Workbook 6 – Ratios · Workbook 6 – Ratios 2 Highlights 1. Learn the sixteen ratios that tell...

Workbook 6 – Ratios

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Contents Highlights ................................................................................................................................................ 2

Quick practice session on ratios ............................................................................................................. 3

Financial Quiz 5 – Ratios ......................................................................................................................... 4

Learning Zone – Ratios ............................................................................................................................ 5

Ratios are used to guide future strategies and review past performance ..................................... 6

Profitability ratios ............................................................................................................................... 7

Gross profit margin ......................................................................................................................... 7

Net profit margin ............................................................................................................................ 8

Overheads: Sales ............................................................................................................................. 9

Net profit/Total assets (ROI) ......................................................................................................... 10

Net Profit/Capital Employed (ROCE) ............................................................................................. 11

Stability Ratios .................................................................................................................................. 11

Liquidity ratios............................................................................................................................... 11

Quick Ratio .................................................................................................................................... 12

The issues involved in raising long term capital (Gearing) ............................................................... 15

Gearing ratios ................................................................................................................................ 16

Debt: Equity .................................................................................................................................. 17

Equity: Total assets ....................................................................................................................... 17

Interest cover ratio ....................................................................................................................... 18

Asset Utilisation ................................................................................................................................ 19

Sales/Total assets .......................................................................................................................... 19

Sales / Fixed assets ........................................................................................................................ 19

Sales/Current Assets ..................................................................................................................... 20

Debtors days ................................................................................................................................. 21

Stock (Inventory) turnover ............................................................................................................ 22

Progress test 6 – Ratios ......................................................................................................................... 23


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Highlights 1. Learn the sixteen ratios that tell almost everything about a business

2. Use ratios to interpret and assess performance in the three key areas of

a. Profitability

b. Stability

c. Asset Utilisation

3. See how the performance improvement tactics explored in previous sections can be used to

improve ratio scores

Important Note This element of the programme will give you the skills and knowledge to understand and use

Ratio Analysis.

Step 2 at www.fabeducation.com provides FaBLinker5 and two major exercises to build

your skills in ratio and trend analysis

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3

Quick practice session on ratios Explore ratios on the model following section

4 (and 5 as no changes emerged from that

section)

Work to use the ratios as a "Dashboard" to inform

guide actions to improve your business model

e.g. if you use FaBLinker to explore answers to the

question...

What would I need to change to improve the Gross

Profit ratio?

You will see that the elements that have an impact

are:

Changes in the Selling Price and in the Purchase

Price

While changes in overheads would have no impact

but changes in the Net Profit ratio would be

affected by all three elements.

This ability to use financials to guide your business

strategies will be a major advantage in business

Tip After exploring the ratios in your own way try the

“Ratios Exercise” in Step 2 to see how ratio Analysis

can be done in a structured systematic way.


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Financial Quiz 5 – Ratios* # Questions Your

answer

Correct

answer

1 Billy wants to test three tactics in his business model - reducing fixed

overheads by 10 percent, eliminating variable overheads and replacing

the bank loan with additional equity. What will his Gross Profit ratio be after all these changes?

2 What would Billy's Fixed Asset turn be if he paid €9000 instead of

€6000 for fixed assets?

3 What is the minimum Selling Price that Billy needs to get past 15%

Net profit margin all else remaining unchanged?

4 Billy could let his debtor days slide to 180 and show a good current

ratio but what would his closing cash position be?

5 What would Billy's debt to equity ratio be at the end of the year if he

invested €3000 instead of €15000 assuming all else was unchanged?

*Answer based on Billy's business model as it was after section four "How to Generate Profit". That is with a Net profit of €12950 and closing cash balance of €16831


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Learning Zone – Ratios

Ratios highlight key performance indicators easily missed by looking only at the absolute figures

This section examines the sixteen ratios most commonly used in business analysis and for each ratio

explains:

How it is calculated

What it means

The Actions that would improve it

Any important features or anomalies

Smart entrepreneurs, bankers and investors instinctively know where to look to see beyond the

figures.

They have learned the concepts and practised them for years. You will develop practitioner level

skills in hours through systematic practice on www.fabeducation.com

There is so much more to the story of a business than the absolute values of the assets, liabilities,

revenues and expenses.

