RATIO ANALYSIS

RATIO ANALYSIS Ratios can be used analyse a business and to compare the performance of a business between years and with other similar businesses. Ratios can be broadly divided into 3 main types, profitability ratios, liquidity ratios and efficiency ratios.

PROFITABILITY RATIOS USED TO ANALYSE INCOME STATEMENTS The 3 main profitability ratios used to analyse trading profit and loss accounts are the GROSS PROFIT PERCENTAGE NET PROFIT PERCENTAGE RETURN ON CAPITAL EMPLOYED

GROSS PROFIT PERCENTAGE A Trader Trading, Profit and Loss Account for year ending 31 March 2001 Sales £250,000 Cost of Sales £90,000 Gross Profit £160,000 Expenses £100,000 Net Profit £ 60,000 The gross profit percentage of the business A Trader is Gross Profit Sales X 100 = £160,000 X 100 = £250,000 = 64%

WHAT CAUSES GROSS PROFIT PERCENTAGE TO CHANGE? A Trader Trading, Profit and Loss Account for year ending 31 March 2001 Sales £250,000 Cost of Sales £90,000 Gross Profit £160,000 Expenses £100,000 Net Profit £ 60,000 A Trader Trading, Profit and Loss Account for year ending 31 March 2002 Sales £250,000 Cost of Sales £100,000 Gross Profit £150,000 Expenses £100,000 Net Profit £ 50,000 The gross profit percentage fell for the above business from 64% to 60%. Changes in this ratio can only come about when there is a change in the selling price and or a change in the price of goods bought for sale. For A Trader the gross profit percentage decreased because cost of sales increased.

HOW CAN A BUSINESS IMPROVE ITS GROSS PROFIT PERCENTAGE? A business can improve its gross profit percentage by increasing the mark-up. Mark-up is the amount added to the cost price of goods to arrive at their selling price, or put more simply by increasing selling price. Gross profit % can also be improved by paying a lower price for goods purchased and by keeping selling price the same or making it higher. Year Cost Mark-up Selling Gross Gross Price Price Profit Profit % 1 £2 £1 £3 £1 33% 2 £2 £2 £4 £2 50% 3 £1 £3 £4 £3 75%

NET PROFIT PERCENTAGE Profit for the Year Net Profit % = X 100 Sales This ratio tells us how much net profit is being made on each £1 of sales, eg if net profit is 15% then 15 p has been made on each £1 of sales.

Trading, Profit and Loss Account for year ending 31 March 2001 NET PROFIT PERCENTAGE A trader Trading, Profit and Loss Account for year ending 31 March 2001 Sales £250,000 Cost of Sales £90,000 Gross Profit £160,000 Expenses £100,000 Profit for the year £ 60,000 The net profit percentage of the business A Trader is Net Profit Sales X 100 = £60,000 £250,000 X 100 = = 24%

WHAT CAUSES NET PROFIT PERCENTAGE TO CHANGE? A Trader Trading, Profit and Loss Account for year ending 31 March 2001 Sales £250,000 Cost of Sales £90,000 Gross Profit £160,000 Expenses £100,000 Net Profit £ 60,000 A Trader Trading, Profit and Loss Account for year ending 31 March 2002 Sales £260,000 Cost of Sales £100,000 Gross Profit £160,000 Expenses £ 90,000 Net Profit £ 70,000 The net profit percentage improved from 24% to 27%. Net profit percentage can change when anything which affects net profit changes ie changes in gross profit, changes in sales revenue and or changes in expenses.

HOW CAN A BUSINESS IMPROVE ITS NET PROFIT PERCENTAGE? A Trader Trading, Profit and Loss Account for year ending 31 March 2001 Sales £250,000 Cost of Sales £90,000 Gross Profit £160,000 Expenses £100,000 Net Profit £ 60,000 A Trader Trading, Profit and Loss Account for year ending 31 March 2002 Sales £260,000 Cost of Sales £100,000 Gross Profit £160,000 Expenses £ 90,000 Net Profit £ 70,000 A business can improve its net profit percentage by taking actions which will improve its sales income eg through increased and improved advertising and promotion, or by changes in price. It could also reduce expenses.

Below are details of A Carters Accounts Below are details of A Carters Accounts. For Year 1 and Year 2 calculate Gross Profit Percentage and Net Profit Percentage. Explain any changes in these figures. Year 1 Year 2 £000 £000 Sales (net) 432 540 Cost of goods sold 300 390 Opening inventory 38 46 Closing inventory 46 52 Expenses 78 105 Opening capital 360 414 Current assets 216 225 Current liabilities 80 50

Below are details of A Carters Accounts Below are details of A Carters Accounts. For Year 1 and Year 2 calculate Gross Profit Percentage and Net Profit Percentage. Explain any changes in these figures. Year 1 Year 2 £000 £000 Sales (net) 432 540 Cost of goods sold 300 390 Gross Profit 132 150 Gross Profit % 31% 28% Expenses 78 105 Profit for the year 54 45 Net Profit % 13% 8%

Below are details of A Ford Accounts Below are details of A Ford Accounts. For Year 1 and Year 2 calculate Gross Profit Percentage and Net Profit Percentage. Explain any changes in these figures. You will need to calculate Gross Profit and Net Profit first. Year 1 Year 2 £000 £000 Sales (net) 756 945 Cost of goods sold 550 675 Opening inventory 70 80 Closing inventory 80 100 Expenses 136 182 Opening capital 630 700 Current assets 380 400 Current liabilities 150 90

