Financial Reports and RatiosAnalytical Techniques

The analytical technique of ratio analysis permits businesses to study end of period reports in order to base decisions for the future.

Ratio Analysis

• Valuable tool for interpreting financial ratios

• Efficient way to express relationship of one number to another

RATIOS

• Presented as % or as ratios• Assist in:

– decision making– Interpreting financial reports– Assessment of enterprise’s:

• Profitability• Stability• Effectiveness

Ratios

ProfitabilityProfitability is the ability to earn income within the present financial structure of an enterprise.

Profitability Ratios

• Gross profit ratio• Net profit ratio• Ratio of expenses to sales

Gross Profit Ratio

Indicates the ability of a trading enterprise to generate gross profit from sales.

Compare result to industry benchmarks to determine suitability of business performance

x100Sales NetProfit Gross

Result indicates:

• for every $ of sales – number of cents retained as gross profit

• how effective business is in passing on increases in COGS to customers

High result may indicate:• ability of business to cover all

costs• capacity to earn acceptable net

profit and return to owner

Low result may indicate inability to:• meet further costs• return satisfactory net profit• return satisfactory rate to owner

Recommendations

Improve sales• Ascertain:

– stock levels - should be high enough to meet demand

– appropriateness of stock to appeal to market

– demand for stock held– Appropriateness of selling price

• Conduct market research/analysis to assist with the above.

Institute policy to minimise COGS

• Investigate alternative suppliers selling similar quality products for less

• Take advantage of discounts offered to lower costs

Net Profit Ratio

•Indicates the ability of a trading enterprise to generate a return on the owner’s investment.

•Compare result to industry benchmarks to determine suitability of business performance

x100Sales NetProfit Net

• Result indicates:

• for every $ of sales – number of cents retained as net profit

• how effective business is in minimising expenses

• poor GP ratio will impact on NP ratio

High result may indicate:• High operating revenue• Low operating expenses

Low result may indicate inability to:• inappropriate pricing policy• inadequate stock• inappropriate stock• expenses too high

Recommendations

Improve sales• as per Gross Profit recommendations

Minimise expenses• Set budgets for departments• Investigate alternative suppliers to

lower costs• As per Gross Profit recommendations

Rate of Return on Equity Ratio

Indicates the return to the owner on the amount invested in the business

Aim for a return of, around, 14% which allows funding for future growth and a return on investment.

x100Equity sOwner' Average

Profit Net

OE Avg /2end OE beg OE

High result may indicate:• efficient operation• business may be under-

capitalised (owner has not contributed equity to the optimum level)– Under-capitalisation can be

identified when NP ratio is close to or under industry benchmark yet ROE is well above industry benchmark

Low result may indicate:• owner’s money may perform better

invested elsewhere• business may be over-capitalised (if

owner has invested over the optimum sum into the business)– Can be identified when NP ratio is close to

industry benchmark yet the ROE result is well below industry benchmark

• management may take little risk therefore business is cautiously run

• inefficient management making poor decisions, lack of foresight.

Recommendations

Improve net profit result using previous recommendations.

Check level of capitalisation to ensure appropriateness for industry.

– If under-capitalised owner should consider investing further funds into the business.

– If over-capitalised owner should consider investing excess funds into alternative investments.