What is Ratio

Analysis all about?

Ratios are really useful things...TRUST ME! Examiners love

to ask you lots of questions about them so let’s see if we

can help you to understand them.

Well a ratio is a way of using numbers to

look at how well or how badly a business is

doing.

Ok so what is a Ratio?

Cool....so how can I use

ratios to help me ?

Ahh....well let’s start by

looking at the Gross

Profit Ratio.

GROSS PROFIT RATIO

This ratio can help Sidney our dodgy

salesman to understand how much

profit he is making from the buying

and selling of his goods.

Right well to work out the answer we

first need to look back at Sidney’s

Trading, Profit and Loss Account

from a previous worksheet.

£ £

SALES REVENUE 35,000

Opening Stock 1,000

Purchases 12,000

Closing Stock 2,000

COST OF GOODS SOLD 11,000

GROSS PROFIT 24,000

Nice one....so go on then

tell me how much I made!

Now what?

Well....we simply follow the following formula.

GROSS PROFIT x 100

SALES REVENUE

Do you think that you can work

out the answer? Go on...have a try

below. The answer is a %

How did you do? You should have

taken £24,000 and divided this by

£35,000. You then multiply this

answer by 100. ANSWER=68.57%

Blimey 68.57% sounds a

lot. That’s good isn’t it?

Sidney seems happy with this figure as it looks really

high. It shows us that he has made 68.57% profit on the

buying and selling of goods.

Sadly it is not quite as easy

as that. Examiners love to

see you explain your

answers when it comes to

Ratios.

Ok I get the idea thanks but

what detail do you want?

Cool so if I just say that Sidney

has made a high Gross Profit

will I get an A*?

I WANT DETAIL!!!

Alright erm...Sidney

what was your Gross

Profit ratio last year?

So why was your Gross

Profit ratio lower this

year Sidney?

Ahhh...I get it! Unless I have something else to compare

this figure with then the ratio is not very useful. By

comparing Sidney’s 68.57% of this year to his 75% of last

year, all of sudden this figure is not so good!

Well it was actually 75%

Good...lots of questions I

like that! So Sidney,

answer the boy.

Nice...so we now have a really good answer to our

analysis of the Gross Profit ratio value.

We started off by just saying that 68.57% was good. We

have learnt that actually it was LESS than last year which

is bad! We have also learned WHY

the ratio was lower.

We could go even further though to

ensure that we get that A* grade.

Ok well my suppliers were

charging me higher prices...not

that it’s any of your business.

Hi...I’m Jack and I’m Sidney’s

cousin. I work in the same

‘dodgy’ sales business. I made

45% Gross Profit this year.

Cool...we can use this information to gain our A*. We

can compare Sidney’s Gross Profit with other businesses

in the same industry.

By using this data we can tell that Sidney was actually

doing very well. Yes he might have made less money

this year but when we look at how everyone else in the

same industry is doing, he is a success e.g. 68.57%

compared with 45% Gross Profit!

GRADE A*.... Remember that I

want lots of lovely detail in

your answers! Try to ALWAYS

USE THE FIGURES!

Bob the Blob’s Question Time

Answer these questions.

Write down the formula for the Gross Profit Ratio.

An oil company make 69%, a supermarket make 20% and a local

butchers make 32% on their Gross Profit Ratios. Explain why these

values are not very useful in helping us to understand how well each

business is actually doing. (Hints. Are they all in the same type of

industry? Do we have any figures for previous years?)

Try and calculate the Gross

Profit Ratio values for each

year using the figures below.

2005 2006 2007

Sales Revenue £850,000 £915,250 £900,000

Gross Profit £214,000 £200,000 £350,000

Net Profit £54,500 £63,000 £110,500

2005 ANSWER

2006 ANSWER

2007 ANSWER

Did you spot that you did

not need the Net Profit

figures!

HINTS. Have they found a new supplier? How might this have

reduced their costs? Have they been able to charge the customers

higher prices? Have they increased demand for their product? How?

Ah you caught me! Try to explain why

you think that the business is making

so much more Gross Profit in 2007.

Ok what about the

NET PROFIT ratio?

NET PROFIT RATIO

Net Profit really provides a more accurate reading on

how much profit a business has made as it takes away

all of the costs and not just those we had in the buying

and selling of our goods.

