1. Interpreting Accounts
Ratio analysis

2. Introduction
The data and information presented in accounts can be very complex
The data appears in Profit & Loss Accounts, Balance Sheets and Income Statements
To help interpret it, and to investigate the success (or not) of a firm, we use ratio analysis
There are four types of ratio
Profitability
Financial efficiency
Liquidity
Shareholders

3. The Ratios Profitability Ratios Gross Profit Margin Net Profit Margin
Return on Capital Employed
Financial Efficiency
Asset Turnover
Inventory Turnover
Debtors Days
Creditors Days
Liquidity
Current Ratio
Acid Test Ratio
Gearing
 Shareholders’ Ratios
Dividend Per Share
Dividend Yield

4. 1. Profitability Ratios
Ratio analysis

5. 1a) Gross Profit Margin
This tells us the profit a business is making, as a percentage, when accounting for variable costs
Gross Profit = Sales Revenue – Variable Costs
Gross Profit Margin (%) = Gross Profit x 100
Sales Revenue
Clearly a higher number is better

6. 1b) Net Profit Margin
This tells us the profit, as a percentage, when accounting for total costs
Net Profit = Sales Revenue – Total Costs
Net Profit Margin (%) = Net Profit x 100
Sales Revenue
Net Profit Margin will always be less than Gross Profit Margin as all firms have Fixed Costs to include

7. 1c) Return on Capital Employed (RoCE)
This calculation tells us how much net profit is made by a business relative to the amount of capital (money) is invested in the firm
Return on Capital = Net Profit x 100
Capital Employed
This is measured as a percentage

8. 2. Financial Efficiency Ratios
Ratio analysis

9. 2a) Asset Turnover
This measures how effectively assets are being used to generate turnover
Note, this is not profit
Asset Turnover = Sales Revenue
Net Assets
Higher numbers show assets being used more efficiently

10. 2b) Inventory Turnover
This measures how many times a business turns over it’s stock in a year
Inventory Turnover = Cost of Sales
Inventory
By Inventory we mean average stock
It therefore shows how many days items stay in stock. If the turnover was 12 times, stocks would be turned over monthly

11. 2c) Debtor Days
This measures the amount of time (on average) it takes for payment to be received from customers
Debtor Days = Amounts Due x 365
Sales Revenue
It is measured in days
The lower the number the better

12. 2d) Creditor Days
This measures the amount of time (on average) it takes for the business to pay for its supplies
Creditor Days = Amounts to Pay x 365
Cost of Sales
It is measured in days
The key here is to meet targets or contracts

13. 3. Liquidity Ratios
Ratio analysis

14. 3a) Current Ratio
This ratio compares the business’s current assets with its current liabilities
Current Ratio = Current Assets
Current Liabilities
It is always presented as 1:1.07 (for example)
This would mean for every £1 of current liabilities this example has £1.07 of current assets

15. 3b) Acid Test Ratio
This ratio checks out how many liquid assets a firm has to meet its current liabilities
Acid Test Ratio = Current Assets – Stock
Current Liabilities
This takes account of the fact that stock cannot necessarily be sold quickly, especially not at full price
This too is always presented as 1: 1.02

16. 3c) Gearing
The gearing ratio tells us what percentage of a firm’s capital is funded by debt
Gearing = Non-current liabilities X 100
Total Equity + Non-Current Liabilities
If a firm had a Gearing of 72%, this would tell us that a large proportion of the firm’s assets actually have to be repaid and that interest must be paid on it.
However, very low Gearing could mean a firm is too cautious

17. 4. Shareholder Ratios
Ratio analysis

18. 4a) Dividend Per Share
This is a calculation of the return that shareholders receive annually
Dividend per share = Total dividend
Number of shares issued
What is an acceptable dividend (always stated in pence per share) will depend on risk and what returns are available elsewhere

19. 4b) Dividend Yield
This ratio shows what the return is to shareholders compared with the current market price for their shares
Dividend yield = Dividend per share X 100
Market share price
The answer will always be a percentage
Investors can decide whether the return is good enough or whether their money would be better off invested elsewhere