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Chapter 10 Monitoring the

Business Ratio Analysis
Books pg 130

Ms. Fitzharris

26/01/2016

Chapter 10 pg 182
Stakeholders who use financial information

Shareholders:
Managers:
Employees:

Edco 2012

Interested in profitability
and dividends.
Interested in profitability,
budgets and cash flow.
Need to meet targets.
Interested in profitability
and liquidity. Jobs and
wages will depend on
good profit levels and
liquidity.

Its the Business

Lenders/investors:
Suppliers:
Government:

Edco 2012

Interested in liquidity
and repayment of debts.
Also focus on gearing.
Interested in getting
paid for goods and
services. Focus on
liquidity.
Concerned with
profitability and
payment of taxes.
Its the Business

Limitations of financial statements

Dealing in absolute
figures
Company specific
Non-financial information
may also be important

Edco 2012

Its the Business

Ratio analysis
Ratio analysis provides a
useful set of tools that
allows all interested
stakeholders to evaluate
the financial health of a
business.

Edco 2012

Its the Business

Profitability ratios
Measures profit levels and whether
annual profit is improving or declining.
1)Gross profit percentage
2) Net profit percentage
3) Return on capital employed

Edco 2012

Its the Business

GROSS MARGIN
Gross Profit X 100
__________
___
Sales
1

NET MARGIN
Net Profit
__________
Sales

100
___
1

RETURN ON CAPITAL
EMPLOYED
Net Profit
X
100
__________
____
Cap. Employed
1
Capital employed = the total of the Financed by section of a Balance Sheet.

Profitability ratios
All expressed as %.
Important to management as a measure of annual
performance.
Of particular interest to shareholders seeking dividends or
further investment opportunities.
Also of interest to employees seeking pay increases and job
security.

Liquidity ratios
Used to examine cash flow and
reflect a firms ability to pay its
day-to-day expenses.
1)Working capital ratio (current ratio)
2)Acid test ratio (quick ratio)

Edco 2012

Its the Business

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CURRENT RATIO =
Current Assets
Current Liabilities
ACID TEST RATIO =
Current Assets Closing Stock
Current Liabilities

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CURRENT RATIO
Ideally above 2:1
Also called Working Capital Ratio

===============================
=====

ACID TEST RATIO

Ideally above 1:1
Also called Quick Ratio

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Liquidity Ratios
Liquidity ratios are always expressed as a RATIO
in SIMPLEST FORM so as to enable comparison
with ideal measurement (2:1 or 1:1).
Of interest to management, employees and
suppliers who are all concerned with the ability of
a business to pay its short term debts from
available funds.
Poor liquidity is single biggest reason for business
failure.

Gearing/debt equity ratio

It highlights a businesses reliance on borrowings
or debt capital to finance its operations.
Debt capital

Equity capital

Debt capital =

LONG TERM LOANS

+DEBENTURES ETC.

Equity capital = Issued share capital +

reserves

Edco 2012

Its the Business

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Gearing Ratio

Most commonly expressed as a RATIO, but can

also be expressed as a percentage.
For example, a gearing ratio of 2:1 indicates that
debt is 200% of equity.
If Debt > Equity the business is said to be highly
geared.
If Debt < Equity the business is said to be lowly
geared

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Gearing Ratio
It is generally better for a business to be lowly geared.
High gearing indicates that the business has a lot of external
debt and this must be repaid with interest. This increases
pressure on the business to generate sufficient cash-flow to
repay this debt.
High gearing tends to reduce the dividends available to
shareholders.
It may also make it more difficult to raise external finance in
the future as lenders may be unwilling to add to this debt
burden.
Gearing ratio is of particular interest to shareholders, lenders
and investors.