Welcome to Ratio Analysis!
Ever wondered how investors decide if a business is a "winner" or if a bank decides a shop is "safe" enough to lend money to? They don't just look at the total profit; they use ratio analysis. Think of ratios as a "health check-up" for a business. Just like a doctor looks at your heart rate and blood pressure to see how healthy you are, accountants use ratios to see how financially fit a business is.
Don’t worry if the math looks a bit scary at first! We are going to break these down step-by-step. By the end of these notes, you’ll be able to "read" a business's performance like a pro.
1. Liquidity Ratios: The "Can We Pay the Bills?" Check
Liquidity is all about how much cash a business has (or can get quickly) to pay its short-term debts. If a business runs out of cash, it can go bust—even if it's making a profit!
The Current Ratio
This compares everything the business owns that can be turned into cash within a year (Current Assets) against everything it owes within a year (Current Liabilities).
\(\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}\)
Example: If a shop has £2.00 in assets for every £1.00 it owes, its ratio is 2:1. This is usually seen as very healthy!
The Acid Test Ratio
This is a tougher test. It's the same as the current ratio, but we ignore Inventory (stock). Why? Because you can’t always sell your stock quickly in an emergency.
\(\text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}\)
Memory Aid: Think of the "Acid Test" as the "Panic Test." If the doors closed today and we couldn't sell another item, could we still pay our debts?
Quick Review:
- A ratio of 1:1 for the Acid Test is generally considered the "gold standard."
- If the ratio is below 1:1, the business might struggle to pay workers or suppliers if a crisis hits.
Section Summary: Liquidity ratios tell us about survival. Current Ratio is the broad view; Acid Test is the strict view.
2. Profitability Ratios: The "How Successful Are We?" Check
Making £1 million in profit sounds great, but if you had to spend £100 million to get it, it’s actually quite poor! These ratios compare profit to the size of the business.
Gross Profit Margin and Net Profit Margin
These show what percentage of every £1 of sales actually stays as profit.
\(\text{Gross Profit Margin (\%)} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100\)
\(\text{Net Profit Margin (\%)} = \frac{\text{Net Profit}}{\text{Revenue}} \times 100\)
Analogy: If you sell a lemonade for £1, and the lemons cost 20p, your Gross Margin is 80%. But after you pay for your stand's permit and advertising, you might only keep 10p. That 10% is your Net Margin.
Return on Capital Employed (ROCE)
This is arguably the most important ratio. It shows how much profit the business generates from all the money invested in it.
\(\text{ROCE (\%)} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100\)
Did you know? Investors compare ROCE to interest rates. If a bank gives 5% interest but a business only has a 3% ROCE, the investor would be better off just leaving their money in the bank!
Return on Equity
This focuses specifically on the money provided by the shareholders.
\(\text{Return on Equity (\%)} = \frac{\text{Net Profit}}{\text{Total Shareholders’ Equity}} \times 100\)
Section Summary: Profitability ratios help us compare businesses of different sizes. High percentages are always the goal!
3. Efficiency Ratios: The "How Hard Are We Working?" Check
These ratios show how well a business manages its everyday resources like stock and debt.
Stock Turnover
This tells us how many times a year a business sells and replaces its stock.
\(\text{Stock Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}\)
Example: A supermarket wants high stock turnover (selling milk quickly), while a jewelry shop will have low stock turnover (expensive watches sit in the window for a long time).
Debtor and Creditor Turnover (Days)
Debtor Turnover (Receivables): How long it takes customers to pay us.
Creditor Turnover (Payables): How long we take to pay our suppliers.
Common Mistake to Avoid: Don't mix these up! A business wants Debtor Days to be low (get cash fast) and Creditor Days to be high (keep cash in the business longer), as long as suppliers don't get angry!
Non-current Assets Turnover
Shows how much revenue is generated for every £1 of fixed assets (like machinery or buildings) the business owns.
\(\text{Non-current Assets Turnover} = \frac{\text{Revenue}}{\text{Non-current Assets}}\)
Section Summary: Efficiency ratios are about speed and management. Faster turnover usually means better cash flow.
4. Solvency and Gearing: The "Is the Debt Too High?" Check
Solvency looks at the long-term stability of the business. If a business borrows too much, it becomes "high risk."
Gearing
This shows what percentage of the business's long-term funding comes from loans compared to shareholders' money.
\(\text{Gearing (\%)} = \frac{\text{Non-current Liabilities}}{\text{Capital Employed}} \times 100\)
Important Point: A gearing ratio over 50% is considered "highly geared." This is risky because the business must pay interest on loans even if it isn't making a profit.
Interest Cover
This shows how many times over the business could pay its interest costs using its current operating profit.
\(\text{Interest Cover} = \frac{\text{Operating Profit}}{\text{Interest Payable}}\)
Analogy: If your monthly income is £1,000 and your loan interest is £100, your interest cover is 10. You are very safe!
Section Summary: Gearing is about the source of money; Interest Cover is about the ability to afford that money.
5. Shareholder Ratios: The "Is This a Good Investment?" Check
These ratios are used by people who own shares (or want to) to see if they are getting a good deal.
1. Dividend per Share: The actual cash amount paid to a shareholder for each share they own.
2. Dividend Yield: The dividend as a percentage of the current share price.
3. Earnings per Share (EPS): The amount of net profit "earned" by each individual share.
4. Price/Earnings (P/E) Ratio: Compares the share price to the earnings per share. A high P/E often means investors expect high growth in the future.
Section Summary: These ratios help investors decide if the stock market price of a company is "fair" or "expensive."
6. Evaluating Ratio Analysis: The Big Picture
Ratios are powerful, but they don't tell the whole story. When writing an essay, always consider these limitations:
- Historical Data: Ratios use past figures. They tell you where the business was, not necessarily where it's going.
- Window Dressing: Businesses might "tidy up" their accounts at the end of the year to make ratios look better than they really are.
- External Factors: A low profit margin might be due to a sudden rise in oil prices or a recession, not bad management.
- Non-Financial Factors: Ratios don't show staff morale, environmental impact, or customer loyalty.
Key Takeaway for Exams: Never just calculate a ratio. Always ask: "Is this better or worse than last year?" and "Is this better or worse than our competitors?" That is what interpretation is all about!