ratios Flashcards
purpose of ratio analysis
It is sometimes hard to compare different organisations’ performance, or even the same firm’s performance over the years. One method used by businesses to compare their performance is Ratio Analysis.
limits of ratio analysis
profitability ratios
measure how much profit an organisation make
three types of profitability ratios
- Gross Profit Percentage Ratio
- Profit for the Year Percentage
- Return on Equity Employed
gross profit percentage ratios
Gross Profit Percentage Ratio works out the amount of profit from the buying and selling of goods before all other expenses are deducted.
The formula is:** (Gross Profit/Sales Revenue) x 100
**
Two ways of improving this is to:
- raise the selling price of the product
- negotiate deals with less expensive suppliers
profit for the year percentage
Profit for the Year Percentage works out the amount of profit made once all expenses are deducted.
The formula is: (Profit for the Year/Sales Revenue) x 100
Ways of improving this is to:
- decrease expenses, for example finding cheaper premises to rent
- increase the gross profit figurei
return on equity employed
Return on Equity Employed is the ratio often used by venture capitalists or investors such as the Dragons in Dragons’ Den.
This ratio calculates how much money an investor will get back after a period of time.
It is crucial that investors weigh up the amount they will receive from the investment with the risk involved and if they would have received as good a deal (or better) if they had left the money in a bank account accumulating interest.
The formula is:** (Profit for the Year/Opening Equity) x 100**
Two ways of improving this is to:
- increase sales
- reduce expenses
liquidity ratios
Liquidity ratios calculate the organisation’s ability to turn assets into cash in order to pay debts.
types of liquidity ratios
- current ratio
- acid test ratio
current ratio
An ideal ratio of 2:1 is generally agreed. If the ratio is higher, 4:1 it could mean that the firm is inefficient and has too much money tied up in stock. On the other hand, a lower ratio value of 1:1 would mean that it may not be able to meet its debts quickly.
The formula is: current assets: current liabilities
acid test ratios
Acid test ratio is a more severe test of a firm’s capabilities to meet its debts. The formula is the same as the current ratio but with the added problem of writing off all stock. This is because it assumes that stock:
- may be perishable
- may go out of date
- may go out of fashion or become obsolete
In other words, the firm may be left with stock it cannot sell. An ideal value of 1:1 is generally accepted.
The formula is: (current assets – closing inventory): current liabilities
Rate of inventory turnover
Rate of inventory turnover is an efficiency ratio which determines how quickly a firm goes through its stock.
A high stock turnover is preferable as this means stock is selling – marketing and purchasing are doing their jobs properly!
If stock turnover is low then this means stock is not being bought and there may be many reasons such as:
- poor quality of goods
- poor customer service
- poor advertising
- The formula is: Cost of sales:Average inventory
