1. RATIO ANALYSIS FOR DECISION MAKING
GCE PROFESSIONAL BUSINESS SERVICES
AS 3
RATIO ANALYSIS FOR DECISION MAKING

2. RATIO ANALYSIS FOR DECISION MAKING

3. Ratio Analysis – Decision Making
Different types of accounting ratios are used for
different purposes:
Profitability/Performance Ratios – to assess profitability levels
Liquidity Ratios – to assess solvency levels
Gearing Ratio – to assess debt levels
Financial Efficiency Ratios – to assess efficiency levels
Shareholder Ratios – to assess equity investments

4. Profitability/Performance Ratios
Return On Capital Employed (ROCE)
Gross Profit Margin
Net Profit Margin

5. Return on Capital Employed (ROCE)
This shows a firms profitability in relation to the investors capital investment.
ROCE = Profit before tax x 100% = x %
(Total Assets-Current Liabilities)

6. Gross Profit Margin
This shows the gross profit made relative to sales revenue/turnover.
Gross Profit Margin = Gross Profit x 100% = x %
Sales Revenue
A large range of profit may affect the true results
Useful when comparing against the margins of previous years.

7. Net Profit Margin
This indicates amount of profit available, relative to the sales revenue after deducting trading costs and business expenses.
This shows how well a business controls its expenses/ overheads.
Net Profit Margin = Net Profit x 100% = x %
Sales Revenue

8. Liquidity Ratios
Measures the ability of a business to meet short-term obligations, collect receivables, and maintain a cash position
Indicates how well the business is able to meet its short-term obligations from cash/near-cash resources

9. Current Ratio
Measures the ability of a business to pay short-term obligations.
Currrent Ratio = Current Assets Current Liabilities = :1
Suggested Rule of thumb 2:1

10. Gearing Ratio Compares owner's equity (or capital) to borrowed funds.
Shows extent of financial risk of a business, particularly limited companies.
Gearing ratio =
Non−Current Liabilities Total Equity + Non−Current Liabilities × 100 = x %

11. Financial Efficiency Ratios
Trade Receivables Ratio (Debtors Collection):
Shows length of time taken to recover monies from debtors
Trade Receivables Ratio =
Trade Receivables x = x days
Sales Revenue
Benchmark – customers are expected to settle their accounts within 30 days of the date of the invoice
It is prudent to ensure that monies are received from customers, prior to the payment of outstanding supplier invoices

12. Financial Efficiency Trade Payables Ratio (Creditors payment)
Shows the length of time taken to pay monies to suppliers
Trade Payables Ratio =
Trade Payables x = x days
Cost of Sales
Benchmark – it is expected that a customer would pay a supplier for goods purchased within 30 days of the receipt of the invoice

13. Shareholder Ratios
Earnings Per Share (EPS)
Return On Equity (ROE)

14. Earnings Per Share (EPS)
This ratio measures how many pence the company is earning for every share held
Earnings per Share =
Net Profit after tax
No. of ordinary shares = x pence
Must be disclosed in the Income Statement

15. Return on Equity (ROE) Equity x 100 = x %
A measure of how well a company used reinvested earnings to generate additional earnings
Return On Equity =
Net Profit after Tax
Equity x = x %

16. Benefits of using Ratio Analysis
Can assist in interpreting and evaluating the income statement and statement of financial position by reducing the amount of data contained in them to a workable amount
Can make financial data more meaningful
Help to determine relative magnitudes of financial quantities

17. Benefits of using Ratio Analysis
Help managers or business analysts make effective decisions about the firm's credit worthiness
Can assist with predicting potential business earnings
Can assist in seeing financial business strengths
Can assist in spotting business weaknesses

18. Limitations of using Ratio Analysis
Comparing the ratios with past trends and with competitors may be inaccurate as the data may not be easily comparable due to differences in accounting policies, accounting period etc.
It is based on current and past trends, but not future trends.
Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old.

19. Limitations of using Ratio Analysis
There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc.
The ratios are only as good or bad as the underlying information used to calculate them – “window dressing” may be used by management to manipulate the financial results

20. Making Recommendations
Ratio analysis may be used to make recommendations for improvement, but will also depend on other factors such as:
Inflation
External factors e.g. changes in interest rates
Management changes
Business Performance
State of the economy
Performance of competitors

21. Ratio Analysis
Notes: