Creditors
Creditor purchases x 365
• E.g. if a firm has $225,000 owed to its suppliers with
£1.75M worth of cost of sales, the creditor days is 47
days
• This means on average it takes a business 47 days to
pay its suppliers
• In general the higher this figure the better for the
business as it means repayment terms are prolonged
• If it is too high however suppliers may impose financial
penalties for late payment