Key Business Ratios and Financial Analysis Techniques

Posted on Jan 5, 2025 in Economy

Accounting Ratios

Ratio Analysis looks at the pairing of financial data in order to get a picture of the performance of the organization.

  • Ratios allow a business to identify aspects of their performance to help decision-making.
  • Ratio Analysis allows you to compare performance between departments and over time.
  • Five different types of ratios can be used to measure:
  1. Profitability – how profitable the firm is.
  2. Liquidity – the business’s ability to pay.
  3. Asset Efficiency Ratios – Firms need to use their assets as efficiently as possible.
  4. Investment/Shareholders – allows businesses to look at risk and potential earnings of investments.
  5. Gearing – looks at the balance between loans and shares in a business.

Profitability Ratios

Return on Capital Employed (ROCE)

ROCE = (Net Profit / Capital Employed) x 100

This shows the profitability of the investment by calculating its percentage return. The return shown can then be compared with the expected return from other investments. The normal figure used by companies is profit on ordinary activities before taxation rather than after tax (the tax charge may vary from year to year, so using profit after tax would not lead to comparing like with like). If PBIT – profit before interest and tax – is used, the profit figure is compared with capital employed, i.e. share capital plus long-term loan capital.

Typically, it should be 20-30%. Need to compare to previous years and competitors to get a clear picture. Can improve this by increasing profits without increasing fixed assets/capital.

ROCE can be sub-divided:

ROCE = Profit Margin × Asset Turnover

PBIT / Capital Employed = (PBIT / Sales) × (Sales / Capital Employed)

The profit margin ratio (see below) shows whether the company is making a low or a high profit margin on its sales; the asset turnover ratio measures how efficiently the company’s net assets are being used to generate its sales.

Asset turnover ratio looks at a business’s sales compared to the assets used to generate the sales.

Asset Turnover = Sales (Turnover) / Net Assets

Net Assets = Total Assets – Current Liabilities

The value will vary with the type of business:

  • Businesses with a high value of assets who have few sales will have a low asset turnover ratio.
  • If a business has high sales and a low value of assets it will have a high asset turnover ratio.

Businesses can improve this by either increasing sales performance or getting rid of any additional assets.

Gross Profit Margin (GP Ratio, or GP %)

GP Ratio = (Gross Profit / Turnover) x 100

This indicates the percentage of turnover – net sales (sales less VAT and any returns) – represented by gross profit. If the gross profit margin is 30%, this means the firm’s cost of sales are 70% of its turnover (because turnover = cost of sales + gross profit).

The higher the better. Allows the firm to assess the impact of its sales and how much it cost to generate (produce) those sales.

A gross profit margin of 35% means that for every £1 of sales, the firm makes 35p in gross profit.

Net Profit Margin (NP Ratio, or NP %)

NP Ratio = (Net Profit / Turnover) x 100

This shows the percentage of turnover represented by net profit, i.e. how many pence out of every £1 sold is net profit. The NP margin will fall if the GP margin has fallen and rise if the GP% has increased: but it is also affected when the firm’s other expenses as a percentage of turnover have changed.

Includes overheads / fixed costs. Net profit is more important than gross profit for a business as all costs are included. A business would like to see that this ratio has improved over time.

Liquidity Ratios

Liquidity ratios help establish whether a firm is overtrading, expanding without sufficient long-term capital. This puts pressure on its working capital, the excess of current assets over current liabilities.

Working Capital (Current) Ratio

Working Capital Ratio = Current Assets (CA) : Current Liabilities (CL)

If current liabilities exceed current assets, the firm may have difficulty in meeting its debts. Extra short-term borrowing, to pay off creditors, costs the firm money (interest). If the firm sells assets to help meet its debts, it risks loss of production and future expansion.

Liquid Ratio (Acid Test or Quick Assets)

Liquid Ratio = (CA minus Stock) : CL

Using this ratio lets us see whether the firm can meet short-term debts without having to sell stock, which is regarded as the least liquid current asset (and the prudence concept encourages accountants to assume the firm will not automatically sell – realise – its stock).

1:1 is seen as ideal.

Again, if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance.

If it is too low then the business may face working capital problems.

Some types of business need more cash than others so the acid test would be expected to be higher.

Debtors Collection Period (Debtor Days)

Debtor Days = (Debtors / Sales) x 365

This liquidity (or efficiency) ratio shows the time, measured in average days, that it takes debtors to pay the firm.

