Ratios Flashcards
What is the purpose of ratio analysis?
Compare the performance of the business with previous years.
Compare the performance of a business to that of its competitors.
Compare against industry averages.
Highlight areas of the business that need attention.
Highlight trends to aid future decision-making.
What are the limitations of ratio analysis?
Ratio information is historical so is not relevant to the current or future position.
Ratios do not take into account external factors e.g. recessions.
Ratios do not take into account internal factors e.g. low staff morale.
Ratios do not take into account product developments.
It is difficult to find competitors of the exact type and size to make valid comparisons.
What are the profitability ratios?
Gross profit percentage
Profit for the year percentage
Return on equity employed
What are the liquidity ratios?
Current ratio
Acid test ratio
What is the efficiency ratio?
Rate of inventory turnover
What is gross profit percentage?
This measures the percentage of profit made from buying and selling.
The higher the percentage, the better.
(gross profit / sales revenue) x 100
How do you improve gross profit percentage?
Increase sales revenue e.g. by increasing prices.
Switch to a cheaper supplier of purchases.
What is profit for the year percentage?
This measures the percentage of profit made once expenses are deducted from gross profit.
The higher the percentage, the better.
(profit for the year / sales revenue) x 100
How do you improve profit for the year percentage?
Reduce expenses e.g. lower wage costs by making staff redundant.
Increase sales revenue.
Improve gross profit to have a knock-on effect.
What is return on equity employed?
This measures the percentage of investment that is returned to investors such as shareholders.
The higher the percentage, the better.
(profit for the year / equity) x 100
How do you improve return on equity employed?
Attempt to increase profit for the year e.g. by reducing expenses or improving revenue.
What is current ratio?
Measures the ability of a business to pay back short-terms debts.
Expressed as x:1.
Over 2:1 is ideal.
current assets / current liabilities
How do you improve current ratio?
If ratio is less than 2:1-
Try to secure more current assets e.g. by selling non-current assets for cash.
Reduce current liabilities.
If the result is too high-
Invest in some current assets.
What is acid test ratio?
Measures the ability of a business to pay back short-term debts in a crisis situation.
1:1 is acceptable.
(current assets - closing inventory) / current liabilities
How do you improve acid test ratio?
If ratio is less than 1:1-
Secure more current assets e.g. encouraging cash sales to improve cash flow.
If current ratio is okay but acid test ratio is too low-
Too much money tied up in inventory so should implement just-in-time inventory control.
What is rate of inventory turnover?
Measures the amount of times a business re-stocks its inventory during the year.
Expressed in times.
cost of sales / average inventory*
*(opening inventory + closing inventory) / 2
How do you improve the rate of inventory turnover?
Most businesses want a high figure as it indicates that products are selling well and money is not tied up in inventory.
If the result is too low they should use JIT to avoid overstocking.
Sell of excess stock or perhaps negotiate sale or return with suppliers.
