What is a ratio?
Essentially one number expressed in terms of another!
Ratios are used to analyse performance by taking data from the financial accounts (Profit and Loss Account AND / OR the Balance Sheet
Ratios can be used to assess the current year or examined historically!
Ratios can also be ‘benchmarked’ against other companies within the same industry for more meaningful results!
Ratio example
The goal is to understand who is the most efficient in marking and to express this efficiency as a ratio.
Results:
- Teacher A: Marks 90 books in 6 hours.
- Teacher B: Marks 80 books in 5 hours.
- Teacher C: Marks 120 books in 10 hours.
Question #1
Which teacher is the most efficient?
Now, we can compare the efficiency of the three teachers:
- Teacher A: 15 books/hour
- Teacher B: 16 books/hour
- Teacher C: 12 books/hour
The ratio of books marked per hour can be expressed as:
Teacher A : Teacher B : Teacher C = 15 : 16 : 12
Question #2
Do you give anybody a pay rise?
Looking at the above scenario, it might suggest that teacher B deserves a pay rise!
What other factors might need examining before you decide whether to give a pay rise or not?
GROSS PROFIT AND GROSS PROFIT MARGIN
QUESTION #3
Using the formula: Calculate the Gross Profit margin for 2024, 2025 and 2026 (predicted)
FORMULA
NET PROFIT AND NET PROFIT MARGIN
QUESTION #4
Using the formula: Calculate the Net Profit margin for 2024, 2025 and 2026 (predicted)
FORMULA
RETURN ON CAPITAL INVESTED (ROCE)
FORMULA
ROCE requires both the P&L and Balance Sheet
Loan capital = the sum of long term liabilities (all long term loans)
Share capital = can be found in the ‘Financed by’ section.
Retained Profit = can be found in the ‘Financed by’ section.
QUESTION #5
Calculate the return on capital investment for the business (using the profit and loss and balance sheet
LIQUIDITY RATIOS
Look at whether a firm can afford to pay its short term liabilities.
This is important to make sure a business has the ability to ‘stay afloat’. Lots of businesses go bust because they are asset rich and cash poor!
Essentially, having adequate liquidity means that you can pay your debts, pay your workers, which are called ‘working capital’!
A business could be profitable, selling lots of items and have assets and value – yet run out of money (liquidity)! This is very common.
CURRENT RATIO
Current ratio considers a firms liquid assets and whether or not is has enough to cover its short term debts.
It is generally accepted that a firm should have 1.5* the liquid assets (cash, debtors and stock) compared to its current liabilities (overdraft and creditors).
In fact, the desired ratio can be higher so we express it as 1.5 / 2 : 1
1.5 / 2 : 1
ACID TEST RATIO
Acid test is the same as ‘current ratio’ with one small difference!
Stock has been removed!
Stocks are dedicated here as they may not be very liquid (easily converted into cash). For example, stocks of high technology for whom there is no customer! Or, fashion goods that may not sell! Or, parcels of land that may take a long time to sell because they appeal to a small audience! Or, the economy is in recession and everybody is broke! The minimum ratio should be 1 : 1
Minimum ratio 1 : 1
QUESTION #8
Discuss the relative attractiveness of Jensen’s versus Viareggio to potential examining the ratios [6]
Comment on how these ratios could be improved [6]
SUGGESTED ANSWERS:
Question 1: Which teacher is the most efficient?
Teacher B @16 books per hour!
Question 2: Do you give anybody a pay rise?
The question is asking for other factors to be considered!
Teacher B is the most efficient, but what is the overall standard? Is it just tick and flick or is there serious marking going on?
What were the results last year in terms of books per hour marked?
How does these results compare to other departments?
Other factors are worth considering – beyond just the number presented.
Question 3: Using the formula, calculate the gross profit margin for 20024, 2025 and 2026
2024: $1,20000 – $600,000 = $600,000 (2024: 600,000 / 1,200,000 * 100 = 50% )
2025: $1,000,000 – $600,000 = $400,000 (2025: 400,000 / 1,000,000 * 100 = 40%)
2026 (predicted): $900,000 – $800,000 = $100,000 (2026 (predicted): 100,000 / 900,000 * 100 = 11.1%)
Question 4: Using the formula, calculate the net profit margin for 20024, 2025 and 2026
2024: 500,000 / 1,200,000 * 100 = 41.6%
2025: 300,000 / 1,000,000 * 100 = 30%
2026 (predicted): 50,000 / 900,000 * 100 = 5.5%
Question 5: Using the formula and information from BOTH the P&L and Balance Sheet, calculate the Return on Capital invested (ROCE)
ROCE = Net profit (before interest and tax) / Loan capital + Ordinary Share capital + Retained profits
300 / (100 + 160 + 400) * 100 = 45.45%
Question 6: Using the data given, calculate the current ratio for the business
Current assets / current liabilities: 450 / 250 * 100 = 1.8 : 1
Question 7: Using the data given, calculate the acid test ratio for the business
Current assets (stock) / current liabilities : 350 / 250 * 100 = 1.4 : 1
Question 8:
a) Discuss the relative attractiveness of Jensen’s versus Viareggio to potential examining the ratios [6]
Gross profit for both businesses has declined across the 3 year period.
Meanwhile – net profit has increased. This indicates a problem with COGS and the cost of goods sold! Viareggio has outperformed Jensen’s in this ratio – which indicates the cost control (cost of goods sold) has been better!
Both businesses improved their net profit though Viareggio by a greater (though negligible margin)!
The ROCE ratio has fallen for Jensen’s whereas Viareggio has seen a 3.4% increase! Over a 3 year period, neither ROCE value is good enough to compensate investors for the risk taken, but Viareggio has still outperformed Jensen’s. A ROCE value should equal (at the absolute minimum) the market rate of interest plus a risk factor payment. The ROCE values should be compared to a market average or industry average to show to what extent they underperformed!
In terms of quick ratio, both companies had slightly excessive levels of current assets (both over 2 : 1) which shows a degree of inefficiency. These excess current assets could have been better utilised elsewhere! Perhaps this could be linked to poor ROCE values!
However, by the end of the 3 year period, both businesses have reduced their ratio to acceptable levels (closer to 1 : 1).
Gearing ratio indicates that Jensen’s has the higher gearing, which suggests it carries a higher risk of default, higher debt repayment. Given the higher risk, the ROCE is worse because investors will be expecting to be compensated for taking a higher risk that comes with higher gearing,
b) Question 9: Discuss how these ratios could be improved [6]
Stock Turnover Days
- Reduce inventory levels: Implement just-in-time (JIT) stock management to avoid overstocking.
- Increase sales: Enhance marketing efforts or reduce prices to accelerate inventory turnover.
- Better forecasting: Use demand analysis to maintain optimal stock levels
- Creditor Days
- Negotiate longer payment terms: Work with suppliers to extend credit periods.
- Manage cash flow efficiently: Delay payments until the agreed due date without incurring penalties.
- Consolidate purchases: Increase bulk buying to gain favorable credit terms.
- Debtor Days
- Tighten credit policies: Shorten credit terms or require upfront payments.
- Improve collections: Send timely reminders or implement penalties for late payments.
- Screen customers: Assess creditworthiness before extending credit.
- Gearing Ratio
