Ratios Simple interpretation of financial statements using ratios Gross and net profit, current and acid test ratio, return on capital employed (ROCE). Alternative ways that businesses can judge their success e.g. ROCE, market share. Using accounting ratios make evaluative comments on the success and performance of a business. Use a balance sheet to aid decision making. Interpret the performance of a business by using simple accounting ratios (return on capital, gross and net profit margin, current ratio). Understand the concept of liquidity.

Enough working capital? Working capital = Current asset – current liability

Enough working capital? If you don’t have enough you can’t pay your day to day expenses. The CURRENT RATIO and ACID TEST RATIO Two ratios to help you work out if you have enough working capital.

Current ratio Compare current assets and current liabilities If current assets are greater than current liabilities the business can cope with a crisis… You can afford to have current liabilites increase.

Current ratio: Current ratio = Current Assets Current liabilities The HIGHER the ratio, the higher the amount of working capital in the business. Therefore the higher the ratio the ‘safer’ the business.

Current ratio: Current ratio = 100,000 50,000 2:1 You have $2 for every $1 you owe

Current Ratio Accounts recommend a business should have 1.5 :1 to 2:1 If less than this the business may struggle to pay its bills and may be forced to close down. If it is more the business may have resourced tied up in unproductive assets.

Current Ratio Work it out! ASSETS Million Stock11 Debtor29 Cash at bank46.3 Total current assets86.3 LIABILITIES Trade creditors 18 Taxes11.2 Dividend1.1 Other creditors12.9 Total current liabilities43.2 Working Capital43.1

Answer Current ratio = £86.3 mil £43.2 mil 1.9 to 1

The ACID TEST RATIO Stock is part of working capital of the business However, it might be difficult to sell stock quickly if a business needs cash. So a better measure of whether a business has enough working capital is the acid test ratio. This excludes stock from current assets when calculating the ratio.

ACID TEST Acid test ratio = Current Assets - stock Current liabilities The higher the ratio the safer the business. A typical business should be 0.5 to 1

ACID TEST – work it out ASSETS Million Stock11 Debtor29 Cash at bank46.3 Total current assets86.3 LIABILITIES Trade creditors 18 Taxes11.2 Diviend1.1 Other creditors12.9 Total current liabilities43.2 Working Capital43.1

Answer Current ratio = £86.3 mil - £11 £43.2 mil So its acid test ratio was 1.74 to 1

Gross profit margin Gross profit – the difference between Sales and cost of sales. £ Sales300,000 Cost of sales100,000 Gross profit200,000

Ratio of gross profit to Sales turnover = Gross Profitx100 Sales turnover

Work it out £mil Sales1520 Cost of sales1014 Gross profit5 6 Which year was better for the business?

Compare with 2012 = 33% 2013 = 30% Means the sales cost are RISING in relation to the value of sales. This is worrying means business is losing control of the costs as it expands…

NET PROFIT Gross profit is important but doesn’t include overheads. Ration of NET profit to Sales turnover = Net Profitx100 Sales turnover

Work it out! £ Sales15 Cost of sales10 Gross Profit5 Overheads2 Net profit3 Ratio = 20%

Comparisons Competition – a business may cut prices to maintain sales. Cutting prices leads to lower revenue, therefore a fall in profit margins The economy – a recession (cut prices, less sales) The value of the pound – if increases the prices of UK exports more expensive, less sales. Taking lower profit to increase sales

Judging performance Rate of return on capital employed. Looks at profit in relation to capital e.g if you put $20 in a bank, and received $10 interest over a year you would have a 50% return on your money. A business doesn’t know how well it has done until it compares profit with money invested (Capital)

Rate of return on capital employed ROCE (%) = Net Profitx100 Capital employed Capital employed is defined as the fixed assets and the net current assets, minus any liabilities.

RatioFormulaWhat are we looking for? Why will it go up?Why will it go down? Gross Profit Percentage = Gross Profit X 100 Sales The higher the percentage the bigger the gross profits. Volume of sales may have increased Cost of Sales may have decreased. Volume of sales may have decreased Cost of Sales may have increased. Net Profit Percentage = Net Profit X 100 Sales The higher the percentage the bigger the 'final' net profits. The volume of sales may have increased Expenses may have decreased. The volume of sales may have decreased Expenses may have increased. Return on Equity Net profit x 100 Total equity The higher the ROE the better the return on the investment High ROE can be achieved by Increasing sales Increasing Profit Margins ROE is likely to be lower if The markets are in decline Unit costs are increasing and the firm cannot increase price Sales are falling Current Ratio = Current Assets Current Liabilities About 2:1 is best. Any more is a waste of resources. They may have more debtors/stock/bank reserves and less creditors. They may have less debtors/stock/bank reserves and more creditors. Acid Test = Current assets – stock Current Liabilities As long as it is over 1:1 the firm can still meet its liabilities and remain solvent. They may have reduced their level of stock or there may be a change in the current ratio. They may have increased their level of stock or there may be a change in the current ratio.