Let’s go back to our dodgy salesman Sidney and see

what his Net Profit Ratio was for last year.

£

SALES REVENUE 35,000

NET PROFIT BEFORE TAX 12.225

So...... 12,225

x 100 = 34.93

%

35,000

NET PROFIT x 100

SALES REVENUE

Hey, how come my

Gross Profit Ratio

was so much higher?

Oh Sidney you were not paying attention were you!

Remember that your Net Profit Ratio takes into account

ALL of your costs.

That means we have taken into account all of your

expenses that you had to pay for such as renting your

warehouse, paying wages to your staff and buying fuel

for your vehicles. YOUR NET RATIO WILL ALWAYS BE

LOWER!

REMEMBER THE GOLDEN RULES:

1. How did other firms in the

same industry do?

2. How did Sidney do last

year?

So is 34.93% any

good then?

So do you think you can

explain how Sidney might

improve his Net Profit Ratio?

Hint. Think about how he might be able to reduce his expenses!

Give advantages and disadvantages for each suggestion.

Study these figures in the table and then answer the question on

the next page.

2005 2006 2007

Sales Revenue £850,000 £915,250 £900,000

Gross Profit £214,000 £200,000 £350,000

Net Profit £54,500 £63,000 £110,500

Try and calculate the Net Profit Ratio for each year.

2005 ANSWER

2006 ANSWER

2007 ANSWER

Did you remember to

show ALL of your working

out?

Let’s move on to

the Current Ratio.

THE CURRENT RATIO

You might have noticed that both the Gross Profit and

Net Profit ratios used the Trading, Profit & Loss Account

to get their figures. The next two ratios use the Balance

Sheet.

Basically, the Current Ratio will help you to

understand how easily a business can meet all

of their liabilities.

For Sidney, this means does he have enough

money available to allow him to pay for all of his debts if

he was required to pay them

straight away. It is giving us a

measure of his LIQUIDITY.

Hmm I’m a bit confused

but let’s see what my

Current Ratio is.

£ £

CURRENT ASSETS

Debtors 75,000

Cash at Bank 20,000

Stock 140,000

235,000

CURRENT LIABILITIES

Creditors 25,000

Overdraft 55,000

80,000

CURRENT ASSETS

CURRENT LIABILITIES

So then we divide £235,000

by £80,000 and we get the

answer of 2.9

Ok but is 2.9 any

good?

Well any answer between 1.5 and 2.0 is excellent as this

means that Sidney has enough money available to pay

all of his debts.

In our example, Sidney actually has even more than this

at 2.9. This means that he has nearly three times more

current assets than current liabilities! This is good...but

Sidney needs to be careful not to have too high a figure

as this might mean that he has too much money just

lying about and not working for him.

If Sidney’s Current Ratio was LOWER than 1.5 then he

might have problems paying back all of his debts!

Try to remember the ratio

formulas and their ideal

values for the exam!

What’s the Acid Test

Ratio all about?

THE ACID TEST RATIO

This ratio again uses the Balance Sheet for its figures.

This time we TAKE AWAY STOCK from our Current Assets

before dividing the value by our Current Liabilities.

£ £

CURRENT ASSETS

Debtors 75,000

Cash at Bank 20,000

Stock 140,000

235,000

CURRENT LIABILITIES

Creditors 25,000

Overdraft 55,000

80,000

CURRENT ASSETS - STOCK

CURRENT LIABILITIES

Go on....have a try at

working out the Acid

Test Ratio.

Answer = £235,000 - £140,000 =£95,000

£95,000 / £80,000 = 1.19

ANSWER =

Did you remember to take

away the stock value from

your current assets first and to

then divide this figure by

current liabilities?

What do I need to

know about this for

an exam?

Well the reason why we take away stock from our

current assets is that stock is known to be ILLIQUID. This is

a fancy way of saying that stock usually takes a long

time to sell and to turn into cash.

Well let’s see for ourselves shall

we. I’ve arranged for Sidney to

show us around his warehouse

and to show us exactly what he

has to sell.

See if you can identify what items

Sidney might have some trouble

selling!

Hey all of my stock is

top quality stuff!

Right matey feast your

eyes on these great

little bargains!

