accounting - module 2 - unit 4

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Unit 4 - Analysing business performance

Profitability Ratios

1. Gross Profit Margin % = Gross Profit / Revenue x 100

Measures the percentage of revenue that is gross profit.

An increase in the gross profit margin implies the business has either:

Raised the selling price and kept the cost price unchanged

Raised the cost price and kept the selling price unchanged

2. Mark Up % = Gross Profit / Cost of Sales x 100

Measures the percentage added to the cost price to arrive at the selling price.

An increase in the mark-up implies the business has either:

Raised the selling price and kept the cost price unchanged

Raised the cost price and kept the selling price unchanged

A fall in the mark-up will mean a lower gross margin.

3. Profit in Relation to Revenue % = Net Profit / Revenue x 100

This represents the percentage of revenue that is net profit after all overheads in running the business have been deducted.

4. Overheads in Relation to Revenue % = Overheads / Revenue x 100

Represents the proportion of revenue represented as overheads.

A rise in the Overheads in relation to revenue ratio means the buiness has become less efficient because overheads account for a higher proportion of sales revenue.

A fall in the Overheads in relation to revenue ratio means the

buiness is more efficient because overheads account for a lower

proportion of sales revenue.

5. Return on Capital Employed %

Capital employed = Owner's capital + Loan capital

Sole Trader = net profit / capital employed x 100

Limited Company = operating profit / capital employed x 100

ROCE represents the return generated on capital employed in the business, and is the most important measure of how well the business is using its resources to generate profit.

A ROCE of 10% means that for every £1 invested in the business, it is generating a return of 10p.

A rise in the ROCE implies the business is using its assets more efficiently to generate profits.

Liquidity Ratios

1. Net Current Asset ratio = current assets / current liabilities : 1

Expresses current assets as a ratio to current liabilities.

A net current asset ratio of 2 would imply:

The current assets are twice the value of current liabilities.

The business has £2 of current assets for every £1 of current liabilities.

2. Liquid Capital ratio = (current assets - stock) / current liabilities : 1

Expresses liquid assets as a ratio to current liabilities.

Stock is excluded from this ratio because it takes time to sell, and may even be unsaleable.

A liquid ratio of 0.9 implies:

The business has 90p of liquid assets to cover £1 of current liabilities.

Liquid assets can be used to generate cash in the next financial year to pay current liabilities as they fall due.

Credit Control Ratios

1. Receivable days (Debtor collection period) = Trade receivables / Credit Sales x 365 days

Measures the time taken in days to collect money from trade debtors.

A rise in receivable days means credit collection has worsened because it is taking longer to collect money from customers, increaing the risk of bad debts.

A fall in the receivable days mans credit collection has improved because it is taking less time to collect money from credit customers.

2. Payable days (Creditor payment period) = Trade payables / credit purchases x 365 days

Measures the time taken in days to to pay money to trade creditors.

A rise in payable days means credit control has worsened because the trader is taking longer to pay suppliers, increasing the risk of losing discounts or incurring an interest charge on late payment.

A fall in the payable days means credit control has improved because the trader is paying suppliers eariler, and can benefit from trade discounts.

Ideally for a business, the payable days should exceed receivable days.

This will mean the trader is receiving payments before paying the supplier, and this will improve cash flow and the bank balance.

If recevable days are longer than payable days, the trader is having to pay suppliers before receiving money from customers, resulting in negative cash flow, and possibly cause the bank to become overdrawn.

Inventory (stock) Turnover = cost of sales / Average inventories

Average inventories = (opening + closing inventories) / 2

This indicates the number of times the average inventories of the business are replaced during the year.

A rise in the stock turnover implies:

The business in selling more stock, or holding less stock.

The business therefore has more cash to pay current liabilities.

A fall in the stock turnover implies:

The business is selling less stock, or holding more stock.

The business is generating less cash to pay its creditors.

A reduction in the by cutting selling prices can lead to a rise in sales and a higher rate of inventory turnover.

Holding fewer inventoris should improve the liquid ratio.

Gearing Ratio % = Loan capital / total equity x 100

Measures the degree of risk for the owners of the business, and represents the percentage of loan capital as a percentage of total equity.

A gearing ratio above 100% is high

A gearing ratio below 100% is low

A high gearing ratio means

The company has more non-permanent capital than permanent capital

High interest rates will reduce profits available as dividends to shareholders

The company is less able to borrow oney in the future

In the event of administration, the shareholders are unlikely to get their money back

A low gearing ratio means

The company has more permanent capital than non-permanent capital

Interest payments are low meaning profits are higher, higher dividends are available to shareholders

The company can issue more loans in the future to raise finance

In administration, shareholders are more likely to get their money back

The Pros and Cons of using Ratios to analyse business performance

a)

Limitations

of comparing businesses using ratios:

·

Must

compare businesses of a similar size and in similar markets.

·

One year

is not sufficient enough to make a proper judgment – 3-5 is more acceptable.

·

User may

not understand their significance.

·

Only as

accurate as data on which they are based.

·

Ratios

do not identify causes.

·

Only

measures past performance.

·

Ratios

should be compared to an industry average.

b)

Benefits

of ratios:

·

Assists

management in identifying strengths and weakness of business.

·

A

measure of business of performance.

·

Can be

used to set targets.

accounting - module 2 - unit 4