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Ratios can be broadly classified as:

Profitability ratios

These ratios measure the profit in relation to sales or capital employed.

Gross profit margin

Gross Profit Margin shows the relationship of gross profit and sales turnover.

Gross Profit Margin=

Gross Profit

X 100

Sales turnover

 

A lower ratio may be the result of the following factors

  • Decrease in selling price of goods sold
  • Increase in cost of goods sold
  • Over valuation of opening stock or under valuation of closing stock

 

Net profit margin

It is an index of efficiency and profitability of a business.

Net Profit Margin=

Net Profit

X 100

Sales turnover

 

Mark up cost refers to profit expressed as a percentage of cost price.

Mark Up=

Gross Profit

X 100

Cost of goods sold

 

Rate of return on Capital (ROCE)

It shows the return on the investment made by the owner.

Return on Capital employed=

Net Profit

X 100

Capital

 

Efficiency ratios

These ratios state how efficiently certain areas of the business are performing.

Stock turnover ratio

It indicates the number of times in a year the average stock can be sold off. The more times the stock is sold the more efficient the business.

Stock turnover ratio=

Cost of goods sold

Average stock at cost price

 

Average Stock is calculated as (Opening stock + Closing stock)/2

Asset turnover ratio

Asset turnover is a measure of how effectively the assets are being used to generate sales. It is one of the ratios that would be considered when interpreting the results of profitability ratio analyses like ROCE.

Asset turnover ratio=

Sales turnover

Total assets-current liabilities

 If the asset turnover is high than its competitors, it shows as an over investment in assets.

However, a new firm may have a higher asset turnover ratio than its competitors as the assets are newer and have a higher value. Moreover, some firms may use a lower rate of depreciation than its competitors.

In some cases, firms may purchase assets whereas its competitors firms are leasing assets.

Trade debtor collection period (Debtors days)

This ratio indicates how efficient the company is at controlling its debtors.

Debtors days=

Total Debtors

X 360

Total Sales turnover

 

 Trade creditor payment period (Creditors Days)

This ratio indicates how the company uses short term financing to fund its activities.

Creditors days=

Total Creditors

X 360

Cost of sales

 

Both these ratios are useful for intra-firm comparison.

Liquidity ratios

It measures the availability of cash and other liquid assets to meet the current liabilities of the firm.

Current Ratio

The current ratio compares total current assets to total current liabilities and is intended to indicate whether there are sufficient short-term assets to meet the short-term liabilities.

Current assets: Current liabilities

The ratio when calculated may be expressed as either a ratio or 1, with current liabilities being set to 1, or as ‘number of times’, representing the relative size of the amount of total current assets compared with total current liabilities.

A ratio of 2:1 or current assets as 2 times is considered to be healthy for a business.

Acid test ratio

It is quite similar to Current ratio. The only difference in the items involved between the two ratios is that the acid test ratio or quick ratio does not include stock.

Acid Test ratio

=

Current assets-Stock

Current liabilities

 An acid test ratio 1:1 is considered as healthy. If it is below 1 it suggest the business has insufficient liquid assets to meet their short term liabilities.

Limitations of Ratio Analysis

  • Differences in definitions
  • Comparisons are made difficult due to differences in definition of various financial terms.

Ratio Analysis can be used for:

  • Inter-firm Comparisons: Comparing the performance of one firm with another firm in the same industry.

  • Intra-firm Comparisons: Comparing the performance of a firm with previous years performance.

 download 'types of ratios' handoutpdf

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