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.
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
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
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
- 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%
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