45 Confidently using performance ratio's in business accounts

10/10 Key term test - on Ratio Analysis 

1. Financial statements - a business needs to create TWO main financial statements.  The first identifies its ability to turn all its activities and its resources into a PROFIT.  This is known as a PROFIT and LOSS Account.  The other statement is a BALANCE SHEET.  This sets out the ASSETS and LIABILITIES that a business has on a particular day
2. Gross Profit Margin - is the ratio of a business's sales revenue less its cost of sales (GROSS PROFIT) expressed as a percentage of its sales revenue. (usually over a time frame of a year)
3. Net Profit Margin - This is a businesses sales revenue minus all its fixed and variable costs (cost of sales and other overheads) expressed as a percentage of the sales revenue. (usually over a time frame of a year)
4. Profitability - how effective the business is at converting a profit from the business activity i.e by increasing its sales activity or reducing the total costs or both in order to maximise its profits 
5. Liquidity - This is the amount of cash that a business has and shows whether the business can pay its debts over the coming months.
6. Current assets - these are the items that a business owns but is not expected to keep for more than one year e.g. cash and stock
7. Current liabilities - These are the debts that a business has that are due for payment within one year e.g. payments to suppliers, overdraft etc
8. Stock - This is the raw materials that have not yet been used or products that have been made but not sold.
9. Current ratio - This is the ratio of current assets divided by the current liabilities. e.g. if a business has current assets of £125,000 and current liabilities of £50,000 the ratio would be 2.5:1 or £2.50 for every £1 that it owes! Anything less than a ratio of 1:1 would mean that the business is insolvent 
10. Acid test ratio - The acid test ratio is similar to the current ratio above but with the deduction of stock. e.g. current assets - stock / current liabilities or current assets of £125,000 less stock of £50,000 divided by the current liabilities of £50,000 the ratio of 2:1 or now £2 for every £1 owed.

In the news How does a business manage to lower the price of a product or service and yet increase its profit ratio?  Its all down to keeping costs under control.  Apple hit the market with a new product the iphone that was different, fashionable and an immediate 'must buy' but it had its drawbacks not least its lack of 3G capacity and many criticised it for not doing as much as other phones in this area. It was also tied to a single provider in the UK and USA when it first came out.  Nevertheless, the hype around which the new Apple product was launched meant that people were prepared to queue up just to own one.  But was it profitable and is the new 3G and 4S launched as a replacement as profitable?.  Surprisingly the new phones with greater technology and with greater flexibility are more profitable than the original 2G phone.  isuppli, a market analyst says that the manufacturing and component costs of the new phone has been reduced.  By taking apart a 3G device and adding the cost of its components along with the cost of marketing the device iSuppli estimated that Apple has a 55% profit margin.  It has estimated the cost of the iPhone in the US at $174.33 much lower than the estimated cost of the $227 original iPhone.  These totals include materials and manufacturing costs but do not include research, development and packaging and distribution costs.  The real profit margin when these costs are added in, along with the cost of the deal with the phone companies, brings the cost of the 8 gigabyte iPhone to approximately $225.  As the price of an 8GB iPhone in the US is $500, this represents a 55% gross profit margin       

Ratios are generally divided up into:

• Profit Ratios 
• Liquidity Ratios

roup activity Pu

The trading account sales r

The profit and loss account gros

The appropriation account net profit - tax - dividend = retained profit 

Discussion The 

Web-based activity Look

Typical examination questions on 'Ratio Analysis' 

1. Define what is meant by gross profit margin?
2. Define what is meant by net profit margin?
3. What is a ratio?
4. From which published accounts would you take the figure for profitability ratios?
5. How would you work out a profitability ratio?
6. Why do we use percentages to compare ratios?
7. What is a liquidity ratio?
8. From which published accounts would you take the figure for liquidity ratios?
9. How would you work out an acid test ratio?
10. Why is the acid test ratio so important ?

Worksheets

Nine mark question