Business Formulae

8/8/2019 Business Formulae

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Gross Profit Ratio

%Gross profit ratio (GP ratio) is the ratio ofgross profit to net sales expressed as a percentage

The basic components for the calculation of gross profit ratio are gross profit and net sales. Net salesmeans that sales minus sales returns. Gross profit would be the difference between net sales and cost of

goods sold

Gross profit ratio may be indicated to what extent the selling prices

of goods per unit may be reduced without incurring losses on

operations. It reflects efficiency with which a firm produces its

products. As the gross profit is found by deducting cost of goodssold from net sales, higher the gross profit better it is. There is no

standard GP ratio for evaluation. It may vary from business to

business. However, the gross profit earned should be sufficient to

recover all operating expenses and to build up reserves after

paying all fixed interest charges and dividends.

Gross Profit

SalesGross Profit Ratio =

Gross Profit


Gross Profit


Gross Profit



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Operating Profit RatioOperating Profit

SalesOperating Profit Ratio = %Operating profit ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is

generally expressed in percentage.

Operating profit ratio measures the cost of operations per of sales.

The two basic components for the calculation ofoperating profit ratio are operating cost (cost of

goods sold plus operating expenses) and net sales..

Operating ratio shows the operational efficiency of the business. Lower

operating ratio shows higher operating profit and vice versa. An

operating ratio ranging between 75% and 80% is generally consideredas standard for manufacturing concerns. This ratio is considered to be

a yardstick of operating efficiency but it should be used cautiously

because it may be affected by a number of uncontrollable factors

beyond the control of the firm. Moreover, in some firms, non-operating

expenses from a substantial part of the total expenses and in such

cases operating ratio may give misleading results.


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Return on Investment (ROI)

The return on investment measures the rate of return that investment managers are able to generate on their

assets

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a

number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of

the investment; the result is expressed as a percentage

The calculation for return on investment and, therefore the definition, can be modified to suit the situation - it all

depends on what is considered as the Investment = often, share capital is used

%

Return on investment tells you the percentage return you have made over a specified

period as a result of investing in a business.

Return on Investment (ROI) analysis is one of several commonly used approaches for

evaluating the financial consequences of business investments, decisions, or actions.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit

the user's purposes, and the result can be expressed in many different ways.

Distributable Profit

InvestmentReturn on Investment =Return on Investment =


InvestmentReturn on Investment =


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Interest Cover

This ratio relates the fixed interest charges to the income earned by the business. It indicates whether the

business has earned sufficient profits to pay periodically the interest charges.

Interest cover is a measure of the adequacy of a company's profits relative to interest payments on its debt. The

lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover interest

payments

A value of more than 2 is normally considered reasonably safe, but companies with

very volatile earnings may require an even higher level, whereas companies that

have very stable earnings, such as utilities, may well be very safe at a lower level.

Similarly, cyclical companies may well have a low interest cover but investors who

are confident of recovery may not be overly concerned by the apparent risk.

The interest coverage ratio is very important from the lender's point of view. Itindicates the number of times interest is covered by the profits available to pay

interest charges.

It is an index of the financial strength of an enterprise. A high debt service ratio or

interest coverage ratio assures the lenders a regular and periodical interest income.

But a weakness of the ratio may create some problems to the financial manager in

raising funds from debt sources.

Interest Cover =

Operating Profit

InterestInterest Cover =

Operating Profit

Interest


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Earnings Per Share

Earnings Per Share =Distributable Profit

NumberOf Shares

Earnings per share (EPS) is calculated by dividing the net profit after taxes by the total number of shares

The portion of a company's profit allocated to each share of stock in the companyEarnings per share serves as an indicator of a company's profitability

Earnings per share is generally considered to be the single most important variable in determining a

share's price

the viability of any business depends on the income it can generate. A money losing business willeventually go bankrupt, so the only way for long term survival is to make money. Earnings per share

allows us to compare different companies power to make money. The higher the earnings per share with

all else equal, the higher each share should be worth.

The earnings per share is a good measure of profitability and when compared with EPS of similar

companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio calculated

for a number of years indicates whether or not the earning power of the company has increased.

A positive trend ofEPS should be visible in order to make sure that the company is finding more ways to

make more money.Otherwise, the company is not growing and thus should be considered only if you areconfident that it can at least sustain its income.

Earnings Per Share =Distributable Profit

NumberOf SharesEarnings Per Share =


NumberOf SharesEarnings Per Share =


NumberOf Shares


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Return on Capital Employed =Operating Profit

Capital Employed

%Return on Capital Employed(ROCE)

The prime objective of making investments in any business is to obtain satisfactory return on capitalinvested. Hence, the return on capital employed is used as a measure of success of a business in realising

this objective.

Return on capital employed establishes the relationship between the profit and the capital employed. It

indicates the percentage of return on capital employed in the business and it can be used to show the overall

profitability and efficiency of the business.

Capital Employed = Share Capital + Reserves + Loans

Return on capital employed ratio is considered to be the best measure of

profitability in order to assess the overall performance of the business. It indicates

how well the management has used the investment made by owners and creditors

into the business. It is commonly used as a basis for various managerial decisions.

As the primary objective of business is to earn profit, higher the return on capital

employed, the more efficient the firm is in using its funds. The ratio can be found

for a number of years so as to find a trend as to whether the profitability of the

company is improving or otherwise.


