Ratio Analysis
It is occasionally challenging to compare different business' performance, or maybe the same company's performance over an extended period of time. One commonly used method which is done by businesses to compare how well they perform is Ratio Analysis.
The Ratio Analysis covers 3 major areas:
- Efficiency
- Liquidity
- Profitability
The Profitability ratios are designed to measure the amount of profit the firm makes. Here we will look at the three major and important profitability ratios.
The Gross Profit Percentage Ratio is able to work out the total amount of profit from the purchasing and selling of goods. There are 2 ways of improving this ratio. Firstly they can increase the selling price of the product, or to find and deal with cheaper suppliers.
The formula for this is:
Gross Profit / Net Sales X 100
The Return on Capital Employed (also known as ROCE) is the ratio commonly used by the investors (people who are willing to invest in the business for a share in the profits).
This ratio is able to calculate the amount of money any investor will get back after a certain period of time.
It is vitally important that investors balance the amount they will receive from the investment with the risk involved.
If they have received as good a deal or if should leave the money in a bank account creating interest.
The formula is:
Net Sales / Capital at the Start X 100
Liquidity Ratios
The Liquidity ratios are there to calculate the firm’s ability to turn assets into money in order to pay off any debts they may have.
The Current ratio and the working capital ratio clearly display the business’ ability to meet its short-term creditors. A good ratio of 2:1 is commonly agreed upon.
If the ratio increases, for example it reaches 4:1 this could mean that the business is not effective. However, a much lower ratio value of 1:1 would mean that it might not be able to meet its debts in the shortest space of time possible.
The formula is:
Current Assets / Current Liabilities
Acid Test Ratio is a far more serious test of a business’ capabilities to meet its debts. The formula is identical as the Current Ratio however it has the added problem of writing off all the stock. This is due to the fact that it assumes that stock might disappear, it could go out of date, or it people might lose interest in the product. This means the organisation might be left with stock it cannot sell. The preferable value of 1:1 would normally be accepted.
Efficiency Ratios
Rate of stock turnover is the efficiency ratio which is able to identify how rapidly a business can go through the available stock.
A high stock turnover is what the business need as this means that the stock is being sold; this means that marketing is effective.
If stock turnover is low then this usually means that stock is not being sold this could be due to the fact advertising is poor, personal touch (customer service) is not to the satisfaction for the customers or the goods are of a poor quality.
The formula is:
Cost of Goods Sold / Average Stock
Advantages and Disadvantages of Ratio Analysis Advantages:
Advantages:
- Ratios help to compare current performance of the business with previous years.
- Ratios help compare how well a business’ performs against its competitors.
- Ratios help identify any problems so that it can be resolved.
Disadvantages:
- Ratio analysis information is quite old (out dated).
- Ratio analysis does not consider the effects of factors outside the control of the firm (external factors) this could be a bad economic climate.
- Ratio analysis does not monitor nor does it measure the human element of a business.