Financial analysis is the process of identifying the strengths and weaknesses of a business by establishing relationships between items in the income statement and statement of financial position. Figures in the financial statements do not give much insight about the financial performance and position of a business. Financial analyst uses accounting ratios to diagnose the financial health of an enterprise. Accounting ratios are used by managers to analyse the profitability, liquidity and efficiency of a business.
Advantages of ratio analysis
Disadvantages of ratio analysis
Accounting ratios is more meaningful when compared with standards. This may include
Accounting ratios are commonly classified as
1. Gross Profit Margin
The gross profit margin analyses the relationship between gross profit and net sales. It is the percentage of gross profit earned by a business over net sales. It indicates efficiency of management in converting sales into profit before deducting expenses. The higher is the margin the more successful is the business in trading activities and indicates higher profitability.
Margin = Gross Profit × 100
Gross Profit = Revenue – Cost of sales
Revenue = Sales – Return Inwards (Sales Return)
Cost of sales = Opening inventory + Net Purchases – Closing inventory
2. Gross Profit Markup
This is a variation of the margin. Markup analyses the relationship between gross profit and cost of sales. It represents the percentage added to the cost price of goods to cover expenses. It used by businesses to determine selling price of a product.
Mark up = Gross Profit × 100
Cost of sales
Convert Margin to Mark up
Convert Markup to Margin
If margin = 20%
Gross Profit = 20 × Sales
Cost of sales = 80 × Sales
If markup = 25%
Gross Profit = 25 × Cost of sales
Gross Profit = 25 × Sales
3. Expenses to sales ratio
This measures the total expenses as a percentage of sales. The lower is the ratio the more profitable is the business. A low expense to sales ratio also indicates that management was efficient to control its expenses.
Expenses / Sales ratio = Total Expenses × 100
= Gross Profit Margin – Profit margin
Operating expenses / Sales ratio = Operating Expenses × 100
Operating expenses to sales ratio is a variation to the expenses to sales ratio. This ratio excludes finance cost (interest) and tax to give a more meaningful comparison
4. Profit margin
The net profit margin measures the profit for the year as a percentage of sales. It indicates management efficiency in converting sales into profit. The higher is the profit margin the more profitable is the business.
Net profit margin = Profit for the year × 100
Profit for the year = Profit after finance cost (interest) and tax
= Operating profit – Finance cost - Tax
5. Return on capital employed (ROCE)
This measure the operating profit as a percentage of capital employed. It shows how efficiently management is using total resources available in the business to generate profit. It is the most important profitability ratio. The higher is the ROCE the more profitable is the business.
ROCE = Operating profit × 100
Operating profit = Profit before interest and Tax
Capital employed = Non current assets + Current assets – Current liabilities
= Owner’s capital + Non-current liabilities
= (Capital + Profit – Drawings) + Non-current liabilities
= Ordinary share capital + Reserves + Non-current liabilities
1. Current ratio
This shows whether the business has sufficient financial resources to pay back its short term debts. If the current ratio is greater than 1 the business has a better liquidity position to pay back its current liabilities. If the current ratio is less than 1 then the business is said to be insolvent and may face financial difficulties to do normal trading activities in the near future. The ideal current ratio is 2:1 and it is also known as the Working capital ratio.
Current ratio = Current Asset
= Closing inventory + Trade receivables + Bank
2. Quick ratio
This is a variation of the current ratio. It is calculated and interpreted the same way. The only difference is that closing inventory is ignored in the calculations since it is considered as the least liquid asset (not easily convertible into cash). It is also known as the acid test ratio.
Quick ratio = Current Assets – Closing inventory
= Trade receivables + Bank
1. Rate of inventory turnover
This shows the number of times inventory has been renewed during a financial year. The higher is the inventory turnover the more efficient is the sales department in selling goods. A high rate of inventory turnover also indicates good inventory management and improved profitability and liquidity.
Rate of inv. Turnover = Cost of sales
Average inventory = Opening inventory + Closing inventory
Inventory Turnover is an alternative showing the number of days taken by the business to sells its inventory.
Inventory turnover = Average inventory × 365
Cost of sales
2. Trade receivables turnover
This measures the number of days taken by the debt collection department to collect money from credit customers. It also indicates the days taken by the business to convert sales into cash. A high trade receivable turnover shows that credit customers are paying their debts quickly which in turn is improving the liquidity of the business. It is also referred to as the Trade receivables collection period.
Trade rec. turnover = Trade receivables × 365
3. Trade payables turnover
This measures the number of days taken by the business to pay back its credit suppliers. A short trade payables turnover indicates a healthy liquidity position and sound relationship with credit suppliers. It is also knows as Trade payables payment period.
Trade pay. turnover = Trade payables × 365
4. Non current asset Turnover
This is a measure of how efficiently and effectively the business is consuming the benefits generated from the non current assets. It shows how much revenue is generated from each dollar of non current assets used.
Non current assets turnover = Net Revenue
NCA at net book value
NOTE : Other efficiency ratios and investment ratios will be discussed in A-Level Chapters.