The analytical technique of ratio analysis permits businesses to study end of period reports in order to base decisions for the future.
Ratio Analysis• Valuable tool for interpreting financial ratios• Efficient way to express relationship of one number to another
RATIOS• Presented as % or as ratios• Assist in: – decision making – Interpreting financial reports – Assessment of enterprise’s: • Profitability • Stability • Effectiveness
Profitability Profitability is the ability to earn income within the present financial structure of an enterprise.
Profitability Ratios• Gross profit ratio• Net profit ratio• Ratio of expenses to sales
Gross Profit RatioIndicates the ability of atrading enterprise togenerate gross profitfrom sales. Gross Profit x100Compare result to Net Salesindustry benchmarks todetermine suitability ofbusiness performance
Result indicates:• for every $ of sales – number of cents retained as gross profit• how effective business is in passing on increases in COGS to customers
High result may indicate:• ability of business to cover all costs• capacity to earn acceptable net profit and return to ownerLow result may indicate inability to:• meet further costs• return satisfactory net profit• return satisfactory rate to owner
RecommendationsImprove sales• Ascertain: – stock levels - should be high enough to meet demand – appropriateness of stock to appeal to market – demand for stock held – Appropriateness of selling price• Conduct market research/analysis to assist with the above.
Institute policy to minimise COGS• Investigate alternative suppliers selling similar quality products for less• Take advantage of discounts offered to lower costs
Net Profit Ratio•Indicates the ability ofa trading enterprise togenerate a return on theowner’s investment. Net Profit•Compare result to x100industry benchmarks to Net Salesdetermine suitability ofbusiness performance
• Result indicates:• for every $ of sales – number of cents retained as net profit• how effective business is in minimising expenses• poor GP ratio will impact on NP ratio
High result may indicate:• High operating revenue• Low operating expensesLow result may indicate inability to:• inappropriate pricing policy• inadequate stock• inappropriate stock• expenses too high
RecommendationsImprove sales• as per Gross Profit recommendationsMinimise expenses• Set budgets for departments• Investigate alternative suppliers to lower costs• As per Gross Profit recommendations
Rate of Return on Equity RatioIndicates the return tothe owner on theamount invested in thebusiness Net Profit x100Aim for a return of, Average Owner s Equityaround, 14% whichallows funding for futuregrowth and a return oninvestment. ( OE beg + OE end) /2 = Avg OE
High result may indicate:• efficient operation• business may be under- capitalised (owner has not contributed equity to the optimum level) – Under-capitalisation can be identified when NP ratio is close to or under industry benchmark yet ROE is well above industry benchmark
Low result may indicate:• owner’s money may perform better invested elsewhere• business may be over-capitalised (if owner has invested over the optimum sum into the business) – Can be identified when NP ratio is close to industry benchmark yet the ROE result is well below industry benchmark• management may take little risk therefore business is cautiously run• inefficient management making poor decisions, lack of foresight.
RecommendationsImprove net profit result using previousrecommendations.Check level of capitalisation to ensureappropriateness for industry. – If under-capitalised owner should consider investing further funds into the business. – If over-capitalised owner should consider investing excess funds into alternative investments.