ratio analysis

What are ratios

Interpretation of financial statements using further investigation

Who are ratios used by

Various stakeholder groups to evaluate business performance and maybe make decisions

How are ratios shown

As a ratio

As a %

Number of days

Number of times per annum

Gross profit margin explanation

Expressed gross profit as a % of revenue

Formula for gross profit margin

Gross profit/revenue x 100= %

Interpretation of gross profit margin

The higher the percentage the better

Ways to improve gross profit margin

Interest unit selling price - but could lead to severe in sales volume

Reduce unit cost price - but may lead to worse quality

Trade discount through buying in bulk - lead to increased inventory holding costs

What is markup

Expresses gross profit as % of cost of sales

Formula for markup

Gross profit/cost of sales x 100 = %

Interpretation of mark up

Higher % mark up is better

Profit in relation to revenue

Expresses profit for the year as % of revenue

Formula for profit in relation to revenue

Profit for year / revenue x 100 = %

Interpretation of profit in relation to revenue

Higher % of profit in relation to revenue is better

Method to improve profit in relation to revenue

Increase the gross profit

Increase other incone

Decrease expense in relation to revenue

Expenses in relation to revenue explanation

Expressed expenses as % of revenue

Formula for expenses in relation to revenue

Expenses/revenue x100 = %

Interpretation for expenses in relation to revenue

Expenses could be an individual expense or category of expenses however most questions use total of all expenses from income statement

Method to improve expenses in relation to revenue

Decrease expenses

Rent - move to cheaper premises however this could reduce operating capacity

Light and heat - change to cheaper supplier

Wages and salaries - staffing costs a large proportion however redundancies could reduce customer service or quality of product

ROCE explanation

Expressses profit for the year as a % of capital employed

Formula of ROCE

Profit for the year/capital employed x 100= %

Interpretation of ROCE

Higher ROCE better from owners perspective

What does capital employed consist of

Non current liabilities and capital

Method to improve ROCE

Increase profit for the year medics non current liabilities

Liquidity ratios

Current ratio liquid capital ratio

Current ratio explanation

Expresses current asset compared to current liabilities

Formula for current ratio

Current assets/ current liabilities = number:1

Interpretation of current ratio

Above 1:1 can pay all short term debts and have remaining net current assets (working capital)

Below 1:1 cannot pay debts and has no working capital

Notes on current ratio

No ideal ration depends on nature

If too high indicates underutilisation of current assets

Why current ratio may be too high

Excessive inventory

High trade receivables

High bank or cash balance

Liquid capital ratio explanation

Expressed current assets excluding inventory to current liabilities

Formula for liquid capital ratio

(Current assets- inventory) / current liabilities

Interpretation of liquid capital ratio

Above 1:1 can pay short term debts without need of inventory

Below 1:1 cannot pay short term debts without need of inventory

Notes for liquid capital ratio

No ideal ratio

Depends on nature of business

Inventory least liquid current asset so is excluded

Inventory excluded is closing inventory

Efficiency ratios

Trade receivable days

Trade payable days

Rate of inventory turnover

Trade receivable days explanation

Measures average time for customer to pay for food sold on credit basis

Formula for trade receivable days

Trade receivables / credit sales x 365

Interpretation of trade receivable says

Loser number of receivable days is better

What is typical credit terms

30 days

Benefits of having lower amount of days

Cash flow improved due to earlier receipt from customers

Reduced risk of irrecoverable debts

Implied better credit control

Ways to encourage early payment

Offer cash discount for early payment

Charge interest on late payments

Trade payable days explanation.

Measures average time to pay suppliers for goods purchased on credit basis

Formula for trade payable days

Trade payables/ credit purchases x 365

Interpretation of trade payable days

Higher number of days can be better

Advantages of higher trade payable days

Delaying payment improves cash flow

Disadvantages of delaying payments

Loss of cash discount

Potentially charges interest for late payment

Poor credit rating (blacklisted)

Risking suppliers to stop future supply of goods

Only being allowed cash payments

Difficult to find alternate suppliers

Rate of inventory turnover explanation

How quickly on average inventory is being sold from business

Formula for rate of inventory turnover

Cost of sales/average inventory= times per annum

Average inventory/cost of sales x 365 = days to turnover inventory once

Cost of sales formula

Opening inventory + purchases - closing inventory

How to work out Average inventory

Opening inventory + closing inventory / 2

Interpretation of rate of inventory turnover

Quicker is better

Benefits of faster inventory turnover

Higher volume of sales

Reduces inventory holding costs like storage

Reduces risk of inventory deterioration

Reduces risk of inventory becoming obsolete

Reduces problem of opportunity cost where cash tied up in inventory

Risk of low stock holdings

Risk of a stock out which may negatively impact reputation and customers may seek alternate suppliers