Ratio Analysis GCSE Business Studies tutor2u™ Revision Presentations 2004

Introduction Analysing financial performance is about judging the successes and failures of a business by considering a number of financial measures. Most of these measures are known as ratios. A ratio is a measure of one piece of information in terms of another A non-financial ratio might be the numbers of boys to girls in a class, or the number of GCSE passes in business studies as a percentage of all the GCSE passes in the school. Ratios are normally compared with the previous years’ figures or with figures from competitors to see whether the business has improved or not and whether it is better or worse than a rival. The main areas that ratios look at are: Profitability Financial efficiency Liquidity

Who Might Use Ratio Analysis Anyone with an interest in the financial performance of the business will find ratio analysis useful Owners/shareholders (e.g. return on investment; profitability ratios) Employees (e.g. profitability ratios) Managers (the full range) Creditors and banks (e.g. liquidity ratios) Competitors (profitability and liquidity ratios) Government (e.g. the Inland Revenue – who calculate how much tax is due by a business)

Profit and Profitability Profit is an absolute measure – it equals sales revenue less costs Profitability is a relative measure – it shows amount of profit “relative” to what created profit e.g. ROCE investment ratio measures relative profitability of a business compared with amount of capital invested in business.

Profitability Ratios What are they? Why use them? Gross profit margin Operating profit margin Why use them? Insights into how well the business is trading in its markets Is sales revenue being maximised? Are costs being kept under control? Analyse and spot favourable and unfavourable trends Compare performance with competitors

Gross Profit Margin Calculation Why it might increase Gross profit divided by sales (expressed as a percentage) Why it might increase Increase in selling price of existing products Introduction of new products which achieve a higher gross profit margin Reduction in cost of sales e.g. a fall in raw material prices

Gross Profit Margin - Example

Return on Capital Employed (“ROCE”) How calculated: Net profit as a percentage of capital employed Also known as primary efficiency ratio - a better indicator than profit alone of how well a business is using money invested Shows how much profit is being generated from investment compared with alternative investments in similar businesses or with interest from bank deposits

ROCE Example

What does ROCE Tell Us? Three main things to look for The change in ROCE from one year to the next The ROCE earned by other companies (if this information is available) A comparison of the ROCE with the cost of borrowing money (i.e. is the business making a ROCE that makes borrowing worthwhile?) Ways to increase ROCE Increase net profits without increasing or introducing new investment Reduce amount invested in business by selling assets that do not contribute to profit earned

Net Profit Margin How calculated Amount of net profit generated per pound of sales Calculated as net profit divided by total sales (or revenues) Expressed as a percentage

Net Profit Margin - Example

Liquidity Ratios Concerned with ability of business to pay its debts Ratio of short-term liabilities to liquid assets Indicate ability of business to cover its short term liabilities Liquid assets are those assets that held in cash form (e.g. cash at bank) or can be turned into cash very quickly Main ratios: Current ratio Acid test ratio

Current Ratio Calculation: Current assets divided by current liabilities Interpretation How to improve the current ratio Increase value of profitable sales Turn its overdraft into a long term loan (reduces short-term liabilities and increases capital)

Acid Test Ratio Liquidity ratio – similar to current ratio It is a tougher test of liquidity Stock takes longer to turn into cash – so are excluded from current assets in calculation

Stock Turnover Number of times stock is turned into sales Higher figure, more quickly stock has been sold or turned over A fruit stall will have a higher figure of stock turnover than a car dealership

Reasons for an Increase in Stock Turnover Lower stock levels Disposal of slow moving or obsolete stock Reduction in range of products stocked

Debtor Days Working capital ratio Number of days it takes for a business to collect money from customers who have bought products on credit

Encouraging Debtors to Pay Quicker Offer discounts for early payment Threaten to take customer to court Refuse to supply more products or hold back part of an order until payment has been made

Creditor Days Number of days it takes for business to pay creditors.