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What is Ratio
Analysis all about?
Ratios are really useful things...TRUST ME! Examiners love
to ask you lots of questions about them so let’s see if we
can help you to understand them.
Well a ratio is a way of using numbers to
look at how well or how badly a business is
doing.
Ok so what is a Ratio?
Cool....so how can I use
ratios to help me ?
Ahh....well let’s start by
looking at the Gross
Profit Ratio.
GROSS PROFIT RATIO
This ratio can help Sidney our dodgy
salesman to understand how much
profit he is making from the buying
and selling of his goods.
Right well to work out the answer we
first need to look back at Sidney’s
Trading, Profit and Loss Account
from a previous worksheet.
£ £
SALES REVENUE 35,000
Opening Stock 1,000
Purchases 12,000
Closing Stock 2,000
COST OF GOODS SOLD 11,000
GROSS PROFIT 24,000
Nice one....so go on then
tell me how much I made!
Now what?
Well....we simply follow the following formula.
GROSS PROFIT x 100
SALES REVENUE
Do you think that you can work
out the answer? Go on...have a try
below. The answer is a %
How did you do? You should have
taken £24,000 and divided this by
£35,000. You then multiply this
answer by 100. ANSWER=68.57%
Blimey 68.57% sounds a
lot. That’s good isn’t it?
Sidney seems happy with this figure as it looks really
high. It shows us that he has made 68.57% profit on the
buying and selling of goods.
Sadly it is not quite as easy
as that. Examiners love to
see you explain your
answers when it comes to
Ratios.
Ok I get the idea thanks but
what detail do you want?
Cool so if I just say that Sidney
has made a high Gross Profit
will I get an A*?
I WANT DETAIL!!!
Alright erm...Sidney
what was your Gross
Profit ratio last year?
So why was your Gross
Profit ratio lower this
year Sidney?
Ahhh...I get it! Unless I have something else to compare
this figure with then the ratio is not very useful. By
comparing Sidney’s 68.57% of this year to his 75% of last
year, all of sudden this figure is not so good!
Well it was actually 75%
Good...lots of questions I
like that! So Sidney,
answer the boy.
Nice...so we now have a really good answer to our
analysis of the Gross Profit ratio value.
We started off by just saying that 68.57% was good. We
have learnt that actually it was LESS than last year which
is bad! We have also learned WHY
the ratio was lower.
We could go even further though to
ensure that we get that A* grade.
Ok well my suppliers were
charging me higher prices...not
that it’s any of your business.
Hi...I’m Jack and I’m Sidney’s
cousin. I work in the same
‘dodgy’ sales business. I made
45% Gross Profit this year.
Cool...we can use this information to gain our A*. We
can compare Sidney’s Gross Profit with other businesses
in the same industry.
By using this data we can tell that Sidney was actually
doing very well. Yes he might have made less money
this year but when we look at how everyone else in the
same industry is doing, he is a success e.g. 68.57%
compared with 45% Gross Profit!
GRADE A*.... Remember that I
want lots of lovely detail in
your answers! Try to ALWAYS
USE THE FIGURES!
Bob the Blob’s Question Time
Answer these questions.
Write down the formula for the Gross Profit Ratio.
An oil company make 69%, a supermarket make 20% and a local
butchers make 32% on their Gross Profit Ratios. Explain why these
values are not very useful in helping us to understand how well each
business is actually doing. (Hints. Are they all in the same type of
industry? Do we have any figures for previous years?)
Try and calculate the Gross
Profit Ratio values for each
year using the figures below.
2005 2006 2007
Sales Revenue £850,000 £915,250 £900,000
Gross Profit £214,000 £200,000 £350,000
Net Profit £54,500 £63,000 £110,500
2005 ANSWER
2006 ANSWER
2007 ANSWER
Did you spot that you did
not need the Net Profit
figures!
HINTS. Have they found a new supplier? How might this have
reduced their costs? Have they been able to charge the customers
higher prices? Have they increased demand for their product? How?
Ah you caught me! Try to explain why
you think that the business is making
so much more Gross Profit in 2007.
Ok what about the
NET PROFIT ratio?
NET PROFIT RATIO
Net Profit really provides a more accurate reading on
how much profit a business has made as it takes away
all of the costs and not just those we had in the buying
and selling of our goods.
