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**Unit 3 Accounts & Finance**

Ratio Analysis

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**Learning Objectives To be able to calculate ratios**

To be able to use ratios to interpret and analyse financial statements from the perspective of various stakeholders HL – To evaluate the possible financial and other strategies to improve the values of ratios

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**Five main groups of ratios**

Profitability ratios Gross Profit Margin Net Profit Margin ROCE Mark-up Liquidity ratios Current Ratio Acid Test Ratio Financial efficiency ratios Stock (inventory) Turnover Ratio Debtor Days Ratio Creditor Days Ratio Shareholder or investment ratios Dividend Yield Ratio Earnings per share ratio Gearing ratios Gearing Ratio Accounting Ratios Key word – Efficiency How well a firm is using its resources

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Profitability Ratios Profitability – How profitable a firm is in relation to sales and assets 1. Profit Margin Ratios Gross profit margin and net profit margin ratios are used to see how successful a business has been at converting sales revenue into both gross and net profit They measure the performance of a company and its management team

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**Profit Margin Ratios Gross profit margin (%) = gross profit**

sales revenue Net profit margin (%) = net profit You can work out gross profit like this… Total Revenue – Cost of sales X 100 X 100

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**How to use Gross profit and Net profit margin ratios**

Gross profit margin is a good indicator of how effectively managers have ‘added value’ to the cost of sales It is misleading to compare the ratios of firms in different industries because the level of risk and gross profit margin will differ greatly When 2 firms are being compared and their gross profit margins are very different but net profit are more alike it suggests one company may have relatively high overheads Can also compare with previous years

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**Evaluting ways to increase profit margins**

Method to increase profit margins Examples Evaluation Increase gross and operating profit margin by reducing direct costs Use cheaper materials Cut labour costs by re-locating production to low labour cost countries Cut labour costs through automation Cut wages Quality issues Quality issues – communication problems with distant factories Purchasing machinery will increase overhead costs Motivation levels may fall Increase gross and operating profit margin by increasing price Raise the price of the product with no significant increase in variable costs. EG. Raising prices 1. Total profit could fall if too many consumers switch to competitors Increase net profit margin by reducing overhead costs Cut overhead costs, such as ret, promotion or management costs but maintain sales levels 1. Moving to a cheaper area could damage reputation, fewer managers could reduce efficient operation of business HL

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**2. Return on capital employed (ROCE)**

Profitability Ratios 2. Return on capital employed (ROCE) Most commonly used means of assessing the profitability of a business – sometimes referred to as the PRIMARY EFFICIENCY RATIO ROCE (%) = net profit capital employed X 100 Capital Employed = (non-current assets + current assets) – current liabilities

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**2. Return on capital employed (ROCE)**

Higher the value of this ratio, greater the return on the capital invested in the business The return can be compared with other companies and with the ROCE of previous year’s performance Result can also be compared with the return from interest accounts (Could the capital be invested in a bank at a higher rate of interest and no risk? ROCE should be compared with the interest cost of borrowing finance – If it is less than this interest rate, then any increase in borrowings will reduce returns to shareholders ROCE can only be raised by increasing the profitable, efficient use of the assets owned by the business, which were purchased by the capital employed

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**Profitability Ratios X 100 3. Mark-Up Ratio**

Mark up is the amount of profit added to the cost of sales. A low mark up might indicate an attempt to increase profit by gaining a larger market share Mark-Up (profit margin) = Gross profit Cost of goods sold X 100

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