RatiosSimple interpretation of financial statements using ratios
Gross and net profit,
current and acid test ratio,
return on capital employed (ROCE).
Alternative ways that businesses can judge their success e.g. ROCE, market share. Using accounting ratios make evaluative comments on the success and
performance of a business.
Use a balance sheet to aid decision making.
Interpret the performance of a business by using simple accounting ratios (return on capital, gross and net profit margin, current ratio).
Understand the concept of liquidity.
Enough working capital? Working capital = Current asset – current
liability
Enough working capital? If you don’t have enough you can’t pay your
day to day expenses. The CURRENT RATIO and ACID TEST
RATIO Two ratios to help you work out if you have
enough working capital.
Current ratio Compare current assets and current
liabilities If current assets are greater than current
liabilities the business can cope with a crisis…
You can afford to have current liabilites increase.
Current ratio:
Current ratio = Current Assets Current liabilities
The HIGHER the ratio, the higher the amount of working capital in the business. Therefore the higher the ratio the ‘safer’ the business.
Current ratio:
Current ratio = 100,000 50,000
2:1 You have $2 for every $1 you owe
Current Ratio Accounts recommend a business should
have 1.5 :1 to 2:1 If less than this the business may struggle
to pay its bills and may be forced to close down.
If it is more the business may have resourced tied up in unproductive assets.
Current Ratio Work it out!ASSETS MillionStock 11Debtor 29Cash at bank 46.3Total current assets 86.3
LIABILITIESTrade creditors 18Taxes 11.2Dividend 1.1Other creditors 12.9Total current liabilities 43.2
Working Capital 43.1
Answer Current ratio = £86.3 mil
£43.2 mil
1.9 to 1
The ACID TEST RATIO Stock is part of working capital of the business However, it might be difficult to sell stock quickly if
a business needs cash. So a better measure of whether a business has
enough working capital is the acid test ratio. This excludes stock from current assets when
calculating the ratio.
ACID TEST Acid test ratio = Current Assets - stock Current liabilities The higher the ratio the safer the business. A typical business should be 0.5 to 1
ACID TEST – work it outASSETS MillionStock 11Debtor 29Cash at bank 46.3Total current assets 86.3
LIABILITIESTrade creditors 18Taxes 11.2Diviend 1.1Other creditors 12.9Total current liabilities 43.2
Working Capital 43.1
Answer Current ratio = £86.3 mil - £11
£43.2 mil
So its acid test ratio was 1.74 to 1
Gross profit margin Gross profit – the difference between Sales
and cost of sales.
£
Sales 300,000
Cost of sales 100,000
Gross profit 200,000
Ratio of gross profit to Sales turnover
= Gross Profit x100
Sales turnover
Work it out
2012 2013
£mil
Sales 15 20
Cost of sales 10 14
Gross profit 5 6
Which year was better for the business?
Compare with
2012 = 33%
2013 = 30% Means the sales cost are RISING in
relation to the value of sales. This is worrying means business is losing control of the costs as it expands…
NET PROFIT Gross profit is important but doesn’t
include overheads. Ration of NET profit to Sales turnover = Net Profit x100
Sales turnover
Work it out! £Sales 15Cost of sales 10Gross Profit 5Overheads 2Net profit 3
Ratio = 20%
Comparisons Competition – a business may cut prices to
maintain sales. Cutting prices leads to lower revenue, therefore a fall in profit margins
The economy – a recession (cut prices, less sales)
The value of the pound – if increases the prices of UK exports more expensive, less sales.
Taking lower profit to increase sales
Judging performance Rate of return on capital employed.
Looks at profit in relation to capital e.g if you put $20 in a bank, and received $10
interest over a year you would have a 50% return on your money.
A business doesn’t know how well it has done until it compares profit with money invested (Capital)
Rate of return on capital employed
ROCE (%) = Net Profit x100
Capital employed Capital employed is defined as the fixed
assets and the net current assets, minus any liabilities.
Ratio Formula What are we looking for?
Why will it go up? Why will it go down?
Gross Profit Percentage
= Gross Profit X 100 Sales
The higher the percentage the bigger
the gross profits.
Volume of sales may have increased
Cost of Sales may have decreased.
Volume of sales may have decreased Cost of Sales may have increased.
Net Profit Percentage
= Net Profit X 100 Sales
The higher the percentage the bigger the 'final' net profits.
The volume of sales may have increased
Expenses may have decreased.
The volume of sales may have decreased
Expenses may have increased.
Return on Equity
Net profit x 100
Total equity
The higher the ROE the better the return on the investment
High ROE can be achieved by
Increasing salesIncreasing Profit Margins
ROE is likely to be lower if
The markets are in declineUnit costs are increasing and the
firm cannot increase priceSales are falling
Current Ratio
= Current Assets Current Liabilities
About 2:1 is best. Any more is a waste of
resources.
They may have more debtors/stock/bank reserves and
less creditors.
They may have less debtors/stock/bank reserves and
more creditors.
Acid Test
= Current assets – stock Current Liabilities
As long as it is over 1:1 the firm can still
meet its liabilities and remain solvent.
They may have reduced their level of stock or there may be a change in
the current ratio.
They may have increased their level of stock or there may be a change in
the current ratio.