Ratios

1. Gross Profit Percentage Ratio

This calculates the percentage of profit made from the buying and selling of goods before all other expenses are deducted. Assume that the accounts of a business show the following:

Sales revenue = £150,000
Cost of sales = £100,000

The gross profit is calculated by:
sales - cost of sales = £50,000

The Gross Profit ratio is (Gross Profit/Sales Revenue) × 100
In this case . . . (50,000/150,000) × 100
So the Gross Profit Percentage = 33.3%

To improve GPP a business can:

  • Increase the selling price of its product

  • Decrease cost of sales

  • Finding a cheaper supplier or negotiate trade discounts

2. Profit for the Year Ratio

This calculates the percentage of overall (net) profit made from after all other expenses are deducted. Assume that the accounts of a business show the following:

Sales revenue = £150,000
Cost of sales = £100,000
Operating expenses = £20,000

The net profit is calculated by:
sales - cost of sales - operating expenses = £30,000

The Net Profit ratio is (Profit for the Year/Sales Revenue) × 100
In this case . . . (30,000/150,000) × 100
So the Net Profit Percentage = 20%

To improve NPP a business can:

  • Increase the gross profit figure

  • Increase sales

  • Reduce expenses such as rent, heating, and insurance

3. Return on Equity Employed

Return on equity employed calculates how much money an investor will get back after a period of time. Assume that the accounts of a business show the following:

Profit for the year = £30,000
Owner’s equity = £120,000

The ROE is (Profit for the Year/Opening Equity) × 100
In this case . . . (30,000/120,000) × 100
So the Return on Equity = 25%

To improve ROE a business can:

  • Increase sales or reduce the cost of sales

  • Reduce expenses

Liquidity ratios

Businesses that lack working capital are not in a strong position to pay their debts. Some business in this position will go into liquidation, resulting in all their assets being sold (liquidated) to pay the debts of the business. This will mean they are no longer able to trade.

Liquidity ratios calculate the organisation’s ability to pay short-term debts. The 2 main liquidity rations are Current Ratio and Acid Test.


Current Ratio

Assume the current assets of a business are £100,000 and its current liabilities are £50,000.

Formula: current assets divided by current liabilities.

100,000 / 50,000
Current ratio = 2:1

A 2:1 current ratio is generally accepted as being healthy. A higher ratio such as 5:1 might mean that the business is inefficient and has too much money tied up in inventory. A lower ratio such as 1:1 might mean that the business is unable to pay its debts on time.

A business can improve its current ratio by:

  • Increasing current assets.

  • Selling non-current assets, such as machinery or vehicles.

  • Decreasing current liabilities, eg renegotiating discounts and trade terms offered by suppliers.


Acid Test Ratio

Assume the current assets of a business are £100,000, which include a closing inventory value of £30,000 and its current liabilities are £50,000.

Formula: current assets (less closing inventory) divided by current liabilities.

(100,000 - 30,000) / 50,000
Acid test ratio = 1.4:1

A 1:1 acid test ratio is generally accepted as being healthy.

A business can improve its acid test ratio by:

  • Increasing (non-inventory) current assets – cash at bank.

  • Reducing inventory levels – possible by offering a sale or generous discounts to customers.

  • Selling non-current assets, such as machinery or vehicles.

  • Decreasing current liabilities, eg renegotiating discounts and trade terms offered by suppliers.

Efficiency ratios

Rate of Stock (or inventory) Turnover

Rate of inventory turnover is an efficiency ratio which determines how quickly a firm goes through its inventory.

A high inventory turnover is preferable as this means inventory is selling well. The product is in demand and the production and marketing teams are performing their roles effectively.

If stock turnover is low then this means the product is not sufficiently in demand and there may be many reasons. eg:

  • Poor product quality of goods, eg through lack of quality assurance or poor raw materials.

  • Ineffective marketing activities, eg lack of market research.

  • Poor customer service, such as after sales service.

  • Negative reputation of the business, eg, through poor publicity on ethical issues.

The formula is: Cost of Sales: Average inventory

Benefits and limitations of ratio analysis

Advantages of Ratio Analysis

  1. Forecasting and Planning
    The trend in costs, sales, profits and other facts can be known by computing ratios of relevant accounting figures of last few years. This trend analysis with the help of ratios may be useful for forecasting and planning future business activities. Ratio analysis can give signal of financial problems in advance so that timely measures can be taken to prevent future difficulties.


  2. Budgeting
    Budget is an estimate of future activities on the basis of past experience. Accounting ratios help to estimate budgeted figures. For example, sales budget may be prepared with the help of analysis of past sales.

  3. Communication
    Ratios are effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners, employees, potential investors or other parties.


  4. Inter-firm Comparison
    Comparison of performance of two or more firms reveals efficient and inefficient firms, thereby enabling the inefficient firms to adopt suitable measures for improving their efficiency.


  5. Indication of Liquidity Position
    Ratio analysis helps to assess the liquidity position i.e., short-term debt paying ability of a firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks, creditors and other suppliers of short-term loans.


  6. Indication of Overall Profitability
    Owners and managers are always concerned with the overall profitability of the firm. Profitability ratios show if the business is healthy and working well overall, and whether there is likely to be a reasonable return to its owners in the form of dividend.


  7. Aid to Decision-making
    Ratio analysis helps to take decisions like whether to supply goods on credit to a firm, whether bank loans will be made available etc.

Limitations of Ratio Analysis

  1. Historical Information
    Financial statements provide historical information. They do not reflect current conditions, which means they are not wholly reliable in predicting the future.


  2. Quantitative Analysis
    Ratios are tools of quantitative analysis only – ie they deal only with numbers and measurable data. They don’t take into account qualitative factors are such as the human element of the business, or market trends.


  3. Does not Account for External Factors
    Ratio analysis does not reflect external factors such as changes in market trends, the emergence of new competitors, economic conditions such as a recession.


  4. Limited Use for Comparison
    If ratio analysis is being used to compare the performance of the business against other firms, it is only reliable/valuable if the other businesses of the same size and type.