Ratio Analysis
Ratio Analysis |
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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
- Gross Profit = Sales – Cost of Sales
- Net Profit = Gross Profit – Expenses
- Working Capital = Current Assets – Current Liabilities
- Capital Employed = Equity Capital + Debt Capital
- 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) |
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Comparison of ratios
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:
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Student Activity
| Q1 | The following figures relate to Keeffe Ltd.
Calculate the following: (Show your workings)
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| Q2 | (a) Using the figures below calculate the Current Ratio for DLS Ltd (Show your workings)
(b) Comment on the liquidity position of DLS Ltd |
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| Q3 | (a) Explain the term ‘Return on Investment’ (ROI). (b) Using the figures below calculate the ROI for Murphy Ltd
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| Q4 | The following figures relate to Sinnott Ltd for the past two years:
(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. |
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| 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.
Profitability:
Liquidity
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| Q6 | The following figures relate to a Ryan Ltd for the past two years.
(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. |
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