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3.6 - Ratio Analysis

# 3.6 - Ratio Analysis

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05/12/2014

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3.6 Ratio Analysis
Ratios allow for the business position to be assessed, to examine trends, and compare with
other businesses and the average results of the sector.
Profitability Ratios
These look at the ratio of profit to sales revenue to determine the business performance.
The data for these ratios is usually taken from the balance sheet.
Gross Profit Margin
  
  
This is expressed as a percentage. It can be improved by raising the revenue:
Increasing or decreasing the selling price, depending on price elasticity
Marketing strategies
Or reducing costs:
Using cheaper suppliers and materials
Reducing labour costs
Net Profit Margin
 
 
  
Here, the net profit before interest and tax is usually used. It is expressed as a percentage. It
is a better measure of profitability for the business. This ratio can be improved by:
Negotiating preferential payment terms
Cheaper rent
Reducing indirect expenses
Liquidity Ratios
Liquidity is how quickly a business assets can be turned into cash. These ratios determine
how well a business can pay off its debts using only its liquid assets.
Current Ratio
 
 

This is expressed as a ratio X : 1. Most agree that X should = 1.5-2.0 for an appropriate safety
margin to be maintained. If the ratio is too low, the business would be in deep trouble if
creditors demanded payment, whilst being too high means that they should invest some of
their money in more long-term investments.

Acid Test Ratio
   
 

This ratio is more accurate because often stock is very difficult to turn into cash. The ratio
should be at least 1:1 for the business to be in a good position. Otherwise, they are at risk of
a liquidity crisis.

Lenders may look at this ratio in order to see what risk is involved with lending to this
business. To improve this ratio, the business should try to reduce its current liabilities.
Efficiency Ratios
Stock Turnover
   
 
This ratio shows the average rate at which a business sells all its stock.
 
    
The cost here is the actual production cost. Higher turnover means more profit because
they are receiving greater revenue. This ratio can be increased by:
Holding less stock for more frequent replenishment
Removing any stocks that do not sell well
Reducing the range of stocks only to those that sell well.
The industry and nature of the business will determine the optimum result for this test.
Return on Capital Employed
     
 
 

This looks at how well a business is performing, compared to the amount they had invested.
Much of the data is on the data booklet. This should be compared to the interest rate
offered by banks, to see which investment is the more worthwhile.

Gearing Ratio
  
  
This looks at the long term liquidity of the business.
 
  

A high ratio shows high dependence on that source of finance. They are also more likely to suffer financial difficulties. In order to determine the acceptability of the ratio, the business must consider their size, interest rates and potential profitability