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Gearing :

Gearing is the relationship between different types of funding of a businessGearing compares the shareholders equity (or capital) to borrowed funds. Gearing is a measure of financial

leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's

funds.

Gearing, called leverage in the US and some other countries, essentially measures the extent to which a

company is funded by debt

Debt = Long-term loans + Short-term loans + Overdraft

Equity = Total ShareholderEquity

The higher a company's degree of leverage, the more the company is considered risky - ahighly geared company is one where there is a high proportion of debt to equity, and can be

considered a risky investment as there is a higher likelihood of the company being unable to

pay its large debts. As for most ratios, an acceptable level is determined by its comparison to

ratios of companies in the same industry.

A high level of debt is a cause for concern, but it does accelerate profit growth as well as

declines. Companies with more stable operating profits can safely take on higher levels ofdebt, so what is acceptable depends on the business.

Financial Gearing =Debt

Equity


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Current Ratio :Current Ratio =

Current Assets

Current Liabilities

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations

It is a measure of general liquidity and is most widely used to make the analysis for short term financial

position or liquidity of a firm. It is calculated by dividing the total of the current assets by total of the current

liabilities.

This ratio is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushionavailable to the creditors

A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current

obligations in time and when they become due. On the other hand, a relatively low current ratio

represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current

liabilities in time without facing difficulties. An increase in the current ratio represents improvement in the

liquidity position of the firm while a decrease in the current ratio represents that there has been adeterioration in the liquidity position of the firm. A ratio equal to or near 2 : 1 is considered as a standard

or normal or satisfactory. The idea of having double the current assets as compared to current liabilities

is to provide for the delays and losses in the realization of current assets. However, the rule of 2 :1

should not be blindly used while making interpretation of the ratio. Firms having less than 2 : 1 ratio may

be having a better liquidity than even firms having more than 2 : 1 ratio. This is because of the reason

that current ratio measures the quantity of the current assets and not the quality of the current assets. If

a firm's current assets include debtors which are not recoverable or stocks which are slow-moving or

obsolete, the current ratio may be high but it does not represent a good liquidity position.


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Acid-test Ratio or Liquid Ratio : Acid-test Ratio =

Current Assets - Stock

Current Liabilities

Liquid ratio or Acid Test Ratio or "Quick Ratio is the ratio of liquid assets to current liabilities. The true

liquidity refers to the ability of a firm to pay its short term obligations as and when they become due.

A stringent test that indicates whether a firm has enough short-term assets to cover its immediate

liabilities without selling inventory as stock is considered the least liquid of current assets.

The acid-test ratio can be far more true than the current ratio, primarily because the current ratio allowsfor the inclusion of inventory assets.

The acid test ratio is very useful in measuring the liquidity position of a firm. It measures the firm's capacity to pay

off current obligations immediately and is more rigorous test of liquidity than the current ratio. It is used as a

complementary ratio to the current ratio. Liquid ratio is more rigorous test of liquidity than the current ratio because

it eliminates inventories and prepaid expenses as a part of current assets. Usually a high liquid ratios an indication

that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low

liquidity ratio represents that the firm's liquidity position is not good. As a convention, generally, a quick ratio of"one to one" (1:1) is considered to be satisfactory.

Although liquidity ratio is more rigorous test of l iquidity than the current ratio, it should be used cautiously and 1:1

standard should not be used blindly. A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position of

the firm if all the debtors cannot be realized and cash is needed immediately to meet the current obligations. In the

same manner, a low liquid ratio does not necessarily mean a bad liquidity position as inventories are not

absolutely non-liquid. Hence, a firm having a high liquidity ratio may not have a satisfactory liquidity position if it

has slow-paying debtors. On the other hand, A firm having a low liquid ratio may have a good liquidity position if it

has a fast moving inventories. Though this ratio is definitely an improvement over current ratio, the interpretationof this ratio also suffers from similar limitations as of current ratio.


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DepreciationCost of asset Residual value

Useful lifeStraight-line depreciation =

= Amount to be depreciated per year

Depreciation is a method which spreads the cost of a non-current (fixed) asset over its

useful life based on the matching principle when recording non-current (fixed) assets inaccrual accounting

A non-current (fixed) asset is a long term asset with a life of generally more than 1

year the company controls and gets future benefit from these non-current (fixed)

assets beyond the scope of the current financial year

The cost of a non-current (fixed) asset should be written off over its useful life this is

depreciation (for tangible assets) or amortisation (for intangible assets) which is a non-cash expense

Depreciation is required due to the fact that expensing a non-current (fixed) asset for

solely the financial year within which it was bought would severely distort the profits for

the year this is not fair to charge the full price of the non-current (fixed) asset as an

expense in the year of purchase as it will be used over future years to generate income

for the business (taking into account the matching principle)


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The Business Cycle

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over severalmonths or years.

These fluctuations occuraround a long-term growthtrend, and typically involveshifts over time betweenperiods of relatively rapid

economic growth (expansion orboom), and periods of relativestagnation or decline(contraction or recession)


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Limitations of Ratios and Formulae

when Analysing Financial Data and

Reports

It is important not to rely on any one

financial measure, but to use it inconjunction with statement analysis and

other measures.

Documents

Business Formulae