Financial Ratios

Financial Ratios

1. Why do we do ratios?

   • Interpret and analyse financial statements
   • Vertical analysis - 1 financial year
   • Horizontal analysis - between financial years
   • Trend analysis - 3-5 years

2. Liquidity

   • Short term financial stability
   • Current assets and liabilities
   • Convert current assets to cash
   • Current ratio
     • Current ratio = Current assets/current liabilities
     • Ideal ratio is 2:1
       • For every $1 debt the business has $2 in assets

3. Gearing (solvency)

   • Long-term financial stability
   • Gearing (leverage)
   • Shows
     • a) ability to pay long term debt
     • b) can owners get a good return on their inverstment
   • Measuring debt vs equity
   • Greater risk means greater potential to make a profit
   • The type of business determines how much debt they can carry

4. Profitability

   • How profitable the business is
   • Gross Profit Ratio= Gross Profit/Sales
     • Works out for every $1 of sales
     • How much gross profit the business makes after paying for its stock
   • Net Profit Ratio= Net Profit/Sales
     • For every $1 of sales how much net profit the business makes after paying its expenses.

5. Efficiency

   • Shows how good the business is at keeping expenses low, how long it takes to receive money from accounts receivable and maximising the use of assets to increase profits.
   • Efficiency Ratio = Total expenses/Sales
   • Turnover Ratio = Sales/Accounts Receivable

6. Comparative Ratio Analysis

   • The ratios that are calculated using the financial reports are used to make comparisons
   • Comparing this years results to previous years to identify trends in profit costs and financial stability
   • The financial manager wants to determine if the business is reaching its financial goals of increasing profitability, efficiency, liquidity and solvency
   • The results are also compared to other businesses in the same industry. Is the business above average? If the results are below the industry standard the business plan will need to be reviewed and new strategies worked out.
   • The final results will be compared to what is considered to be the best possible result. The business is aiming for a benchmark.