1. Finance and Accounts
Ratio Analysis

2. Ratio Analysis
The function of accounting is to provide information to stakeholders on how a business has performed over a period of time

3. Ratio Analysis
This is an examination of accounting data by relating one factor to another. Usually the information is taken from the final accounts and will hopefully identify a trend.
The information will then be used as a basis for a decision i.e. should we do business or invest in this business.

4. Ratio Analysis
Accounting ratios are very easy to calculate and they enable a business to highlight which areas of its finances are weak and therefore require immediate attention.

5. Ratio Analysis
Profitability ratios, these analyse the profit made over the last year.
Activity/efficiency ratios, these analyse the efficiency of the business in terms of the use of its resources
Shareholders’ ratios, these measure the strength of the company, its share price and its dividends
Liquidity ratios, these measure the businesses ability to meet short-term debts.
Gearing ratio, this compares the proportion of the money the business has borrowed to it’s share Capital

6. Who uses Ratio Analysis
Managers
They wish to know how well they have done and what needs to be improved
Employees
Interested in their long term prospects and useful when negotiating pay increases
Shareholders
Prospective and present shareholders use it to assess if they should hold or sell shares

7. Who uses Ratio Analysis
Creditors
They wish to know if the business will be able to pay them
Bankers
If the business requires additional finance is it in a position to repay any borrowings?
Competitors
How are we doing in comparison it our opponents
Government

8. The Ratio Analysis process
1 Reason- What are needing to find out?
2 Identify- Find the figures you will need
3 Process- What calculations will you need?
4 Calculation
5 Comparison- Compare with other information
6 Interpretation- What does the info tell you?
7 Action- What do we need to do?

9. Profitability ratios
These analyse the profit made over the last year or previous years.
It may compare profit with those of a competitor, B&Q v Homebase
There are 3 ratios you need to know:
Gross Profit Ratio
Net Profit Ratio
Return on Capital Employed

10. Gross Profit Ratio
Gross profit is the difference between sales turnover and the cost of goods sold.
So comparing the Gross Profit to sales is a simple measure of a businesses performance.
Gross Profit Ratio= Gross Profit/Salesx100%
GP= £15m. Sales= £45m. 15/45x100= 33.33%

11. Gross Profit Ratio
For any ratio to mean anything it has to be compared to other businesses or years
Company B
Gross Profit= £16m. Sales £64
Company C
Gross Profit= £18m. Sales £45
Who has done best A,B or C?

12. The effectiveness of G.P.R.
As you are probably aware Gross profit is only the first measure of profit so to rely too heavily on it would be wrong.
It is better to use a firm’s final profit figure to make a comparison.
If a business wants to improve it’s GPR it must seek to reduce the cost of it’s goods sold as a percentage of the sales price

13. Net Profit Ratio
Taking the final profit figure gives a much better measure of a businesses performance.
The Net Profit Ratio is calculated:
Net Profit/ Sales x 100%
Sales= £100,000 Net Profit = £25,000
NPR= 25,000/100,000 x 100%= 25%

14. Example Company A Sales 600,000 Cost of Sales 150,000
Gross Profit ,000
Operating Expenses
250,000
Net Profit ,000
GPR= 75%
Net Profit Ratio=200/600
= 33.3%
Company B
Sales 800,000
Cost of Sales 200,000
Gross Profit ,000
Operating Expenses
300,000
Net Profit ,000
GPR= 75%
Net Profit Ratio=300/800
= 37.5%

15. Net profit Ratio
If a business is trying to improve it’s Net profit ratio it must seek to reduce it’s operating expenses.
So it must seek to reduce it’s wage costs or use of electricity. Making workers more efficient through training or better equipment might help

16. Return on Capital Employed
This is often referred to as the ‘primary accounting ratio’ and it expresses the annual percentage return that an investor would receive on their capital.
For example, if a business had a net profit of £2.2m and a capital employed of £7.6m, then the Return on Capital Employed figure would be :
= 28.9%
Man Utd have a Net profit of £39.4m is this good or bad?

