Ratio

Additional Information

Formula

Meaning of result

Accounts to consider

Rules of Thumb

Solutions

Broader Issues (Evaluation)

Profitability
Gross Profit Ratio

Net Profit Ratio

Gross profit
.
Sales Revenue x 100

Result is a percentage %

Indication of profit available to pay

for expenses

Sales and cost of Goods Sold

Net profit before Interest & Tax

Sales Revenue x 100

Result is a percentage %

How much of each dollar of sales

represents net profit

Gross Profit (Sales and cost of goods

Sold) and other expenses

Result is a percentage %.
Return on Capital
Employed (ROCE)

Net Profit Before Interest &Tax

Capital Employed
x
100

Capital employed = Loan capital (or longterm liabilities) + share capital + retained
profit

Increase sales without increasing COGS, by increasing the

sale price or finding ways to cut COGS (new suppliers). May
impact quality.
10% is usually a minimum

Should be greater than current interest

How much profit the business is
Net profit (sales revenue and
rates if an investor was to put money
generating as a percentage from its expenses) and finance sources (long- into the bank (for example, 5%). Bank
main sources of finance
term liabilities and equity.
investment significantly less risk, so
ROCE should be several percent more.

Is the business labour or capital

intensive. This may impact the
amount of cost of goods sold

Generate higher levels of Gross profit, or cut other costs such

as salaries or energy costs without reducing sales. An
Increased expenses may be due to
investment in advertising may also lead to higher sales. May growth plans - need to weigh up
impact quality.
Net profit solutions above. Could also reduce amounts
payable to lenders by repaying loans, returning share capital
to investors or pay dividends to reduce the retained profits.
Need cash to be able to do these.

If the business has recently received a

large amount of finance, it may not
have had time to generate profit from
it yet.

Liquidity

Current Ratio

Acid Test (Quick) Ratio

Current assets
Current liabilities

Result is a ratio X:1

The ability of the business to cover

(pay) its debts in the next 12
months

Current assets - stock

Current liabilities

Result is a ratio X:1

The ability of the firm to cover (pay)

cash, debtors, creditors, overdrafts
immediate debt obligations (next
and short-term loans (not stock)
month)

cash, stock, debtors, creditors,

overdrafts and short-term loans

Should be about 2:1. Anywhere between

1.5:1 - 3.5:1 acceptable. If too low
Increase current assets such as cash at bank or debtors by
business unable to pay liabilities. Too
increasing sales or taking a loan; or decrease liabilities by
high current assets not used adequately reducing creditors (however this will require cash).
to increase profits

Business may not be able to get more

cash through borrowing if already
highly geared

Should be above 1:1. below 1:1

business at high risk (not able to cover
current liabilities)

Nature of business may require higher

levels of stock to meet fluctuating
demand.

Increase cash held by holding lower levels of stock when

possible. Decrease current liabilities by reducing creditors.

Higher Level
Efficiency

Result is number of days it takes to turnover

stock and
cost of goods sold = total credit purchases
How efficient is the business at
or
selling (turning over) its stock (days
Result is number of times per year stock is
or times per year)
turned over and
average stock = (open stock+closing
stock)/2

Average stock x 365

Cost of Goods Sold
Stock Turnover

or
Cost of Goods Sold
Average Stock

Debtor Days

Result is number of days it takes to receive

How efficient is the business at
payment from credit customers

Debtors x 365
Total Sales Revenue

Total sales revenue = total credit sales

Creditor Days

Result is number of days it takes to pay

suppliers

Creditors x 365
Cost of Goods Sold

Cost of Goods Sold = Total Credit Purchases

Stock and cost of goods sold

cash, accounts payable and other

current acounts (not inventories)

Most businesses offer 30 days to pay, so

Regularly follow up with customers to encourage prompt
the target should be 30 days. If more
payment. Offer small disconts to customers who pay on time.
than 45 days business may have cash
Use debt factoring to recover unpaid debts.
flow problems.

How efficient is the business at

paying its suppliers when given
trade credit

cash, inventories, accounts payable

and other current acounts

Should pay within 30 days to maximise

any discounts offered and maintain
strong relationship. If paying too early,
may result in cash flow problems.

Improve financial management and use software to track

when payments are due. Develop payment routines within
finance department

How much does the business rely

on liabilities to fund the business
compared to other sources

Loan capital and other long-term

liabilities. Share capital and retained
profits

A maximum percentage of 50%. Any

higher and the business is
overborrowing, which incurs high
interest payments and creates a high
level of risk.

Need to reduce the reliance on outside sources for finance

and should seek new sources of investment. This could be
from new investors or by holding higher levels of retained
profits in the business. The busines could also sell dormant
assets to repay some of the liabilities.

receiving payment from its credit

customers

Result is a percentage %.
Gearing Ratio

Loan Capital
Capital Employed

.
x

100

Capital employed = Loan capital (or longterm liabilities) + share capital + retained
profit

This will depend on the nature of the

Decrease average stock held by making smaller, more
stock held by the business - fast moving
frequent purchases of stock (using Just-in time), changing
perishables should be less days than
supplier if necessary. Increasing sales amounts will increase
long-lasting goods. Compare to industry
COGS and result in higher turnover.
specifically

Overstocking could lead to higher

waste as well as additional cost (such
as rent, electricity) to store excess
stock). Stock could also go out of
style.

Already high levels of borrowing (over

50% ratio) may hurt the business
trying to borrow more. Not paying
dividends may also create conflict
with shareholders.