Let’s go back to our dodgy salesman Sidney and see
what his Net Profit Ratio was for last year.
£
SALES REVENUE 35,000
NET PROFIT BEFORE TAX 12.225
So...... 12,225
x 100 = 34.93
%
35,000
NET PROFIT x 100
SALES REVENUE
Hey, how come my
Gross Profit Ratio
was so much higher?
Oh Sidney you were not paying attention were you!
Remember that your Net Profit Ratio takes into account
ALL of your costs.
That means we have taken into account all of your
expenses that you had to pay for such as renting your
warehouse, paying wages to your staff and buying fuel
for your vehicles. YOUR NET RATIO WILL ALWAYS BE
LOWER!
REMEMBER THE GOLDEN RULES:
1. How did other firms in the
same industry do?
2. How did Sidney do last
year?
So is 34.93% any
good then?
So do you think you can
explain how Sidney might
improve his Net Profit Ratio?
Hint. Think about how he might be able to reduce his expenses!
Give advantages and disadvantages for each suggestion.
Study these figures in the table and then answer the question on
the next page.
2005 2006 2007
Sales Revenue £850,000 £915,250 £900,000
Gross Profit £214,000 £200,000 £350,000
Net Profit £54,500 £63,000 £110,500
Try and calculate the Net Profit Ratio for each year.
2005 ANSWER
2006 ANSWER
2007 ANSWER
Did you remember to
show ALL of your working
out?
Let’s move on to
the Current Ratio.
THE CURRENT RATIO
You might have noticed that both the Gross Profit and
Net Profit ratios used the Trading, Profit & Loss Account
to get their figures. The next two ratios use the Balance
Sheet.
Basically, the Current Ratio will help you to
understand how easily a business can meet all
of their liabilities.
For Sidney, this means does he have enough
money available to allow him to pay for all of his debts if
he was required to pay them
straight away. It is giving us a
measure of his LIQUIDITY.
Hmm I’m a bit confused
but let’s see what my
Current Ratio is.
£ £
CURRENT ASSETS
Debtors 75,000
Cash at Bank 20,000
Stock 140,000
235,000
CURRENT LIABILITIES
Creditors 25,000
Overdraft 55,000
80,000
CURRENT ASSETS
CURRENT LIABILITIES
So then we divide £235,000
by £80,000 and we get the
answer of 2.9
Ok but is 2.9 any
good?
Well any answer between 1.5 and 2.0 is excellent as this
means that Sidney has enough money available to pay
all of his debts.
In our example, Sidney actually has even more than this
at 2.9. This means that he has nearly three times more
current assets than current liabilities! This is good...but
Sidney needs to be careful not to have too high a figure
as this might mean that he has too much money just
lying about and not working for him.
If Sidney’s Current Ratio was LOWER than 1.5 then he
might have problems paying back all of his debts!
Try to remember the ratio
formulas and their ideal
values for the exam!
What’s the Acid Test
Ratio all about?
THE ACID TEST RATIO
This ratio again uses the Balance Sheet for its figures.
This time we TAKE AWAY STOCK from our Current Assets
before dividing the value by our Current Liabilities.
£ £
CURRENT ASSETS
Debtors 75,000
Cash at Bank 20,000
Stock 140,000
235,000
CURRENT LIABILITIES
Creditors 25,000
Overdraft 55,000
80,000
CURRENT ASSETS - STOCK
CURRENT LIABILITIES
Go on....have a try at
working out the Acid
Test Ratio.
Answer = £235,000 - £140,000 =£95,000
£95,000 / £80,000 = 1.19
ANSWER =
Did you remember to take
away the stock value from
your current assets first and to
then divide this figure by
current liabilities?
What do I need to
know about this for
an exam?
Well the reason why we take away stock from our
current assets is that stock is known to be ILLIQUID. This is
a fancy way of saying that stock usually takes a long
time to sell and to turn into cash.
Well let’s see for ourselves shall
we. I’ve arranged for Sidney to
show us around his warehouse
and to show us exactly what he
has to sell.
See if you can identify what items
Sidney might have some trouble
selling!
Hey all of my stock is
top quality stuff!
Right matey feast your
eyes on these great
little bargains!
