Earning capacity ratios

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Earning capacity ratios

  1. 1. Ratios 1
  2. 2. The analytical technique of ratio analysispermits businesses to study end of periodreports in order to base decision making forthe future. 2
  3. 3. RATIOS Presented as % or as ratios Assist in:  Decision making  Interpreting financial figures  Assessment of enterprise’s:  Profitability  Stability  Effectiveness 3
  4. 4. ProfitabilityProfitability is the ability to earn income within thepresent financial structure of the enterprise 4
  5. 5. Profitability Ratios• Gross Profit Ratio• Net Profit Ratio• Return on Equity Ratio 5
  6. 6. Gross Profit RatioIndicates the ability of abusiness to retain profit Gross Pr ofit x100from sales NetSalesCompare result toindustry benchmarks todetermine suitability ofbusiness performance 6
  7. 7. Result indicates: for every $ of sales – indicates the number of cents retained as gross profit how effective business is in passing on increases in COGS to customers 7
  8. 8. High result may indicate: ability of business to cover all expenses capacity to earn acceptable net profit and return to ownerLow result may indicate inability to: meet further expenses Return acceptable net profit return satisfactory rate to owner 8
  9. 9. Recommendations Improve 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. 9
  10. 10. Institute policy to lower COGS Investigate alternative suppliers selling similar quality products for less Take advantage of discounts offered to lower costs 10
  11. 11. Net Profit RatioIndicates theeffectiveness ofmanagers to minimiseexpenses per dollar ofsales Net Pr ofit x100 NetSalesCompare result toindustry benchmarks todetermine suitability ofbusiness performance 11
  12. 12. 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 12
  13. 13. High result may indicate: High operating revenue Low operating expensesLow result may indicate inability to: Inappropriate pricing policy Inadequate sales Inappropriate stock expenses too high 13
  14. 14. RecommendationsImprove Gross Profit• as per Gross Profit recommendationsMinimise expenses• Set budgets for departments Investigate alternative suppliers to lower costs As per Gross Profit recommendations 14
  15. 15. Rate of Return on EquityRatioIndicates the rate ofreturn generated by anentity on investment ofthe owner Net Pr ofitAim for a return of, around, Averageowner sequity x10014% which allows fundingfor future growth and a Owner sequitybegreturn on investment. /2 Owner sequityend 15
  16. 16. High result may indicate: Efficient operations 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 16
  17. 17. 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 managed inefficient management making poor decisions, lack of vision. 17
  18. 18. RecommendationsImprove net profit result using previousrecommendations.Check level of capital invested to ensureappropriateness for industry.  If under-capitalised owner should consider investing more funds into the business.  If over-capitalised owner should consider investing excess funds into alternative investments. 18

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