FINANCIAL RATIOS

Making sense of Revenue Statements

And Balance Sheets

Introduction

• Financial ratios are calculations that help managers examine the performance of the business.

• They also assist in determining whether the business is meeting its financial objectives.

• Ratios allow comparison over time, with industry averages and with their competitors, they allow for the prediction of trends and assist in planning.

•IT IS NOT ENOUGH TO SIMPLY CALCULATE RATIOS YOU MUST INTERPRET THEM....

To begin...

• You must be familiar with The Accounting Equation

• Assets = Liabilities + Owners equity

• This equation is the one that ensures that the Balance Sheet actually balances.

The types of ratios

• There are several categories of ratios that businesses use and you need to know which ratio falls under which categoryTYPE/CATEGORY OUTLINE

LIQUIDITY SHORT TERM STABILITY

SOLVENCY LONG TERM STABILITY

PROFITABILITY FINANCIAL RETURN

EFFICIENCY RETURN ON COSTS

Liquidity

• Liquidity measures how easily a business can meet its current liabilities or short term debts.

• It is the relationship between current assets and current liabilities.

• Ideally the business should have more current assets than current liabilities to pay their short term debts as they fall due.

How is liquidity measured

• By using the Current Ratio

• Current Ratio = current assetscurrent liabilities

Generally the industry standard for liquidity is 2:1. This means that for every dollar of liability the business has 2 dollars of assets to pay for it

Worked Example

• Using the Coco’s Coastal Cafe Balance Sheet:• A) Determine the level of current assets and

current liabilities• B) Substitute these numbers into the ratio• C) Write a short statement that describes the

current ratio of Coco’s Coastal Cafe ( is it good?)

Solvency

• Refers to the long term stability of the business and whether it can meet its total financial obligations as they fall due.

• The term used to describe the relationship between debt and equity is gearing. If the business has accumulated more debt than equity it is termed highly geared.

How solvency is measured

• By using the gearing ratio

• Gearing Ratio = Total liabilities X 100Owners Equity

Generally the industry standard for small business is 50% and for larger business 100% This means for a small business that for every dollar of equity invested the business has generated 50c of debt.

Worked Example

• Using the Coco’s Coastal Cafe Balance Sheet:• A) Determine the level of total liabilities and

owners equity• B) Substitute these numbers into the ratio• C) Write a short statement that describes the

gearing ratio of Coco’s Coastal Cafe ( is it good?)

Profitability

• Profitability refers to the businesses ability to make a financial return from their activities.

• Profitability can be determined in 3 ways by calculating:

* Gross Profit Ratio (GPR)* Net Profit Ratio (NPR)* Return on Owners Equity (ROOE)

Gross Profit Ratio

• This ratio indicates the percentage of each dollar of sales, this is gross profit. It indicates the mark up placed on goods sold.

• Generally the higher this percentage the better as this gives the business better opportunities to account for their expenses

GPR

• Gross Profit Ratio = Gross Profit X 100GPR Sales

Worked Example

• Using the Coco’s Coastal Cafe Revenue Statement:

• A) Determine the level of Gross Profit and Sales

• B) Substitute these numbers into the ratio• C) Write a short statement that describes the

GPR of Coco’s Coastal Cafe ( is it good?)

Net Profit Ratio

• Net Profit Ratio takes into account the expenses of a business and this is how it differs from the GPR.

• The Net Profit Ratio (NPR) will be less than the GPR and if expenses were increasing then the NPR would be decreasing.

• This ratio measures what percentage of each dollar of sales is net profit. 13-20% is good for retail businesses.

NPR

• Net Profit Ratio = Net Profit X 100NPR Sales

Worked Examples

• Using the Coco’s Coastal Cafe Revenue Statement:

• A) Determine the level of Net Profit and Sales• B) Substitute these numbers into the ratio• C) Write a short statement that describes the

NPR of Coco’s Coastal Cafe ( is it good?)

Return on Owners Equity

• This is one of the most important indicators as it shows how much the owners investment and risk in the business is earning.

• A high figure is desirable but the trend over time is more significant

• A figure below 10% would be a concern as the owner could invest in much less risky areas for a similar return. E.g. bank and property investments

ROOE

• Return on Owners Equity = Net Profit X100ROOE Owners Equity

Worked Example

• Using Coco’s Coastal Cafe Revenue Statement and Balance Sheet:

• A) Determine the level of Net Profit and Owners Equity

• B) Substitute these numbers into the ratio• C) Write a short statement that describes the

ROOE of Coco’s Coastal Cafe ( is it good?)

Efficiency

• Efficiency means that a business is the maximum returns for the minimum costs.

• Efficiency ratios provide a tool to determine how efficiently the business is using its assets and spending to create sales and profits.

• There are 2 main efficiency ratios– Expense Ratio– Accounts Receivable Turnover Ratio

Expense Ratio

• This ratio shows the relationship between sales and expenses used to make those sales.

• The Expense Ratio needs to be as low as possible so that the business can generate a better NPR.

• Strategies are often used to lower the Expense Ratio once it has been determined.

Expense Ratio

• Expense ratio = expenses X 100sales

• Using Coco’s Coastal Cafe Revenue Statement:• A) Determine the level of Sales and Expenses• B) Substitute these numbers into the ratio• C) Write a short statement that describes the

expense ratio of Coco’s Coastal Cafe ( is it good?)

Accounts Receivable Turnover Ratio

• This ratio shows how long it takes for the business to collect money that is owed to them

• A long period is a concern as it means the business’s cash flow could be jeopardised.

• If a business can collect its debts within 14 days that is excellent but anything up to 60 days is acceptable. The lower the number of days the better.

Accounts Receivable Turnover Ratio

• Accounts Receivable = Accounts ReceivableTurnover Ratio Sales /day

(sales /day is calculated by dividing the value of sales by 365)

• Using Coco’s Coastal Cafe Revenue Statement and Balance Sheet:

• A) Determine the level of Sales and Accounts Receivable

• B) Substitute these numbers into the ratio remember to divide the sales by 365!!!

• C) Write a short statement that describes the Acc/Rec Turnover Ratio of Coco’s Coastal Cafe ( is it good?)