Ratio Analysis Ordinary Levels

8/14/2019 Ratio Analysis Ordinary Levels

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Uses of ratios

When assessing the performance of a business, we will normally use thefinancial data to make this assessment. Profits are the main yardstick use toassess whether a firm has performed well or poorly. However, profits alone willnot tell us too much.

For example, if a firm earned a profit in one year of 15,000, could we tell if thefirm had performed well? Actually, we would probably need to know much moreabout the firm and the industry it operated in, as well as the prevailing economicand other external factors that affected the firm.

Before we even begin to look at how assessment is performed, we should first ofall consider how we are going to use the data. One year's worth of information isnot normally enough. We will need some other standard to measure our dataagainst. The following basis of comparison are often used when assessing

performancePast performance

Comparison of present performance with previous year's performance will tell usa lot about the direction the firm is moving in - is it improving worsening ormaintaining performance levels compared with earlier years? Ideally a number ofprevious year's data can be used to establish a trend performance (the overalldirection after taking into account minor fluctuations, although two years offigures may shed some light on which way the firm is moving).Industry analysis

Comparing one firm's performance with another is a meaningless activity unless

the firms are similar. It would be no use comparing a giant multinational with asmall butcher for instance. Comparison of firm operating in the same industrywill give us much more meaningful information about how a firm is performingcompared with rival competitions. This will be even more meaningful the firmsare of similar size (measured in either turnover or capital employed). Industryanalysis also allows us to see how firms are coping with changes in externalfactors that affect them in a similar way. For example, analysing how footballclubs have coped with the collapse of ITV digital, or how mobile phonecompanies are coping with the slow take up of third generation phones.

Ideally, we could combine the analysis of past performance and industry analysis

to see how the industry as a whole has performed over a number of years. Thiswill provide valuable information to see which firms are struggling and whichfirms are managing to perform well in the circumstances. For example, if profitshave been rising over a number of years then this may seem an indicator ofgood performance. However if other firms have seen profits rise even morequickly, them the good performance would have to be called into question.

Ratio analysis

Assessing the performance of a business requires us to be very clear in actuallydefining what we are trying to assess. In most cases, profits are seen as the

main objective of any firm. However, there are many other areas of a firm that,


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although not directly affecting profit, will have an indirect affect of theprofitability of the firm.

To assess the performance of the firm profits alone cannot tell us muchinformation. We need some standard to assess items, such as profits, sales and

so on. Ratio analysis is the combination of figures from the financial statementsof the firm (profit and loss accounts and balance sheets) into a format where

judgements can be made on the overall performance of the firm. For example,comparing profits to sales or profits to capital will allow us to see how effectivethe firm is in generating profits out of sales. Alternatively, comparing profits tocapital gives us some idea of profits in relation to the size of the firm. A ratio issimply two or more figures compared with each other to produce an overallresult, which is more meaningful than the original figures alone.

Ratios require formulas to be memorised. There are a number of different ratiosthat can be used to assess different areas of the firm. Ratios are thereforegrouped according to type, or area.

Pro fitability ratios

These ratios focus specifically on the profits of the firm (both gross and netprofits). The profits are compared with sales, capital to provide some standardfor comparison. These ratios in this group are as follows:

Return on capital employedGross profit margin (gross profit in relation to sales)Net profit margin (net profit in relation to sales)

Mark-up

Liquidity

Liquidity is a measurement of whether the firm has enough cash available forimmediate use. These ratios focus on the ability of the firm to meet day-to-dayrunning requirements. They look at the liquid resources (resources easilyconvertible to cash) and compare these with the short-term debts of the firmthat will require payment in the next few weeks or months. Many small or newfirms find liquidity to be one of their greatest problems. The ratios used to

assess liquidity are as follows:

Current ratio (net current asset ratio)Acid test ratio (liquid capital ratio)

Liquidity ratios are sometimes known as solvency ratios


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W ay s to imp rov e l iquid ity i f current ra t io is less than 2 : 1

If the working capital ratio is below the benchmark level 2:1 this means that the firm is not

in the safe side and might face problems is meeting its liabilities as they fall due. The firm

might need to take quick and immediate actions to rectify the situation or face the threat of

going out of business. The business can improve the liquidity in the following ways:

a) Sell of surplus fixed assets: a firm can improve its liquidity by selling off surplus fixed assetsand raise additional cash to solve the cash flow problems. However selling of fixed assets

might result in inefficiency.

b) Convert bank over draft into long term loans: converting overdrafts into loan might be agood option for a firm facing liquidity problems as the obligation of payment will be delayed.

