Calculation And Evaluation of Ratios (Copy)
1.6.2 Calculation and Evaluation of Ratios – Cheat Sheet
1. Profitability Ratios
- Gross Profit Margin:
Gross Profit Margin = (Gross Profit / Sales Revenue) * 100
Where:
- Gross Profit = Sales Revenue – Cost of Sales
- Mark-Up:
Mark-Up = (Gross Profit / Cost of Goods Sold) * 100
- Profit Margin:
Profit Margin = (Net Profit / Sales Revenue) * 100
- Return on Capital Employed (ROCE):
ROCE = (Operating Profit / Capital Employed) * 100
Where:
- Operating Profit is EBIT (Earnings Before Interest and Taxes).
- Capital Employed is Total Assets – Current Liabilities.
- Expenses to Revenue Ratio (Operating Expenses to Revenue Ratio):
Expenses to Revenue Ratio = (Operating Expenses / Sales Revenue) * 100
2. Liquidity Ratios
- Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Where:
- Current Assets include assets expected to be converted into cash or used within one year.
- Current Liabilities are obligations due within one year.
- Acid Test Ratio (Quick Ratio):
Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities
Where:
- Inventory is excluded because it may not be as easily converted into cash in the short term.
3. Efficiency Ratios
- Non-Current Asset Turnover:
Non-Current Asset Turnover = Sales Revenue / Non-Current Assets
- Trade Receivables Turnover (Days):
Trade Receivables Turnover (Days) = (Trade Receivables / Sales Revenue) * 365
Where:
- Trade Receivables is the amount of money owed by customers.
- Trade Payables Turnover (Days):
Trade Payables Turnover (Days) = (Trade Payables / Cost of Sales) * 365
Where:
- Trade Payables is the amount the company owes to its suppliers.
- Inventory Turnover (Days):
Inventory Turnover (Days) = (Inventory / Cost of Sales) * 365
- Rate of Inventory Turnover (Times):
Inventory Turnover (Times) = Cost of Sales / Average Inventory
Where:
- Average Inventory is the mean of beginning and ending inventory for the period.
Evaluation of Profitability, Liquidity, and Efficiency
- Profitability:
- High gross profit margin and net profit margin suggest the business is effective at generating profits.
- ROCE greater than the industry average indicates efficient use of capital.
- Liquidity:
- A current ratio greater than 1 indicates the company can cover its short-term liabilities.
- A quick ratio above 1 means the company can cover its immediate obligations without selling inventory.
- Efficiency:
- A high inventory turnover ratio suggests efficient inventory management.
- A low trade receivables turnover suggests the company is collecting receivables quickly.
- A low trade payables turnover suggests the company is paying its suppliers quickly.
Measures to Improve Profitability, Liquidity, and Efficiency
- Improve Profitability:
- Increase sales or reduce cost of goods sold.
- Implement more efficient operations or cost-cutting strategies.
- Improve Liquidity:
- Improve cash flow by collecting receivables faster or delaying payables.
- Reduce inventory levels to free up cash.
- Improve Efficiency:
- Improve asset utilization, reducing excess assets.
- Streamline operations to reduce overhead costs and improve operational efficiency.
Limitations of Accounting Information
- Historical Data: Ratios are often based on past financial performance and may not reflect the current or future performance of a company.
- Industry Variations: Ratios may vary significantly from industry to industry, so comparing across industries may not be meaningful.
- Subjectivity: Accounting policies and estimates (e.g., depreciation methods, inventory valuation) can affect financial results, making comparisons difficult.
- Non-Financial Factors: Financial ratios do not capture all aspects of a company’s performance, such as customer satisfaction, brand strength, or market position.