Welcome to the World of Ratio Analysis!

Ever looked at a business's final accounts and thought, "Okay, they made $1 million in profit... but is that actually good?"

That is exactly what we are going to learn in this chapter. In Accounting, numbers on their own don't tell the full story. To understand if a business is truly healthy, we use ratio analysis. Think of it like a doctor looking at your heart rate and blood pressure instead of just your weight. It helps us "read between the lines" to see how a business is really performing.

Don't worry if this seems tricky at first! We will break every formula down into simple steps and use real-life examples to make it stick.

1. Profitability Ratios

These ratios tell us how good a business is at turning sales into profit. It’s not just about how much you sell, but how much you keep!

Gross Profit Margin %

This shows how much Gross Profit a business makes for every $1 of sales. It helps us see how well the business is managing its trading (buying and selling).

Formula: \( \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \)

Markup %

This is often confused with Margin, but they are different! Markup looks at profit as a percentage of the cost of the goods.

Formula: \( \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100 \)

Example: If a shop buys a shirt for $10 (Cost) and sells it for $15 (Revenue), the Gross Profit is $5. The Markup is 50%, but the Margin is 33.3%.

Profit in Relation to Revenue % (Net Profit Margin)

This takes into account all the other expenses (like rent and wages) to see what percentage of sales is left as actual profit for the owners.

Formula: \( \frac{\text{Profit for the Year}}{\text{Revenue}} \times 100 \)

Expenses in Relation to Revenue %

This helps a manager see if their overheads (costs) are getting too high compared to their sales.

Formula: \( \frac{\text{Total Expenses}}{\text{Revenue}} \times 100 \)

Return on Capital Employed (ROCE) %

This is arguably the most important ratio. It tells the owners: "For every $100 put into this business, how many dollars of profit did it generate?" It measures the overall efficiency of the money invested.

Formula: \( \frac{\text{Profit from Operations}}{\text{Capital Employed}} \times 100 \)

Note: Capital Employed = Equity + Non-Current Liabilities.

Quick Review Box:
High profitability ratios are usually "good," but they must be compared to previous years or competitors to be meaningful.

2. Liquidity Ratios

Liquidity is all about survival. It asks: "Does the business have enough cash (or assets that can turn into cash quickly) to pay its short-term bills?"

Current Ratio

This compares all your "quick" assets to your "quick" debts.

Formula: \( \frac{\text{Current Assets}}{\text{Current Liabilities}} \)

Analogy: If your ratio is 2:1, it means for every $1 you owe tomorrow, you have $2 in your pocket or the bank. You are safe!

Liquid Capital Ratio (Acid Test)

This is a "tougher" version of the current ratio. It excludes inventory (stock) because inventory is the hardest current asset to turn into cash quickly—you can't always guarantee a sale!

Formula: \( \frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}} \)

Common Mistake to Avoid: Don't assume a very high ratio (like 5:1) is perfect. It might mean the business is "lazy" and has too much cash sitting around doing nothing!

3. Efficiency Ratios

These ratios measure how well the business uses its resources.

Rate of Inventory Turnover

This tells you how many times a year you empty your warehouse and refill it. A high number is usually better!

Formula: \( \frac{\text{Cost of Sales}}{\text{Average Inventory}} \)

(Average Inventory = (Opening Inventory + Closing Inventory) / 2)

Inventory Turnover (Days)

This tells you exactly how many days on average an item sits on the shelf before being sold.

Formula: \( \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365 \)

Trade Receivable Days

This shows how long, on average, your customers take to pay you. If this number is high, your customers are "keeping your money" for too long!

Formula: \( \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \)

Trade Payable Days

This shows how long you take to pay your suppliers.
Tip: Usually, you want your Receivable Days to be shorter than your Payable Days. This means you get cash from customers before you have to pay your own bills!

Formula: \( \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \)

Key Takeaway: Efficiency ratios are like a "speedometer" for the business. They tell you how fast money is moving through the system.

4. Capital Structure (Gearing)

Capital Gearing

Gearing looks at where the business got its long-term money from. Is it from the owners (Equity) or from borrowing (Long-term loans/Debentures)?

Formula: \( \frac{\text{Non-Current Liabilities}}{\text{Capital Employed}} \times 100 \)

High Gearing (over 50%) means the business is "risky" because it has a lot of debt to pay back with interest.

5. Cash vs. Profit: The Great Debate

Did you know? A business can make a huge profit and still go bankrupt! How?

Profit is calculated when a sale happens (the Accruals concept), but cash only moves when the customer actually pays. If a business sells $100,000 worth of goods on credit, its Profit goes up, but its Cash stays at zero until the customer pays. If the business has to pay rent before the customer pays, it might run out of cash!

Memory Aid: "Profit is a matter of opinion, but Cash is a matter of fact."

6. Limitations of Ratio Analysis

Ratios are helpful, but they aren't perfect. We must consider both financial and non-financial factors.

Financial Limitations:

• Historical Data: Ratios use past figures. They don't guarantee what will happen in the future.
• Window Dressing: Businesses might try to make their accounts look better just before the year-end (e.g., delaying a purchase to keep cash high).
• Inflation: Rising prices can make comparisons between different years misleading.

Non-Financial Factors (The "Human" Side):

• Staff Morale: A company might have great profits but unhappy staff who are about to quit.
• Reputation: A business might be profitable but have a bad environmental record, which could hurt it later.
• Competition: Ratios don't show that a new competitor just opened next door!

Final Summary:
To truly analyze a business, you need a "balanced view." Use the ratios to see the mathematical health, but look at non-financial factors to see the real-world situation.