Furthermore profitability will also improve as interest rate for loan is usually lower than that

of an overdraft.

c) Making debtors pay early: a firm can also try to persuade debtors pay early and settle thecreditors as they fall due.

d) Delaying payments to creditors: delaying payment might be short term measure to resolvethe ongoing working capital problems. However this might result in creditors refusing to

supply goods resulting in stock outs and loss of sales.

e) Reduce bad debts: a firm can try to reduce bad debts by checking on the customerreferences before providing credit. This will help them cut down on the bad debts and

achieve profits and safer liquidity position.

W ay s to impr ove l iquid i ty i f current ra t io is m ore than 2: 1

If the working capital ratio is more than the ideal position of 2:1 it signifies that the firm has more

than necessary assets which are lying idle and optimum return from those assets is not being

earned. Having a more than 2:1 ratio means that the firm is not being able to utilise the potential

and should do more investments to improve profitability as well as liquidity. Some of the ways in

which a firm can do so are:

a. Invest in more profitable ventures: having a high current ratio means that the business hassurplus assets and can be used in other profitable ventures and boost profitability and

liquidity of the business as well.b. Repay any loans: the business can also get the situation under control by repaying any loans

early and save itself from excessive interest payments.

c. Delay payments to creditors: the firm can also try to delay the payments to creditors andinvest in other areas which will bring in higher returns.

d. Purchase fixed assets: buying fixed assets which will reduce the operating expenses mightbe an appropriate way to utilise the excess assets available and also boost profitability

through falling expenses.


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W ay s to impr ove gross pr of i t ma rgin:

If the gross profit margin is low this means that the firm is not being able to charge the

amount of prices it should be charging or the cost of product is high. The following measures

can be used to improve gross profit margin:

a. Better ordering techniques: a firm can undertake an efficient ordering technique tominimise the cost of carriage and reduce the cost of goods.

b. Bulk buying: buying in bulk always leads to huge trade discounts and favourable termswhich can crucial for a firm looking for ways to improve its gross profit margin.

c. Trade discounts: the business can offer trade discounts to encourage sales in biggerquantities and thus help to increase the gross profit.

d. Newer, fashionable stocks: the firm can also provide goods which are fashionable andthe customers would be willing to pay more for the stocks. This is more applicable to

firms dealing in fashionable items such as women wear, shoes etc.

e. Better payment terms with the suppliers: the firm can also try to pay the creditors earlyto qualify for cash discounts and persuade them for other facilities like delivery, aftersale service to minimise costs and maximise profits.

Efficiency

There are other ratios, which are more likely to be used by internal groups to thefirm (i.e. mangers and directors) for assessing performance. Although theseratios do not look specifically at profits, these ratios will measure the overallfinancial efficiency of the firm which could eventually affect profits. Commonareas to assess are how a firm manages its stockholding, or its debtor andcreditor control. Also, how efficient the firm is in controlling expenditure will alsobe assessed with these ratios. The activity ratios will cover:

Stock turnover (stock turn)Debtor collection period (debtor days)Creditor collection period (creditor days)Turnover in relation to fixed assetsTurnover in relation to net current assetsOverheads in relation to turnover

Profitability ratios

For most firms, achieving profits are the main goal of the organisation. In limitedcompanies this is even more likely to be the case. This is because the companyis owned by shareholders who, expect possibly in the case of private limitedcompanies, have purchased shares with the aim of maximising their returns. Theprofitability ratios will analyse accounts from the perspective of the size of theprofits, and then compare these profits to other figures.


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Return on capital employed

Have a go at working this out for Buzz and then follow the link below to see howyou got on.

Pro fit margins

Both the gross profit margin and the net profit margin are calculated in a verysimilar way (the only difference is in the measure of profits used in the ratio -gross and net profits). It makes sense to consider these ratios together, as theywill often be affected in the same way by changes affecting the firm.

The formulae for the profit margins are as follows:

Gross profit margin - what does this tell us?

This ratio compares gross profits to the sales revenue. It tells us how much ofthe sales revenue earned actually consists of gross profits - and therefore, howmuch consist of costs of goods sold.

Net profit margin - what does this tell us?

Similar to the gross profit margin, this ratio compares the net profit to the salesrevenue. This tells us how much (as a percentage) or the firm's sale revenue is

made up of net profits.What do falling profit margins mean?

The reason for a falling profit margin means that the 'gap' between sales and themeasure of profit has narrowed. This could be due to one or more of thefollowing:

Selling prices have fallenCosts have increased

Imagine if the firm reduced its selling price to boost sales volume. This may lead

to higher profits. However, the profits on each sale made will be lower due to the


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lower selling price. This would lead to an overall reduction in the net and grossprofit margins - even though profit levels have risen.