A VIDEO TAPE RECORDER A TYPE WRITER
A PERSONAL STEREO
A BLACK & WHITE TV
Why might Sidney have problems selling this stock?
All of Sidney’s £140,000 worth
of stock is tied up in old items
that nobody wants anymore!
Well you should show the
examiner that you
understand that stock
can be very difficult to sell quickly.
Say that stock is ILLIQUID that should impress them!
Sidney’s Current Ratio value of 2.9 made us believe that
he could meet all of his debts quickly. It is only now
when we use the Acid Test Ratio that we can see that in
fact Sidney has most of his money tied up in old stock
that nobody wants! If his creditors all asked for their
money back then Sidney would have a big problem.
Remember though to ALWAYS think about what industry
Sidney is in and what his figures were for last year. He
might actually be doing better!
So what do I write about then
in my exam?
And now for the last
ratio we need to
learn....the ROCE Ratio.
FROM THE BALANCE SHEET
FROM THE PROFIT AND
LOSS ACCOUNT
RETURN ON CAPITAL EMPLOYED
This is the only ratio that needs you to use BOTH the Profit
& Loss Account and the Balance Sheet.
This ratio is all about looking at how much money you
get back from investing in a business. The higher the
value of the ratio the better! Remember to always look
at what other firms in the industry are doing though and
how the business has done in the past.
OPERATING PROFIT x 100
CAPITAL EMPLOYED
Right I get this, so can
we calculate the value
and see what we get.
TRADING, PROFIT & LOSS ACCOUNT EXTRACT
EXPENSES
Electricity & Gas 2.950
Vehicles (Petrol) 500
Telephone 325
Rent 5,500
OPERATING PROFIT 14,725
BALANCE SHEET EXTRACT
FINANCED BY:
Mortgage 300,000
Long-Term Loans 155,000
Share Capital 100,000
CAPITAL EMPLOYED
555,000
Can you work out the
ROCE Ratio for Sidney?
THINK! Are there any reasons
why the ROCE might be so low?
Did you get it right? The
answer is £14,725 / £555,000
x 100 = 2.65%
This is a VERY poor return
for your money! You would
be better putting your
money in the bank.
Bob the Blob’s Question Time
Try and answer the following question.
Look carefully at the extracts of a Balance Sheet and a Trading, Profit
and Loss Account. I then want you to carry out a FULL financial
analysis of these accounts. This means you will need to calculate ALL
of the ratios that we have covered in this worksheet and most
importantly, you need to try and provide a good understanding of
what each result is showing you.
THIS IS A VERY COMMON EXAM QUESTION!
TRADING, PROFIT & LOSS ACCOUNT EXTRACT
2006 2007
SALES REVENUE £56,000 £64,500
GROSS PROFIT £34,500 £48,000
NET PROFIT BEFORE TAX £18,000 £20,450
EXPENSES £12,500 £22,550
OPERATING PROFIT £22,000 £25,450
BALANCE SHEET EXTRACT
CURRENT ASSETS £75,000 £98,000
CURRENT LIABILITIES £60,000 £62,000
STOCK £20,000 £21,500
CAPITAL EMPLOYED £125,000 £135,000
GROSS PROFIT RATIO ANALYSIS
NET PROFIT RATIO ANALYSIS
CURRENT RATIO ANALYSIS
ACID TEST RATIO ANALYSIS
RETURN ON CAPITAL EMPLOYED ANALYSIS
(HINTS. Always calculate the ratio for each year. Show all working.
Explain if the ratio values are getting better or worse than last year. Do
we know how other businesses are doing? Look for clues in the figures
e.g. why might expenses have gone up? Is this a good business to
invest your money in?)
Bob the Blob’s Question Time
What Am I?
I start with the letter A
I offer you a more exact measurement of Liquidity.
I do not include stock as they take time to sell.
I am current assets - stock / current liabilities.
I AM A............................................
I start with the letter N
I show you the profit you earn after expenses.
I am more precise than the Gross Profit Ratio.
I am net profit / sales revenue.
I AM N............................................
I start with the letter R
I show investors how much profit they might make.
I need a high value to attract people to invest in me.
I use figures from the Balance Sheet and Profit & Loss.
I AM R............................................