Ratio analysis is a valuable analytical technique that allows businesses to study end-of-period financial reports to inform future decisions. Ratios can be presented as percentages or ratios and are used to assess profitability, stability, and effectiveness. Key profitability ratios include gross profit ratio, net profit ratio, and expense-to-sales ratio. These ratios indicate ability to earn income, generate gross/net profit from sales, and control expenses. Higher ratios may suggest good performance while lower ratios could mean inability to cover costs or earn satisfactory profits. Recommendations include improving sales, minimizing costs of goods sold, and setting expense budgets.

1. Financial Reports and Ratios
Analytical Techniques

2. The analytical technique of ratio
analysis permits businesses to
study end of period reports in
order to base decisions for the
future.

3. Ratio Analysis
• Valuable tool for interpreting
financial ratios
• Efficient way to express
relationship of one number to
another

4. RATIOS
• Presented as % or as ratios
• Assist in:
– decision making
– Interpreting financial reports
– Assessment of enterprise’s:
• Profitability
• Stability
• Effectiveness

5. Ratios

6. Profitability
Profitability is the ability to
earn income within the present
financial structure of an
enterprise.

7. Profitability Ratios
• Gross profit ratio
• Net profit ratio
• Ratio of expenses to sales

8. Gross Profit Ratio
Indicates the ability of a
trading enterprise to
generate gross profit
from sales.
Gross Profit
x100
Compare result to Net Sales
industry benchmarks to
determine suitability of
business performance

9. 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

10. High result may indicate:
• ability of business to cover all
costs
• capacity to earn acceptable
net profit and return to owner
Low result may indicate inability
to:
• meet further costs
• return satisfactory net profit
• return satisfactory rate to
owner

11. 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.

12. Institute policy to minimise COGS
• Investigate alternative suppliers
selling similar quality products for
less
• Take advantage of discounts
offered to lower costs

13. Net Profit Ratio
•Indicates the ability of
a trading enterprise to
generate a return on the
owner’s investment.
Net Profit
•Compare result to x100
industry benchmarks to Net Sales
determine suitability of
business performance

14. • 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

15. High result may indicate:
• High operating revenue
• Low operating expenses
Low result may indicate inability to:
• inappropriate pricing policy
• inadequate stock
• inappropriate stock
• expenses too high

16. Recommendations
Improve sales
• as per Gross Profit
recommendations
Minimise expenses
• Set budgets for departments
• Investigate alternative suppliers to
lower costs
• As per Gross Profit
recommendations

17. Rate of Return on Equity
Ratio
Indicates the return to
the owner on the
amount invested in the
business
Net Profit
x100
Aim for a return of, Average Owner' s Equity
around, 14% which
allows funding for future
growth and a return on
investment.
( OE beg + OE end) /2 = Avg OE

18. 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

19. 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.

20. Recommendations
Improve net profit result using previous
recommendations.
Check level of capitalisation to ensure
appropriateness 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.