It is possible that the falling profit margins would be part of the firm's policy.However, it may also be the case that profit margins fall due to circumstances

beyond the firm's control.

Possible reasons are as follows

Higher cost of materials or higher labour costs in productionLower selling prices - possible due to a promotional campaign or other specialofferIncreased competition forcing prices downSwitch from profit maximisation to sales maximisation (i.e. price cuts)

Supermarkets operate with very low profit margins. Supermarkets, however, arevery profitable. This is because, although they earn very little profits on each'unit' sold, there output is sold at a very rapid rate - thus the overall profitsquickly build up.

An antique dealer would not expect sales to be achieved in such as rapid rate.This means that the antique dealer would probably have to charge high sellingprices - which mean a higher profit margin - in order to compensate for theslower rate of sales. This means that profits build up at a slower rate, but inbigger steps.

Mark-up & margin

The terms mark-up and margin are frequently used by those in business andaccounting, often in an incorrect manner. Each of these terms refers to therelationship between the selling price of output and the cost of that output.

Mark-up refers to the amount of profit added on to the cost of a unit of outputin order to set a selling price - normally added on a percentage of the cost

Margin refers to the amount of profit in the selling price of a unit of output -normally the percentage of the selling price that is profit

Both terms are looking at profits but from different perspectives, so there isbound to be some link between the two measures.

Both mark-up and margin are often expressed in percentage terms. Forexample, the phrase 'mark-up output by 20%' would mean that to set the sellingprice, the cost of the output is increased by 20%.


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The relationship can be summarised as follows:

Mark-up - Margin

Therefore

Or

Margin - Mark-up

Therefore

Efficiency ratios

These are mainly measures of financial control. They are rarely seen in mediaheadlines (or any other business stories) because they do not dramatically affectthe performance (either in profitability or liquidity) of the firm. As a result, theseratios are more likely to be of interest to internal stakeholders of the firm,(managers, budget holders, etc).

These ratios affect how efficiently the firm operates in terms of its workingcapital management. As stated earlier, these ratios do not directly affect profit,but improvements in these could affect future profitability.

Stock turnover

This ratio measure how quickly the firm 'turns over' (i.e. sells) its stocks. It,measures the rate of stock turnover in terms of the time the average holding ofstock is held by the firm.

The formula to calculate the stock turnover is as follows:

The average stock is simply the arithmetical mean of the opening and closingstock levels:

This will give us an answer in terms of the 'number of times' stock is sold duringa year.


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There are no 'ideal' figures for what a firm's stock turnover should be. Firms thatsell consumer goods (especially perishable goods - supermarkets for instance)would be expected to have a high stock turnover (perhaps as high as 100 ormore). Firms selling industrial goods, or slow moving consumer goods (jewellers,for instance) may have a lower stock turnover of less than 10.

There is a link here with the profit margins. As stated earlier, firms can operatewith low profit margins, if they have a rapid stock turnover. Firms with lowerstock turnover (a lower rate of sales) will need higher profit margins to'compensate'.

Debtors collection period and creditors payment period

These ratios measure how long the firm takes to settle its accounts with bothcustomers and suppliers. They give a result in terms of the average number ofdays taken by our debtors to pay us, and how long the firm takes on average topay its creditors.

There are no ideal figures for debtor days and creditor days (common alternativenames for these ratios). Most firms will offer free credit periods to other firms sowe would expect to see result of at least 30 days or more. A survey taken in thelast five years found that the average length for debtor days would in the UKwas over 70 days.

Main areas to look out for would be as follows:

Increase in the length of time taken to settle accounts

Debtors collection period rising far quicker than creditor payment period

The firm would be concerned if there was a large discrepancy between the timetaken to collect from debtors and the time taken to pay its creditors. Theseshould be roughly the same. A firm could reduce the debtor's day figures byoffering discounts (or larger discount if already offered) for immediate or promptsettlement of accounts.

The formulae used to calculate these ratios are as follows:

In most cases, all the purchases and sales will be on credit terms but be carefulnot to include cash sales or purchases in this ratio.

The result will be in the form of 'number of days' taken.


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Other efficiency ratios

The following ratios are used mainly to examine if the firm is controlling itsexpenses efficiently i.e. expenses are increasing disproportionately fast), or ifassets are being used effectively in generating sales.

The following ratios may be used for this purpose:Asset turnover ratio - turnover in relation to fixed assets

This shows how 'effectively' the net assets (total assets less total liabilities) ofthe firm are being used to generate turnover. It will depend on the industry, buta rising figure may indicate that assets are being used more efficiently togenerate extra sales.

