Accounting Ratios

 An Introduction to Ratio Analysis

 Ratio analysis involves extracting information from financial accounts to assess business
performance.
 It helps managers to answer key questions, including-
 Why is one business more profitable than another one in the same industry?
 Is a business growing?
 How effectively is a business using assets and capital invested?
 What return on investment is expected?
 How risky is the financial structure of the business?
 Ratios can be compared over time and between businesses or functions to determine how well
financial objectives are being met.

 Profit Margins
Profit margins measure how effectively a business converts revenue into profit. They can be compared to
previous years to understand business performance better.
 Higher and increasing profit margins are preferable, as more revenue is converted to profit.
(i) The Gross Profit Margin
This calculation shows the proportion of revenue that is turned into gross profit.
It is calculated using the following formula and is expressed as a percentage-

Gross Profit
Gross Profit Margin = × 100
Sales
 Improving the Gross Profit Margin
The gross profit margin can be improved in two ways-
1. The business can increase its sales revenue
2. The business can reduce its direct costs/expenses
Ways to Increase the Gross Profit Margin
Method Explanation
 Increase the value of sales
 Raise prices:
 If costs remain the same, this will improve profitability, as the
difference between the selling price and costs will be greater.
 Sell premium products:
 If customers are willing to spend money on these goods, the
business could earn more profit per item sold.
Increase revenue  Increase the volume of sales
 Price tactics:
 Use price tactics to encourage higher quantity or more frequent
purchases.
o For example, 'Buy one, get one-half price' doubles the number of
items a customer purchases, increasing revenue.
 Increase marketing activities:
 Engage in more marketing activities to increase sales volume.
 Purchase cheaper/alternative resources
Reduce direct costs  Negotiate with suppliers or find new suppliers
  However, businesses must ensure that reducing variable costs
will not adversely affect the quality or desirability of products.
 Buy Inventory in greater quantities.
 Purchase in bulk amounts less frequently.
 Investment in increased storage space may be needed, which
will reduce the impact of cost savings made.
 Reduce wastage of raw materials and components.

(ii) The Operating Profit Margin

This calculation shows the proportion of revenue that is turned into operating profit. It is calculated
using the formula below, and the outcome is expressed as a percentage:

Operating Profit
Operating Profit Margin = × 100
Sales
 Improving the Operating Profit Margin
The operating profit margin can be improved in two ways
 Increase the gross profit margin (see above)
 Reduce expenses by cutting staffing levels, relocating to cheaper premises, or changing
utility companies.
 Reducing staffing levels may affect staff morale and negatively impact productivity.
 Relocation costs may outweigh some benefits of moving to a cheaper location.
 Replacing inefficient or outdated equipment may require staff training.
(iii) Return on Capital Employed
The Return on Capital Employed (ROCE) measures how effectively a business uses the capital invested
in it to generate profit. It is calculated using the formula below and expressed as a percentage:
Operating Profit
ROCE = × 100
Capital Employed
 ROCE can be compared over time and with competitors.
 It can also be compared with other potential capital investments, such as savings rates
 The Capital Employed figure is usually provided for you.
If required, it is calculated using the formula-
Capital Employed = Non− current Liabilities + Equity

Improving ROCE
 When analyzing the ROCE, the higher the rate, the better, as it indicates that the business is
profitable and using its capital efficiently.
 Investors prefer businesses with stable and rising levels of ROCE, as this indicates low -
risk growth is being achieved.
 To increase the ROCE, a business can
 Increase the level of profit generated without introducing new capital into the business.
 Maintain the level of profit generated while reducing the amount of capital in the business.

Using ROCE to make decisions

o ROCE can support strategic decisions (e.g., investment or divestment decisions) to determine the
most profitable option given the capital employed.
 Liquidity
 The Importance of Liquidity
 Liquidity is defined as the ability of a business to pay back its short-term debts, e.g., suppliers.
 A business that cannot pay its debts is considered insolvent.
- If a business cannot pay its suppliers, raw materials or components may not be delivered, and
production will be delayed.
- If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will
suffer.
- Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid.
 Stakeholders interested in liquidity include-
- Suppliers want to be reassured that a business will likely be able to pay for them.
- Financial providers such as banks want evidence that a business is likely to be able to repay
loans or overdrafts.
- Customers want to be sure that a supplier can produce and deliver the goods they order.

Methods to Improve Liquidity

Summary
1. Gross Profit Percentage :
Gross Profit
Gross Profit Margin = × 100
Sales
Gross Profit = Sales – (Opening stock + Purchase – Closing stock)
This ratio shows how effectively a business controls its cost of goods. The Gross Profit ratio will
change if:
a) The selling price of goods changes
b) The cost price of goods change
2. Net Profit Percentage
Net Profit
Net Profit Margin = × 100
Sales
This ratio shows how effectively the expenses of the business are controlled. The Net Profit ratio will
change if:
a) the gross profit ratio changes
b) expenses change
3. Return on Capital Employed:
Operating Profit
ROCE = × 100 =? %
Capital Employed
This ratio shows the net profit made for each $100 invested by the owner into the business. The
higher this percentage, the better.

