Financial Ratios
Using your notes, the website, the Tutor2U docs and the handouts provided (in class and in this file), complete the following summary sheet for each of the financial
ratios. You should have a list of 11 (including the current ratio)
Ratio
Current Ratio Current Assets
Current Liabilities
Liquid Capital Ratio (AKA acid test
ratio)= (Current assets -
inventory)/current liabilities = x:1
Gearing = (Non-current
liabilities)/*Total Capital
Employed X:1
Total capital employed = equity +
non current liabilities
Gross Profit Margin (%) = (Gross
Profit/sales revenue) x100
What does it What does it tell you?
assess/measure?
Liquidity Whether the business is able to pay its short-term
debts.
E.g 2:1
For every £1 of short-term debt the business has
£2 in current assets to pay the debt.
Liquidity Shows us the ability of a business to pay its short
term debts with its quickly available assets. More
accurate than the current ratio as it does not include
stock which has to be sold before it can be used to
pay short term debts.
Capital Gearing tells us how the activities of a business are
structure ratio financed. What % comes from owners capital and
therefore is not impacted by changes in the interest
rate and what % is financed through long term loans
and is affected by changes in the interest rate which
will lead to a fall or rise in the costs of a business.
Profitability This tells us how much gross profit is being made in
relation to revenue.
What is an ideal figure?
How can it be improved?
1.5:1. Higher shows too much cash being held - can be
used elsewhere. Check industry average and trends
over time too.
Reduce the business’s short-term debts and / increase
cash sales; reduce the receivables days etc…
Happy when increasing is able to pay debts.
Happy when around industry average.
Reduce current liabilities and increase current
assets.
Holding less stock - use just in time stock control.
Increasing year on year or
Higher than industry average (check not from
price cuts)
Reducing (or increasing) long-term liabilities
Increasing year on year or
Higher than industry average (check not from
price cuts)

Gross Profit Mark-up (%) = (Gross Profitability
profit/cost of sales) x 100 = X%
Profit in relation to revenue (%) = Profitability
(profit for the year/sales
revenue) x 100x%
Expenses in relation to revenue Profitability
% = (Expenses/sales revenue) x
100
Return on Capital Employed = Profitability
(Profit for year/Capital) x 100
Or
(Operating profit/Capital
employed(equity+ncl)) x 100
Source cheaper raw materials
Increase selling price/sales revenue
This compares the gross profit to the cost directly Increasing year on year or
related to generating sales (raw materials).
Higher than industry average (check not from
price cuts)
Source cheaper raw materials
Increase price/sales revenue
This tells us how much profit for the year is made in Increasing year on year or
relation to the revenue coming into the business.
Higher than industry average (check not from
price cuts)
Reduce costs
Increase sales revenue
This tells us what percentage of sales revenue is Decreasing year on year or Lower than industry
spent on paying the expenses of a business. average
Reduce expenses
Increase sales revenue
This tells us how much profit in pence is made for Increasing year on year or
every £1 of capital in the business. More profit being
generated overall or less capital invested. Higher than industry average (check not from
price cuts)
Increase profit or Reduce capital invested without
reducing profit
Rate of inventory turnover
(times) = Cost of sales/average
inventory*
*(Open-Closed)/2
Rate of Inventory Turnover
(days) = (*Average
inventory/Cost of sales) x 365
*(Open-Closed)/2
Payables Days = (trade
payables/credit purchases) x 365
Receivables Days = (trade
receivables/ credit sales) x 365
Efficiency This compares the average inventory to the total cost
of inventory sold during a period.
Efficiency This compares the average inventory to the total cost
of inventory sold during a period.
Efficiency How many days its taking to pay credit suppliers. May
be happy when increasing but only if agreed and not
at the expense of discounts for prompt payment. It
increasing could also be a sign of problems with cash
flow.
Efficiency How many days credit customers take to pay. Happy
when falling as getting money in sooner.
Increasing year on year or Higher than industry
average (check not from price cuts)
Sell more inventory
Hold less inventory
Increasing year on year or Higher than industry
average (check not from price cuts)
Take steps to lower the inventory held - depends
on the business though. Negotiate sale or return
with supplier. JIT stock control.
May be happy when increasing, only if the date
agreed and not at the expense of discounts.
Negotiate more favourable terms with credit
suppliers
When decreasing as they get the money sooner.
Managing credit customers well and chasing late
payments.
Explain three benefits of using financial ratios to assess the performance of a business:

● They can highlight areas of improvement for a business. By comparing specific ratios with other businesses and the industry average, a business can see if they are
too reliant on loans for example.
● Allows a business to forecast profitability for the future therefore allowing them to see if they could afford to expand their business.
● They are useful in judging operating efficiency so a business can make cuts or invest in machinery to make the business more profitable.

Explain three limitations of using financial ratios to assess the performance of a business:
● They do not take into consideration external factors such as inflation or recession which could make a business seem like it is unprofitable when it is in fact
adjusting to the changes of the economic climate.
● They can only be compared between businesses of the same size and type meaning that it could be harder to estimate the success or failure of a business.
● Manipulation of these ratios can appear to make a business more successful when in fact it might be going bankrupt, this can be damaging if people start investing
into a failing business, not only will they lose their money but they will be seen as cooperating in presenting unfaithful accounts.