Ratio Analysis
GCSE Business Studies
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Revision Presentations 2004
Introduction
Analysing financial performance is about judging the successes and
failures of a business by considering a number of financial
measures. Most of these measures are known as ratios.
A ratio is a measure of one piece of information in terms of
another
A non-financial ratio might be the numbers of boys to girls in a class,
or the number of GCSE passes in business studies as a percentage
of all the GCSE passes in the school.
Ratios are normally compared with the previous years’ figures or
with figures from competitors to see whether the business has
improved or not and whether it is better or worse than a rival.
The main areas that ratios look at are:
 Profitability
 Financial efficiency
 Liquidity
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Who Might Use Ratio Analysis
Anyone with an interest in the financial performance of the
business will find ratio analysis useful
Owners/shareholders (e.g. return on investment; profitability
ratios)
Employees (e.g. profitability ratios)
Managers (the full range)
Creditors and banks (e.g. liquidity ratios)
Competitors (profitability and liquidity ratios)
Government (e.g. the Inland Revenue – who calculate how
much tax is due by a business)
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Profit and Profitability
Profit is an absolute measure – it equals sales revenue less
costs
Profitability is a relative measure – it shows amount of profit
“relative” to what created profit
e.g. ROCE investment ratio measures relative profitability of a
business compared with amount of capital invested in
business.
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Profitability Ratios
What are they?
 Gross profit margin
 Operating profit margin
Why use them?
 Insights into how well the business is trading in its markets
 Is sales revenue being maximised?
 Are costs being kept under control?
 Analyse and spot favourable and unfavourable trends
 Compare performance with competitors
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Gross Profit Margin
Calculation
 Gross profit divided by sales (expressed as a percentage)
Why it might increase
 Increase in selling price of existing products
 Introduction of new products which achieve a higher gross profit
margin
 Reduction in cost of sales e.g. a fall in raw material prices
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Gross Profit Margin - Example
Jan
£'000
Feb
£'000
Mar
£'000
Apr
£'000
Sales Revenue
1000
1250
1400
900
Cost of Sales
Raw Materials
Labour Costs
Packaging
Total costs
250
300
25
575
300
315
30
645
325
325
35
685
225
295
20
540
Gross Profit
425
605
715
360
42.5%
48.4%
51.1%
40.0%
Gross Profit Margin
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Return on Capital Employed (“ROCE”)
How calculated:
 Net profit as a percentage of capital employed
Also known as primary efficiency ratio - a better indicator than
profit alone of how well a business is using money invested
Shows how much profit is being generated from investment
compared with alternative investments in similar businesses
or with interest from bank deposits
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ROCE Example
1999
£'000
2000
£'000
2001
£'000
2002
£'000
Fixed Assets
5000
5000
5250
5400
Current Assets
Stocks
Debtors
Cash
Creditors
1100
1500
350
-750
1015
1600
300
-800
1200
1750
400
-825
1250
2000
375
-860
Net Assets
7200
7115
7775
8165
800
750
850
925
11.1%
10.5%
10.9%
11.3%
Profit Before Tax
ROCE
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What does ROCE Tell Us?
Three main things to look for
 The change in ROCE from one year to the next
 The ROCE earned by other companies (if this information is
available)
 A comparison of the ROCE with the cost of borrowing money
(i.e. is the business making a ROCE that makes borrowing
worthwhile?)
Ways to increase ROCE
 Increase net profits without increasing or introducing new
investment
 Reduce amount invested in business by selling assets that do
not contribute to profit earned
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Net Profit Margin
How calculated
 Amount of net profit generated per pound of sales
 Calculated as net profit divided by total sales (or revenues)
 Expressed as a percentage
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Net Profit Margin - Example
2000
£'000
2001
£'000
2002
£'000
10,150
4,250
12,535
4,700
15,100
5,950
Gross profit
5,900
7,835
9,150
Less expenses
4,235
5,675
6,480
Net profit
1,665
2,160
2,670
Gross Profit Margin
58.1%
62.5%
60.6%
Net Profit Margin
16.4%
17.2%
17.7%
Revenue
Less cost of sales
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Liquidity Ratios
Concerned with ability of business to pay its debts
Ratio of short-term liabilities to liquid assets
Indicate ability of business to cover its short term liabilities
Liquid assets are those assets that held in cash form (e.g.
cash at bank) or can be turned into cash very quickly
Main ratios:
 Current ratio
 Acid test ratio
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Current Ratio
Calculation: Current assets divided by current liabilities
Interpretation
How to improve the current ratio
 Increase value of profitable sales
 Turn its overdraft into a long term loan (reduces short-term
liabilities and increases capital)
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Acid Test Ratio
Liquidity ratio – similar to current ratio
It is a tougher test of liquidity
Stock takes longer to turn into cash – so are excluded from
current assets in calculation
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Stock Turnover
Number of times stock is turned into sales
Higher figure, more quickly stock has been sold or turned
over
A fruit stall will have a higher figure of stock turnover than a
car dealership
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Reasons for an Increase in Stock
Turnover
Lower stock levels
Disposal of slow moving or obsolete stock
Reduction in range of products stocked
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Debtor Days
Working capital ratio
Number of days it takes for a business to collect money from
customers who have bought products on credit
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Encouraging Debtors to Pay Quicker
Offer discounts for early payment
Threaten to take customer to court
Refuse to supply more products or hold back part of an order
until payment has been made
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Creditor Days
Number of days it takes for business to pay creditors.
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