The real fun and power in finance is finding the answer to questions such as…

Will we have enough money to pay our debts?

Do we risk losing control because we depend too much on borrowings?

Or are we holding the business back by not borrowing for more rapid expansion?

Are our profit margins high enough?

Do we make use of the assets we employ in the business?

Are we carrying too much stock?

Do we collect money from our debtors effectively?

Are we making enough return on our investment?

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Ratios are used to guide future strategies and review past performance

By adding ratio analysis to your core skills-set, you rocket-boost your ability to contribute to decision

making and problem solving.

Note that care must be taken in drawing conclusions from ratio analysis because:

Ratios involving Balance Sheet items are calculated at a specific date

The ratios are struck at the date of the Balance Sheet and if the business has seasonal variations in

the level of trading, the ratios may not be indicative of other times in the year

Judgements on the results must be related to the business’ strategy

For example, a business with high borrowings may appear unstable but this may be a rational

management policy when profits are high and the cost of borrowing relatively low

Specific situational conditions

Ratios may vary locally from international norms due to special circumstances – for example,

especially high interest rates or difficulties in obtaining supplies (which may make it prudent to carry

high levels of inventories).


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Profitability ratios

Gross profit margin

Calculation What this ratio shows

Gross Profit/Sales x 100 Example: Sales 90 Cost of sales 30 Gross profit 60

60/90 x 100 = 66.67%

The Gross profit margin measures management’s ability to control the crucial factors of selling prices and cost of sales. If cost of sales includes fixed costs then sales volumes will be included. Companies with high gross profit margins are in a very strong position to cover overheads and generate net profit if they can increase sales volume. Different industries have different gross profit norms. Companies with low gross profit margins will require high sales volumes and would be very sensitive to changes in selling prices.

Actions to improve this ratio

Increasing Sales income by increasing average selling prices

Reducing Cost of sales by negotiating a lower purchase price for your products/services

Reducing Cost of sales by reducing waste

Including more of the higher profit products/services in the sales mix

Reducing any overheads included in Cost of sales (“above the line items”)

Increasing sales volume if Cost of sales contains fixed expenses

Seek out alternative suppliers for lower costs

Identify cheaper replacement materials or products, whose quality will not damage sales

Reconsider redesigning the product/service

Re-examine inventory policy and stores to eliminate waste.

Observations

Note that increasing sales volume will only have an effect where Cost of sales includes fixed costs.

Where Cost of sales is entirely a variable cost – and it often is - this ratio is independent of volume.

For example,

If you buy a book for €10 and sell it for €16, your Gross profit is €6 and as a percentage of sales is

37.5%.

If you sell 100 books at the same price/cost parameters, your total Gross profit will increase to €600

but the ratio will stay the same – that is, 600/1600 = 37.5%.

So, in this situation, increasing volume has no effect on this ratio.


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However, where Cost of Sales is a fixed cost (or contains a fixed cost element) change in the volume

of sales will change this ratio.

For example,

If you charter a 100-seater airplane for €10,000 and charge €200 for each ticket and sell all the

tickets you will achieve a 50% gross margin.

(Sales are €20,000 and your Cost of Sales is €10,000)

But if you sell only 50 tickets, the Cost of sales remains at €10,000 but Sales drop to €10,000 and the

Gross Profit to Sales ratio is zero.

This is not to say that volume is not important to financial performance, merely that it may not have

an impact on this ratio.

Net profit margin


Net profit/Sales x 100

Example: Sales 90 Cost of sales 30 Gross profit 60 Overheads 40 Net profit 20

20/90 x 100 = 22.22%

The Net profit: Sales ratio measures the overall performance in managing prices, costs of sales and all overheads.


Since Net profit is the difference between Gross profit and Overheads,

Net profit = Gross profit – Overheads

Actions to improve this ratio include those for the Gross profit ratio plus:

Reducing Overheads (see detailed tactics in the Overheads to sales ratio below) and

Increasing Sales volume

Observations

Sales volume almost always has an effect on the Net Profit to Sales ratio because many overheads in

businesses are fixed.


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Overheads: Sales


Overheads/Sales x 100 Example: Sales 90 Cost of sales 30 Gross profit 60 Overheads 40 Net profit 20

40/90 x 100 = 44.44%

This ratio measures management’s performance in administering the business. High scores might indicate that the costs of items such as rental of premises, advertising, travelling and telephones are not justified by the levels of sales generated.


