IGCSE Business studies Accounting and finance Ratio Analysis

Calculation and interpretation of the main ratios from which business performance may be assessed: gross profit ratio net profit ratio return on capital employed (ROCE) current ratio acid test. make comparisons with previous years and/or with other business organisations describe their function in achieving/furthering business objectives show an understanding of the financial information they provide. (Students will be provided with formulae in the examination questions.)

Profitability ratios - a measure of how much profit its activities generate Profit Margin – relates profit to turnover (sales revenue) In general the higher the profit margin the better. A profit margin of 10% means that the firm makes 10p profit for every £1 of goods sold. Narrow margins – tend to be on products which are high volume, mass market products which are highly competitive Wide margins – tend to be on products/services that are low volume, high value with relatively high degree of monopoly power

Gross Profit: Sales Revenue – costs of goods sold Gross Profit Margin = -------------- x 100 Turnover Net Profit: Gross profit- expenses/overhead Net Profit Net Profit Margin = -------------- x 100 Note that a net profit margin over 10% is good, but remember compare to past years and other similar companies.

Return on capital employed (ROCE) A measure of the efficiency of the firm in using its finances to generate profit. A ROCE of 15% suggests that the firm uses every £1 to generate profits of 15p Generally – the higher the ratio, the more effective the firm is in using its assets to generate profits. Profit for the Year ROCE = ----------------------------------- ---------- x100 Capital employed (in balance sheet)

The ROCE will vary between industries The ROCE will vary between industries. The greater thye risk , the greater the expected ROCE. But ROCE should always be higher than the rate of interest from the bank , or else you would be better off selling the business and putting the money in the bank

Liquidity ratios – ability of a business to meet its debts Look at the ability of a firm to meet its current liabilities. Careful management of its income and expenditure is important to its cash flow and its ultimate long term survival More firms fail through cash flow problems than any other reason

Working Capital – having sufficient funds at the right time to be able to meet liabilities Working capital management is crucial to the success of a firm Working capital = the difference between current assets and current liabilities

The Current Ratio – the proportion of assets to liabilities. =Current assets/current liabilities A current ratio of 2 means the firm has sufficient liquidity to cover its liabilities twice over A current ratio of 0.75 would suggest that the firm is unable to meet its liabilities and could be in a weak financial position A ratio below 1 does not mean the firm will collapse but it will be in a very vulnerable position Ideally between 1.5- 3

Acid Test Ratio = (Current Assets - Stocks) / Current Liabilities The Acid Test Ratio gives an indication whether a firm can meet its liabilities without having to dispose of its stocks. It gives a clear and quick indication of the state of the firm’s liquid assets. The reasons why stocks are not included is that they may be difficult to sell/get rid off. (eg the school has stocks of stationary- could we sell exercise books off to meet our current liabilities??) Ideally, the answer should be between 1 and 1.2. A figure less than 1 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 1.2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.