Ratio Analysis

Ratio Analysis

business_square2

Key Learning Outcomes


  • Understand how to calculate and interpret the main profitability ratios
  • Understand how to calculate and interpret the main liquidity ratios
  • Understand how to calculate and interpret a ratio which analyses the sources of long-term finance
  • An understanding of final accounts and balance sheets, including gross profit, net profit, working capital and capital employed

Introduction: Ratio Analysis


In the Business Syllabus, Unit 4, subsection 4, Monitoring the Business, requires knowledge of the use, understanding and interpretation of accountancy and business data.

We will use the following figures from the final accounts of McCarthy Ltd to calculate these ratios:

McCarthy Ltd
Sales 860,000
Gross Profit 215,000
Net Profit 77,400
Current Assets (Including closing stock) 162,000
Current Liabilities 81,000
Closing Stock 64,800
Ordinary Share Capital 800,000
Long Term Loan 516,000
Retained Earnings 232,000

 

A. Profitability Ratios:

1. Gross Profit Percentage (Gross Margin)
= (Gross Profit / Sales) x 100
= 215,000 / 860,000 x 100
= 25%

2. Net Profit Percentage (Net Margin)
= (Net Profit / Sales) x 100
= 77,400 / 860,000 x 100
= 9%

3. Return on Investment (ROI)
= (Net Profit / Capital Employed) x 100
= (77,400 / (800,000 + 232,000 + 516,000) ) x 100
= (77,400 / 1,548,000) x 100
= 5%
(Note: Capital Employed = Ordinary Shares + Retained Earnings + Long Term Loan)

B. Liquidity Ratios

1. Current Ratio
= Current Assets : Current Liabilities
= 162,000 : 81,000
= 2 : 1

2. Acid Test Ratio
= Current Assets – Closing Stock : Current Liabilities
= (162,000 – 64,800) : 81,000
= 97,200 : 81,000
= 1.2 : 1

C. Debt/Equity Ratio
= Long Term Debt : Equity Capital
= 516,000 : (800,000 + 232,000)
= 516,000 : 1,032,000
= 0.5 : 1
(Note: Equity Capital = Ordinary Share Capital + Retained Earnings (Reserves))

Glossary

  1. Gross Profit = Sales – Cost of Sales
  2. Net Profit = Gross Profit – Expenses
  3. Working Capital = Current Assets – Current Liabilities
  4. Capital Employed = Equity Capital + Debt Capital
  5. Equity Capital = Ordinary Share Capital + Retained Earnings (Reserves)

 

Sample Exam Q&A


 Question

Bianua Ltd, a medium size company, operating in the agrifood sector, supplies quality prepared food products in the Irish and UK markets.

The average performance of companies in the same industry as Bianua Ltd for 2011 is detailed in the table as follows:

Industry Average Results 2011

ROI 11%
Current Ratio 2:1
Acid Test Ratio 1.2 :1
Debt/Equity Ratio 0.3:1

The following figures are taken from the final accounts of Bianua Ltd for 2011.

Bianua Ltd figures for 2011

Net Profit 50,000
Sales 975,000
Current Assets (including closing stock) 155,000
Long Term Loan 300,000
Ordinary Share Capital 500,000
Current Liabilities 85,000
Retained Earnings 100,000
Closing Stock 80,000

(i)

Calculate the following for 2011 for Bianua Ltd:
1. Return On Investment (ROI)
2. Current Ratio
3. Acid Test Ratio
4. Debt/Equity Ratio(20 Marks)

Sample Answer (i)

1. Return on Investment (ROI)
= Net Profit / Capital Employed x 100
= 50,000 / (500,000 + 100,000 + 300,000) x 100
= 50,000 / 900,000 x 100
= 5.56%

2. Current Ratio
= Current Assets : Current Liabilities
= 155,000 : 85,000
= 1.82:1

3. Acid Test Ratio
= Current Assets – Closing Stock : Current Liabilities
= (155,000 – 80,000) : 85,000
= 75,000 : 85,000
= 0.88 : 1

4. Debt/ Equity Ratio
= Long Term Debt : Equity Capital
= 300,000 : (500,000 + 100,000)
= 300,000 : 600,000
= 0.5 : 1

(ii)

Analyse the profitability and liquidity of Bianua Ltd for 2011, with reference to the industry average results shown in the box above, and make recommendations for Bianua Ltd.
(20 Marks)

Sample Answer (ii)

Comparison of ratios

Bianua Industry Average
ROI 5.56% 11%
Current Ratio 1.82 : 1 2 : 1
Acid Test Ratio 0.88 : 1 1.2 : 1

1. Profitability

Return on Investment

The ROI for Bianua Ltd is 5.6%, which measures the return on capital for investors in a business. This is half the average performance of companies in the same industry. However, it is a new company and its ROI still compares favourably with the prevailing interest rates currently available on deposit accounts e.g. Permanent tsb personal savings account offering a return of 2.1%.

