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BUSINESS RATIOS

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									                          BUSINESS RATIOS




How well is a business doing?

There are a great variety of people who will be interested in how a
business is doing:

Owners –    to check their money has been invested wisely.
Managers – they are responsible to the owners for running the business
            well. They will also want the business to do well for their own
            reputations.
Employees - they want to know their jobs are safe, and will be hoping for
            the better pay and conditions a successful business can
            offer.
Creditors - they have lent money to the business, or sold them goods or
            services on trade credit terms. They will want to know they
            are going to be repaid with interest. A successful company
            will ensure this happens.
Customers – successful firms are able to maintain their standards of
            quality and customer care.
Government Successful businesses can guarantee jobs and help the UK’s
            trade with the rest of the world. Also, more profit equals
            more tax for the government.

To find the answers they are looking for, they need to measure business
performance.

Business ratios give measures of how well a business is doing. The
ratios analyse the firm’s profitability and liquidity. The five ratios you
need to know are:

1)   Gross profit to sales revenue
2)   Net profit to sales revenue        Profitability Ratios
3)   Return on capital employed
4)   Current ratio
                            Liquidity Ratios
5)   Acid test ratio


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Profitability Ratios

These ratios are ways of measuring how profitable a business is so that
its performance can be assessed.

   1. Gross Profit to Sales Revenue (or Gross Profit Margin)

The figures for this ratio may be obtained from a business’s profit and
loss account:

Gross profit x 100 = %
 Sales Revenue

The purpose of this ratio is to show what percentage of turnover is
represented by gross profit,
 - or how many pence out of every £1 of sales is gross profit.

Example

In 2000, the turnover at Oranges & Lemons Fruit Sellers Ltd was
£160,000 and its gross profit was £120,000. What is its gross profit to
sales ratio?

120,000 x 100 = 75%.
  160,000

Oranges & Lemons Fruit Sellers Ltd made a gross profit of 75% on its
sales revenue, or for every £100 of revenue, £25 went on costs of sales,
leaving a gross profit of £75.

In 2001, the figures are sales revenue of £200,000, and gross profit of
£140,000.

   a) Calculate the gross profit to sales revenue ratio.




   b) What does this mean, compared to 2000?




                                    2
   2. Net Profit to Sales Revenue (or Net Profit Margin)

These figures can also be taken from the profit and loss account.

Net profit x 100 = %
 Sales Revenue

The purpose of this ratio is to show what percentage of turnover is
represented by net profit,
 - or how many pence out of every £1 of sales is net profit.

Example

Oranges & Lemons Fruit Sellers Ltd’s net profit in 2000 is £80,000, and
in 2001 is also £80,000.

          a) Calculate the net profit to sales ratio for 2000 and 2001.

2000                                        2001




          b) Compare the trend from 2000 to 2001.




   3. Return on Capital Employed (ROCE)

Both the profit and loss account and the balance sheet are required for
this ratio.

  Net profit (from the P&L A/c)                    x 100 = ROCE %
Capital Employed (from the balance sheet)




                                       3
The purpose of this ratio is to show how profitable the owners’
investment is by calculating the percentage return,
or out of every £ invested, or capital employed, how much is net profit.

Investors can then compare this figure to other companies to check if it
is worthwhile continuing to invest in the company.

Example

We already know that the net profit in 2000 and 2001 for Oranges &
Lemons Ltd was £80,000. The capital invested was £1,200,000 for 2001
and £1,250,000 for 2001.

a) Calculate the ROCE for both years 2000 and 2001.

2000                                    2001




b) What is the trend across these two years for the owners?




To decide whether to continue to invest in the company, its owners can
look at:

-   The ROCE for previous years.
-   The ROCE earned by similar sized companies.
-   The average ROCE earned by businesses in the company’s industry.
-   The gross and net profit to sales ratios.
-   The typical rate of interest earned on savings accounts.




                                    4
Liquidity Ratios

Liquidity ratios attempt to measure a business’s performance by
examining its ability to pay short-term debts using current assets
i.e. they look at cash flow.

Any assets that can easily be turned into cash are said to be “liquid”.
Liquid assets are an important way for firms to be able to meet their
debts.

All the figures for liquidity ratios can be found in the balance sheet.

Current assets and liabilities from balance sheet for Oranges & Lemons
Fruit Sellers Ltd for year ended 31 December 2000:

Current assets:              £25,000                  -Stock       £ 3,500
                                                      -Debtors     £ 4,500
                                                      -Cash        £17,000
Current liabilities:         £10,000




   4.Current ratio (or Working Capital Ratio)

The purpose of this test is to check the ability of a business to pay its
short-term debts.
                             Current assets
                            Current liabilities

So for our example:
                             25,000 = 2.5:1
                             10,000

This shows that the business can meet its debts two and a half times
over from its current assets.

Typical ratio:         1.5:1 to 3:1
Less than 1.5:1        means the business might have trouble paying its
                       immediate debts
More than 3:1          company may not be using its assets efficiently




                                         5
   5.Acid Test Ratio (or Liquid Capital Ratio)

The purpose of this ratio is to see whether or not the business can meet
its short-term debts without having to sell any stock – a firm could have
difficulty selling its goods quickly.

The Acid Test ratio does not include any figure for stocks.



Acid test ratio    =      Current assets – stocks

                           Current liabilities


So, back to our example

                   25,000 – 3,500       =    21,500       =     2.15
                      10,000                 10,000




What does this show?




Based upon information in AQA Business Studies B (Denby & Thomas) and
Letts Revise GCSE Business Studies.




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