Ratio Analysis 

Ratio Analysis – mathematical approach to investigating accounts by comparing two related figures. 

Two main types of Ratios 

• Profitability Ratios – measures the performance of the business and focuses on profit, revenue and the amount invested in the business. 
• Liquidity Ratios – measures how easily a business can pay its short-term debts, such as wages or suppliers. 

Gross Profit Margin 

Gross Profit Margin works out the amount of profit from the buying and selling of goods before all other expenses are deducted. 

The formula is: (Gross Profit/Sales Revenue) x 100 

Two ways of improving this is to: 

• raise the selling price of the product 
• negotiate deals with less expensive suppliers 

Operating Profit Margin 

The operating profit margin helps to measure how well a business controls its expenses and costs of sales. If the difference between the gross profit margin and the operating profit margin is small, this suggests that expenses are low. The operating profit margin can be calculated by:

Operating profit margin = (operating profit / revenue) x 100

Ways of improving this is to: 

• decrease expenses, for example finding cheaper premises to rent 
• increase the gross profit figure 

Return On Capital Employed (ROCE) 

Profit of a business as a percentage of the total amount of money used to generate it. One of the most important profitability ratios is the return on capital employed (ROCE). It compares the profit (return) made by the business with the amount of money invested (its capital). The advantage of this ratio is that it links profit to the size of the business. ROCE can be calculated using the formula:

ROCE – operating profit / capital employed x 100

Two ways of improving this is to: 

• increase sales 
• reduce expenses 

Mark-Up 

Some businesses are interested in the profit made per item sold. This is called the mark-up and is calculated by:

Mark-up = profit pre item / cost per item x 100

Liquidity ratios 

Liquidity ratios calculate the organisation’s ability to turn assets into cash in order to pay debts. 

Current ratio 

Current ratio or the working capital ratio demonstrates the firm’s ability to meet its short-term creditors.

An ideal ratio of 2:1 is generally agreed. If the ratio is higher, 4:1 it could mean that the firm is inefficient and has too much money tied up in stock. On the other hand, a lower ratio value of 1:1 would mean that it may not be able to meet its debts quickly. 

Ways of improving this is to: 

• increase current assets 
• if ratio is too high you can sell non-current assets 
• decrease current liabilities for example, reducing trade credit terms 

Acid test ratio 

Acid test ratio is a more severe test of a firm’s capabilities to meet its debts. 

The formula is the same as the current ratio but with the added problem of writing off all stock. This is because it assumes that stock: 

• may be perishable 
• may go out of date 
• may go out of fashion or become obsolete 

In other words, the firm may be left with stock it cannot sell. An ideal value of 1:1 is generally accepted. 

Purpose of Ratio Analysis 

• ratios help compare current performance with previous records 
• ratios help compare a firm’s performance with similar competitors 
• ratios help monitor and identify issues that can be highlighted and resolved 
• ratios help with future decision making 

Limitations of Ratio Analysis

• ratio analysis information is historic – it is not current 
• ratio analysis does not take into account external factors such as a worldwide recession 
• ratio analysis does not measure the human element of a firm 
• ratio analysis can only be used for comparison with other firms of the same size and type 
• it may be difficult to compare with other businesses as they may not be willing to share the information