17. Return on Capital Employed (ROCE)
Company A
Sales 600,000
Capital invested £1.2m
Operating Expenses
250,000
Net Profit ,000
Net Profit Ratio=33.3%
ROCE= Net profit/Capitalx100%
200,000/1.2m x 100= =16.67%
Company B
Sales 800,000
Capital invested £1.9m
Operating Expenses
300,000
Net Profit ,000
Net Profit Ratio=37.5%
ROCE= Net profit/Capitalx100%
300,000/1.9m x 100=
=15.79%

18. Return on Capital Employed (ROCE)

19. Return on Capital Employed (ROCE)

20. Return on Capital Employed (ROCE)
To mean anything ROCE needs to be compared to previous financial information or to other businesses
Firm A Profit Capital Employed
Yr1 0.30m Yr1 1.5m
Yr m Yr2 1.6m
Yr m Yr3 1.7m
Yr m Yr4 1.7m

21. Return on Capital Employed (ROCE)
To mean anything ROCE needs to be compared to previous financial information or to other businesses
Firm A Profit Capital Employed
Yr1 0.30m Yr1 1.5m %
Yr m Yr2 1.6m %
Yr m Yr3 1.7m %
Yr m Yr4 1.7m %

22. Improving Return on Capital Employed
To do this a business has to be ruthless, they must
Ensure assets are being used well
Think seriously about any money invested
Don’t hesitate to get rid of assets/ investments giving a high enough return-
Scottish and Newcastle Breweries have recently sold off all their pubs

23. Activity Ratios
Once you have analysed the profit situation you may then find you wish to delve deeper into a businesses records. What are it’s strengths or weaknesses.
As a manager what do you have to make the the business do better.
These ratios look at different aspects of the businesses operations

24. Stock Turnover Ratio
We have already said in other parts of the course that holding too much stock is bad for a business
This ratio simply calculates how many times the business sells it’s stock in a year
Stock turnover = Cost of Sales
Stock
The figures come from the trading Account and Balance sheet

25. Stock Turnover Ratio = Cost of Sales Stock
The result will be a figure like 4 or 5 or 6, it simply means they have sold their stock and bought in new stock 6 times.
Some use the formula
-Cost of Sales
Average Stock ( Op. Stock+ Cl. Stock)/2

26. Stock Turnover Ratio

27. Stock Turnover Ratio

28. Stock Turnover Ratio
Obviously the more times you can turnover your stock the better, Companies like McDonald’s would aim to do so very often. Their low profit margins mean they have to.
A firm selling luxury cars or jewellery would not have to have as high a stock turnover as they can make a big profit from relatively few sales.
Stock turnover is something a Manager may choose to target.

29. Assets Turnover
This simply compares the businesses Net Assets to the Sales the business has achieved.
Sainsbury’s may have a Asset Turnover of 4.5 whereas Tesco’s of 5.1.
This means that Tesco’s are generating more sales from their assets than Sainsbury’s
Or to put it another way Tesco’s generate £5.10 from every £1 of Net Assets whereas Sainsbury’s generate £4.50

30. Assets Turnover Ratio
Net Assets can be found in the Balance sheet and it is:
Fixed Assets + Current Assets- Current Liabilities
Assets Turnover = Sales
Net Assets
£5,000,000
800,000+(75, ,000)
= 5,000,000/850,000= 5.88 times

31. Assets Turnover Ratio

32. Assets Turnover Ratio

33. How to improve your Asset Turnover
This simply means making your assets work harder
A football club might hold concerts or international matches
A restaurant may open for Breakfast and Lunch
Supermarkets trade for longer hours or sell different products- Tesco’s Bank, Insurance
Easyjet or Ryanair ensure their planes spend the maximum time in the air