IMPORTANT – often, examiners will take capital employed to mean Average Capital. This means
adding the open and closing balance of capital and dividing by 2 to get the average. If you are only
given the closing Capital, then use this figure.
4. Rate of Inventory Turnover
Cost of goods sold
Inventory Turnover = × 100 =? Times
Average Inventory

𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 + 𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

Average Inventory =
𝟐
Cost of goods sold = Opening stock + Purchase – Closing stock
This ratio shows how quickly a business sells its Inventory. The higher this ratio, the better.
5. Current Ratio
Current Asset
Current Ratio =
Current Liabilities
=?:1
This ratio compares the ability to use current assets to pay the current liabilities.
An ideal ratio is 2:1. A ratio too high means that the business has more current assets than it needs.
6. Acid test (Liquidity) Ratio
Current Asset −Closing Inventory
Liquidity Ratio =
Current Liabilities
=?:1
This ratio shows whether there are enough cash assets to pay current liabilities. Inventory is the least
cash–like current asset, so it is subtracted. An ideal ratio is 1:1.
7. Debtors to Sales Ratio
Debtors
Debtors to Sales Ratio = × 365
Credit Sales
= ? Days
This ratio shows how long it takes a business to collect money from its Debtors. The higher the ratio,
the worse the business is at getting debtors to pay on time and the more likely it is to have a high
level of bad debts and cash problems.
8. Creditors to Purchases Ratio
Creditors
Creditors to Purchases Ratio = × 365
Credit Purchase
= ? Days
This ratio shows how long a business takes to pay its creditors. Taking too long to pay creditors is
not good, as discounts for early payment are lost, and suppliers could refuse to supply goods to the
business on credit.
Limitations of Ratios
I. Results do not explain the results but merely show which business areas need further
investigation.
II. Ratios do not take seasonal factors into account.
III. For ratios to be accurate, the information must be timely and useful—it may not be available long
after the end of the financial year.
IV. Ratios must be accurate to be useful—some information may not be shown in the business's
accounts.

Practical Math
1. The following information is available about a retail business owned by Albert Gonzalez.

Year ended 31 Year ended 31

March 2010 March 2011
£000 £000
Sales 500 600
Cost of sales 250 270
Expenses 100 120
Capital employed 750 900

Current ratio 2.5:1 1.5:1

Acid test 1.5:1 0.8:1

(a) Using these figures:

(i) Calculate the gross profit for each year.

(ii) Calculate the net profit for each year.

(b) Stating clearly the formula used, calculate the gross profit margin for each of the
two years.
Formula

Gross profit margin for year ended 31 March 2010

Gross profit margin for year ended 31 March 2011

(c) Stating clearly the formula used, calculate the net profit margin for each of the two years.

Formula
Net profit margin for year ended 31 March 2010

Net profit margin for year ended 31 March 2011

(d) Stating clearly the formula used, calculate the return on capital employed for each of the two
years.

Formula

Return on capital employed for the year ended 31 March 2010

Return on capital employed for the year ended 31 March 2011

Albert believes that the financial performance of his business has improved between 2010 and 2011.
(e) Evaluate Albert’s claim, giving reasons backed up with figures. In your answer, you are expected to
make equal reference to profitability and liquidity.

Profitability

Liquidity
 2. On 31 March 2018 the financial director of Tavish Ltd provided the following information.
Year ended 31 March
2017 2018
£000 £000
Turnover 1 600 2 400
Gross profit 400 600
Net profit 192 240
Capital employed 240 320
(a) Stating the formula used, calculate the following ratios for each of the two years.
Year ended on 31 March
Ratio Formula 2017 2018

Gross profit margin

Net profit margin

Return on capital
employed

The managing director believes that due to the increased turnover and net profit, the company must
have experienced a very successful year.
(b) Evaluate the company's profitability over the two years and state, with reasons, whether you
agree with the managing director’s statement.
 (c) State one ratio that could be used to measure liquidity.

3. The partnership trading account for the year ended 31 October 2013 provided the following
information.

£
Opening stock 36 000
Closing stock 48 000
Purchases 120 000
Sales 240 000

a) Calculate the gross profit percentage for the year ended 31 October 2013. State clearly the formula
used.

Formula

b) Calculate the rate of stock turnover (in days) for the year ended 31 October 2013. State clearly the
formula used.
Formula Rate of Stock Turnover (in days)
The figures for the year ended 31 October 2012 were:

Gross profit percentage 75%

Rate of stock turnover 110 days

c) Evaluate the causes of the change in these two ratios between 2012 and 2013.