Ratio analysis\Accounts analysis

It is sometimes hard to compare different organizations’ performance, or even the same firm's
performance over the years. One method used by businesses to compare their performance
is Ratio Analysis.

Ratio analysis is mathematical approach to investigating accounts by comparing two related

figures.

Ratio analysis covers the following areas :

 Profitability ratio
 Liquidity ratio

Profitability ratios
Profitability ratios measure how much profit an organization makes or measures the performance
of the business and focus on

*Profit

*Revenue

*Capital invested in the business(Capital employed.

Extracts from the accounts of Ecohomes 2016

 1.Gross Profit Percentage Ratio

Two ways of improving gross profit margin is to:

 raise the selling price of the product

 negotiate deals with less expensive suppliers
2. Operating profit margin
 3. Return on Equity\capital Employed (ROCE)

Return on Capital Employed is the ratio often used by venture capitalists or investors
(shareholders) this ratio calculates how much money an investor will get back after a period of
time.

It is crucial that investors weigh up the amount they will receive from the investment with the
risk involved and if they would have received as good a deal (or better) if they had left the
money in a bank account accumulating interest. ROCE can be calculated using the formula:

Two ways of improving this is to:

 increase sales
 reduce expenses
 Mark-up

Liquidity ratios
Liquidity refers to the ease and speed with which assets can be converted into cash.

Non-current assets such as machinery and tools are not liquid assets because they cannot be
easily converted into cash.

Cash is the most liquid asset followed by trade receivable (trade credit expected to be paid within
90 days) then the least liquid asset stock\inventories.

Inventories such as finished goods are considered the least liquid assets because it is not
guaranteed that they will be sold soon although the expectation is that they will be sold.

If a business doesn’t have enough liquid assets, it may not be able to raise enough cash to pay its
immediate bills. A serious lack of liquidity could mean that a business collapses.
 Two ratios can be sued to assess the liquidity of a business:

1. Current ratio

Current ration assesses the firm’s liquidity by dividing current liabilities into current liabilities into
current assets. Current ratio or the working capital ratio demonstrates the firm’s ability to meet its
short-term debts. It is calculated using the formula:

Ways of improving this is to:

 increase current assets

 if ratio is too high you can sell non-current assets
 decrease current liabilities for example, reducing trade credit terms
Acid test ratio

Acid test ratio is a more severe test of a firm’s capabilities to meet its debts. The formula is the
same as the current ratio but with the added problem of writing off all stock. This is because it
assumes that stock:

 may be perishable
 may go out of date
 may go out of fashion or become obsolete
 Purpose of Ratio Analysis

 ratios help compare current performance with previous records

 ratios help compare a firm’s performance with similar competitors
 ratios help monitor and identify issues that can be highlighted and resolved
 ratios help with future decision makingHIS AD

Limitations of using accounts and ratio analysis

 Ratios are based on past accounting data and will not indicate how the business will perform in the
future
 Managers will have all accounts, but the external users will only have those published accounts that
contain only the data required by law- they may not get the ‘full-picture’ about the business’ performance.
 Comparing accounting data over the years can lead to misleading assumptions since the data will be
affected by inflation (rising prices)
 Different companies may use different accounting methods and so will have different ratio results,
making comparisons between companies unreliable.

THE END