Ratio Analysis

LO. Define & provide examples of the 5 main financial ratios.

RatiosRatios are used to measure and compare performance and liquidity of a business.

Ratio analysis

Performance ratiosReturn on capital employed

ROCE (%) = Operating profitCapital employed X 100

Shows how successful the managers are at earning a profit from capital used in the business.

CalculationsFixed assets ฿

Land 10,000Vehicle 5,000Machines 1,000

Current AssetsDebtors 1,000Cash 500Stock 2,000

Current LiabilitiesCreditors 600Bank loan 800

Net-Current Assets(Working capital)

Net assets---------------------------------------------------Financed by:Profit / Loss 10,000Share capital 8,100

Capital employed

2,100

18,100

18,100

Return on Capital Employed

ROCE (%) = Operating profitCapital employed X 100

ROCE (%) = 10,00018,100 X 100

=55%Analysis For every baht (฿) invested, the business makes 55% extra.

Performance ratiosGross profit margin

Gross profit margin (%) = Gross profit

Sales turnover X 100

Shows how much gross profit is made for every $ earned

Calculations ฿Sales turnover 50,000Cost of Sales 8,000Gross profit

ExpensesRent 15,000Utility bills 4,000Wages 10,000

Net profit

42,000

13,000

Gross profit margin (%) =

Gross profitSales turnover X 100

Gross profit margin (%) =

42,00050,000 X 100

=84%Analysis For every baht (฿) make from sales, 84% is kept as gross profit

Performance ratiosNet profit margin

Net profit margin (%) = Net profit

Sales turnover X 100

Shows how much Net profit is made for every $ earned

Calculations ฿Sales turnover 80,000Cost of Sales 20,000Gross profit

ExpensesRent 35,000Utility bills 10,000Wages 10,000

Net profit

60,000

5,000

Net profitmargin (%) =

Net profitSales turnover X 100

Net profitmargin (%) =

5,00080,000 X 100

=6%Analysis For every baht (฿) make from sales, 6% is kept as Net profit profit

Which ratio to use?

Gross profit margin (%) =

Gross profitSales turnover X 100

Gross profit margin (%) =

42,00050,000 X 100

=84%Analysis For every baht (฿) make from sales, 84% is kept as gross profit

Gross profit margin (%) =

Net profitSales turnover X 100

Net profitmargin (%) =

5,00080,000 X 100

=6%Analysis For every baht (฿) make from sales, 6% is kept as Net profit profit

Liquidity ratiosCurrent Ratio

Current ratio = Current assetsCurrent liabilities

Shows haw many times a business can pay its short term debts with current assets.A good current ratio would be between 1.5 : 1 – 2 : 1 A ratio less than 1 would mean that a business could not pay its short term debts, and could be forced to cease trading. (It has no working capital)

CalculationsFixed assets ฿

Land 10,000Vehicle 5,000Machines 1,000

Current AssetsDebtors 1,000Cash 500Stock 2,000

Current LiabilitiesCreditors 600Bank loan 800

Net-Current Assets(Working capital)

Net assets---------------------------------------------------Financed by:Profit / Loss 10,000Share capital 8,100

Capital employed

2,100

18,100

18,100

Liquidity ratio

=2.5:1Analysis 2.5:1 means the business can pay it’s short term debts two and a half times. It has high liquidity!

Current ratio = Current assets

Current liabilities

Current ratio = 3,5001,400

Liquidity ratiosAcid test ratio OR Liquidity ratio

Acid test = Current assets - stockCurrent liabilities

Similar to current ratio, however without stock because the nature of some companies may mean it is difficult to sell stock quickly (their stock is not liquid) for example a estate agent / car sales. A good acid test ratio is between 0.5 : 1 – 1 : 1

CalculationsFixed assets ฿

Land 10,000Vehicle 5,000Machines 1,000

Current AssetsDebtors 1,000Cash 500Stock 50,000

Current LiabilitiesCreditors 600Bank loan 800

Net-Current Assets(Working capital)

Net assets---------------------------------------------------Financed by:Profit / Loss 10,000Share capital 8,100

Capital employed

50,100

79,600

18,100

Liquidity ratio

=1:1Analysis 1:1 means the business can JUST pay it’s short term debts. It has virtually no Liquidity!

Current ratio = Current assets - stock

Current liabilities

Current ratio = 3,5001,400

Revision Questions

What is meant by a financial budget? [2]

A financial budget is a numerical/quantitative plan showing future financial targets (goals orlimits) for a specific time period. [2]

Think, Pair, Share... Write your answer on your white board

Calculate the net profit margin for BTX in 2009. [2]

Profit margin is profit/sales %. [1]

250/1100 × 100 = 22.72% Answer = 22.72% [2]22% – 23 % acceptable for [2]

Method alone or arithmetic error [1], correct number without % [1]If figures for 2008 are used (correctly) then 1 method mark could be available.

Think, Pair, Share... Write your answer on your white board

Explain what the current ratio tells Manfred about BTX’s financial position. [4]

Think, Pair, Share... Write your answer on your white board

Knowledge of current ratio can be shown by indicating what it is or how it is calculated [2]

An answer that simply says ‘shows current assets and current liabilities of a business’ [1]

Analysis of usefulness: analysis implies saying something about what the change means toBTX using the data [2]

So an answer that says ‘the figure has changed from 1.2 to 0.7’ is merely a description not an analysis and therefore would not be given a mark.

Current ratio is a measure of the relationship between

current assets and short-term debts. It is a liquidity test

designed to show the ease by which a company can pay

debts on demand. (How easily assets can be turned in to

cash). A fall in the ratio shows a decline in liquidity and

therefore is not seen as a good thing because it implies

that not all short-term debts can be met quickly.

Knowledge of current ratio [2]Analysis of usefulness [2]

Do you think that the management of BTX should be worried about the performance of the company in 2009? Justify your answer. [6]

Think, Pair, Share... Write your answer on your white board

• sales fall (8.3%) bad• net profit rise (25%) good• profit margin rise (16.6 % to 22.72%) good• return on capital (ROCE) down (20% to 16.6%) bad• current ratio down (below safe levels) bad

Identification of directional changes in relevant indicators of BTX’s success [2] (The sales have fallen by 8.3%, this suggests the management should be worried about the performance because…

Analysis of data [2] Interpretation of the information could be quantitative or qualitative (However, net profits have risen…)

Evaluative comment [2] This will involve a positive assertion supported by a justification comment based on the analysis. Therefore I think they should be worried because… ROCE OR I think they should not be worried because… PROFIT MARGIN