ratio analysis

return on capital employed

It measures the efficiency with which the firm generates profit from the funds invested in the business.

(Net Profit before Interest) / (Total Assets-Current Liabilities) x100

If the ROCE Ratio is improving it could be said that management are using the resources of the business effectively:

 The business could have a strong ROCE Ratio or an improving ratio if it increased its operating profit without raising further finance.

 The business could also have reduced its capital employed by repaying some long-term debt.

gross profit margin (percentage)

This ratio indicates the profitability of trading operations. (Gross Profit/Sales) x 100% = GP % Gross Profit/Revenue

If the business has an improving or high gross profit margin the business must be controlling its cost-of-sales (direct costs) properly if the ratio is high or higher than previous years

If the ratio is low or has fallen the business must not be controlling its cost-of-sales (direct costs) properly:

 This could be an indication of poor management.

- Increased costs of raw materials thus putting up costs.

- A reduction in selling price lowering the gross profit margin.

Increase Revenue:

Reduce Cost of Goods Sold (COGS):

net profit margin (percentage)

This ratio indicates the profitability of running the business. Net Profit = Gross Profit - Total Expenses (Net Profit/Sales) x 100% = NP %

 As with gross profit, a higher percentage result is preferred.

 The net profit margin establishes whether or not the firm has been efficient in controlling its expenses.

 It should be compared with previous years’ results and other companies in the same industry to judge relative efficiency

Increase Revenue

Reduce Costs

Improve Efficiency

current ratio

It compares the total of the current assets to the total of the total current liabilities, and indicates if the business can pay its immediate short term debts from available resources. Current Assets/ Current Liabilities = X:1

 A low current ratio means that a business may not be able to pay its debts.

 This may imply that suppliers would refuse further deliveries, workers would not work until paid and the bank may seek to have its overdraft repaid.

 This would hinder the operation and continuation of the business.

It becomes an issue when it is a long term feature of the business.

Sell off fixed assets no longer vital to operations

Effectively market product to stimulate demand.

gearing

It measures the firm’s level of debt. This shines a light onto the long term financial stability of a business.

Long Term Debt/ x 100 = Gearing %

Long Term Debt + Equity Capital

Benefits of High Gearing

1. There are relatively few shareholders, so it is easier to keep control of the company.

2. The company can benefit from a very cheap source of finance when interest rates are low.

3. Interest payments to a bank may be lower than the dividend demands of shareholders.

Benefits of Low Gearing

1. There is less risk of creditors forcing the business into liquidation.

2. It avoids the pressure of having to repay debts, with interest.

Reduce Debt Levels

Increase Equity

Asset Management

Increase Profits and Cash Flow

earnings per share

This measures how much each share is earning. It does not show how much money is actually paid to shareholders, but how much is available to be paid.

Profit After Tax/ = x pence

Number of Shares in Issue

 As a measure of performance, this ratio indicates the profitability of the company in the first instance.

 It is express in terms of pence per share, and should ideally be as high as possible.

 Considered in isolation, it is limited but compared to a previous year or another company can provide a better insight into the profit movements experienced over time on a per share basis.

 A rising EPS is likely to please shareholders.

Increase Net Income

Improve Profit Margins:

return on equity

This ratio can be used to measure the return on the funds contributed by shareholders, as represented by equity in the business. In the context, shareholders equity is defined as ordinary shareholders capital plus reserves.

Profit After Tax x 100/ = X %

Shareholders Equity

A high ROE is desirable because it indicates that the business is generating strong returns relative to the equity invested by shareholders. As a result, it can enhance investor confidence and make the company more attractive to potential shareholders.

However, if ROE is unusually high, it may also indicate excessive reliance on debt, which increases financial risk.

Increase Net Income

Efficient Use of Assets

Improve Profit Margins