GCSE Business Studies/Ratio Analysis

Ratios are calculations by which a company tells how well it is doing. By themselves, ratios have very little use. They become useful when compared with to previous years of the same company, or to other companies in the same industry.

Profitability (performance) ratios
Profitability ratios attempt to work out how profitable a company is. With all of these ratios, the higher the value, the better the business is performing.

Gross Profit Margin
The calculation for this ratio is:
 * $$\frac{Gross~Profit}{Sales} * 100$$

The gross profit margin shows how much profit the business earns above the cost of making the product. An increase from a previous year means that either revenue has increased faster than costs, or that the cost of goods sold has decreased, possibly as a result of changing suppliers or through cost negotiations.

Net Profit Margin
The calculation for this ratio is:
 * $$\frac{Net~Profit}{Sales} * 100$$

The net profit margin shows how much profit is left after all of the business's costs have been paid. The ratio of Net Profit to Sales is lower than Gross Profit, as all expenses have been deducted from gross profit. Basically it shows how much of the money spent by customers is turned into profit.

Return on Capital Employed (ROCE)
The calculation for this ratio is:
 * $$\frac{Operating~Profit}

{Capital~Employed} * 100$$ The ROCE shows how much profit is made as a proportion of the capital that has been invested in the business. The higher the result, the greater return on capital. Higher scores indicate greater efficiency, and greater "bang for our buck".

Liquidity ratios
Liquidity ratios attempt to work out a firm's ability to pay its debts.

Current (working capital) ratio
The calculation for this ratio is:
 * $$\frac{Current~Assets}{Current~Liabilities}$$

For example, if a business had $100000 of current assets and $50000 of current liabilities, the calculation would be:
 * $$\frac{100~000}{50~000} = 2$$

The current ratio shows what proportion of the business's current liabilities will be met by its current assets. Basically, it shows whether the firm has enough money to pay its current debts. In the above example, the current ratio is 2 : 1, which means that for every dollar they owe, they have two dollars. Ideally the ratio should be around 1.5 : 1, as it means the business can easily pay off its debts. If the ratio is lower than 1 : 1 the business owes more money that it has. This might not be a problem if more money will be coming in soon. However the more below 1 the figure is, the greater the difficulty the firm has in paying its debts. If the ratio is above 2 : 1 the business probably has too much money, and it should invest more back into the business.

Acid test (liquid capital) ratio
The calculation for this ratio is:
 * $$\frac{Current~Assets (excluding Stock)}{Current~Liabilities}$$

This ratio is similar to the current ratio. Stock takes the longest time to be turned into cash (it is the most illiquid), so if a business can pay its debts whilst ignoring stock, it is in a better position. For this reason, a good ratio is considered to be about 1 : 1.

Using Ratios
Ratios need to be used with care. Different businesses will have different ratios for different reasons.
 * After calculating the ratios for one year, compare them with the ratios from previous years. This will help you spot trends and analyse the performance of the business over the past.
 * When comparing the ratios for different businesses, the businesses need to be in the same market, otherwise they can't be compared. For instance, you can't compare the performance of a software designer against a chocolate bar manufacturer.