Key Topics:
Types of Ratios
Uses of Ratio Analysis
Limitations of Ratio Analysis

Types of Ratios
Liquidity Ratio
Profitability Ratios
Efficiency Ratio
Gearing Ratio

Profitability Ratios
Measures the business' success.
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Some Factors To Consider That Contribute to Profitability Ratios

Gross profit margin
- shows the value of gross profit as a percentage (%)
- the portion of sales revenue left over after all direct costs have been paid
- higher the GPM ratio the better for the business
Gross Profit Margin= (Gross Profit) / (Sales Revenue) x 100%

Net profit margin
- shows the % of sales revenue that is turned into net profit
- the portion of sales revenue left over after all direct and indirect costs have been paid (expenses)
- NPM ratio is a stronger method of measuring profit since it accounts for costs AND expenses
Net Profit Margin= (Net Profit before Interest and Tax) / (Sales Revenue) x 100%

Improving Profitability Ratios:
- increasing price of products
- sales promotions to attract more customers (discounts)
- reduce costs associated with selling products (labor, advertizing, materials etc.)
- reduce indirect costs (rent, travel, insurance etc.)

Liquidity Ratios
Measures how quickly assets can be turned into cash.
*too high of a liquidity ratio is not too good---> business is holding too much cash that could be used in other areas
--->too many debtors (bad debt)
---> too much stocks
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Example of Liquidity Ratio Calculations

Current ratio
- reveal whether the firm can cover it's short-term debts
- current ratio of 1.5 to 2.0 acceptable
- 1.5 to 2.0 current ratio ensures a safety margin in case assets can not be sold quickly
Current Assets / Current Liabilities

Acid test ratio (quick ratio)
- same with current ratio except it ignores stock
- typically more meaningful since stock cannot always be relied upon to convert to cash
- recommended ratio of 1:1
- lower than 1:1 ratio suggests liquidity crisis (firm unable to pay debts)
Current Assets-Stock / Current liabilities

Improving Liquidity Ratios:
- raise value of current assets
- reduce the value of current liabilities (pay debt)
- negotiate delayed payment to creditors

Efficiency Ratios
Measures how well a business uses it's resources
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A Possible Limitation When Considering Efficiency Ratios

Stock turnover
- how many times stock turns over in the period (year)
- speed at which firm sells and replenishes stock
- different types of companies have different target stock turnovers
stock turnover = (Cost of Goods) / (Average Stock)
stock turnover= (Average Stock) / (Cost of Goods Solds) x 365

Return on capital employed (ROCE)
- amount of profit a business makes at the end of the year
- shows profit as a percentage of the capital used to generate it
- measures how well a firm is able to generate profit from funds
- higher ROCE the better for the business
(Net Profit Before Interest and Tax) / (Capital Employed) x 100%

Improving Efficiency Ratios
Stock Turnover
- holding lower levels of stock (replenished more regularly)
- dispose of stock too slow to sell
- reduce the range of products sold
ROCE
- boost net profits

Gearing Ratio
Measure the firm's long-term liquidity position (percentage of capital that comes from long-term debt)
- shareholders and potential investors will be interested in the gearing ratio to asses risk
Whether or not gearing ratio is acceptable depends on a few factors:
- size and status of business
- interest rates
- potential profitability
(Long Term Liabilities) / (Capital Employed) x 100%
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Improving Gearing Ratios
a high or low gearing ratio is not necessarily good or bad, however gearing ratio can be manipulated by changing the amount of long-term liabilities

Uses of Ratio Analysis
Employees: job security, salary, potential raise/promotion
Managers and Directors: probability of reaching profits, identify areas of weakness
Creditors: whether or not the business can repay them
Shareholders: return on investments
Financiers: whether or not the business has funds to pay loans
Local Community: job security, job opportunities, secure fundings

Limitations of Ratio Analysis
- does not take into account the effects of external environment
- different accounting policies of businesses=difficult to make comparisons between businesses
- does not evaluate the CURRENT or FUTURE financial situation
- ignores qualitative factors (i.e. staff motivation, public opinion)
- does not take into account objectives of the business