Recommendations for Bianua Ltd

Bianua Ltd will want the ROI to be as high as possible and to remain above the bank interest rate. To improve its position it needs to reduce its capital employed figure or improve its net profit by, for example, controlling its expenses/overheads or trying to increase its sales.

2. Liquidity

The Current Ratio

The average industry result in 2011 had a very healthy level of working capital. It had €2 available to pay for every €1 of liabilities. Maintaining this healthy working capital is essential for a businesses’ cash flow. Bianua Ltd has €1.82 available to pay for every €1 owed, a little below the ideal of 2:1. It should make every effort to maintain its current ratio so that it can pay its short-term debts as they fall due. If the liquidity position of a new business is poor and it cannot pay its current liabilities it may have to go into liquidation.

Or

The Acid Test Ratio

In 2011 the average industry result was 1.2:1 indicating that on average €1.20 was available immediately to pay for every €1 owed. The situation for Bianua Ltd in 2011 was 0.88:1 with the business only having 88c available to pay for every €1 it owes. Neither the industry average, nor Bianua Ltd manages to attain the ideal acid test ratio of 1: 1. Bianua Ltd will have difficulty raising cash quickly to pay its bills as they fall due. Failure to improve on this could result in Bianua Ltd having difficulty in buying goods on credit in the future.

Recommendations for Bianua Ltd to improve the liquidity position:

    • Sell slow-moving stock at a discount.
    • Effective cash flow forecasting in order to avoid liquidity problems.
    • Effective credit control will reduce the risk of bad debts.
    • Effective stock control will reduce the amount of money tied up in stock.
    • Increase cash sales.

Student Activity


Q1 The following figures relate to Keeffe Ltd.

Sales 350,000
Gross Profit 105,000
Net Profit 63,000

Calculate the following: (Show your workings)

  1. Gross Profit Percentage
  2. Net Profit Percentage
Q2 (a) Using the figures below calculate the Current Ratio for DLS Ltd (Show your workings)

Debtors 52,000
Bank Overdraft 12,500
Cash 15,000
Creditors 25,000
Closing Stock 8,000

(b) Comment on the liquidity position of DLS Ltd

Q3 (a) Explain the term ‘Return on Investment’ (ROI).
(b) Using the figures below calculate the ROI for Murphy Ltd

Net Profit 66,000
Ordinary Share Capital 700,000
Reserves 156,000
Long-term Loan 144,000
Q4 The following figures relate to Sinnott Ltd for the past two years:

2014 2013
Authorised Share Capital 600,000 600,000
Ordinary Share Capital 330,000 320,000
Long-term Loans 200,000 120,000
Retained Earnings 30,000 40,000

(a) Calculate the Debt/Equity ratio for 2013 and 2014.

(b) Indicate whether the trend is improving or disimproving and give one possible reason for this.

Q5 Analyse the profitability (using three ratios) and the liquidity (using two ratios) trends in Buckley Ltd from the following figures for 2013 and 2014. Suggest how these trends might be improved.

2014 2013
Current Assets 16,800 15,900
Net Profit 12,285 15,100
Equity Share Capital 105,000 100,000
Current Liabilities 7,400 8,100
Closing Stock 12,400 9,100
Gross Profit 40,950 45,150
Retained Earnings 21,000 20,000
Sales 157,500 169,500

Profitability:

Gross Profit %
2013 =
2014=
Working
= (Gross Profit / Sales) x 100
Net Profit %
2013 =
2014=
Working
= (Net Profit / Sales) x 100
Return on Investment
2013 =
2014=
Working
= (Net Profit / Capital Employed) x 100

Liquidity

Current Ratio
2013 =
2014 =
Working
Current Assets : Current Liabilities
Acid Test Ratio
2013 =
2014 =
Working
(Current Assets – Closing Stock) : Current Liabilities
Q6 The following figures relate to a Ryan Ltd for the past two years.

2014 2013
Current Assets 80,000 55,000
Current Liabilities 60,000 40,000
Closing Stock 20,000 25,000

(a) Calculate the Acid Test Ratio for 2013 and 2014.

(b) State whether the trend is improving or disimproving, and give one possible reason for this.