34. Debtors Collection Period
2 out of 3 businesses fail from a lack of cash to pay their bills.
The Government recently had it’s credit rating downgraded for slowness paying it’s debts.
The faster any business gets paid the faster it can then use the money to generate more sales. This ratio measures how quickly a business gets it’s money =
Debtors/ Sales x 365 days 120/600=0.2 x 365=
73 days

35. Assets Turnover Ratio

36. Assets Turnover Ratio

37. Debtors Collection Period
How to improve the collection period?
If faced with problems the business might resort to:
Factoring
Being more selective about customers
Offering terms for quick payment
Employing staff to chase debts

38. Shareholders ratios
A range of ratios calculated from share and dividend information to calculate how well the business has done:
Dividend per share
Dividend yield

39. Shareholders ratios
Dividend per share
This is calculated by dividing the dividend paid by the number of shares issued.
Dividend Paid £500,000=25p
Shares Issued 2million

40. Shareholders ratios
The problem with Dividend per share is it ignores the actual price of the share
If you paid £3.00 for a £1 share then 25p is not a good return

41. Shareholders ratios
Dividend Yield gets round this, it takes into account the market price of the share:
Dividend yield = Dividend x 100%
Market Price
25/3.00x100= 8.33%

42. Shareholders ratios

43. Liquidity Ratios
As we have already said the importance of cash flow to any firm cannot be overstated.
For that reason there are 2 ratios that focus on a firms liquidity
The Current Ratio
The Acid Test Ratio

44. The Current Ratio
This ratio measures the businesses ability to pay it’s debts. To do this you need to take 2 pieces of information from the Balance Sheet the Current Assets and Current Liabilities
Current Ratio = Current Assets = 1.25:1
Current Liabilities
This business has £1.25 of C.Assets for £1 of Debt, which is good

45. The Current Ratio

46. The Current Ratio

47. The Current Ratio
Most businesses want to keep their current ratio at about 1:1, although some industries may differ. Falling below this ratio could be seen as being bad.
Our business started about .93:1 and improves to as high as 1.1:1

48. Acid Test Ratio
As we have already highlighted holding too much stock is bad for a business.
If your creditors were to demand payment on the same day they would be disappointed as they might not want 6 cases of Fairy liquid or boxes of Tayto crisps.
The Acid Test ratio removes Stock from the previous formula

49. Acid Test Ratio Current Ratio = Current Assets - Stock
Current Liabilities
100-25= .9375:1 80
Here the business has £ cash for each pound of debt.

50. Acid Test Ratio

51. Acid Test Ratio

52. Acid Test Ratio
It is generally accepted that a business with a ratio of 0.8 : 1 is safe
The previous businesses ratio rises from about 0.81 to .91
If a business wishes to improve it’s Acid Test Ratio it needs to
Manage it’s Stockholding better
Manage it’s credit control

53. Gearing Ratios
Put simply this is the ratio of borrowed funds to owners own funds.
Think of it as a mortgage, if you have a 100% mortgage you are heavily in debt. Whereas someone with a 50% mortgage owns half the building.
If a business is highly geared it has to pay a lot in interest and this can be dangerous

54. Gearing Ratios Gearing is calculated:
Long-term liabilities+ Preference shares X 100
Total Capital Employed (from balance sheet)
Preference shares= Shares that have a guaranteed payback if the business goes bust. (Ordinary shares do not have this assurance)

55. Gearing Ratio

56. Gearing Ratio

57. Gearing Ratios
Once a businesses gearing gets above 50% this can be be seen as being dangerous
in the 1990’s when interest rates went up to 15% many highly geared firms struggled
Bankers, investors and Directors take a keen interest in Gearing Ratios.
Investors and bankers are reluctant to put extra money into a highly geared firm.

58. Summary
Ratio Analysis is like a medical check up for a business. It can tell an expert where the problems are. Hopefully they should then be able to take action to improve things.