Financial ratios

FINANCIAL RATIOS

BUSINESS

Financial ratios are essential tools for stakeholders, such

as investors, analysts, creditors, and management, to

evaluate and compare the financial health and

performance of a business.

Gross profit ratio: the relationship between the gross profit and income.

BUSINESS

Gross profit / sales revenue x 100

Formula:

It measures the success of a business by comparing the gross profit and the
total revenue

This is an indicator of how effectively business has added value to the
cost of sales.

GROSS PROFIT MARGIN

NET PROFIT MARGIN

BUSINESS

Net profit margin: measures the success of a business by comparing the net
profit (before tax and interest) and the total revenue

Net profit / sales revenue x 100

Formula:

The result of means that the percentage of every dollar in sales was profit.

The higher the percentage of this ratio, the higher profitability for the business.
It does not depend only on sales, but on the effective management.

POSSIBLE STRATEGIES TO IMPROVE PROFITABILITY RATIO

BUSINESS

Reduce direct

costs

Use lower-cost materials

Cut labor costs: relocate the
place or outsource employees

Product quality and reputation can be
damaged.

Communication and distance can be
affected, therefore quality too.

Increase productivity by
introducing technology

This purchase will reduce short-term
profitability

Immediate increase on each
item sold

Customer may not switch to
competitors if price is too high

Increase
prices

Reduce promotion costs
Sales might fall without a promotion
investment
Reduce
overhead

costs

Increase non-operating
income

Capacity might be fully employed in
the operations.

Relocate to a low-cost place
A lower rent imply additional costs
and move to a less attractive place.

Evaluate possible strategies to improve profitability must include potential problems.

TYPE OF LIQUIDITY RATIOS

BUSINESS

Liquidity Ratios: evaluates the company's short-term payment capacity.

CURRENT LIQUIDITY RATIO

•It measures the ability of a business to pay its short-term debts.

Current assets / Current liabilities

Formula:

•Accountants recommend as good results between 1.5 and 2, but
it depends on the industry the business operates.

•

It means that for every dollar the company owes, it can cover
1.5 or 2 times through their current assets.

CURRENT LIQUIDITY RATIO

BUSINESS

EXAMPLE:

•NP is in a more liquid position than PLP. For every $1 of short term
debts, it has $2 of current assets to pay for them. This is a relative
“safe” position.

•PLP is a worrying position. It only has $1 of current assets to pay for
each $1 short-term debt. If their creditors demand repayment at the
same time, it would struggle to pay them all.

TYPE OF LIQUIDITY RATIOS

BUSINESS

ACID TEST RATIO

•It measures liquidity without including inventory, so it is referred as
the “quick ratio”.

Current assets - stock / Current liabilities

Formula:

•To analyze these results, it is always important to compare with
previous year situation, since current assets constantly varies, so
it depends on the period.

ACID TEST RATIO

BUSINESS

EXAMPLE:

•PLP has a result below 1, which means that the business has less
than $1 of liquid assets to pay each dollar of short-term debt. The
company has a liquidity problem.

•The acid test ratio shows the result of the business cash availability,
since it does not include inventory.

•Companies with high volume of inventories will have very different
results between the Acid test ratio and Current liquidity ratio.

TYPE OF EFFICIENCY RATIOS

BUSINESS

Return on capital employed (ROCE): measures profitability of a business.

It is known as the primary efficiency ratio, since it compares profit with
the invested capital

*Employed capital: the total value of all long-term finance

invested = non current liabilities + equity

Profit before interest and tax / employed capital x 100
ROCE Formula

%:

•ROCE works to find out how much the company earned through its
investments.

•The ROCE can be raised by increasing the profitable, efficient use
of the assets owned by the company.

TYPE OF FINANCIAL RATIOS

BUSINESS

Stock turnover ratio: reflect the use of resources in the company, and it measures
the number of times inventory is converted into sales in a year.

•If this ratio increases over time, it means the business is increasing the
efficiency of its stock management.

Cost of sales / average value of stock
Stock turnover Formula

(number of times):

The average value of stock is calculated by this formula:

Opening stock at start of the year + closing stock at the end of the year / 2

Average value of stock / cost of sales x 365
Stock Turnover Formula

(number of days):

•The higher the number, the more efficient the way the company is selling
its inventory.

DEBTOR AND CREDITOR DAYS RATIO

BUSINESS

Debtor days Ratio: shows an average of days that the business takes to
recover payment from customers that have paid on credit.

Debtors / Total revenue x 365

Formula:

•Total revenue should subtract sales for cash, and the total amount of
days mean that companies must use working capital to maintain liquidity
until customers pay.

Creditor days Ratio: shows the average length of time the business takes to
pay their suppliers

Creditors / Cost of sales x 365

Formula:

•It is important to take in consideration all credit purchases only, and the
company can use this value as liquidity for other operations.

GEARING RATIO (APALANCAMIENTO)

BUSINESS

Gearing Ratio: shows the extent to which the company's assets are being
financed by long-term financing sources.

•This ratio measures the degree to which the capital is financed from long-
term loans.

•A highly geared business risks of not been able to pay interest expenses
or repay the loans if profits decrease.

Non current liabilities / employed capital x 100

Formula %:

•A low gearing ratio indicates a safe business strategy, since debts must be
repaid and this could lead the business to a low liquidity.

•This ratio should be compared to other business of the same industry, or
other time periods to analyze a trend of the company.

INSOLVENCY VERSUS BANKRUPCY

BUSINESS

INSOLVENCY:
• This term means when a business experiences serious financial problems

and cannot pay its debts.

• An individual or a company becomes insolvent when their liquid assets are

insufficient to pay short-term debts.

• If the individual or company owns assets, creditors should prefer to wait

them to be sold to receive the pending payment

BANKRUPTCY: applies to individuals, such as sole traders or members of
partnerships. It consists in a legal procedure to release individuals from their
debts, and provide creditors the opportunity to repay.

LIQUIDATION: applies to companies, and it is the process of ending the business
and distributing its assets to creditors.