There are two ways to improve this ratio

Increase Sales (The tactics are listed in the Gross margin above)

Reduce Overheads

o Get quotations from new suppliers

o Change practice and procedures to reduce Insurance

o Promote “cost aware” work practices

o Focus on “Volatile” items such as travel expenses and phone bills.

o Improve internal Controls to ensure expenses don’t creep up.

But bear in mind (again) that where overhead expenses are variable, increasing sales volume will not

affect the ratio. It will simply create an exactly-proportionate increase in the variable overhead.

If the overhead expense is based on a percentage of sales revenue rather than units sold, then even

an increase in selling price will not affect the ratio.

Observations – Smart management of overhead expenses

This is an important target for management control, but is often complicated by the time lag

between making the expenditure and seeing results in terms of increased sales.

For example, a new showroom, advertising campaign, or sales person may not generate significant

additional sales for weeks or even months.

Classifying overheads as follows can help managers focus their efforts.

Stable Overheads: These are predictable expenses such as insurance, rent and audit fees. Management control includes:

“Shopping around” for alternative suppliers

Negotiating better terms at renewal times


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Exploring the potential for changing environmental or work practices to reduce costs e.g.

o Disposing of unused space

o Better records systems to reduce unnecessary audit and accounting fees

o improved safety practices to reduce insurance costs

Dependent Overheads:

These are overheads that arise from decisions made elsewhere:

Depreciation – determined by decisions on investment

Leasing charges and loan interest – determined by funding decisions

Once the investment and funding decisions have been made, there is little that can be done other

than vigilance in checking banks charges and routinely monitoring opportunities for cheaper funding

and opportunities to sell off underperforming fixed assets.

Volatile Overheads:

This is where smart managers focus their attention i.e.:

Repetitive expenses such as travel, motor, maintenance charges, telephone and electricity.

Discretionary expenses such as promotion and advertising.

Net profit/Total assets (ROI)


Net Profit/Total Assets x 100

Example: Sales 90 Cost of sales 30 Gross profit 60 Overheads 40 Net profit 20

Total Assets 250

20/250 x 100 = 8%

This Return on Investment (ROI) is often referred to as the “Primary” ratio.

It shows the profit generated by all assets used in the business – and therefore all the funds invested.

Obviously, the lower the costs of the assets required, the higher the ROI for the same level of profit.


Increase Net profit (Tactics covered in the previous ratios)

Sell underperforming fixed assets

Reduce inventory

Reduce debtors


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Net Profit/Capital Employed (ROCE)


Net Profit/Capital Employed x 100 Example: Net profit 20 Share capital 200 Retained Profits 100 Owners’ equity 300 Long term loans 150 Capital employed 450

20/450 x 100 = 4.448%

This ratio measures the return on the long-term capital (owners’ funds and loans) invested in the business and emphasises the goal of maximising return on investment.

NB The Net profit figure used in the calculation does not include interest charged in respect of Long term loans.


The influences are profit and effective utilisation of assets to reduce the requirement for capital.

The influences on profit have been dealt with in the earlier ratios. The utilisation of assets will be

covered in detail in Asset utilisation ratios later in this chapter.

Stability Ratios

Liquidity ratios

These ratios answer the question: “How easily will my business generate cash?”

They show the ability of the business to meet its day-to-day financial commitments by comparing

the money it can expect to take in and pay out in the short term, based on the Balance Sheet

position at the time the ratio is calculated.

The two main ratios are:

Current ratio

Quick ratio.

And we can include a subsidiary ratio which can be very informative:

“Creditor days” – how long the business takes to pay suppliers


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Current Ratio


Current Assets/Current liabilities Example: Current assets Stock 90 Debtors 150 Cash 110 350 Current liabilities 280

350/280 = 1.25 Times

Current assets are expected to convert into cash within the next 12 months at least and current liabilities are expected to be paid within the next 12 months. Therefore, a ratio of 1.25 says that, based on the business’ current financial situation, for every €1.00 the business is currently committed to pay over the next 12 months, it expects to receive €1.25 and would not anticipate problems in meeting its obligations.

