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/liq
uidity/

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)
Corporation Tax

195
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.