AQA Business Studies/Ratio Analysis

Ratios in a business, are important in order to compare the efficiency with either another company in the same or a similar market or previous years.

There are 5 types of Ratios we will look at:

• Shareholders Ratios
• Profitability Ratios
• Liquidity Ratios
• Activity Ratios
• Financial Ratios

Shareholders Ratios

Dividend Per Share

The amount of the overall dividend that each share will get - what essentially shareholders are investing for.. The Dividend is announced each year and can be found in the Trading, Profit and Loss Account after Tax has been taken off.

$Dividend\ Per\ Share={\frac {Overall\ Dividend}{Number\ of\ Shares}}$

Dividend Yield

The percentage of the Market Price that the Shareholders will get in dividend. This shows potential investors how much a company values it's shareholders investment.

$Dividend\ Yield={\frac {Dividend\ Per\ Share}{Market\ Price\ Per\ Share}}$

Profitability Ratios

Gross Profit Margin

Gross Profit is the Revenue minus the cost of making the products.

Gross Profit Margin is the measure of how efficiently a company is making the products to sell and turn into revenue (remember - Sales revenue and sales turnover are the same things). The higher the percentage, the better for the business because it means that the Profit Margin on each product is high - for a 'company', a higher dividend could be given.

To increase the Gross Profit Margin:

• Supplier costs could be decreased if a cheaper one is available
• Price per unit can be increased
• Sales turnover can be increased (marketing or price decrease - but has an adverse effect on overall profit)

$Gross\ Profit\ Margin={\frac {Gross\ Profit}{Sales\ Turnover}}\times 100$

Net Profit Margin

Net Profit is Revenue minus all the costs of the day to day running of the business - Costs of making the products, Overheads, Vehicles, Machinery, etc.

Net Profit Margin is the measure of how efficiently a company is turning Revenue into Net Profit. The higher the Net Profit Margin, is again the better. It shows what percentage of the revenue is available to cover taxes to be paid to inland revenue and how healthy the dividend will be.

To increase the Net Profit Margin:

• (Everything used to increase Gross Profit Margin)
• Carefully monitor Overhead usage (turning lights off, turning heating off)
• Budget on expenditure carefully

${\mbox{Net Profit Margin}}={\frac {\mbox{Net Profit}}{\mbox{Sales Turnover}}}\times 100$

Return on Capital Employed (ROCE)

ROCE is also known as the primary accounting ratio. It measures how efficiently a business is investing capital in a business in order to make profit. Sales revenue can again be found on the Trading, Profit and Loss account and the Capital Employed on the balance sheet. Capital Employed can be worked out by adding the Shareholders capital and Long-term liabilities.

The higher the figure, the more attractive investment the business would be to investors (More returns on their capital!).It can be compared to previous years (show levels of previous investment and expected returns and whether it is satisfactory or not) or other businesses ROCE. It should also be compared to bank interest rates - what's the point in the risk of investing it in a business if you could invest it in a risk-free bank and earn more in interest rates than you would on ROCE?

ROCE can be adjusted by:

• Earning more revenue with the same amount of capital employed
• Earning the same amount of revenue but decreasing the Capital used to generate the revenue.

$ROCE={\frac {Sales\ Turnover}{Capital\ Employed}}\times 100$

Liquidity Ratios

Liquidity ratios measure how effectively a business can sell it's assets to cover it's liabilities.

Acid Test Ratio

Acid test is the measure of how effectively a business can liquidate (pay off creditors) without considering the stock. Stock is taken off because it is the most illiquid asset that a business owns. In order to sell it immediately the stock becomes very cheap and so loses its value.

It is recommended a business keeps this at about 0.8 as the stock will always be worth something even if a very small proportion to what it's actual value is. If the number becomes lower, the business may experience difficulties covering it's short term debts. If the number increases, the business is probably using the cash in an unprofitable or unproductive form.

$Acid\ Test={\frac {Current\ Assets\ -\ Stock}{Current\ Liabilities}}$

Current Ratio

Not actually needed (it's not in the syllabus) but useful to know as the theory for acid test links in.

$Current\ Ratio={\frac {Current\ Assets}{Current\ Liabilities}}$

Gearing Ratio

Shows how reliant a business is on External sources of finance. It is used by banks and lenders to see how risky a business is before they give them the loan. Highly geared companies are known as the riskiest type of business because they are reliant on loans for the day to day running of assets, which they haven't yet paid off.

$Gearing={\frac {Long\ term\ Liabilities}{Capital\ Employed}}$

Financial Ratios

Asset Turnover

$Asset\ Turnover={\frac {Sales\ Turnover}{Net\ Assets}}$

Stock Turnover

$Stock\ Turnover={\frac {Overall\ Cost\ of\ Goods\ Sold}{Average\ Number\ of\ Stock}}$

Debtor Days

$Debtor\ Days={\frac {Debtors}{Sales\ Turnover}}$