Chapter 18

The three main themes covered by ratio analysis are:

• Profitability - relationship between profit and sales revenue, assets and capital employed
• liquidity - the stability of the business on a short-term basis
• Capital structure -The stability of the business on a long term basis.

Making use of ratio analysis 

• Establishing trends from past years and comparing
• Compare against other businesses in the same industry
• Compare with standards assumed to be satisfactory with banks etc.

Profitability: The ratios examine the relationship between profit and revenue, assets, equity and capital employed

Gross profit margin =   Gross profit / revenue    x 100

Gross profit mark-up = Gross profit / cost of sales   x 100

Net profit margin = net profit / revenue  x 100

Return on Capital employed/ ROCE = Net profit / capital employed x 100

Difference between profit and cash 

Cash - is the actual amount of money held in the bank or as cash

Profit - A calculated figure which shows the surplus of income over expenditure for the year

These ratios measure the financial stability of the business - the ability to operate on a  short-term basis. We focus on Current assets and Current liabilities sections of the balance sheet

 current ratio  = Current assets/ current liabilities 

Acid test =  current assets - inventories / current liabilities

Rate of inventory turnover = average inventory / cost of sales x 365 days
average inventory = opening inventory + closing inventory / 2

Trade receivables days = trade receivables/ revenue x 365 days

Trade payables days = Trade payables/ cost of sales x 365 days 

Capital ratio = gearing ratio focuses on long term finacing of the business

- loan capital + preference shares/ ordinary shares + reserves
 
= debts/ equity 

• Retrospective nature - based on performances in the past and may not be helpful for future predictions
• Inflation - As assets and liabilities are recorded at cost and financial statements are prepared on a historic basis, it may result in invalid comaprisons
• Reliance on standards-  e.g 2:1 on the current raio is an idea standard. If a business relies too heavily on these standards they could ignore other factors in the balance sheet.