===Turnover in relation to net current assets

Profitability and liquidity

The fact that a firm is profitable does not guarantee that it will have enoughcash to remain trading (being 'solvent'). It may seem surprising that a firm thatis making a profit or has made profits in the past can run out of cash, but thisdisbelief stems from a common misunderstanding of what the terms 'cash' and'profit' actually mean. People often assume that at the end of each year there isan amount of money in the firm's bank account equivalent to its profit and that

this can be withdrawn and spent by the owner(s) of the firm. However, it ismore likely that the profits will be tied up in many different areas of the firm. Forexample, the profit may have been used to acquire new equipment or stock; ifthe goods have been sold on credit the revenue may still be in the form ofdebtors. It is possible, therefore, for a firm to be profitable but to also be shortof cash because:

Differences between cash and profit

Many sales are on credit. These sales will be counted immediately towardsthe profit even though the cash from the sale may actually appear months

later. Accepting and order for sales may mean that a firm has to spend moreon production without generating the cash flow from the sale until muchlater. This problem is known as overtrading - where a firm experiences cashflow by accepting extra sales without the necessary cash flow to produce theoutput.

The firm may have invested heavily in capital items such as equipment.Although this will involve a cash outflow, the 'cost' of these assets in theprofit and loss account will be 'written off' as depreciation over the workinglife of the asset. This means that capital expenditure will affect cash flow notprofit.


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The firm may have invested in stocks. These will appear as an asset on thebalance sheet but will not appear as a cost until they are used up. The cashoutflow will occur when they are bought.

If a firm has paid for something in advance but not used it up yet (e.g. it has

paid for the use of some equipment or property in advance) this will reducecash flow but will only be recorded as a cost when the service or good is usedup next period. Conversely, if the firm has used up something, such aselectricity, this will count as a cost even if the bill has not been paid for. Thisis summarised in the accruals concept.

Why is cash flow important?

Firms usually exist in order to make a profit. This may not always be their mainobjective. It is also, however, important for firms to monitor their cash flowposition. This is because a firm will need cash to pay for the daily running of thebusiness.

Cash will be needed to pay wages, to pay bills, to pay suppliers and for thegeneral upkeep of the firm. If a firm cannot pay one of its creditors, then thefirm may ultimately face a bankruptcy order forced on to the firm by those whoit cannot pay. If it cannot pay its own workers then industrial action is likely tooccur.

Sufficient levels of cash are needed to ensure that a firm is liquid; it isimportant, therefore, that managers track the cash flow position of the business.This is likely to involve drawing up cash flow forecasts which estimate the likely

amounts of cash inflows and cash outflows over the near future. Very short-termcash flow forecasts may be particularly important for small or newly establishedfirms, which often have to target cash flow over a daily or weekly period ratherthan on a month by month basis. This is because a new or small firm is thoughtto be more likely to fail than a larger firm. As a result, the sources of cash flowavailable to a larger firm (such as extended credit periods offered, or extensionsto overdrafts) may not be offered to small firms if their cash flow becomesnegative.

Which is more important - cash or profit?

In the long run there is probably little point undertaking an activity if the valueof the sale is less than the value of the inputs used up (i.e. if turnover is lessthan costs). This means that over time a firm will need to make a profit if it is tocontinue with an activity. Firms will generally measure not just the absolute sizeof the profits but also their size relative to the capital employed, to decide if anactivity is worthwhile.

In the short run, however, the priority is to keep the business going; this meansthe firm must be liquid and have sufficient cash flow. There is little point ingetting involved in a project that is potentially profitable if, in fact, the businesswill not survive long enough to be able to sell the products it produces. Firms

must pay attention to their cash flow as well as their profit. If a bill has to bepaid, cash is likely to be regarded as more important than profit; however, when


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reviewing the firm's activities over a period of time it will usually be expected toachieve a suitable rate of return in terms of profit.

A firm must be careful when engaging in activities to monitor the effect on eachtransaction on both profit and cash flow. Many firms may forget that the cash

flow will be, in some cases, more important than the profits.

Limitations of ratios

It is important to realise that with ratio analysis that the question will rarelyfocus on the calculation of ratios alone, most of the time the calculation of theratio will only be the first step on some investigation into some aspect ofbusiness performance. Therefore it is especially important that you can interpretand analyse what the result of the ratios actually mean,

Areas that are important in ratio analysis are as follows:

1.Analysing the ratios of a particular area of a firm (e.g.: profitability,efficiency, liquidity, etc.)

