Author: Alison Harrison

Ratios

There are a number of different ratios that can be used by companies to help them measure and analyse their performance. The ratios are often compared to previous year’s performance as well as the average results for your industry. This can then be used to measure how well you may be doing in different aspects of your business. There are 5 different categories of ratios that each ratio falls under. These are: profitability ratios, market ratios, debt ratios, activity ratios and liquidity ratios.

Profitability ratios are probably the most commonly used ratios, they measure how a company would use its assets and how it controls its expenses to produce a good rate of return. Market ratios are used to show the return on investment for the business. They are often used when trying to sell a business to show potential investors that the company is worth buying into and will be profitable. Debt ratios are often used to measure how quickly a business can pay off any long tern debts, for example a bank loan or mortgage. Activity ratios are used to measure whether a business is getting the most out of their resources and also whether their cash is being utilised. Liquidity ratios are used to measure whether a business is capable of paying of their debts, for example a business may have a lot of cash in the bank but if their liabilities are higher than their assets then their company is not liquid.

You do however need to be careful when using any single ratio as it will never give you the full picture of how well your business may be doing. An example of how this may happen is if you use the gross profit margin ratio  and compare it to the net profit margin ratio.

A simple example of this is shown below.

Looking at the results above you can see two very different results but they are both correct so must be used correctly. If for example you had set a target at the beginning of the year to make a 25% profit. If you were to use the gross profit margin you can see that the profit you have made would be 30% which is great as it looks like you have beaten your target. However as you are able to see this doesn’t show you the full picture as the 30% doesn’t include any of your expenses. When you take your expenses into account you can see that your profit margin falls to only 5%.

Another ratio that is good to use is the current ratio  (also known as the working capital ratio). This is one of the basic liquidity ratios as it simply uses the company’s current assets to see if they would be able to cover their current liabilities. An example of this is shown below:

As you can see in this example the company’s current ratio is 2.0. This means that for every £1 of liabilities that they have, it is covered by £2 worth of assets. A common rule of thumb that is used is that if you have at least a 2.0 current ratio your company is often in a good position.

VAT  (or Value Added Tax to give its full name) was introduced in the UK IN 1973 and is the third largest source of government revenue  after income tax and National Insurance.  VAT is levies on the sale of goods and services by UK businesses.

The standard rate of VAT is currently 20% and this rate has been in place since 4^th January 2011.   This rate covers most goods and services.

The other rates are:-

Reduced rate of 5%, which covers some goods and services, such as domestic  fuel or children’s car seats.

Zero rate, examples of which are children’s clothes and some foods.

Some items are exempt from VAT altogether, such as postage stamps and insurance.  No VAT is charged on anything that is outside the scope of the UK VAT system.

VAT is charged by a business  at the point of sale of goods and services.   The threshold for a  business  to register for VAT is when the  VAT taxable turnover exceeds £83,000 (April 2016).   (Taxable turnover is the total value of everything sold that is not exempt from VAT.  There are, however, different thresholds for buying and selling from other EU countries).

To register for VAT, a business will need to contact HMRC if the business goes over the VAT threshold in a rolling 12 month period.  In fact, a business should monitor its turnover regularly  to check whether it will go over the threshold.   It is generally possible to register with HMRC and it is possible to appoint an agent such as Harmonea to submit VAT returns behalf of the business.

The de-registration level for a business is less then £81,000 (April 2016).

There are various VAT schemes and here are examples of some of the schemes:-

The VAT Accrual Scheme:-

This is commonly used.  The return is calculated on the difference between the sales and purchase invoices within the relevant period, in this case, the last quarter.  The return does not take account of whether the sales and purchase invoices have been paid or are still outstanding.     A return is submitted to HMRC every quarter.

The Flat Rate Scheme:-

With this scheme, a business will pay a fixed amount of VAT.  The business will retain the difference between what it pays to HMRC and what it invoices its customers for.   However, no VAT can be claimed on the business’s purchases.  There is an exception to this, where it is possible to reclaim VAT on a single purchase of capital expenditure, where the amount of the purchase, including VAT, is over £2000.

The threshold for joining this scheme is £150000 and is over £230000 to leave.  The scheme cannot be rejoined  until 12 months after leaving.

There are incentives for the first year of registration.

Cash Accounting Scheme:-

With this scheme, VAT is not included on the sales of a business until the customer pays the invoice.  With regard to the purchases, the VAT on these cannot be reclaimed until the purchases have been paid.  Cash Accounting is ideal for those with slow payers.

