Chapter-12-Ratio-analysis

Ratio Analysis - Chapter 12

The Importance of Accounting Ratios

  • Accounting ratios are essential for managing and evaluating business efficiency.

  • Profit serves as the primary indicator of business performance.

Gross Profit

  • Defined as profit from sales after deducting direct costs.

  • Takes into account:

    • Efficiency of making and selling products.

    • Gross Profit Margin (GPM) is a key metric for assessment.

Gross Profit Margin (GPM)

  • Formula: GPM = (Gross Profit / Sales) x 100

  • Example: With a gross profit of £438,700 and sales of £956,500:

    • GPM = (438,700 / 956,500) x 100 = 45.8%

Interpreting GPM

  • Variance in GPM can arise due to:

    • Internal Factors: Size of the business, stock quality, management of expenses.

    • External Factors: Interest rates, industry type, target market.

  • Examples:

    • Supermarkets may have a lower GPM (~18%) due to higher sales volume but lower margins.

    • Corner shops may maintain a higher GPM due to relatively high expenses compared to lower sales volume.

    • Industries differ significantly in GPM, i.e., jewellers (60-80% GPM) vs. dairy farmers (low GPM).

Net Profit

  • Net profit indicates overall business profitability, considering all revenues and expenses.

  • Requires a different measure for efficiency known as the Net Profit Margin (NPM).

Net Profit Margin (NPM)

  • Formula: NPM = (Net Profit / Sales) x 100

  • Example: With a net profit of £136,500 and sales of £956,500:

    • NPM = (136,500 / 956,500) x 100 = 14.2%

  • Commenting on NPM is often easier than GPM due to less variance across industries.

Judging NPM

  • NPM can reflect business efficiency in managing costs:

    • NPM of 18%+ is generally good.

    • NPM of 10–17% is satisfactory but may need improvement.

    • NPM below 10% indicates potential issues in cost management.

Industry Examples of NPM

  • Walmart has a low NPM (<3%).

  • Microsoft boasts a high NPM (~48%).

Comparing Performance

  • Assess performance relative to similar businesses in the same industry for validity.

  • Long-term trends (5-year analysis) provide a better reflection of performance rather than one-off figures.

  • Identifying cost drivers for low margins is crucial in analyzing profitability.

Discussion Themes

  • What is Profit? Understanding GPM and NPM through educational resources, e.g., MoneyWeek investment tutorials.

  • Discuss the statement: "A low NPM is not always an indicator of poor performance."

  • Evaluate opinions on whether profitability ratios are the only measures of business performance.