In this article, which will especially help those studying Business A2 and preparing for the BUSS 3 exam, it is important to know the ratios and formulas you can use to help interpret that figures from a balance sheet. If you still don’t know what a balance sheet is, you can find more information on balance sheets here. Other than that, this article will go over liquidity ratios, acid test ratio, profitability ratios such as return on capital employed, gross and net profit margin and efficiency ratios such as asset turnover, inventory (stock) turnover, payables, recievables, gearing (investment appraisal) and shareholder ratios such as dividend per share and dividend yeild. Feel free to skip to the parts most relevant to you.
The liquidity ratios assess the cashflow position of a business.
- Can they cover short term debts? (which are also known as current liabilities)
- How much can the business payback debts for each pound they make?
- Have they got enough current assets (short term sources of finance) to cover current liabilities (short term debts)?
Current Ration = CA / CL or CA:CL
If Current Assets is bigger than Current Liabilities, then the answer is bigger than 1. Let’s have an example where CA = 8 and CL = 5 (I know it’s basic!). Using the formula CA:CL, the current ratio is 1.6 which means for every £1 the business goes in debt, they have £1.60 available to pay for the debt. A high current ratio is what the business want as it means they are in a healthy position.
If Current Assets is smaller than Current Liabilities, then the answer is smaller than 1. Let’s say CA now equals 4 and CL = 5. This makes the current ratio 0.8 which means for every pound the business go in debt by, they only have £0.80 to pay the debt off with. This produces signs of cashflow problems. From this, you could suggest the business look at short term sources of finance to solve their low current ratio.
Acid Test Ratio
The acid test ratio is very similar to current ratio. The only difference is that it doesn’t include any unsold stock. This makes the acid test ratio more accurate at representing the cash flow position of a business better than current ratio.
To work out the acid test ratio of a business, you will need to use the formula:
Acid Test Ratio = (CA – Stock) / CL
Remember that stock on a balance sheet is also known as ‘inventories’. A lot of businesses consider an acid test ratio of 0.5 to be the benchmark:
- Below 0.5 = Bad
- Above 0.5 = Good
The return on capital employed is the percentage profit a business makes from the money invested into the business.
To work out the return on capital employed, you will need to use the following equation:
ROCE = Operating Profit / Equity + non-current liabilities
Operating Profit can also be known as Net Profit.
Equity is the shareholder’s investment.
The answer for ROCE will tell us how much profit a business will make on every pound invested. For this reason, ROCE can be compared to the opportunity cost being placing the capital in a bank where the interest rate would be around 2%.
Gross Profit Margin
Gross profit margin is the percentage of gross profit the business makes. You can find out what gross profit is from reading the article ‘Understanding Income Statements’
To work out the gross profit margin, you will need to use the following equation:
Gross Profit Margin = Gross Profit / Sales x 100
Net Profit Margin
Net profit margin is the percentage of net profit the business makes. You can find out what net profit is from reading the article ‘Understanding Income Statements’
To work out the gross profit margin, you will need to use the following equation:
Net Profit Margin = Operating Profit / Sales x 100
Efficiency ratios analyse:
- How well the business is using resources.
- How well the systems are working.
Asset turnover analyses the efficiency of the business through analyse the use of assets in generating sales revenue/income for the business.
To work out the asset turnover, you will need to use the following equation:
Asset Turnover = Revenue / Net Assets
This asset turnover measures of money that has been put into the business and measures per pound of money that the business is getting it. Asset turnover can be easily misunderstood with ROCE. To make things clear:
- ROCE measures the past of the business.
- Asset Turnover measures the future of the project in a business.
The answer to the equation tells us how much sales revenue we get from shareholder owner assets.
Inventory (Stock) Turnover
Inventory turnover measures how many times a year the business turnsover/replenishes its stock on average.
To work out the inventory turnover, you need to use the following equation:
Inventory Turnover = Cost of Sales / Average Inventories Stock Held
It is important to ignore the negative for the cost of sales that can be located on an income statement . To work out inventory turnover, you will need an income statement for the cost of sales and a balance sheet for average inventories stock held. The answer will tell you how many times a year the business turns over its stock on average.
Payables measure the time taken in days it takes for the business to pay its debts.
To work out the payables of a business, you need to use the following equation:
Payables Days = Payables / Cost of Sales x365
Payables can also be known as the ‘creditors’ which you own money to.
The longer payables is for a business, the better it is (usually as its a sign of strength that you have power over the time taaken to pay the business’ debts.
Recievables measure the time taken in days for the business to recieve the money customers owe to them.
To work out the payables of a business, you will need to use the following equation:
Recievables (days) = Recievables / Revenue x 365
Recievables can also be known as the money thatt customers owe to you which is currently in credit.
The sooner recievable days are, the better because it is a sign of strength.
Positive Credit Control – the money is coming in quicker than coming out.
The figures for payables and recievables tell us about the business’ credit control.
Positive credit control is when Recievables is greater than payables.
Negative credit control
is when Recievables is greater than payables.This means takes longer for money to come in from the customers and shorter for money to go out of the business to payables (creditors).
Gearing Measures the percentage loans against the capital employed into the business. It is used for investment appraisal to gain loans from banks.
To work out the gearing of a business, you need to use the following equation:
Gearing = Non Current Liabilities / Total Equity + Non Current Liabilities
which can be shorteneded down to:
Gearing = Loans / Shares + Loans
Where loans is all the long term debts of the business and ‘Shares + Loans’ is the total capital employed into the business.
It is considered…
- Anything Over 50% = Highly Geared
- Below 50% = Low Geared
Being Low Geared
- Easier to obtain new loans.
- Harder for another company to aggressively take over the business (more shares means they have to buy more shares).
- But, should the business be considering growth? it is inefficient.
Being High Gearing
- Take over threat?
- Struggle to get loans.
- Need to do a share issue issue to balance gearing?
- Often more risk tolerant.
Dividends per Share
The dividend per share tells you how much is paid out in to each share of the business.
To work out dividends per share, you need to use the following equation:
Dividends Per Share = Total Dividen Payment / Number of Shares
This is used to enourage people to buy shares in a business. If the dividends per share is relatively high and beats all the competition, it will encourage people to buy shares in the business giving the business another source of finance.
- Doesn’t include the cost of the shares which may be a big factor.
- It is of some use if looking at dividends paid by one company over time.
Dividend yeild measures the amount of money you gain as a shareholder from the money you put into the shares of a business.
To work out dividend yeild, you will need to use the following equation:
Dividend Yeild = Dividend Per Share / Share Price
Potential investors will compare the return when considering the purchase of new shares. Dividend yeild takes into account the share price. This is useful as the dividends per share may only be high because the price of the shares is high. Yet, the dividends per share / share price will be an extremely small percentage.