1. Monitoring the Business
Chapter 11
Monitoring the Business
Using Ratios to Analyse Financial Statements

2. Analyses the Profit earned by the business
Profitability Ratios
Gross Profit Margin (Gross Margin)
Net Profit Margin (Net Margin)
Return on Investment/Return on Capital Employed

3. 1. Gross Profit Margin (Gross Margin)
Measures the gross profit for the year as a percentage of the sales for the year
Gross Profit x 100 = % Sales 1 Example: x 100 = 27.78%
The higher the gross profit margin the better – the firm will be able to pay the expenses of running the business

4. 2. Net Profit Margin (Net Margin)
Measures the net profit for the year as a percentage of the sales for the year
Net Profit x 100 = % Sales 1 Example: x 100 = 16.67%
The higher the net profit margin the better for the firm as this is the percentage profit on sales after all expenses have been paid

5. 3. Return on Investment/Return on Capital Employed
Compares the net profit (return) earned for the year with the amount of finance being used by the firm i.e. the profitability of the business compared to the money invested in it
Net Profit x 100 = % Capital Employed * 1 Example: x 100 = 16.67% *Capital Employed = Ordinary Share Capital + Preference Share Capital + Reserves + Long Term Loan
A firm will want the Return on Investment to be as high as possible and to be above the bank interest rate – commonly used to compare the profitability of different businesses

6. Liquidity Ratios Current Ratio/Working Capital Ratio
Analyses the ability of the firm to pay its short-term debts as they fall due
Liquidity Ratios
Current Ratio/Working Capital Ratio
Acid Test Ratio/Quick Ratio

7. 4. Current Ratio/Working Capital Ratio
Compares the current assets with the current liabilities
Current Assets Current Liabilities Example: = 2 (2:1) 21000
Ideally this figure should be 2 or 2:1, then the firm is liquid meaning it can pay its short-term debts as they fall due

8. 5. Acid Test Ratio/Quick Ratio
Takes into account the fact that stock as a current asset may not be easily and quickly converted into cash
Current Assets – Closing Stock Current Liabilities Example: =
If the acid test ratio is close to 1:1, then the firm is liquid meaning it can pay its short-term debts as they fall due, if its lower than this then the firm may have problems

9. 6. Debt Equity Ratio/Gearing Ratio
Examines the types of long term-finance or capital being used by the firm
Debt Capital* Equity Capital** Example: = 0.18: *Preference Shares + Loans/Debentures **Ordinary Shares + Retained Earnings
Analyses the proportions of debt finance and interest-free capital being used by the firm
The lower this ratio, the less fixed interest that will have to be paid – low debt/equity allows the ordinary shareholders to receive more of the profits

10. Calculate the (1) gross margin and (2) net margin for 2005 and 2006
2006
2005 €
Trading , Profit and Loss a/c
Balance Sheet
Sales
100000
80000
Current Assets
160000
120000
Gross Profit
30000
20000
Current Liabilities
60000
Net Profit
15000
16000
Closing Stock
50000
Calculate the (1) gross margin and (2) net margin for 2005 and 2006
Calculate the (4) working capital ratio and the (5) acid test ratio for 2005 and 2006

11. 2006
2005 €
Closing Stock
46000
38000
Long Term Debts
180000
126000
Retained Earnings
54000
50000
Current Liabilities
36000
40000
Current Assets
71000
86000
Equity Share Capital
210000
Net Profit
100000
90000
Calculate the (3) Return on capital employed and (6) debt/equity ratio for 2005 and 2006