Quick Ratio


(Debtors + Cash)/Current liabilities Example: Current assets Stock 90 Debtors 150 Cash 110 350 Current Liabilities = 280 Debtor + Cash = 260

260/280 = 0.93 times

This ratio shows the ability of a business to pay its debts should it have to or chose to do so more quickly than would be the case under normal trading conditions. The result of 0.93 shows that the business would be able to pay its current liabilities in all but the most extreme situations

Actions to improve Liquidity

There are two strands to improving liquidity:

To improve overall liquidity, you must look to capital structure and to profits

To improve the make-up of your liquidity, you must look to inventory control and credit

control (see further ratios below).

Overall liquidity is determined in the first instance by the funding structure used in your business.

Unless you have an effective capital structure in place i.e. unless you have adequate Equity (Owners’

or External) and Loans (Owners’ or External) - you may find that your business is reliant on short-

term measures such as bank overdrafts and extending the credit period taken from suppliers.


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This will lead to poor liquidity ratios and indicates that you may easily find your business pushed into

disruptive activities solely aimed at shoring up cash-flow without any consideration for profits and

the long-term good of the business.

Liquidity is also determined by your business’ profit margin. A large profit margin on sales increases

the value gap between debtors and creditors, thus improving the liquidity ratios. Although a large

profit margin lessens the impact of a poor financial structure, it is no substitute for it.

Tactics to improve overall liquidity include:

Introduce more long-term funds: Use equity or long-term loans to reduce bank overdrafts and/or

payables. Look at your business’ Debt: Equity ratio (see below) to see whether your business can

support further borrowings. Use effective financial modelling software to model the effect of

different borrowing types and amounts (see Step 3)

Increase profitability: Profit-increasing strategies will improve liquidity by increasing the value of

amounts receivable from debtors and/or reducing the value of amounts payable to creditors.

In a start-up company, profit-increasing strategies are unlikely to be enough to correct a significant

liquidity problem and the focus has to be on sources of long-term funds, as the primary corrective

action.

The closer that current assets are to cash, the more truly liquid the business! Your business should

convert inventory and amounts receivable from debtors into cash as quickly possible, without

impinging on customer service through stock-outs and over-aggressive credit control.

Observations

Simply setting current assets and current liabilities against one another as done by the current ratio

is often too blunt an instrument to provide a clear picture of liquidity.

The main items in Current assets - Cash, Debtors and Inventory - represent the main stages in the

business cycle where items are bought and/or manufactured (inventory) before being sold to

customers (debtors) and finally converted into cash when the debts are settled.

The further back in the business cycle, the higher the risk that the values recorded in the Balance

Sheet may not be achieved – for example, inventory loses value through waste or obsolescence, and

debtors may default (Bad debts)

Obviously, a business whose current assets are comprised mainly of cash and debtors is better

equipped to meet day-to-day payments than one whose current assets are made up predominantly

of inventory.

Inventory has a further limitation, in that its value and the ease with which it can be converted into

cash can be difficult to independently verify.

For these reasons an additional liquidity ratio - the Quick ratio or Acid Test ratio, which eliminates

inventory from the calculation, is used.


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Major differences between the two ratios – Current and Quick – could be a cause for concern and

might indicate an undue reliance on Inventory.

To improve the make-up of your liquidity, look to subsidiary ratios on credit and inventory control.

The other important measures of managing liquidity are:

The rate at which a business settles amounts due to suppliers

The rate at which it collects amounts receivable from debtors

The levels of inventory it carries.

Creditors Ratio


Creditors/Purchases on credit x 365* Example: Purchases on credit €300000 Creditors € 30000

€30000/€300000 x 365 = 36.5 Days This ratio is measured in days. *Traditionally the calculation used 360 but most modern software applications will use 365.

The 360 was easier to calculate, gave less fussy results in terms of fractions and breaks down smoothly to 12 months (of 30 days) a quarter (90 days) and half year.

This ratio measures the average credit period taken by the business from its suppliers. If this ratio is higher than the industry norm or progressively increasing it might be an indication of cash flow difficulties. If suppliers are prepared to offer extended credit, they may recoup the cost of the credit in some other way – through higher prices, slower service, etc. Make sure that you keep the right balance between pushing supplier credit to the limit and other factors that will impact on your business’ success. Always bear in mind that your primary objective in business is to generate profit – don’t sacrifice this by ruining your relationships with key suppliers and suffering higher average prices

Actions to improve the Creditors ratio

This is a ratio that is heavily influenced by situations and strategies.

