Monitoring the BusinessUsing Ratios to Analyse Financial Statements

Chapter 11

Profitability Ratios1. Gross Profit Margin (Gross

Margin)2. Net Profit Margin (Net

Margin)3. Return on Investment/Return

on Capital Employed

Analyses the Profit earned

by the business

1. Gross Profit Margin (Gross Margin)Gross Profit x 100 = %Sales 1

Example:50000 x 100 = 27.78%180000 1

Measures the gross profit for the year as a percentage of the sales for

the year

The higher the gross profit margin the better – the firm will be able to pay the expenses of running the

business

2. Net Profit Margin (Net Margin)Net Profit x 100 = %Sales 1

Example:30000 x 100 =16.67%180000 1

Measures the net profit for the year as a percentage of the sales for

the year

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

3. Return on Investment/Return on Capital Employed

Net Profit x 100 = %Capital Employed * 1

Example:30000 x 100 = 16.67%180000

*Capital Employed = Ordinary Share Capital + Preference Share Capital + Reserves + Long Term Loan

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

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

Liquidity Ratios4. Current Ratio/Working

Capital Ratio5. Acid Test Ratio/Quick Ratio

Analyses the ability of the

firm to pay its short-term

debts as they fall due

4. Current Ratio/Working Capital RatioCurrent AssetsCurrent Liabilities

Example:42000 = 2 (2:1)21000

Compares the current assets

with the current

liabilities

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

5. Acid Test Ratio/Quick Ratio

Current Assets – Closing StockCurrent Liabilities

Example:43000 - 12000 = 1.48 21000

Takes into account the fact that stock as a current asset may not be easily

and quickly converted into

cash

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

6. Debt Equity Ratio/Gearing Ratio

Debt Capital*Equity Capital**Example:30000 = 0.18:1162000

*Preference Shares + Loans/Debentures**Ordinary Shares + Retained Earnings

Analyses the proportions of debt finance and interest-free capital

being used by the firm

Examines the types of long term-finance or

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

A. Calculate the (1) gross margin and (2) net margin for 2005 and 2006

B. Calculate the (4) working capital ratio and the (5) acid test ratio for 2005 and 2006

  2006 2005  2006 2005

  € €  € €Trading , Profit and Loss a/c    Balance Sheet    

Sales10000

0 80000Current Assets 160000 120000

Gross Profit 30000 20000Current Liabilities 100000 60000

Net Profit 15000 16000Closing Stock 80000 50000

  2006 2005  € €Closing Stock 46000 38000Long Term Debts 180000 126000Retained Earnings 54000 50000Current Liabilities 36000 40000Current Assets 71000 86000Equity Share Capital 210000 210000Net Profit 100000 90000

Calculate the (3) Return on capital employed and (6) debt/equity ratio for 2005 and 2006