BusinessReview24_3_ratio_analysis.pptx

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Ratio analysis
Hodder & Stoughton © 2018

What is a ratio analysis?
This is a financial tool used to:
 help unpick the masses of data within annual reports
 allow measurement, analysis and evaluation of a firm’s strength,
efficiency and financial performance
 raise questions, but doesn't always answer them.

Ratio overview
There are three types of ratios that exist:
1. Liquidity ratios: these look at the businesses ability to pay its debts and short-
term bills. It includes current ratio but students should also have an
understanding of the acid test ratio.
2. Profitability ratios: profitability ratios allow for the analysis of a firm’s profits in
relation to either its trading performance or in terms of the capital invested in
that company.
3. Efficiency ratios: these ratios will assess how efficiently management are
controlling operations and the day-to-day running of the business.

Liquidity ratios (1)
Current ratio = Current assets
Current liabilities
e.g. a figure of 2.45 means that the business has £2.45 of current assets for each
£1 of current liabilities that it owes.
A current ratio of less than 2 means that the business may have liquidity problems.
If the ratio is less than 1, this means that the business has fewer current assets
than current liabilities — a serious problem.

Liquidity ratios (2)
How to improve the liquidity ratios?
If the ratio is low then the business needs to bring more cash into the
business. It can do this in the following ways:
 selling under-used fixed assets
 postponing planned investments
 raising more share capital

Student task: liquidity
Analyse the following two businesses and assess the health of their liquidity
position:
Clothes retailer
Current ratio 1.8
Acid test ratio 1.2
Supermarket
Current ratio 2.4
Acid Test ratio 0.6

Profitability ratios (1)
Profitability ratios allow for the analysis of a firm’s profits in relation to its trading performance.
Gross profit margin
This calculation looks at the profit before overhead costs have been taken away
Gross profit margin = Gross profit x 100 = £50m x 100
Sales revenue £100m
e.g. a margin of 50% shows that for each £1 of sales, 50p gross profit is made.
This purely looks at trading, and the higher the figure the better. Although a 50% margin
sounds fantastic the business has not taken away any overhead expenses.

Operating profit margin
This considers the actual profits after all expenses have been taken away.
Operating profit margin = Operating profit x 100 £20m x 100
Sales revenue £100m
e.g. A margin of 20% shows that for each £1 of sales, 20p operating profit is made.
The highest possible percentage is preferred here. The operating profit establishes whether
the firm is efficient at controlling its expenses. If it has a falling operating profit margin it would
mean that expenses have increased and this will need to be investigated.

How to improve the profitability ratios?
If the ratio is low then the business needs to bring more cash into the
business. It can do this in the following ways:
 reduce material costs by sourcing cheaper suppliers
 reduce expenses
 increase the selling price

Student task: profitability
Analyse the following two businesses and assess the profitability as a result
of trading.
Supermarket A 2016 2017
Gross profit margin 28% 28.2%
Net profit margin 4.9% 2.7%
Supermarket B
Gross profit margin 32% 32.5%
Net profit margin 4.1% 8.9%

Efficiency ratios (1)
These ratios will assess how efficiently management are controlling operations and
the day-to-day running of the business:
Inventory turnover
This ratio measures how many times a year a business sells and replaces its stock.
A high inventory turnover figure means a business is frequently selling stock to
generate sales revenue.
Inventory turnover = Cost of sales £600m
Inventory held £50m
e.g. a figure of 12 means that the business sells their stock 12 times a year (once a
month)

Debtor days (receivables)
This simply measures how long it takes the company to collect debts owed by customers.
Debtor Days = Debtors x 365
Sales
e.g. a figure of 25 means that it takes the business an average of 25 days to collect payments
This figure shows how efficient management are at collecting outstanding debts. The shorter
the better and a low figure means that cash is boosted and this can help the liquidity ratios.
The figure should be compared to the credit days given by the company e.g. if they offer 45
days credit then a return of 25 days is very effective.

Creditor days (payables)
This measures how long it takes the business to pay its bills e.g. how long it takes to pay
suppliers.
Payable Days = Payables x365
Cost of Sales
e.g. a figure of 75 means that it takes the business an average of 75 days to pay suppliers
It must be noted that the business should not pay back the suppliers too quickly if credit days
are available as this will help their liquidity. However, accounts are published and any
potential suppliers will be aware of these figures and they will make decisions accordingly.

Gearing ratio
Gearing ratio = Non-current liabilities x 100
Total equity + Non-current liabilities
This shows the percentage of a business’s capital that has come from borrowing, e.g. if the
figure is 50% then it tells us that half of the capital invested in the business is from loans.
A percentage of over 50% is a high gearing ratio. A business that is too highly geared will
have to pay a lot of interest on its loans. In addition, it is very unlikely that banks will loan to
companies with high gearing ratios, so it can become very difficult to raise extra finance. The
only problem of a low gearing Ratio is that there are more shareholders to receive a share of
future dividends.

Student task: efficiency
Analyse the following two businesses and assess which one is performing
more efficiently.
Clothing retailer A
Payable days 58
Receivable days 30
Gearing 65%
Clothing retailer B
Payable days 22
Receivable days 24
Gearing 45%

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