The lower the figure the better as get cash more quickly.

However, sometimes need to offer credit terms to customers so this may increase it.

Need to ensure keep track of any changes in credit terms as these should impact this ratio.

Creditors Collection Period (Creditor Days)

Creditor Days = (Creditors / Purchases) x 365

This ratio calculates the average length of credit the firm receives from its suppliers.

Asset Efficiency Ratios

Firms need to use their assets as efficiently as possible. The efficiency of both current and fixed assets can be measured.

Rate of Stock Turnover (Stockturn)

Stockturn = Cost of Sales / Average Stock (stated as … times per period)

The purpose is to calculate how frequently the firm sells its stock: if stock turnover is slowing, the firm is holding more stock than before, it may be facing problems selling its products, or it may have bought additional stock to take advantage of discounts offered.

An alternative calculation to display stock days is (Average Stock / Cost of Sales) x 365.

This is a useful analysis when used in conjunction with debtor days and creditor days in showing cash-flow timings.

High stock turnover means increased efficiency.

However, it depends on the type of business.

Low stock turnover could mean poor customer satisfaction as people might not be buying the stock.

Asset Turnover

Asset Turnover = Sales / Net Assets

This secondary ratio from ROCE (see above) assesses the value of sales generated by the net assets representing the capital being employed in the firm. It illustrates how efficiently the firm is using its assets to generate turnover.

Investment / Shareholders

Shareholders are interested in the following ratios:

Dividends per Share

  • Total Dividends / Number of Shares Issued
  • A higher figure means the shareholder got a larger return.
  • Good to compare with competitors.
  • Businesses can improve this themselves by increasing dividend payments.

Dividend Yield

  • (Ordinary Share Dividend / Market Price) x 100
  • Compares the return amount with what would be needed to purchase a share.
  • The higher the better.
  • This ratio varies daily with changes to a company’s share price.

Gearing

This is an efficiency ratio.

Looks at the relationship between borrowing and fixed assets.

Gearing Ratio = (Long Term Loans / Capital Employed) x 100

The higher it is the greater the risk the business is under if interest rates increase.

Limitations with Accounting Ratios

To be most beneficial the results need to be compared with other data including:

  • The results for the same business over previous years.
  • The results of ratio analysis for their competitors.
  • The results of ratio analysis for other firms in other industries.

Other Factors to Consider

  • The market the business is trading in.
  • The position of the firm in the market.
  • The quality of the workforce and management.
  • The economic environment.

Investment Decision-Making

Investment refers to the purchasing of productive capacity or capital expenditure (spending by a business to buy fixed assets e.g. property, vehicles etc).

Why Invest?

Businesses need to invest to grow.

They might want to increase capacity so they can produce more.

If they produce more then they can sell more and increase sales revenue.

They could also look to invest to increase the efficiency of their operations.

Because of the major capital outlay involved, managers try to calculate expected profitability and expected cash flows for the proposed investment. They use three methods of investment appraisal.

Payback Period Method

This method of investment appraisal calculates how long it takes a project to repay its original investment. The method therefore concentrates on cash flow, highlighting projects that recover quickly their initial investment. Here is an example of how it works.

A company is considering two different capital investment projects. Both are expected to operate for four years. Only one of the projects can be financed.

The payback periods are calculated by adding annual depreciation back to the cash flows: depreciation is a non-cash expense that reduces profit, and so the profit figures given understate the cash inflows by the amount of the depreciation. Cash flow in year 4 is also increased by the scrap values for each project.

This method is easy to calculate and understand.

  • Its use emphasizes liquidity because calculations are based solely on cash flow.
  • It also helps managers to reduce risk by selecting the project that recovers its outlay most quickly.

Early cash flows can be predicted more accurately than later ones and are less affected by inflation.

The main drawback of this method is that it completely ignores profit and profitability. It also takes no account of interest rates.

Accounting Rate of Return (ARR) Method

This method of investment appraisal calculates the expected profits from the investment, expressing them as a percentage of the capital invested. The higher the rate of return, the better (i.e. the more profitable) is the project. The ARR is therefore based on anticipated profits rather than on cash flow.

ARR = (Expected Average Profits / Original Investment) x 100

The accounting rate of return method is easy to use and simple to understand.

