ratios.doc

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22 Apr 2012
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In our introduction to interpreting financial information we identified five main areas for
investigation of accounting information. The use of ratio analysis in each of these areas is
introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an acceptable
rate. The key ratios are:
Ratio
Calculation
Comments
Gross
Profit
Margin
[Gross Profit /
Revenue] x 100
(expressed as a
percentage
This ratio tells us something about the business's ability
consistently to control its production costs or to manage the
margins its makes on products its buys and sells. Whilst sales
value and volumes may move up and down significantly, the
gross profit margin is usually quite stable (in percentage
terms). However, a small increase (or decrease) in profit
margin, however caused can produce a substantial change in
overall profits.
Operating
Profit
Margin
[Operating Profit /
Revenue] x 100
(expressed as a
percentage)
Assuming a constant gross profit margin, the operating
profit margin tells us something about a company's ability to
control its other operating costs or overheads.
Return on
capital
employed
("ROCE")
Net profit before tax,
interest and dividends
("EBIT") / total assets
(or total assets less
current liabilities
ROCE is sometimes referred to as the "primary ratio"; it tells
us what returns management has made on the resources
made available to them before making any distribution of
those returns.
Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those resources
invested in fixed assets and working capital.
Ratio
Calculation
Comments
Sales
/Capital
Employed
Sales / Capital
employed
A measure of total asset utilisation. Helps to answer the
question - what sales are being generated by each pound's
worth of assets invested in the business. Note, when
combined with the return on sales (see above) it generates
the primary ratio - ROCE.
Sales or
Profit /
Fixed
Assets
Sales or profit / Fixed
Assets
This ratio is about fixed asset capacity. A reducing sales or
profit being generated from each pound invested in fixed
assets may indicate overcapacity or poorer-performing
equipment.
Stock
Turnover
Cost of Sales /
Average Stock Value
Stock turnover helps answer questions such as "have we got
too much money tied up in inventory"?. An increasing stock
turnover figure or one which is much larger than the
"average" for an industry, may indicate poor stock
management.
Credit
Given /
"Debtor
Days"
(Trade debtors
(average, if possible)
/ (Sales)) x 365
The "debtor days" ratio indicates whether debtors are being
allowed excessive credit. A high figure (more than the
industry average) may suggest general problems with debt
collection or the financial position of major customers.
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