Ratios Flashcards
Ratio Analysis
It is sometimes hard to compare different organisations’ performance, or even the same firm’s performance over the years. One method used by businesses to compare their performance is
Ratio Analysis.
Ratio analysis covers three areas:
- profitability
- liquidity
- efficiency
Profitability Ratios
Measure how much profit an organisation makes.
Gross Profit Percentage Ratio
(profitability ratios)
Gross Profit Percentage Ratio works out the amount of profit from the buying and selling of goods before all other expenses are deducted.
The formula is: (Gross Profit/Sales Revenue) x 100
Two ways of improving this is to:
- raise the selling price of the product
- negotiate deals with less expensive suppliers
Profit for the Year Percentage
(profitability ratios)
Profit for the Year Percentage works out the amount of profit made once all expenses are deducted.
The formula is: (Profit for the Year/Sales Revenue) x 100
Ways of improving this is to:
- decrease expenses, for example finding cheaper premises to rent
- increase the gross profit figure
Return on Equity Employed
(profitability ratios)
Return on Equity Employed is the ratio often used by
venture capitalists or investors such as the Dragons in Dragons’ Den.
This ratio calculates how much money an investor will get back after a period of time.
It is crucial that investors weigh up the amount they will receive from the investment with the risk involved and if they would have received as good a deal (or better) if they had left the money in a bank account accumulating interest.
The formula is: (Profit for the Year/Opening Equity) x 100
Two ways of improving this is to:
- increase sales
- reduce expenses
Liquidity Ratios
Liquidity ratios calculate the organisation’s ability to turn
assets into cash in order to pay debts.
Current Ratio
(liquidity ratios)
Current ratio or the working capital ratio demonstrates the firms ability to meet its short-term creditors.
An ideal ratio of 2:1 is generally agreed. If the ratio is higher, 4:1 it could mean that the firm is inefficient and has too much money tied up in stock. On the other hand, a lower ratio value of 1:1 would mean that it may not be able to meet its debts quickly.
The formula is: current assets: current liabilities
Ways of improving this is to:
- increase current assets
- if ratio is too high you can sell non-current assets
- decrease current liabilities for example, reducing trade credit terms
Acid Test Ratio
(liquidity ratios)
Acid test ratio is a more severe test of a firm’s capabilities to meet its debts. The formula is the same as the current ratio but with the added problem of writing off all stock. This is because it assumes that stock:
- may be perishable
- may go out of date
- may go out of fashion or become obsolete
In other words, the firm may be left with stock it cannot sell. An ideal value of 1:1 is generally accepted.
The formula is: (current assets – closing inventory): current liabilities
Rate of Inventory Turnover
(efficiency ratios)
Rate of inventory turnover is an efficiency ratio which determines how quickly a firm goes through its stock.
A high stock turnover is preferable as this means stock is selling – marketing and purchasing are doing their jobs properly!
If stock turnover is low then this means stock is not being bought and there may be many reasons such as:
- poor quality of goods
- poor customer service
- poor advertising
The formula is: Cost of Sales:Average Inventory
Purpose of Ratio Analysis
- ratios help compare current performance with previous records
- ratios help compare a firm’s performance with similar competitors
- ratios help monitor and identify issues that can be highlighted and
resolved - ratios help with future decision making
Limitations of Ratio Analysis
- ratio analysis information is historic – it is not current
- ratio analysis does not take into account external factors such as a
worldwide recession - ratio analysis does not measure the human element of a firm
- ratio analysis can only be used for comparison with other firms of
the same size and type - it may be difficult to compare with other businesses as they may
not be willing to share the information