  • It measures and highlights the profitability of each project.

Its disadvantages are that it ignores the timing of a project’s contributions. High profits in the early years – which can be estimated more accurately, and which help minimize the project’s risk – are treated in the same way as profits occurring later. It also concentrates on profits rather than cash flows, ignoring the time value of money (profits in the later years being eroded by the effects of inflation).

Discounted Cash Flow (DCF) Method

The principle of DCF is based on using discounted arithmetic to get a present value for future cash inflows and outflows. This method is sometimes divided into two elements, which complement each other:

  • The Net Present Value (NPV) method, which takes account of all relevant cash flows from the project throughout its life, discounting them to their present value.
  • The Internal Rate of Return (IRR) method, which compares the rate of return expected from the project with that identified by the company as being the cost of its capital – projects having an IRR that exceeds the cost of capital are worth considering.

If the NPV is positive – cash benefits exceed cash costs – this means that the project will earn a return in excess of its cost of capital (the rate of interest/discounting used in the calculations).

If the NPV is negative, this means the cost of investing in the project exceeds the present value of future receipts, and so it is not worth investing in it.

KEY POINTS – Organizations undertake investment appraisal to evaluate the likely success and value of capital investments, which tie up the firm’s finance for a long period, normally for a number of years.

Marketing & Planning

Marketing Budget

A marketing budget sets out the costs and revenues that are allocated to the marketing department. The marketing budget will influence the promotional tools that a business is able to utilize.

Sales Forecasting

Sales forecasting sets out targets for overall sales for products and is a goal for the firm to achieve.

It influences other decisions:

  • Production schedule.
  • Cash flow forecast.
  • Human resources decisions.

Producing a Sales Forecast

  • It may be based on historical / back data.
  • The firm can use market research to try and identify likely future trends.
  • It may be based on the firm’s best guess.
  • Nature of the forecast depends on nature of the firm’s product and the market situation.

Problems with Forecasts

  • Customer-buying behavior suddenly changes.
  • Original market research was poor.
  • The experts got it wrong.

Reliability of Forecasts

Forecasts are most likely to be correct when:

  • Trend has been extrapolated and market conditions continued as before.
  • Test market is used and represents entire population.
  • Forecast is made by experts.
  • Firm is forecasting in the near future.

Marketing Planning

  • Develop tactics to support the marketing strategy.
  • Sets targets Develops different elements of the mix.
  • Allocates funds to different activities.
  • Decides on a time schedule.

Key Terms

  • Product Life Cycle.
  • Marketing Budget.
  • Test marketing.
  • Sales forecasting.

Advantages of Marketing Planning

  • Sets out in detail what it wants to achieve.
  • Managers can review the firm’s progress by comparing actual outcomes with planned outcomes.
  • It forces managers to think ahead and consider what might happen.
  • Provides direction.

Disadvantages of Marketing Planning

  • The plan may become out of date with changes to the market.
  • Can take up a lot of time and delay vital decision making.

Evaluation of the Plan

  • Is it realistic?
  • Does it help achieve the strategy?
  • Is it affordable?
  • Does it fit with the firm’s strengths?

Sales Budget

A target level of sales for a product (actual or market share) – SALES BUDGET

Size is dependent on:

  • Past sales of the product.
  • Expenditure budget.
  • Market conditions.
  • Objectives and strategy.

Expenditure Budget

This is a target level of expenditure a firm sets to achieve its marketing objectives.

Size depends on:

  • The firm’s overall financial position.
  • The firm’s marketing objectives and strategy.
  • The amount the firm expects to receive back.
  • Competition.

Elasticity

Elasticity measures how responsive demand is to a change in price / income.

PED = % Change in Quantity Demanded / % Change in Price

YED = % Change in Quantity Demanded / % Change in Income

Inelastic: less responsive to a change in price / income.

Elastic: more responsive to a change in price / income.

If YED / PED is greater than 1 it is elastic.

If YED / PED is less than 1 it is inelastic.

If YED / PED is 1 it is neither elastic nor inelastic.

To increase revenue for elastic goods you decrease price.

To increase revenue for inelastic goods you increase price.

Elastic goods tend to be:

  • Luxuries.
  • Many substitutes.
  • Take up a large % of income.

Inelastic goods tend to be:

  • Necessities.
  • Few substitutes.
  • Take up a small % of income.
  • Goods with strong brand.