YEAR 10 BUSINESS NOTES

RATIO ANALYSIS
It is possible to look at the balance sheet and profit and loss account
and draw some conclusion about the financial position of the business.
However, a more precise way is to use ratio analysis.

Ratio analysis is a mathematical (numerical) approach to investigating

accounts by comparing two related figures. It involves taking key figures
from the accounts and calculating financial ratios. A ratio is a
mathematical expression of an amount in terms of another. A ratio may
be expressed as a percentage, as a fraction, or a stated comparison
between two amounts.
1. Profitability Ratios
These measure the performance of the business and focus on profit,
turnover and the amount invested in the business.
These ratios indicate the ability of the firm to control its cost of sales,
operating and financing expenses.
i. Gross Profit Margin
It shows the gross profit made on sales turnover. The ratio indicates the
ability of the firm to control cost of sales expenses e.g. gross profit
margin of 40% means 60% of sales revenue was taken up by cost of
sales while 40% was the gross profit.
It is calculated using the formula:
 Gross Profit Margin = (Gross Profit ÷ Turnover) × 100
For example, the following information was obtained from the accounts
of Eco-homes Plc.
2008 (£) 2007 (£)

Turnover 23,500 18,400

Cost of sales 12,500 10,100

Gross Profit 11,000 8,300

Net Profit 4,600 3,200

Stocks 4,900 5,000

Current Liabilities 8,700 7,800

Current Assets 13,600 11,900

Capital employed 20,000 18,000

Calculate Gross Profit Margin for Eco-homes Plc for 2007 and 2008.

Solution:

For 2007:

Gross Profit Margin = £8,300 × 100

£18,400

= 45.1%
For 2008:

Gross Profit Margin = £11,000 × 100

£23,500

= 46.8%

The Gross Profit Margin for Ecohomes Plc has improved slightly over
the two years from 45.1% to 46.8%.
Note:
Higher gross profit margins are better than lower ones.
To increase the gross profit margin, revenue must be increased or cost
of sales reduced. The gross profit margin will be different for different
industries. For example, firms that sell inventories quickly, such as
supermarkets, can operate with lower gross profit margins.

Courses of Reduction in Gross Profit Margin:

[Link] goods at cut prices
2. Holding seasonal sales
3. Offering trade discounts to customers buying in bulk
4. Not passing on increased costs to customers

Ways of improving Gross Profit margin:

[Link] for cheaper supplies
2. Increasing selling prices
3. Increasing advertising and sales promotions
4. Changing the promotions of the different types of goods sold.

ii. Operating (Net) Profit Margin

This measures how well a business controls its overheads and cost of
sales. The net profit margin can be calculated by:
Net Profit Margin =(Net Profit ÷ Turnover) × 100
For Ecohomes Plc in 2008 and 2007, the Net Profit Margin can be
calculated by.

For 2007:
Net Profit Margin £3,200 X 100
=

£18,400
= 17.4%

For 2008:

Net Profit Margin £4,600 X 100

=

£23,500

= 19.6%
The Net Profit Margin for Ecohomes has improved over the two years
from 17.4% to 19.6%. this suggests that the business kept control of
overheads more effectively in 2008 than in 2007.

Note:
If the difference between the gross profit margin and the operating
profit margin is small, this suggests that expenses are low.
Higher margins are better than lower ones. Operating profit margins
over 10 per cent would be considered as very good.

Liquidity Ratios
This measures how easily a business can pay its debts.

i. Current Ratio
This ratio indicates the No. of times the current liabilities can be paid
from current assets before these assets are exhausted.

The current ratio is a liquidity ratio and focuses on current assets and
current liabilities. It is calculated by:

Current ratio = Current Assets

Current liabilities
For Eco-homes, current ratio for 2007 and 2008 can be calculated by:

For 2007:

Current Ratio = £11,900

£7,800

= 1.53

For 2008:

Current Ratio = £13,600

£8,700

= 1.56

The current ratio for Eco-homes rose very slightly from 1.53 in 2007 to
1.56 in 2008.
Note:
It is suggested a business will have enough liquid resources if the
current ratio is between 1.5 and 2. If the ratio is below 1.5, it might be
argued that a business does not have enough working capital. This
might mean that a business is running short of liquid assets. Operating
above 2 may suggest that too much money is tied up unproductively.
ii. Acid Test Ratio
The acid test ratio is a more severe test of liquidity. This is because
stocks are not treated as liquid resources. Stocks are excluded for two
basic reasons.
 i) They are valued on historical cost basis
ii) They may not be converted into cash very quickly
Acid Test Ratio = Current Assets – Stock
Current Liabilities

The ratio therefore indicates the ability of the firm to pay its current
liabilities from the more liquid assets of the firm.
For Eco-homes Plc, Acid Test Ratio for 2007 and 2008 is:

For 2007:

Acid Test Ratio = Current Assets – Stock

Current Liabilities

= £11,900 - £5,000
£7,800

= 0.88
For 2008:

Acid Test Ratio = Current Assets – Stock

Current Liabilities

= £13,600 - £4,900
£8,700

= 1
Over the two years, the acid test ratio for Eco-homes has improved
slightly from 0.88 in 2007 to 1
in 2008.

