3.3.5+Financial+ratios

Financial Ratios **General information on ratios**

What can we find out from ratios and our financial accounts
 * Is the business profitable? (managers, shareholders and workers)
 * Can the business pay its bills? (suppliers)
 * How does this year compare to last year?
 * How does our performance compare with our competitors? (managers)
 * = How does the business compare to the industry norms? (managers) =

There are 2 main categories of ratio:


 * Profitability ratios ** - these include Return on Capital Employed, Net Profit Margin and Gross Profit margins. These are used to assess how profitable the company is.
 * Short-term liquidity ratios ** - these include the current ratio and the acid test ratio and measure how easily the company can meet its short-term financial commitments like paying its bills.

To fully analyse a set of accounts, you will need a reasonable knowledge of each or these types of ratio, so try to work gradually through the explanations and worksheets to build up your understanding.

=Short Term Liquidity Ratios - Explanation=

Short-term liquidity is the ability of the company to meet its short-term financial commitments. Short-term liquidity ratios measure the relationship between current liabilities and current assets. Short-term financial commitments are current liabilities, which are typically trade creditors, bank overdrafts Tax and any other amounts that must be paid within the next twelve months. Current assets are stocks, debtors and cash that would normally be used to pay current liabilities.

The formulae for the key short-term liquidity ratios are given below.


 * Current Ratio ** = Current assets/ Current liabilities- ideally should be 1.5-2.5

Lower figures indicate cash flow and liquidity problems, and may mean that firms cannot meet their short term debts and may be forced into receivership.
 * Acid Test Ratio ** = Current assets – stock/Current liabilities ideally between 1-1.5

** Working capital :** is another measure of liquidity in a business. This is current assets-current liabilities. Without working capital to pay for short term debts, it can go out of business.

 * Profitability ratios - Explanation **

The level of profit on its own may provide an indication of the size of the business, but on its own it says very little about company performance. In order to evaluate the level of profit, profit must be compared and related to other aspects of the business. Profit must be compared with the amount of capital invested in the business, and to sales revenue. Profitability ratios will inevitably reflect the business environment of the time. So, the business, political and economic climate must also be considered when looking at the trend of profitability for one company over time. Comparisons with other businesses in the same industry segment give an indication of how well the management are performing compared to other firms in the same business environment.

The formulae for the key profitability ratios are given below.

ROCE can also be compared with previous years, rival firmsand its own predetermined targets
 * Return on capital employed (ROCE) ** = Net profit /Total Capital Employed x 100

Can be compared with other possible uses of finance such as rate of interest. Could you have got more from simply putting your money in the bank?


 * Gross profit margin ** =Gross profit /Sales revenue x 100


 * Net profit margin ** =Net profit /Sales revenue x100

The higher the gross and / or net profit margins, the better.


 * Student activity P118-121**