A VIDEO TAPE RECORDER A TYPE WRITER

A PERSONAL STEREO

A BLACK & WHITE TV

Why might Sidney have problems selling this stock?

All of Sidney’s £140,000 worth

of stock is tied up in old items

that nobody wants anymore!

Well you should show the

examiner that you

understand that stock

can be very difficult to sell quickly.

Say that stock is ILLIQUID that should impress them!

Sidney’s Current Ratio value of 2.9 made us believe that

he could meet all of his debts quickly. It is only now

when we use the Acid Test Ratio that we can see that in

fact Sidney has most of his money tied up in old stock

that nobody wants! If his creditors all asked for their

money back then Sidney would have a big problem.

Remember though to ALWAYS think about what industry

Sidney is in and what his figures were for last year. He

might actually be doing better!

So what do I write about then

in my exam?

And now for the last

ratio we need to

learn....the ROCE Ratio.

FROM THE BALANCE SHEET

FROM THE PROFIT AND

LOSS ACCOUNT

RETURN ON CAPITAL EMPLOYED

This is the only ratio that needs you to use BOTH the Profit

& Loss Account and the Balance Sheet.

This ratio is all about looking at how much money you

get back from investing in a business. The higher the

value of the ratio the better! Remember to always look

at what other firms in the industry are doing though and

how the business has done in the past.

OPERATING PROFIT x 100

CAPITAL EMPLOYED

Right I get this, so can

we calculate the value

and see what we get.

TRADING, PROFIT & LOSS ACCOUNT EXTRACT

EXPENSES

Electricity & Gas 2.950

Vehicles (Petrol) 500

Telephone 325

Rent 5,500

OPERATING PROFIT 14,725

BALANCE SHEET EXTRACT

FINANCED BY:

Mortgage 300,000

Long-Term Loans 155,000

Share Capital 100,000

CAPITAL EMPLOYED

555,000

Can you work out the

ROCE Ratio for Sidney?

THINK! Are there any reasons

why the ROCE might be so low?

Did you get it right? The

answer is £14,725 / £555,000

x 100 = 2.65%

This is a VERY poor return

for your money! You would

be better putting your

money in the bank.

Bob the Blob’s Question Time

Try and answer the following question.

Look carefully at the extracts of a Balance Sheet and a Trading, Profit

and Loss Account. I then want you to carry out a FULL financial

analysis of these accounts. This means you will need to calculate ALL

of the ratios that we have covered in this worksheet and most

importantly, you need to try and provide a good understanding of

what each result is showing you.

THIS IS A VERY COMMON EXAM QUESTION!

TRADING, PROFIT & LOSS ACCOUNT EXTRACT

2006 2007

SALES REVENUE £56,000 £64,500

GROSS PROFIT £34,500 £48,000

NET PROFIT BEFORE TAX £18,000 £20,450

EXPENSES £12,500 £22,550

OPERATING PROFIT £22,000 £25,450

BALANCE SHEET EXTRACT

CURRENT ASSETS £75,000 £98,000

CURRENT LIABILITIES £60,000 £62,000

STOCK £20,000 £21,500

CAPITAL EMPLOYED £125,000 £135,000

GROSS PROFIT RATIO ANALYSIS

NET PROFIT RATIO ANALYSIS

CURRENT RATIO ANALYSIS

ACID TEST RATIO ANALYSIS

RETURN ON CAPITAL EMPLOYED ANALYSIS

(HINTS. Always calculate the ratio for each year. Show all working.

Explain if the ratio values are getting better or worse than last year. Do

we know how other businesses are doing? Look for clues in the figures

e.g. why might expenses have gone up? Is this a good business to

invest your money in?)

Bob the Blob’s Question Time

What Am I?

I start with the letter A

I offer you a more exact measurement of Liquidity.

I do not include stock as they take time to sell.

I am current assets - stock / current liabilities.

I AM A............................................

I start with the letter N

I show you the profit you earn after expenses.

I am more precise than the Gross Profit Ratio.

I am net profit / sales revenue.

I AM N............................................

I start with the letter R

I show investors how much profit they might make.

I need a high value to attract people to invest in me.

I use figures from the Balance Sheet and Profit & Loss.

I AM R............................................