The meaning and types of ratio analysis

Ratio analysis involves using mathematical methods to examine financial accounts by comparing related figures. It offers a detailed way to assess a business's financial health by pulling out important numbers from statements and turning them into ratios.

Main types of financial ratios

• Profitability ratios - These evaluate how well a business performs, looking at aspects like profit, revenue, and invested capital.
• Liquidity ratios - These check how readily a business can cover its short-term debts, such as payments to suppliers or staff.

Profitability ratios including gross profit margin, operating profit margin, and mark-up

Profitability ratios help measure a business's ability to generate profit relative to its sales or costs.

Gross profit margin

Gross profit margin shows gross profit as a percentage of total revenue.

$\text{Gross profit margin}=\frac{\text{gross profit}}{\text{revenue}}\times 100$

To improve this ratio, a business could boost revenue through higher sales or cut the cost of sales. Industries like supermarkets, which turn over stock rapidly, often work with lower margins.

Operating profit margin

Operating profit margin expresses operating profit as a percentage of revenue.

$\text{Operating profit margin}=\frac{\text{operating profit}}{\text{revenue}}\times 100$

This ratio indicates how effectively a business manages its cost of sales and other expenses. A narrow gap between gross and operating profit margins points to well-controlled expenses. Margins above 10% are typically seen as strong.

Mark-up

Mark-up calculates the profit on each item sold relative to its cost.

$\text{Mark-up}=\frac{\text{profit per item}}{\text{cost per item}}\times 100$

Some businesses use this to set prices that cover costs and add a profit. The selling price can be found using: price = cost + (cost × mark-up percentage).

Worked example - Calculating gross profit margin and operating profit margin

A business has revenue of £200,000, gross profit of £70,000, and operating profit of £30,000. Calculate the gross profit margin and operating profit margin.

Step 1: Identify the values

• Revenue = £200,000
• Gross profit = £70,000
• Operating profit = £30,000

Step 2: Calculate gross profit margin

$\text{Gross profit margin}=\frac{\pounds \mathrm{70,000}}{\pounds \mathrm{200,000}}\times 100=35\%$

Step 3: Calculate operating profit margin

$\text{Operating profit margin}=\frac{\pounds \mathrm{30,000}}{\pounds \mathrm{200,000}}\times 100=15\%$

Step 4: Interpretation

The operating profit margin is lower than the gross profit margin, suggesting expenses are reducing profitability after accounting for cost of sales.

Worked example - Calculating mark-up and selling price

A product costs £12 to produce, and the business wants a mark-up of 60%. Calculate the mark-up percentage to confirm and find the selling price.

Step 1: Identify the values

• Cost per item = £12
• Desired mark-up = 60%

Step 2: Calculate profit per item

Profit per item = £12 × 0.60 = £7.20

Step 3: Confirm mark-up

$\text{Mark-up}=\frac{\pounds 7.20}{\pounds 12}\times 100=60\%$

Step 4: Calculate selling price

Selling price = £12 + £7.20 = £19.20

The concept of liquidity and liquidity ratios

Liquidity refers to how quickly and easily assets can be turned into cash. It is vital for a business's ongoing operations, as low liquidity might mean it cannot settle immediate bills.

Variations in asset liquidity

• Cash is completely liquid and ready for use.
• Trade receivables are reasonably liquid, with payments usually expected within 90 days.
• Inventories are the least liquid current assets, as selling them is not always assured.
• Non-current assets, like buildings or equipment, are not considered liquid.

Current ratio

The current ratio assesses liquidity by comparing current assets to current liabilities.

$\text{Current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$

A ratio between 1.5 and 2.0 suggests adequate liquid resources. Below 1.5 may indicate a shortage of working capital, while above 2.0 could mean funds are not being used efficiently.

Acid test ratio

The acid test ratio (also known as the quick ratio) is a stricter measure of liquidity, excluding inventories from current assets.

$\text{Acid test ratio}=\frac{\text{current assets - inventory}}{\text{current liabilities}}$

If this ratio falls below 1, it means current assets without inventories do not cover liabilities. Retailers with quick cash sales might manage with lower ratios than manufacturers that extend credit.

Worked example - Calculating current ratio and acid test ratio

A business has current assets of £110,000 (including £25,000 in inventory) and current liabilities of £60,000. Calculate the current ratio and acid test ratio.

Step 1: Identify the values

• Current assets = £110,000
• Inventory = £25,000
• Current liabilities = £60,000

Step 2: Calculate current ratio

$\text{Current ratio}=\frac{\pounds \mathrm{110,000}}{\pounds \mathrm{60,000}}\approx 1.83$

Step 3: Calculate acid test ratio

$\text{Acid test ratio}=\frac{\pounds \mathrm{110,000}-\pounds \mathrm{25,000}}{\pounds \mathrm{60,000}}=\frac{\pounds \mathrm{85,000}}{\pounds \mathrm{60,000}}\approx 1.42$

Step 4: Interpretation

The current ratio of approximately 1.83 indicates reasonable liquidity, and the acid test ratio of about 1.42 shows a somewhat tighter position when excluding inventories.

Return on capital employed

Return on capital employed (ROCE) measures operating profit as a percentage of the total capital used in the business.

$\text{ROCE}=\frac{\text{operating profit}}{\text{capital employed}}\times 100$

Capital employed includes shareholders' equity plus non-current liabilities. This ratio connects profit to the scale of the business and allows comparisons with options like bank savings rates.

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Worked example - Calculating return on capital employed

A business has operating profit of £45,000 and capital employed of £250,000. Calculate the ROCE.

Step 1: Identify the values

• Operating profit = £45,000
• Capital employed = £250,000

Step 2: Apply the ROCE formula

$\text{ROCE}=\frac{\pounds \mathrm{45,000}}{\pounds \mathrm{250,000}}\times 100=18\%$

Step 3: Interpretation

A ROCE of 18% means the business generates £18 in profit for every £100 invested, which could be compared to alternative returns.

Using ratios for comparisons and by different business sizes

Ratios enable businesses to evaluate performance and make informed decisions through various comparisons.

Ways to use ratios for comparisons

• Examine financial health at a single point, such as the end of a quarter.
• Track changes over time, like year-on-year improvements.
• Benchmark against similar businesses in the same sector.
• Exercise caution in comparisons, as factors like diverse products or research spending can affect results.

Ratio analysis by business size

Smaller businesses may not use detailed ratio analysis, often sticking to basic profit checks. Larger firms, with dedicated finance teams, perform in-depth reviews to inform shareholders and guide strategy.