Topic 8 Ratio Analysis. Higher Business Management

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1 Topic 8 Ratio Analysis Higher Business Management 1

2 Learning Intentions / Success Criteria Learning Intentions Ratio analysis Success Criteria Learners should be able to describe and explain: the purpose of ratio analysis the limitations of ratio analysis the interpretation of profitability, liquidity and efficiency ratios to make evaluative comments on business performance. 2

3 Ratio Analysis Accounting information can be analysed in more detail by carrying out ratio analysis. Ratio analysis can be used to : compare an organisation s performance with its own past compare an organisation s performance of a business to that of competitors compare against industry average highlight areas of the business that need attention highlight trends to aid future decision-making. 3

4 Category What is it? Ratios Profitability Liquidity Efficiency Measure of how profitable the organisation is. These ratios are used to analyse the organisation's expenses, cost of stock and the selling price. Measure of how able the organisation is to pay its short-term debts. These ratios would indicate if an organisation needed to arrange additional finance to pay its bills. Measure of how well the capital invested into the company is being utilised and if the organisation is performing as efficiently as it can. Gross Profit Percentage Net Profit Percentage Return on Capital Employed (ROCE) Current Ratio Acid Test Ratio Stock Turnover Ratio 4

5 Profitability Ratios Gross profit percentage Net profit percentage Return on capital employed 5

6 Gross Profit Percentage This ratio shows the profit made from buying and selling stock. Gross Profit Sales x 100 = % The higher the % the better. If in Year 1 the ratio was 30% and in Year 2 it was 35%, this would show that for every pound made from sales, more of it is Gross Profit in Year 2 than in Year 1. 6

7 Gross Profit Percentage Interpretation Interpretation INCREASE in ratio from one year to the next DECREASE in ratio from one year to the next Why would it change? Selling price has been raised. Cost of sales has been lower because cheaper suppliers have been used. Increase in marketing activities has caused demand to increase. Better quality product being sold compared to a competitor and this has increased sales. Cost of sales has increased (cheaper suppliers should be located). Stock might have been lost due to waste or theft. Fewer marketing activities might have caused demand to decrease. Fewer sales due to a better product being sold by a competitor. 7

8 Net Profit Percentage This ratio shows the profit made once expenses have been deducted. Net Profit Sales x 100 = % The higher the % the better. If in Year 1 the ratio was 25% and in Year 2 it was 30%, this would show that for every pound made from sales, more of it is Net Profit in Year 2 than in Year 1. 8

9 Net Profit Percentage Interpretation Interpretation INCREASE in ratio from one year to the next Why would it change? Gross Profit has been higher. Expenses have been lower (possibly because cheaper alternatives have been sourced). DECREASE in ratio from one year to the next Gross Profit has gone down. Expenses have increased (the organisation should source cheaper alternatives). 9

10 Return on Capital Employed This ratio shows the return on the capital investment made by the owner or shareholder in the organisation. Net Profit Capital Employed x 100 = % The higher the % the better. If in Year 1 the ratio was 20% and in Year 2 it was 25%, this would show that in Year 2 a return of 25% has been made. For every 1 invested, a return of 25p has been gained. (NB not dividend). 10

11 Return on Capital Employed Interpretation Interpretation INCREASE in ratio from one year to the next (higher return) Why would it change? Sales have increased (due to reasons given for the Gross Profit Percentage ratio). Expenses have been lower. DECREASE in ratio from one year to the next (lower return) Sales have decreased (due to reasons given for the Gross Profit Percentage ratio). Expenses have been higher. 11

12 Liquidity Ratios Current ratio Acid test ratio 12

13 Current Ratio (also known as the Working Capital Ratio) This ratio shows how able an organisation is to pay its short-term debts. It would indicate if additional finance is required to pay bills. Current Assets Current Liabilities : 1 An ideal ratio is 2:1. This means that it has double the amount of current assets compared to current liabilities. If the ratio was lower than 2:1 the organisation could struggle to pay its short-term debts. If the ratio is higher than 2: 1 the organisation should consider how it would decrease this to ensure it is using its resources in the most effective way. 13

14 Current Ratio Interpretation Interpretation INCREASE in ratio from one year to the next DECREASE in ratio from one year to the next Why would it change? Current liabilities have decreased (e.g. fewer creditors). Current assets have increased (e.g. more stock or more money in the bank). Current liabilities have increased (e.g. more creditors). Current assets have decreased (e.g. less stock or less money in the bank). 14

15 Acid Test Ratio This ratio shows how able an organisation is to pay its shortterm debts without having to sell its stock. This is because stock can be difficult to turn into cash quickly. Current Assets : 1 Current Liabilities A ratio of 1:1 is considered acceptable. This is because it indicates the organisation can pay its shortterm debts without having to rely on selling stock. 15

16 Acid Test Ratio Interpretation Interpretation INCREASE in ratio from one year to the next Why would it change? Current liabilities have decreased (e.g. fewer creditors). Current assets have increased (e.g. more stock or more money in the bank). DECREASE in ratio from one year to the next Current liabilities have increased (e.g. more creditors). Current assets have decreased (e.g. less stock or less money in the bank). 16

17 Efficiency Ratio Stock turnover ratio 17

18 Stock Turnover Ratio This ratio measures the length of time stock is held. If stock is held for a long time this could suggest that stock levels are too high. Alternatively, if stock is only held for a short period of time, it might be because a JIT approach is used or because the re-order stock level is low. The type of product being sold will also influence whether it is held for a long or short period of time. Cost of Sales Average Stock* = times *Average stock = Closing Stock + Opening Stock / 2 18

19 Stock Turnover Ratio Interpretation Interpretation INCREASE in ratio from one year to the next DECREASE in ratio from one year to the next Why would it change? Increase in the cost of goods sold (e.g. purchases). Decrease in average stock holding. Decrease in the cost of goods sold (e.g. purchases). Increase in average stock holding. 19

20 Limitations of Ratios There are some problems or limitations with carrying out ratio analysis. Organisations that carry out ratio analysis need to be aware that: the figures used to calculate the ratios are historic and do not show what could happen in the future comparisons between different organisations are difficult because the results are only useful when compared with an organisation of the same size and type external factors are not taken into consideration, for example recessions the results do not consider any internal factors/workforce related issues such as staff motivation or morale new product development or launches are not considered. 20