Financial Ratios
Do Now!
Name the 6 books of Explain the difference How does a sale a differ to
prime entry between GP and NP part ex in double entry
Name 4 source What are the 5 ethical Which errors are revealed
documents principles by the trial balance
CHALLENGE: What might today’s big Q be & how does above link in?
Do Now!
How can NP margin and Explain the difference How does a sale a differ to
GP margin be between the mark-up and part ex in double entry
improved? margin ratio
How can missing cash Explain how inventory is What are the effects of
be identified? valued using the formula lower inventory value?
CHALLENGE: What might today’s big Q be & how does above link in?
Do Now!
State 2 profitability Explain the difference What are the benefits of
ratios between the mark-up and ratio analysis?
margin ratio
State 2 liquidity ratios How can a low ratio of What are the drawbacks
liquidity be seen as a of ratio analysis?
positive?
CHALLENGE: What might today’s big Q be & how does above link in?
Do Now!
State 2 efficiency ratios Explain the difference What are the benefits of
between the mark-up and ratio analysis?
margin ratio
State 2 liquidity ratios How can a low ratio of What are the drawbacks
liquidity be seen as a of ratio analysis?
positive?
CHALLENGE: What might today’s big Q be & how does above link in?
Do Now!
What are the 3 Explain how each of What is the double
types of them are treated entry for goods for
discount? own use?
How do you Explain the How can TR/ TP be
remember principle of going improved?
accruals and concern
prepayments?
Share an example
CHALLENGE: What might today’s big Q be & how does above link in?
Year 12 Accounting
1. An introduction to the role of the accountant in business
2. Types of business organisation
3. The double entry model
4. Verification of accounting records
What influence do ratios 5. Accounting concepts used in the preparation of accounting
have? records
6. Preparation of financial statements of sole traders
7. Limited company accounts
Why are we learning this 8. Analysis and evaluation of financial information
9. Budgeting
topic? 10. Marginal costing
11. Standard costing and variance analysis
12. Absorption and activity based costing
Why now? 13. Capital investment appraisal
14. Accounting for organisations with incomplete records
15. Partnership accounts
16. Accounting for limited companies
17. Interpretation, analysis and communication of accounting
information
18. The impact of ethical considerations
Learning aim: 3.8
Calculation and interpretation of
financial measures and ratios.
Ratios
• Interpretation of figures
• Applicable for both financial statements
• For internal and external stakeholders
• Guidance for exam questions:
• Show the formula
• Know if it is a %, ratio, days or times
• Comparison of companies
• Comparison of industry averages
• Benefits, limitations
• Analyse significant changes in statements
• Recommendations for improvement
Profitability
Profit measurement against key factors
Gross profit margin
Gross Profit x 100
Revenue
• Gross profit percentage in relation to revenue
• e.g. a 60% result means for every £1 in Revenue (sales), 60p
is gross profit
• Improve by increasing the selling price or reduce cost of sales
– quality?
• Reduce wastage, theft and damaged goods
• Higher the better
Profitability
Profit measurement against key factors
Net profit margin (profit in relation to revenue)
Net Profit x 100
Revenue
• Net profit percentage in relation to revenue
• e.g. a 35% result means for every £1 in Revenue (sales),
35p is net profit
• Improve by increasing alt income or the selling price or
reducing expenses – e.g. impact of less advertising
• Higher the better
Profitability
Mark up
Gross Profit x 100
Cost of Sales
• Gross profit percentage in relation to cost
• e.g. If you achieve a result of 67% this would mean
a profit of 67% - a 67% mark up on cost
• Cost is £0.60p + mark up 67% = a selling price of
£1.00
• (0.60 x 1.67) = £1.00 or £1.00 / 1.67 = £0.60p
• Higher the better
Profitability
Expenses in relation to Revenue
Expenses x 100
Revenue
• Expenses as a percentage of revenue
• e.g. If you achieve a result of 62.5% this would
mean a 62.5% of the revenue value is expenses
• e.g. £4000 in revenue. £2,500 in expenses
• £2,500 / £4,000 is 62.5%
• Lower the better
Profitability
Return on Capital Employed
Net Profit (before interest & tax) x 100
Capital employed
• Percentage of return on capital
• Minimum comparison to interest rates or
other investment opportunities
• Higher the better
Liquidity
Liquidity – the ability to meet short-term debt
(solvent)
Current ratio
Current Assets
Current Liabilities
• A comparison of Assets to Liabilities.
• e.g. £10,000 / £4,000 = 2.5 i.e. 2.5:1
• The company has 2.5 times more assets than liabilities
– therefore it is able to meet short-term debt
• The minimum standard is 2:1 and no less than 1:1
Liquidity
Liquidity – the ability to meet short-term debt
Liquid Capital ratio - Acid test
Current Assets – C/ Inventory
Current Liabilities
• A tougher measure the current ratio
• Inventory is excluded because it can take time to turn
into cash.
• Liquid or illiquid
• Higher the better though having too many assets can be
inefficient i.e. TR being too high can impact bad debt
Efficiency
The management of stocks & finances
Trade Receivable days
Trade Receivables x 365
Credit Sales
• The average duration it takes for customers to pay. If a credit
sales figure isn’t available, use the sales revenue amount.
• Result is expressed as days.
• This can be compared to credit terms
• To improve cash flow, terms can be reduced to bring the cash
in quicker, loss of sales, loyalty
Efficiency
The management of stocks & finances
Trade Payable days
Trade Payables x 365
Credit Purchases
• The average duration it takes to pay suppliers
• If a credit purchases figure isn’t available, use the purchases
amount given.
• To improve cash flow, terms can be negotiated for an
extended term e.g. 30 to 60 days, stay within the term, default
can affect interest, relationships, discounts
For TR and TP ratios, analyse the effect of both
Efficiency
Inventory Turnover
Average Inventory x 365 OR Cost of Sales Times
Cost of Sales Average Inventory
Av Inventory = (opening + closing)/ 2
• The average duration by which stock is held in days or times
• Food vs furniture
• Higher the better to release cash though this can be manipulated
• Lower prices, offer or longer credit periods, level method re-
ordering, stock management JIT, change suppliers
• Debt collection costs, bad debt risk, no stock, quality
Gearing
To be covered in Limited Company Accounts
Benefits of ratio analysis
• Comparable data with other companies
• Highlights key important information
• Summarises financial statement data
• Summarises complex data
• Interprets financial information
• A simplistic and systematic approach to analysis
Limitations of ratio analysis
• Industry averages could be based on poor
performing businesses, or unreliable or
distorted
• Based on past data at a particular point and not
current data thus obsolete and
• Based on summarised and grouped data hiding
the real picture
• If financial records are dressed or manipulated
then ratios will reflect this
• Ratios focus on quantitative data and do not
consider qualitative factors or the external
environment e.g. economical factors
Limitations of ratio analysis
• Accounting policy can change and can be different thus
ratios exclude these changes therefore comparison is
inconsistent
• Does not identify the success factor or cause of the
problem , nor a solution
• Comparison with competitors can be difficult as their
accounts can be quite different e.g. a ltd international
company
• Effective if past data is available and in comparable
form
• Ratios can be based on estimate and assumptions (e.g.
depreciation or stock values hence is analysis accurate
