3.5

• Ratio


  One number expressed in terms of another
• Ratio analysis


  A quantitative management tool that compares different financial figures to examine and judge the financial performance of a business
• Financial accounts used in ratio analysis

  • Balance sheet
  • Profit and loss account
• Assessing whether financial performance has improved, ratios for the current period are compared with historical figures
• The same ratios can be compared to those of rival businesses to judge whether the firm has improved against its competitors
• Profitability ratio


  Examines profit in relation to other figures, such as the ratio of profit to sales revenue
• Profit is a key objective for most businesses and acts as a measure of a firm's financial success
• Profit


  The financial surplus earnings of an organisation once all costs have been deducted from sales revenue
• Main profitability ratios


  • Gross profit margin
  • Profit margin
  • Return on capital employed
• Gross profit margin


  Shows the value of a firm's gross profit expressed as a percentage of its sales revenue
• Gross profit margin calculation

  Gross profit / Sales revenue x 100
• The higher the GPM, the better it is for a business, as gross profit goes towards paying for its expenses
• Strategies to improve gross profit margins

  • Raise revenue
  • Reducing direct costs
• Profit margin


  Shows the percentage of sales turnover that is turned into overall profit
• Profit margin calculation


  Profit before interest and tax / Sales revenue x 100
• A profit margin ratio of 35% means that for every $100 of sales, $35 is profit
• Return on capital employed (ROCE)

  A profitability ratio that measures the financial performance of a firm based on the amount of capital invested
• ROCE calculation


  Profit before interest and tax / Capital employed x 100
• Capital employed


  The sum of total internal sources of finance + all long-term external sources of finances
• Many people regard the ROCE as the single most important financial ratio as it measures how well a firm is able to generate profit from its sources of funds
• The higher the ROCE result, the better it is for the firm as it has been more efficient at generating profit from the funds available
• Limitations of strategies used to improve ratios

  • Every strategy to improve ratios will have drawbacks
• Liquidity ratios look at the ability of a firm to pay its short-term liabilities
• Liquidity ratios studied in this course

  • Current ratio
  • Acid test (quick) ratio
• Current ratio


  Deals with the liquid assets and short-term liabilities of a firm
• Current ratio calculation


  Current assets / Current liabilities
• The ideal benchmark for the current ratio is 1.5 to 2.1
• Acid-Test (quick) ratio


  A ratio that ignores stock when measuring the short-term liquidity of a business
• Quick ratio calculation


  (Current assets - Stock) / Current liabilities
• The ideal benchmark for the quick ratio is 1:1
• Gross profit


  The amount of money left after deducting the cost of goods sold from revenue
• Debtors


  Individuals or businesses that owe money
• Quick ratio


  A ratio which deals with the liquid assets and short-term liabilities of a firm
• Net profit reflects the amount of money you have left with after you have paid all your allowable business expenses
• It is important for potential investors to consider non-financial factors when making investment decisions
• Non-financial factors to consider

  • Environmental risks
  • Social risks
  • Governance risks
  • CSR practices
  • Brand reputation
  • Customer loyalty
• Howard-Lee demonstrates a consistent gross profit margin of 50% initially declining to 40% over the 3 years
• Quintanilla follows a similar trend in gross profit margin
• Howard-Lee maintains a stable profit margin of 20% throughout
• Quintanilla's profit margin slightly decreases from 19% to 18%