Note:
If the acid test ration is less than 1, it means that current assets less
inventories do not cover current liabilities – this might be a problem.
However, as with the current ratio, the acid test ratios of businesses in
different industries tend to vary. For example, retailers that receive
cash for all their sales can often operate effectively with much lower
acid test ratios than, say manufacturers that offer trade credit to
customers.
 3. Return On Capital Employed (ROCE)
It compares the profit (return) made by the business with the amount
of money invested (its capita). This ratio indicates the returns of
profitability for every one shilling of capital employed in the firm.
The advantage of this ratio is that it compares profit to the size of the
business. It is calculated by:

Operating profit
Return on Capital Employed (ROCE) = × 100
Capital employed
For Ecohomes Plc

ROCE for 2007;

Return on Capital Employed (ROCE) = £3,200x100

£18,000

= 17.78%

ROCE for 2008;

Return on Capital Employed (ROCE) = £4,600×100

£20,000

= 23%
Efficiency Ratios
[Link] Turnover ratios

The higher the stock turnover, the better the firm and more likely the higher the
sales.

Stock (inventory) turnover = Cost of sales

Average stock

Average stock = Opening stock + Closing stock

2
Example
Use the following information to calculate the stock turnover for the firm:

Ksh

Cost of goods sold 5,600

Opening stock 500

Closing stock 900

Solution:

Average stock = 500 + 900

=Ksh 700

Therefore, Stock turnover = 5,600

700

= 8 times
Debtors’ collection period (Debtors /sales ratio)

It is the average amount of time that debtors take to pay their accounts.

A decrease in this ratio may indicate that the business has a more efficient credit
control policy.

The older a debt is allowed to become, the greater the risk of it becoming a bad
debt.

Debtors’ collection period = Debtors x 365

Credit sales

Ways of improving the collection period for Debtors:

[Link] cash discount for early settlement of debtors

[Link] interests on overdue debts

[Link] credit control by sending regular statements of accounts.

4. Consider invoice discounting and debt factoring

5. Refusing further supplies until the understanding balance is paid.

Creditors payment period (Creditors/purchases ratio)

It is the average amount of time the business takes to pay its creditors.

Creditors’ payment period = Creditors x 365

Credit Purchases

An increase in this ratio may indicate that the business is short of liquid funds and
is finding it more difficult to pay.
Uses/Application of Ratios
Ratios are used in the following ways by managers in various firms.

i. Evaluating the efficiency of assets utilization to generate sales

revenue i.e. turnover ratio.
ii. Evaluating the ability of the firm to meet its short-term financial
obligation as and when they fall due (liquidity ratios).
iii. To carry out industrial analysis i.e. compare the firm’s performance
with the average industrial performance of the firm with that of
individual competitors in the same industry.
iv. For cross sectional analysis i.e. compare the performance of the
firm with that of individual competitors in the same industry.
v. For trend/time series analysis, i.e. evaluate the performance of the
firm over time.
Limitations of Ratios
Ratios have the following weaknesses:

1. They ignore the size of the firm being compared e.g. in cross-sectional
analysis, the firm being compared might be of different size,
technology and product diversification.
2. Effect of inflation - Ratio ignores the effect of inflation in performance
e.g. increase in sales might be due to increase in selling price caused
by inflationary pressure in the economy.
3. Ratios ignore qualitative or non-quantifiable aspects of the firm e.g.
important assets such as corporate image, efficient management
 team, customer loyalty, quality of product, technological innovation
etc. are not captured in ratio analysis.
4. Ratios are computed only at one point in time i.e. they are subject to
frequent changes after computation e.g., liquidity ratios will
constantly change as the cash, debtors and stock level changes.

5. Monopolistic firms -It is difficult to carry out industrial and cross-

sectional analysis for monopolistic firms since they do not have
competitors and they are the only firms in the whole industry e.g.
Kenya Power and Lighting Company,
6. Historical Data – Ratios are computed on historical information or
financial statement thus may be irrelevant in future decision-making
of
7. Different accounting policies – Different firms in the same industry
use different accounting policies e.g. methods of depreciation and
stock valuation. This makes comparison difficult.

Methods of Improving Profits

i. Increasing the use of advertising and sales promotion
ii. Reducing prices of goods and services to increase demand
iii. Improving credit terms offered to business customers to
encourage bulk buying
iv. Reducing costs of supplies and expenses
v. Offering a wider range of products or services to attract more
customers
vi. Expanding business operations

THE END