Ratio Analysis

Goes through the ratios and what they mean - DOES NOT include limitations

Liquidity

Ability of a business to pay its debts as they fall due

Stability

Ability of a business to survive in the long term

Profitability

Ability of a business to make an acceptable level of profit

Working Capital Ratio or Current Ratio

Measure of the ability of a business to pay its short term debts, that is, debts payable in 12 months or less

Working Capital Ratio or Current Ratio Formula

Current Assets / Current Liabilities

If current ratio is increasing or above ideal amount…

Short term asset base is increasing in proportion to the short term liabilities
Inventory might be sold more slowly
Debtors may be taking longer to pay
May be idle cash

If current ratio is decreasing for below the ideal amount…

Short term asset base is decreasing in proportion to the short term liabilities
Inventory might be sold more quickly
Debtors may be paying more promptly

If current ratio is less that 100%…

Indicates either that a business may find it difficult to pay its short term debts OR the business is operating in an industry in which money is collected from sales very quickly

If current ratio is between 100% - 200%…

Indicates that a business should be able to pay its short term debts

If current ratio is above 200%…

Indicates that a business should be able to pay its short term debts and that the business has extra current assets avaliable

The Quick asset ratio or Acid test ratio is…

The ability of a business to pay its more urgently repayable current liabilities using only its more liquid current assets

The Quick asset ratio or Acid test ratio formula is…

Current assets - inventory and repayments / current liabilities - bank overdraft

If the Quick Asset Ratio is increasing or above the ideal amount…

Business might be able to immediately pay all short term debts
Debtors, short term investments or cash might have increased
Creditors might have decreased

If the Quick Asset Ratio is decreasing or below the ideal amount…

Business might ot be able to immediately pay all short term debts
Debtors, short term investments or cash might have decreased
Creditors might have increased

Quick Asset Ratio is more than 100%…

Indicates that a business should be able to pay its short term debts

Quick Asset Ratio is less than 100%…

Indicates, in an emergency, a business may not be able to pay its short term debts

What is leverage or gearing?

Term used to describe the extent of the borrowings of a business

A highly geared business means…

Business has large interest and loan repayments and has an increased risk of failure

The Debt to Equity formula is…

Total liabilities / Total equity

If the Debt to Equity is increasing or above the ideal amount…

High level of borrowed external funds
Liabilities might have increased
Interest rate pressures might cause problems for the business

If the Debt to Equity is decreasing or below the ideal amount…

Low level of borrowed external funds
Equity might have increased
Interest rates are less of a concer, though lower interest rates might need to be followed up

Does the Debt to Equity ratio have a certain percantage range?

No one acceptable figure for the Debt to Equity ratio
A small business may need to have a debt to equity ratio of about 70% or less
A large business may successfully operate with a Debt to Equity ratio of 100% to 200% or even higher

What is the Gross Profit Ratio?

Shows the percentage of gross profit that is contained in each dollar of sales

The Gross Profit Ratio formula is…

Gross profit / Net sales

If the Gross Profit Ratio is increasing or above the ideal amount

Profit being earned from the sale of stock has risen in proportion to total sales
Business might be selling a greater portion of high profit items
Cost of Sales may have decreased for some reason
Method of valuating stock may have altered
Selling and purchasing price has increased

If the Gross Profit Ratio is decreasing or below the ideal amount

Profit being earned from the sale of stock has decreased in proportion to total sales
Business might be selling a greater portion of low profit items
Cost of Sales may have increased for some reason
Method of valuating stock may have altered
Selling and purchasing price has decreased

The Profit ratio shows…

the percentage of profit that is contained in each dollar of sales

The Profit ratio formula is…

Profit / Net sales

If the Profit ratio is increasing or above the ideal amount…

Profit being earned has risen in proportion to total sales
Business might be selling a greater portion of high profit items
Cost of Sales may have decreased
Expenses may have decreased
Difference between fixed expenses and sales income has changed

If the Profit ratio is decreasing or below the ideal amount…

Profit being earned decreased in proportion to total sales
The business might be selling a higher proportion of low profit items
Cost of Sales may have increased
Expenses may have increased
Fixed expenses now allocated over a lower income account

Expense Ratio is…

comparing the sales of a business to the total of the selling and distribution, general and administration and financial expenses

The Expense Ratio formula is…

Operating expenses / Net sales

If the Expense Ratio is increasing…

Expenses are increasing in proportion to sales
There might have been an extraordinary expense incurred
Look at the impact of all changes to expense ratios

If the Expense Ratio is decreasing…

Expenses are decreasing in proportion to sales
Find out where the business has become more efficient and why

For the Expense Ratio, the owner can determine…

The extent to which the expenses have affected the profit and any differences in previous years

Return on assets measures…

how efficiently a business has used its assets to generate a profit

The Return on assets formula is…

Profit / Average total assets

If the Return on Assets ratio is increasing…

Money invested in the business is being used more efficiently
Greater return may be being earned from the same quantity of assets

If the Return on Assets ratio is decreasing…

Business is using assets less efficiently
Business might need to consider reducing the amount invested in assets
Ensure assets are not idle

The Return on Assets ratio should be compared…

to the return on assets achieved in previous years or to an industry average.