Below are details of A Ford Accounts Below are details of A Ford Accounts. For Year 1 and Year 2 calculate Gross Profit Percentage and Net Profit Percentage. Explain any changes in these figures. You will need to calculate Gross Profit and Net Profit first. Year 1 Year 2 £000 £000 Sales (net) 756 945 Cost of goods sold 550 675 Gross Profit Gross Profit % Expenses 136 182 Profit for the year Net Profit %

Below are details of A Ford Accounts Below are details of A Ford Accounts. For Year 1 and Year 2 calculate Gross Profit Percentage and Net Profit Percentage. Explain any changes in these figures. You will need to calculate Gross Profit and Net Profit first. Year 1 Year 2 £000 £000 Sales (net) 756 945 Cost of goods sold 550 675 Gross Profit 206 270 Gross Profit % 27% 29% Expenses 136 182 Profit for the year 70 88 Net Profit % 9% 9%

RETURN ON CAPITAL EMPLOYED Profit for the year Return on Capital Employed = X 100 Capital at start The return on capital percentage tells us how much profit a business has made as a percentage of the capital invested in it and gives an indication of how profitable the business is. The higher the percentage the more profitable the business.

RETURN ON CAPITAL Statement of Financial Position as at 31 March 20.. Non Current Assets £ £ Premises 250,000 Machinery 25,000 Equipment 10,000 285,000 Current Assets Inventory 1,000 Trade Receivables 2,000 Bank 5,000 8,000 Current Liabilities Trade Payables 4,000 WORKING CAPITAL 4,000 NET ASSETS 289,000 Financed by Capital 1 April 20.. 260,000 Net Profit 29,000 289,000 The return on capital taken from the balance sheet on the left is Net Profit = X 100 Capital £29,000 = X 100 £260,000 = 11%

Year 1 Year 2 £000 £000 Net Profit 35 50 Capital at start 100 120 Below are details of A Ford Accounts. For Year 1 and Year 2 calculate Return on Capital Employed for each year and comment on the change. Year 1 Year 2 £000 £000 Net Profit 35 50 Capital at start 100 120

Year 1 Year 2 £000 £000 Net Profit 35 50 Capital at start 100 120 Below are details of A Ford Accounts. For Year 1 and Year 2 calculate Return on Capital Employed for each year and comment on the change. Year 1 Year 2 £000 £000 Net Profit 35 50 Capital at start 100 120 Return on Capital Employed % 35% 42%

The ratio that show the liquidity of the business are: LIQUIDITY RATIOS The ratio that show the liquidity of the business are: CURRENT RATIO

CURRENT RATIO Current Ratio = Current Assets Current Liabilities This ratio tells us if a business has enough funds to pay its debts and sufficient working capital. If a business has a current ratio of 2:1 it has £2 of current assets for every £1 of current liabilities. It is solvent, it can pay its way, and has enough left over to pay its running expenses.

CURRENT RATIO = = = The current ratio of the business on the left is Statement of Financial Position as at 31 March 20.. Non Current Assets £ £ Premises 250,000 Machinery 25,000 Equipment 10,000 285,000 Current Assets Inventory 1,000 Trade Receivables 2,000 Bank 5,000 8,000 Current Liabilities Trade Payables 4,000 WORKING EQUITY 4,000 NET ASSETS 289,000 Financed by Equity 1 April 20.. 260,000 Net Profit 29,000 289,000 The current ratio of the business on the left is Current Assets Current Liabilities = £8,000 = £4,000 2:1 =

The ratios that show how efficient the business is are: EFFICIENCY RATIOS The ratios that show how efficient the business is are: RATE OF STOCK TURNOVER EXPENSES RATIO DEBTORS COLLECTION PERIOD CREDITORS COLLECTION PERIOD FIXED ASSET TURNOVER

Rate of Stock Turnover = Cost of Goods Sold Average Stock The Rate of Stock Turnover shows how many times a business sells its stock in a year. The higher the rate of turnover the better it is for the business as this means it is earning its profits quicker.

RATE OF INVENTORY TURNOVER Cost of Goods Sold Average Inventory Before the rate of stock turnover can be worked out the average stock held by the business must be found. Average Inventory = Opening Inventory + Closing Inventory 2

RATE OF INVENTORY TURNOVER Trading Account for year ending To calculate RoS for this business average stock must be found first. Average inventory = Trading Account for year ending 31 March Year 1 Sales £250,000 Opening Inventory £15,000 Purchases £80,000 £95,000 Closing Inventory £5,000 Cost of Sales £90,000 Gross Profit 160,000 Opening Inv + Closing Inv 2 £15,000 + £5,000 = 2 = £10,000 Cost of Goods Sold = Average Inventory £90,000 = £10,000 = 9 times

CAUSES OF CHANGES IN RATE OF INVENTORY TURNOVER The rate of inventory turnover will change if the number of goods sold by the business changes. Changes in the demand for a business’s products can be caused by price changes causing more or less people to buy advertising and promoting more or less than previously other businesses competing more or less effectively out of date inventory To increase its rate of inventory turnover a business could try changing price or promoting and advertising more or stocking different products.

EXPENSES RATIO X 100 Expenses Ratio = Expenses Sales

CREDITOR’S PAYMENT PERIOD Creditors’ Payment Period Average Creditors x 365 Total Credit Purchases

DEBTOR’S COLLECTION PERIOD Average Debtors x 365 Total Credit Sales

NON CURRENT ASSET TURNOVER Net Turnover Non Current Assets at Book Value