Ratio Introduction 100 CMD

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Ratio Introduction 100 CMD

  1. 1. Introduction to Ratio Analysis Higher/Int 2 Business Management 2009-2010
  2. 2. Why Do We Need Ratios? <ul><li>Taken on their own , figures from final accounts can be confusing . </li></ul><ul><li>However, when financial ratios are used to analyse the information more closely, the figures become clearer . </li></ul><ul><li>Accounting ratios are used as a tool in the decision-making process and as an aid to financial interpretation and planning . </li></ul>
  3. 3. Analysis is the Key! <ul><li>Ratios are no use on their own. They must be compared to: </li></ul><ul><ul><li>Previous ratios , in order to see trends . </li></ul></ul><ul><ul><li>Competitors , to check competitiveness . </li></ul></ul>
  4. 4. Types of Ratio <ul><li>Ratios can inform us about three main areas of final accounts: </li></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Efficiency </li></ul></ul>
  5. 5. Types of Ratio <ul><li>Profitability </li></ul><ul><ul><li>Is the organisation earning more than it is paying in costs ? </li></ul></ul><ul><li>Liquidity </li></ul><ul><ul><li>Does the organisation have enough money to pay its bills ? </li></ul></ul><ul><li>Efficiency </li></ul><ul><ul><li>Is the organisation making best use of its resources ? </li></ul></ul>
  6. 6. Types of Ratio: Profitability <ul><li>Gross Profit Margin </li></ul><ul><li>Profit Mark-up </li></ul><ul><li>Net Profit Margin </li></ul>
  7. 7. Types of Ratio: Liquidity <ul><li>Current Ratio </li></ul><ul><li>Acid Test Ratio </li></ul>
  8. 8. Types of Ratio: Efficiency <ul><li>Return on Capital Employed </li></ul><ul><li>Rate of Stock Turnover </li></ul>
  9. 9. Gross Profit Margin <ul><li>This ratio relates gross profit to sales revenue : </li></ul><ul><li>GP % = Gross Profit </li></ul><ul><li>Sales Revenue </li></ul>x 100 1
  10. 10. Gross Profit Margin <ul><li>Using the example of Gill’s Gym Equipment Ltd for 2003: </li></ul><ul><li>GP % = 90,000 (Gross Profit) </li></ul><ul><li>850,000 (Sales Revenue) </li></ul><ul><li>= 10.6 % </li></ul>x 100 1
  11. 11. Profit Mark-up <ul><li>This ratio is used to calculate the gross profit as a percentage of cost of goods sold : </li></ul><ul><li>Profit Mark-up % = Gross Profit </li></ul><ul><li>Cost of Goods Sold </li></ul>x 100 1
  12. 12. Profit Mark-up <ul><li>Using the example of Gill’s Gym Equipment Ltd for 2003: </li></ul><ul><li>Profit Mark-up % = 90,000 (Gross Profit) </li></ul><ul><li>760,000 (Cost of Goods Sold) </li></ul><ul><li>= 11.8 % </li></ul>x 100 1
  13. 13. Net Profit Margin <ul><li>This ratio relates net profit to sales revenue : </li></ul><ul><li>NP % = Net Profit </li></ul><ul><li>Sales Revenue </li></ul>x 100 1
  14. 14. Net Profit Margin <ul><li>Using the example of Gill’s Gym Equipment Ltd for 2003: </li></ul><ul><li>NP % = 25,000 (Net Profit) </li></ul><ul><li>850,000 (Sales Revenue) </li></ul><ul><li>= 2.9 % </li></ul>x 100 1
  15. 15. Current Ratio <ul><li>The Current Ratio is also known as the Working Capital Ratio . </li></ul><ul><li>The Current Ratio is used to indicate a business’s ability to meet its short term debts without having to borrow money. </li></ul>
  16. 16. Current Ratio <ul><li>The formula for the Current Ratio is: </li></ul><ul><li>Current Assets : Current Liabilities </li></ul><ul><li>For Gill’s Gym Equipment in 2003: </li></ul><ul><li>550 : 250 </li></ul><ul><li>This can be simplified: 2.2 : 1 </li></ul>
  17. 17. Acid Test (Quick) Ratio <ul><li>The Acid Test Ratio is similar to the Current Ratio although it takes into account the fact that stock may take some time to be turned into cash . </li></ul><ul><li>(Current Assets - Stock) : Current Liabilities </li></ul>
  18. 18. Acid Test (Quick) Ratio <ul><li>Using the example of Gill’s Gym Equipment Ltd for 2003: </li></ul><ul><li>Acid Test = (550 - 300) : 250 </li></ul><ul><li>= 1 : 1 </li></ul>
  19. 19. Return on Capital Employed <ul><li>R eturn on capital employed relates profitability to the capital invested in a business: </li></ul><ul><li>ROCE % = Net Profit </li></ul><ul><li>Capital Employed </li></ul>x 100 1
  20. 20. Return on Capital Employed <ul><li>Using the example of Gill’s Gym Equipment Ltd for 2003: </li></ul><ul><li>ROCE % = 25,000 (Net Profit) </li></ul><ul><li>900,000 (Capital Employed) </li></ul><ul><li>= 2.8 % </li></ul>x 100 1
  21. 21. Stock Turnover Ratio <ul><li>The purpose of this ratio is to give the number of times per period that the average stock is sold . </li></ul><ul><li>Stock Turnover = Cost of Sales </li></ul><ul><li>Average Stock </li></ul><ul><li>Average Stock is calculated by adding the opening and closing stocks together and dividing by 2 </li></ul>
  22. 22. Stock Turnover Ratio <ul><li>Using the example of Gill’s Gym Equipment Ltd for 2003: </li></ul><ul><li>Stock Turnover = 760,000 </li></ul><ul><li>275,000 </li></ul><ul><li>= 2.76 Times </li></ul><ul><li>Note: Average Stock = (250 + 300) / 2 = 275 </li></ul>
  23. 23. Uses of Ratio Analysis <ul><li>Ratio analysis can provide the following information: </li></ul><ul><ul><li>Current performance relative to previous performances (intra-firm). </li></ul></ul><ul><ul><li>Current performance relative to that of competitors (inter-firm). </li></ul></ul><ul><ul><li>Why performance changes occur and how to improve. </li></ul></ul><ul><ul><li>Information for budgeting . </li></ul></ul>
  24. 24. Limitations of Ratio Analysis <ul><li>Accounting information used is historical and so can be irrelevant to the future. </li></ul><ul><li>Any comparisons must be made with firms of similar size in the same industry . </li></ul><ul><li>Findings may not take into account external factors . </li></ul><ul><li>Different stock valuation methods can result in different figures. </li></ul><ul><li>Ratios do not show other elements such as staff morale or staff turnover . </li></ul>
  25. 25. Task <ul><li>Calculate the ratios that we have covered today for Gill’s Gym Equipment Ltd in 2004. </li></ul>

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