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Introduction to Ratio Analysis

Introduction to Ratio Analysis. Higher Grade Business Management 2009. Why Do We Need Ratios?. Taken on their own , figures from final accounts can be confusing . However, when financial ratios are used to analyse the information more closely, the figures become clearer .

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Introduction to Ratio Analysis

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  1. Introduction to Ratio Analysis Higher Grade Business Management 2009

  2. Why Do We Need Ratios? • Taken on their own, figures from final accounts can be confusing. • However, when financial ratios are used to analyse the information more closely, the figures become clearer. • Accounting ratios are used as a tool in the decision-making process and as an aid to financial interpretation and planning.

  3. Analysis is the Key! • Ratios are no use on their own. They must be compared to: • Previous ratios, in order to see trends. • Competitors, to check competitiveness.

  4. Types of Ratio • Ratios can inform us about three main areas of final accounts: • Profitability • Liquidity • Efficiency

  5. Types of Ratio • Profitability • Is the organisation earning more than it is paying in costs? • Liquidity • Does the organisation have enough money to pay its bills? • Efficiency • Is the organisation making best use of its resources?

  6. Types of Ratio: Profitability • Gross Profit Margin • Profit Mark-up • Net Profit Margin

  7. Types of Ratio: Liquidity • Current Ratio • Acid Test Ratio

  8. Types of Ratio: Efficiency • Return on Capital Employed • Rate of Stock Turnover

  9. Gross Profit Margin • This ratio relates gross profit to sales revenue: GP % = Gross Profit Sales Revenue x 100 1

  10. Gross Profit Margin • Using the example of Gill’s Gym Equipment Ltd for 2003: GP % = 90,000 (Gross Profit) 850,000 (Sales Revenue) = 10.6 % x 100 1

  11. Profit Mark-up • This ratio is used to calculate the gross profit as a percentage of cost of goods sold: Profit Mark-up % = Gross Profit Cost of Goods Sold x 100 1

  12. Profit Mark-up • Using the example of Gill’s Gym Equipment Ltd for 2003: Profit Mark-up % = 90,000 (Gross Profit) 760,000 (Cost of Goods Sold) = 11.8 % x 100 1

  13. Net Profit Margin • This ratio relates net profit to sales revenue: NP % = Net Profit Sales Revenue x 100 1

  14. Net Profit Margin • Using the example of Gill’s Gym Equipment Ltd for 2003: NP % = 25,000 (Net Profit) 850,000 (Sales Revenue) = 2.9 % x 100 1

  15. Current Ratio • The Current Ratio is also known as the Working Capital Ratio. • The Current Ratio is used to indicate a business’s ability to meet its short term debts without having to borrow money.

  16. Current Ratio • The formula for the Current Ratio is: Current Assets : Current Liabilities • For Gill’s Gym Equipment in 2003: 550 : 250 This can be simplified: 2.2 : 1

  17. Acid Test (Quick) Ratio • 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. (Current Assets - Stock) : Current Liabilities

  18. Acid Test (Quick) Ratio • Using the example of Gill’s Gym Equipment Ltd for 2003: Acid Test = (550 - 300) : 250 = 1 : 1

  19. Return on Capital Employed • Return on capital employed relates profitability to the capitalinvested in a business: ROCE % = Net Profit Capital Employed x 100 1

  20. Return on Capital Employed • Using the example of Gill’s Gym Equipment Ltd for 2003: ROCE % = 25,000 (Net Profit) 900,000 (Capital Employed) = 2.8 % x 100 1

  21. Stock Turnover Ratio • The purpose of this ratio is to give the number of times per period that the average stock is sold. Stock Turnover = Cost of Sales Average Stock Average Stock is calculated by adding the opening and closing stocks together and dividing by 2

  22. Stock Turnover Ratio • Using the example of Gill’s Gym Equipment Ltd for 2003: Stock Turnover = 760,000 275,000 = 2.76 Times Note: Average Stock = (250 + 300) / 2 = 275

  23. Uses of Ratio Analysis • Ratio analysis can provide the following information: • Current performance relative to previous performances (intra-firm). • Current performance relative to that of competitors (inter-firm). • Why performance changes occur and how to improve. • Information for budgeting.

  24. Limitations of Ratio Analysis • Accounting information used is historical and so can be irrelevant to the future. • Any comparisons must be made with firms of similar size in the same industry. • Findings may not take into account external factors. • Different stock valuation methods can result in different figures. • Ratios do not show other elements such as staff morale or staff turnover.

  25. Task • Calculate the ratios that we have covered today for Gill’s Gym Equipment Ltd in 2004.

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