The joining threshold for this scheme is £1.35 million and the threshold for leaving the scheme is £1.6 million.

Annual Accounting Scheme:-

If this scheme is used, the business will make advance VAT payments to HMRC.  These payments are based on the VAT due for the previous year or on an estimated  return for a new business.

Only once VAT return is submitted each year and this will include the balance of the VAT due.   If the VAT has been overpaid , then it will be necessary to apply for a refund.

The turnover would need to be £1.35 million for joining the scheme and over £1.6 million to leave.

A VAT return can be submitted online and is due one calendar month and seven days after the end of the last quarter, (a quarter is known as the accounting period).  The payment also needs to reach HMRC within this timeframe.  There are various penalties for late submission of a VAT return, the severity of which depends on the amount of previous late submissions and the turnover of the business.

Please contact Harmonea if you would like any more information on VAT.

Ratios

To enable us to appraise the performance of a business there are a number of financial performance indicators that we can use. The key performance indicators (KPI’s) are sometimes referred to as ‘ratios’ and ratio analysis is an important part of how we can understand how well a business is doing. These KPI’s can be set as targets to help manage the performance of the business through the decisions made by management.

There are several categories of ratios that you can look at: profitability, revenue, cost and liquidity

Profitability Ratios:

Margins are a common way of measuring the profitability of a business by considering the profits earned compared to the sales revenue generated. They are sometimes referred to as measures of ‘return on sales’ for this reason.

Margin on Sales

There are two margins that can be calculated:

Gross Profit margin (%) = Gross Profit/ Sales x 100

Net Profit Margin (%) = Net Profit (profits before tax)/ Sales x 100

• Falling margins may be due to increasing costs or reduced selling prices
• Differences between the gross profit margin and the net profit margin allow you to establish whether changes in profitability are due to changes in cost of sales or caused by other operating costs
• Useful for setting prices e.g. increasing your selling price relative to the direct costs will result in an increased gross profit margin.

Return on capital employed (ROCE)

Whilst margins look at profits in relation to sales revenue generated, ROCE looks at profits in relation to investment required to finance the business.

ROCE = Net Profit / Capital employed* x 100

*Capital Employed = Total Assets less Current Liabilities

• It measures how much profit is generated for every £ of assets employed and indicates how efficiently the company uses its assets to generate profit
• The only ration that compares profits to the overall size of the business and is sometimes viewed as the most important ratio for analysis purposes

Revenue Ratios:

Average Selling Price = Total Revenue / No of units sold

• Average price charging for the units that we are selling
• Can be compared to competitors prices to see how competitively priced your products are

Sales per employee = sales / No of employees

• Measures the average value of sales generated per employee

Asset turnover = Sales/ Capital employed

• Measures the value of turnover generated for every £1 of assets employed
• Measures #efficiency’ of the use of assets that you have invested i.e. are the assets being used to generate adequate turnover

Cost Ratios:

It can be useful to measure how well a business is controlling its cost base as the level of trade grows.

Cost of sales as a % of turnover = Cost of sales/ Sales x 100

• If increasing as sales increase it may indicate poor cost control and that that the company is growing to quickly
• If falling as sales increase this may be due to ‘economies of scale’ as volumes rise e.g. bulk purchase discounts.

Liquidity Ratios:

Some ratios help us to consider the cash flow position of the business which is crucial for long term planning. Many profitable businesses become bankrupt due to poor cash flow management.

Current Ratio

This shows if the short-term liquid assets of the business (e.g. cash, trade debtors & inventory) are adequate to cover the short-term liabilities (e.g. Trade creditors Accruals & Tax).

Current ratio = current assets/ current liabilities

• If it falls year on year it may indicate difficulties with cash flow and that we will have difficulty paying creditors when they demand payment which can lead to bankruptcy.

Average receivables collection periods (debtors days)

This shows how long it takes you on average to collect money from trade debtors. It is important that you collect money quickly as this helps with liquidity and cash flow in order to pay suppliers, staff etc.

Debtors days = trade debtors / Sales x 365

• If increasing it indicates you are taking longer to collect debts. You may want to consider tightening up credit control or offering settlement discounts to encourage faster payment.

Average payables period (creditor’s days)

Shows how long you take to pay your suppliers

Creditors days = trade creditors / cost of sales x 365

• By delaying payment to suppliers you can improve your cash flow. However, this can have a negative impact on your relationship with these suppliers.

A ratio figure on its own means very little, to make sense of ratios you need to compare them to something. This could involve comparison with budgets, against previous year figures, against industry averages or perhaps competitors.