## Ratio Analysis

### Ratio Analysis #### 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)

#### 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)

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)

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.