RATIO ANALYSIS

GROSS PROFIT MARGIN

• Gross profit is related to sales
• Proportion of sales which is converted into profits
• Before deducting running expenses
• Degree of success in trading (buying and selling)
• High margin = higher success = higher profits

GROSS PROFIT MARKUP

• Gross profit is related to cost of sales
• Buying price + % profit = selling price
• Indication of rate of return on investment in goods for resale

PROFIT MARGIN

• Relationship between profit for the year and sales
• Efficiency of management in converting sales into profit
• Overall measure of profitability
• High profit margin = good performance

RETURN ON CAPITAL EMPLOYED

• Very good indicator of performance
• Related the profit to total investment in the business
• Indicates how efficiently the business is using resources invested to generate profits
• High ratio = efficiency in using resources

EXPENSES TO REVENUE RATIO

• Yardstick of operating efficiency
• Control of expenses, can be analyzed through this ratio
• High ratio = expenses are out of control

OPERATING EXPENSES TO REVENUE RATIO

• Operating expenses = total expenses - interest - taxation
• Better idea of how well business is controlling operating expenses
• Meaningful comparison and analysis possible

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LIQUIDITY RATIOS

LIQUIDITY RATIOS

• Current Ratio
• Acid test Ratio

CURRENT RATIO

• Indicates how much dollars of current assets can be used to repay back each dollar of current liabilities
• That is, how well is the business able to meet short term debt
• Satisfactory current ratio is 2:1

QUICK RATIO (ACID TEST RATIO)

• Indicates how much dollar of short term, the business is able to repay given the liquid assets only
• Iiquid assets = easily converted into cash
• Better measure of solvency than the current ratio
• When is a business deemed to be solvent ? Liquid ratio of 1:1

EFFICIENCY RATIOS

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• Non current asset turnover ratio
• Trade receivables turnover
• Trade payables turnover
• Inventory turnover(days)
• Rate of inventory turnover (days)

NON CURRENT ASSET TURNOVER (TIMES)

• Efficiency in consuming benefits of non current assets
• Total non current assets is related to sales
• How much revenue is generated for each dollar of non current asset being used

TRADE RECEIVABLES TURNOVER

• Number of days customers are taking to settle their debts
• Also referred to as ‘average collection period’
• Denotes the quality of a business trade receivables
• Low ratio = better

HOW TO IMPROVE THE COLLECTION PERIOD?

IMPROVING COLLECTION PERIOD = LOWERING TRADE RECEIVABLES COLLECTION PERIOD?

• Impose credit control system
• Interest on overdue account
• Cash Discount for payment within specific period
• Issuance of statement of account on a regular basis

TRADE PAYABLES TURNOVER

• Average payment period
• Average number of days taken by business to pay the suppliers
• Short payment period = healthy liquidity position = sound relationship with suppliers
• High ratio = poor debt management

WHAT HAPPENED IF HIGH PAYMENT PERIOD?

• Lose cash discount facilities
• Loss of confidence in the business by suppliers
• Business may have to pay penalties or interests for late payment
• Refusal of suppliers

INVENTORY TURNOVER (DAYS)

• Number of days taken to convert inventory into sales

RATE OF INVENTORY TURNOVER

• Number of times during the year the average inventory has been sold.
• Shows how rapidly stock is converted into sales
• High rate of inventory turnover = good inventory management = improved liquidity

HOW TO IMPROVE RATE OF INVENTORY TURNOVER?

• Reducing level of inventory
• Agressive marketing to generate more sales
• Replacement of inventory only when required ( replenish in time = just in time purchasing )

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