Monitoring the Business Using Ratios to Analyse Financial Statements Chapter 11.
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Transcript of Monitoring the Business Using Ratios to Analyse Financial Statements Chapter 11.
Monitoring the BusinessUsing Ratios to Analyse Financial Statements
Chapter 11
Profitability Ratios1. Gross Profit Margin (Gross
Margin)2. Net Profit Margin (Net
Margin)3. Return on Investment/Return
on Capital Employed
Analyses the Profit earned
by the business
1. Gross Profit Margin (Gross Margin)Gross Profit x 100 = %Sales 1
Example:50000 x 100 = 27.78%180000 1
Measures the gross profit for the year as a percentage of the sales for
the year
The higher the gross profit margin the better – the firm will be able to pay the expenses of running the
business
2. Net Profit Margin (Net Margin)Net Profit x 100 = %Sales 1
Example:30000 x 100 =16.67%180000 1
Measures the net profit for the year as a percentage of the sales for
the year
The higher the net profit margin the better for the firm as this is the percentage profit on sales after all
expenses have been paid
3. Return on Investment/Return on Capital Employed
Net Profit x 100 = %Capital Employed * 1
Example:30000 x 100 = 16.67%180000
*Capital Employed = Ordinary Share Capital + Preference Share Capital + Reserves + Long Term Loan
Compares the net profit
(return) earned for the year with the amount of finance being
used by the firm i.e. the
profitability of the business
compared to the money invested
in it
A firm will want the Return on Investment to be as high as possible and to be above the bank interest rate –
commonly used to compare the profitability of different businesses
Liquidity Ratios4. Current Ratio/Working
Capital Ratio5. Acid Test Ratio/Quick Ratio
Analyses the ability of the
firm to pay its short-term
debts as they fall due
4. Current Ratio/Working Capital RatioCurrent AssetsCurrent Liabilities
Example:42000 = 2 (2:1)21000
Compares the current assets
with the current
liabilities
Ideally this figure should be 2 or 2:1, then the firm is liquid meaning it can pay its short-term debts as they
fall due
5. Acid Test Ratio/Quick Ratio
Current Assets – Closing StockCurrent Liabilities
Example:43000 - 12000 = 1.48 21000
Takes into account the fact that stock as a current asset may not be easily
and quickly converted into
cash
If the acid test ratio is close to 1:1, then the firm is liquid meaning it can pay its short-term debts as they fall due, if its lower than this then the firm may have
problems
6. Debt Equity Ratio/Gearing Ratio
Debt Capital*Equity Capital**Example:30000 = 0.18:1162000
*Preference Shares + Loans/Debentures**Ordinary Shares + Retained Earnings
Analyses the proportions of debt finance and interest-free capital
being used by the firm
Examines the types of long term-finance or
capital being used by the firm
The lower this ratio, the less fixed interest that will have to be paid – low debt/equity allows the ordinary
shareholders to receive more of the profits
A. Calculate the (1) gross margin and (2) net margin for 2005 and 2006
B. Calculate the (4) working capital ratio and the (5) acid test ratio for 2005 and 2006
2006 2005 2006 2005
€ € € €Trading , Profit and Loss a/c Balance Sheet
Sales10000
0 80000Current Assets 160000 120000
Gross Profit 30000 20000Current Liabilities 100000 60000
Net Profit 15000 16000Closing Stock 80000 50000
2006 2005 € €Closing Stock 46000 38000Long Term Debts 180000 126000Retained Earnings 54000 50000Current Liabilities 36000 40000Current Assets 71000 86000Equity Share Capital 210000 210000Net Profit 100000 90000
Calculate the (3) Return on capital employed and (6) debt/equity ratio for 2005 and 2006