2.Limitations of ratios3.A basis for comparing the performance of two firms or one firm over time4.As a tool to help decide a firm's strategy (e.g. has it a safe liquidity

position for expansion, or analysis of gearing to help decide on the bestform of finance)

When answering any question on ratios you must consider the following factors:

1.What type of firm are we dealing with?2.What is the size of the firm and should this have any effect on the ratios?3.Will the time of year have any effect on the ratios? (see liquidity ratios

section for example)4.Have we got enough information to make any serious conclusions?5.What external factors are important?6.Are the accounts supplied reliable? Ratios are only as accurate, true and

fair as the original figures from which they were calculated

Obviously, the first stage should be to calculate the ratios in the correct manner.

Once you have completed this then it is time to start to interpret the results thatyou have calculated.

This interpretation can be in the form of your theoretical knowledge of what theratio tells us. For example, the current ratio will look at the firm's ability to payday-to-day expenditure.

Once you have interpreted the meaning of the results you can then look aroundto consider wider issues, such as the context of the question. For example, itdoes not matter what size the firm's profit margin is if the economy is entering arecession and a firm sells goods that are significantly affected by changes inconsumer spending. Also, you may wish to look at other non-financial factors


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within the firm. A highly motivated workforce may be more important for cashflow than an efficient debtors collection period.

It is important that you realise that although accounting ratios can be a veryuseful tool they also have many serious limitations which can render the results

meaningless, or worse, can cause you to jump to incorrect conclusions.

Common limitations of ratios

Common limitations of ratios are as follows:

Not having more than one years' data. Even two years may not be enough togive a clear picture of the overall direction of the firm.Comparisons with other firms are only meaningful if the firm's are verysimilar (same industry and similar size). Even firms that appear similar mayhave different objectives, making any comparison meaningless.

All firms will be affected by changes in the economy in different ways - thismust be taken into account when analysing firm's results.Firm's can window dress their accounts to make it look as if they areperforming better than they actually are. The actual accounts and the notesto the account should be analysed to find out more about the results.Balance sheets are drawn up on one day. If this day is not a typical day thenthe ratios may give a misleading picture.Concentrating on financial data means that we may ignore important non-financial factors, such as industrial unrest, the training level of the workfaceand managerial problems.

The best way to avoid falling into these traps is to spend time trying tounderstand what the ratios actually mean. This is not just a question of learningwhat they should theoretically show, but rather what thinking lies behind theactual calculation of the ratio. For example, we all know that the current ratioshows us the solvency position of a firm. However, we must look into the ratioitself for it to provide meaning. A firm may have many current assets, but ifthese are stocks which are not very liquid then the firm may face problems. Wealso need to know the limitations of using a single financial statement ratherthan the 'whole picture'. Balance sheets are just snapshots which may havebeen constructed at an atypical time giving us unusual results. It is veryimportant that ratios should be considered with the previous years' equivalent

figures if any meaningful solution is to be offered.

It is also important that the ratios were calculated in a similar way, i.e. you aretreating 'like with like'. If you are engaging in comparing between two firms thenit is common sense to point out that the two firms should be similar firms. Inthis chapter we have seen very successful firm having radically different ratios.

If you are to perform an inter-firm comparison then it is also important that thesame formulas were used and that the data used was of equivalent meaning. Itis also important that the accounting policies are consistent across the firms

being analysed. For example, has machinery been depreciated in a more-or-lesssimilar way such as the straight-line method?


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The results that you calculate may indicate a problem which cannot besummarised through financial figures and may actually require you looking atthe other areas of the firm, such as marketing or human resources. Remember,of course to take into account that the firms will be affected by the economic

cycle. Firms will be affected in different ways, but all will be affected.

The best answers in ratio analysis are those that can join up the theoreticalknowledge with real world factors. It is very important that you structure youranswers carefully. Try to start off with the theory first before opening up towider issues. A common format could be as follows:

1.Calculation of ratios.2.What does the ratio tell us anyway?3.What does theory tell us about our result?4.Can the context of the question explain the results?5.How valid are our results anyway?6.What other factors should we consider?

Exam tips

There is no other way around it; you will have to learn all the formulas forthe ratios - all of them!!

You can help yourself by practicing the ratios as much as possible - you willfind it easier if the ratios have actually been used.

Read the question very carefully. Sometimes questions will want just acalculation and nothing else. However, it is likely that you will have toconsider the scenario of the questions as well as any theoretical knowledgeyou have picked up through the course

The type of firm, time of year and market it operates in will all partly explainthe results of the ratio calculations.

Make sure that you are looking at the appropriate category of ratio - eachcategory will cover a slightly different aspect of the firm's overall financial

position.

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Ratio Analysis Ordinary Levels