RatiosSimple interpretation of financial statements using ratios

Gross and net profit,

current and acid test ratio,

return on capital employed (ROCE).

Alternative ways that businesses can judge their success e.g. ROCE, market share. Using accounting ratios make evaluative comments on the success and

performance of a business.

Use a balance sheet to aid decision making.

Interpret the performance of a business by using simple accounting ratios (return on capital, gross and net profit margin, current ratio).

Understand the concept of liquidity.

Enough working capital? Working capital = Current asset – current

liability

Enough working capital? If you don’t have enough you can’t pay your

day to day expenses. The CURRENT RATIO and ACID TEST

RATIO Two ratios to help you work out if you have

enough working capital.

Current ratio Compare current assets and current

liabilities If current assets are greater than current

liabilities the business can cope with a crisis…

You can afford to have current liabilites increase.

Current ratio:

Current ratio = Current Assets Current liabilities

The HIGHER the ratio, the higher the amount of working capital in the business. Therefore the higher the ratio the ‘safer’ the business.

Current ratio:

Current ratio = 100,000 50,000

2:1 You have $2 for every $1 you owe

Current Ratio Accounts recommend a business should

have 1.5 :1 to 2:1 If less than this the business may struggle

to pay its bills and may be forced to close down.

If it is more the business may have resourced tied up in unproductive assets.

Current Ratio Work it out!ASSETS MillionStock 11Debtor 29Cash at bank 46.3Total current assets 86.3

LIABILITIESTrade creditors 18Taxes 11.2Dividend 1.1Other creditors 12.9Total current liabilities 43.2

Working Capital 43.1

Answer Current ratio = £86.3 mil

£43.2 mil

1.9 to 1

The ACID TEST RATIO Stock is part of working capital of the business However, it might be difficult to sell stock quickly if

a business needs cash. So a better measure of whether a business has

enough working capital is the acid test ratio. This excludes stock from current assets when

calculating the ratio.

ACID TEST Acid test ratio = Current Assets - stock Current liabilities The higher the ratio the safer the business. A typical business should be 0.5 to 1

ACID TEST – work it outASSETS MillionStock 11Debtor 29Cash at bank 46.3Total current assets 86.3

LIABILITIESTrade creditors 18Taxes 11.2Diviend 1.1Other creditors 12.9Total current liabilities 43.2

Working Capital 43.1

Answer Current ratio = £86.3 mil - £11

£43.2 mil

So its acid test ratio was 1.74 to 1

Gross profit margin Gross profit – the difference between Sales

and cost of sales.

£

Sales 300,000

Cost of sales 100,000

Gross profit 200,000

Ratio of gross profit to Sales turnover

= Gross Profit x100

Sales turnover

Work it out

2012 2013

£mil

Sales 15 20

Cost of sales 10 14

Gross profit 5 6

Which year was better for the business?

Compare with

2012 = 33%

2013 = 30% Means the sales cost are RISING in

relation to the value of sales. This is worrying means business is losing control of the costs as it expands…

NET PROFIT Gross profit is important but doesn’t

include overheads. Ration of NET profit to Sales turnover = Net Profit x100

Sales turnover

Work it out! £Sales 15Cost of sales 10Gross Profit 5Overheads 2Net profit 3

Ratio = 20%

Comparisons Competition – a business may cut prices to

maintain sales. Cutting prices leads to lower revenue, therefore a fall in profit margins

The economy – a recession (cut prices, less sales)

The value of the pound – if increases the prices of UK exports more expensive, less sales.

Taking lower profit to increase sales

Judging performance Rate of return on capital employed.

Looks at profit in relation to capital e.g if you put $20 in a bank, and received $10

interest over a year you would have a 50% return on your money.

A business doesn’t know how well it has done until it compares profit with money invested (Capital)

Rate of return on capital employed

ROCE (%) = Net Profit x100

Capital employed Capital employed is defined as the fixed

assets and the net current assets, minus any liabilities.

Ratio Formula What are we looking for?

Why will it go up? Why will it go down?

Gross Profit Percentage

= Gross Profit X 100 Sales

The higher the percentage the bigger

the gross profits.

Volume of sales may have increased  

Cost of Sales may have decreased.

Volume of sales may have decreased Cost of Sales may have increased.

Net Profit Percentage

= Net Profit X 100 Sales

The higher the percentage the bigger the 'final' net profits.

The volume of sales may have increased

 Expenses may have decreased.

The volume of sales may have decreased

  Expenses may have increased.

Return on Equity

Net profit x 100

Total equity

    

The higher the ROE the better the return on the investment

High ROE can be achieved by  

Increasing salesIncreasing Profit Margins

ROE is likely to be lower if 

The markets are in declineUnit costs are increasing and the

firm cannot increase priceSales are falling

Current Ratio

= Current Assets Current Liabilities

About 2:1 is best. Any more is a waste of

resources.

They may have more debtors/stock/bank reserves and

less creditors.

They may have less debtors/stock/bank reserves and

more creditors.

Acid Test

= Current assets – stock Current Liabilities

As long as it is over 1:1 the firm can still

meet its liabilities and remain solvent.

They may have reduced their level of stock or there may be a change in

the current ratio.

They may have increased their level of stock or there may be a change in

the current ratio.