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GLOSSARY
Acid test ratio
Also known as the quick ratio, this short-term liquidity ratio measures an organization’s ability to pay its short-term debts without having to sell anstock (inventories).
Capital employed
This is the value of the funds used to operate the business and to generate a financial return for the organization. It is the sum of non-curren assets and equity finance.
Current ratio
A short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date).
Gross profit margin (GPM)
A profitability ratio that measures an organization’s gross profit expressed as a percentage of its sales revenue. It is also an indicator of how well a business can manage its direct costs of production.
Liquidity
Refers to the ease with which a business can convert its assets into cash without affecting its market value, i.e., it measures a firm’s ability to repay short-term liabilities without having to use external sources of finance.
Liquidity ratios
These are financial ratios that examine an organization’s ability to pay its short-term liabilities and debts, namely the current and acid test ratios.
Profit
The financial surplus after all costs, including expenses, have been paid.
Profit margin ratio
A profitability ratio that measures a firm’s overall profit (after all costs of production have been deducted) as a percentage of its sales revenue. It is also an indicator of how well a business can manage its indirect costs (overhead expenses).
Ratio analysis
A quantitative management planning and decision-making tool, used to analyse and evaluate the financial performance of a business. These can be further categorised as profitability, liquidity, and efficiency ratio analysis.
Return on capital employed (ROCE)
A profitability ratio that measures a firm’s efficiency and profitability in relation to its size (as measured by the value of the organization’s capital employed).
PRACTICE QUESTION
Activity 3.5E Ratio Analysis.pdfActivity 3.5B BP Debt and gearing.pdfGUIDE TO ANSWERING RATIO QUESTIONS
Step 1)
Read question carefully checking for requirements and what industry the business is in
Step 2)
Identify the areas of focus in the ratios eg. liquidity, profitability etc. and if the marks per area are greater than 4 then start each area of analysis with a definition ie. liquidity is...
Step 3)
State ratio results correctly and make specific reference to:
Compare to other company in the question
Look for trends if multiple years
Compare to industry average
Step 4)
If there are more than 4 marks allocated to the area of analysis, look at the figures which make up the formula and make comment eg. wages may have increased 20% or sales decreased by 5% contributing to lower profitability.
Step 5)
If asked or appropriate (>4 marks) advise the business on an appropriate form of action to address the situation ie. improve the ratios.
Step 6)
If you have time, are asked or there are lots of marks allocated suggest relevant financial information which is not available but which would be relevant to making a more informed judgment about the business.
balance sheet.pdfComment on the profitability of Company ABC using two profitability ratios (6 marks)
Profitability is a measure of profit in relation to sales. Two profitability ratios are the Gross Profit ratio and the Profit Ratio
Gross Profit Ratio
The gross profit ratio is a profitability ratio that measures an organisation’s gross profit expressed as a percentage of its sales revenue. It is also an indicator of how well a business can manage its direct costs of production.
The formula for gross profit ratio = (Gross profit / Sales revenue) × 100
In 2018 Company ABC had a gross profit ratio of 40%. This may seem in line with other car companies, however the industry average is 45% and its main rival Company X has a GP ratio of 50%. The higher the number the better, so therefore it can be assumed that Company ABC can/should look to improve this ratio. One way it could do this is by reducing its Cost of Good sold by finding a cheaper supplier of car materials or outsourcing manufacturing to a cheaper country in Asia of Africa.
Profit (Net Profit) ratio
The profit margin is a profitability ratio that measures a firm’s overall profitas a percentage of its sales revenue. The formula for calculating the profit margin ratio is:
Profit margin = (Profit before interest and tax / Sales revenue) × 100
In 2018 Company ABC had a net profit ratio of 17.7%. The higher the number the better and therefore this can be seen as an attractive profit margin as its main rival as a ratio of 10% and the industry average is 9%. This indicates that the company makes good use of it’s operating expenses, and does not need to use as many expenses as it’s rivals to achieve the same amount of profit. One way it could further improve this bratio is by cutting down on some of it’s advertsing expenses were $60000. They could do this by switching to Social Media advertising or some other online type of advertising with lower costs.
Comment on the liquidity of this business (Zai's Sports Store), using one ratio. Zach's Sports store has a CR of 1.9 and the industry average is 2.
Liquidity refers to the ease with which a business can convert its assets into cash without affecting its market value, One ratio to work out the lioquidity of a business is the Current Ratio. The current ratio formula is CA/CL.
Zai's Sport's Store has as CR of 1.26. This is ok because the business has more CA then CL, however it is low compared to its rival (Zach's Sports Store) of 1.9 and considerably lower then the industry avergae of 2.
One thing Zai could do to improve th this ratio is to inject some cash into the business either through a personal contribution or by increasing his revenue by changing his product mix, perhaps by making sure he up to date with current trends (Latest Nikes, Harley Reid guernseys, Jason Tatum Singlets). He could also take out a long term loan to pay off his Line of Credit or Accounts Payable. Or use some of his Cash to pay Accounts Payable.
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