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.