From one perspective, you could say that the longer the business takes to pay its creditors then the

more benefit it enjoys, as the creditors are effectively providing free capital to the business.

But, as mentioned already, taking advantage of suppliers will invariably result in some retaliatory

measures from their side.

The best policy is to agree reasonable repayment times and keep to them. If the times are too short,

renegotiate with the suppliers or find new ones. If they are too generous, check to see if they are

covering higher prices or other negative trading conditions.


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In temporary cash flow situations business will find that they have to “stretch” their creditors but

this must be a short term measure while the situation works itself out or alternative capital is

sourced.

If a business continues to be unable to pay its creditors within acceptable time limits then it will find

it difficult to continue trading.

In that case the business will have to improve its cash flow by:

Reducing capital tied up in debtors and stock or releasing cash by selling assets that are not

essential or can be rented rather than owned.

Improving its capital structure by borrowing or issuing new share capital.

Generating more profits to strengthen the Balance Sheet (long term strategy not a solution

to a liquidity crisis)

Observations

This ratio may be distorted by seasonal trends in trends in trading e.g. where a business has

disproportionate sales or purchases in the period immediately before the Balance Sheet date.

The example provided in the “Debtor days” later in this chapter will illustrate this.

The issues involved in raising long term capital (Gearing) The aim in funding a business is to have enough long term capital to develop the business and

maintain the right balance in the capital between owners’ funds and borrowings in terms of

exposure to costs and safety.

The relevant differences between share capital and borrowing are:

Share capital is safe from the point of view of the business as it does not have to be repaid

and payment of dividends is discretionary

Borrowed capital creates risk and incurs interest charges that have to be paid

When a business needs capital to accelerate growth (as opposed to organic growth from retained

profits) the management and owners have to decide on how much of the capital should be sourced

from share and debt.


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The decision from the existing owners’ perspective

Decision Projected rates of ROCE Constraints

Higher than projected interest rates

About the same as projected interest rates

Lower than projected interest rates

Increase their investment

Valid reasons to invest further and retain ownership.

Development is a risky proposition and unlikely to attract new investors or justify borrowing.

So, it will be up to the existing owners to provide the capital.

Development not an advantage Shelve the proposal

Availability of cash and risk of putting “more eggs in the same basket”

Offer share capital to new investors

Will dilute the existing owners’ stake in future profits but spread the risk. It may be an opportunity to bring in new capital on very favourable terms.

The company’s record in delivering on past profit forecast.

Borrow the capital

Valid reasons to borrow as they will be getting a return on the lenders money from the additional profits remaining after paying interest

Relationship with lenders and level of existing debt i.e. the existing “gearing”

Gearing ratios

Gearing ratios answer the question: “Does the capital structure give me control of my business?”

The ratios look at the dependence of the business on outside funds and can give important

indicators of the weakening of management’s influence over the direction of the business in favour

of the external providers of funding.

The main gearing ratios are:

Debt to Equity Ratio

Equity to Total Assets.

And a subsidiary ratio - Interest cover ratio.


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Debt: Equity


Debt/Equity x 100

Example: € Fixed assets 380 Current assets 350 Current Liabilities 280 Net Current assets 70

Long term creditors 150

Net assets 300 Share capital 200 Reserves 100 300

150/300 x 100 = 50%

This ratio examines the structure of the long term capital used in the business (the “gearing”). When this ratio reaches 100% lenders have as much money invested in the business as the owners and a business is considered to be “highly geared”. Highly-geared companies can expect more difficulty in raising further loans and their profitability will be more vulnerable to an increase in interest rates. (See the Interest Cover ratio). There is no “right” gearing for a business. In times of low interest rates and high profit, it may suit businesses to be highly-geared but this strategy can be very risky if the business cannot pay down loans when the situation reverses and interest rates are high and profits low. The key is whether the gearing is determined by deliberate strategy or because the business is not making sufficient profits.

Equity: Total assets

Calculation What this Ratio shows

Equity/Total Assets x 100 Example: € Fixed assets 380 Current assets 350 Total Assets 730

Share capital 200 Reserves 100 300

300/730 x 100 = 41.10%

This ratio is a broader measure of the extent of the owners’ ownership of the company’s assets. It identifies the percentage of the business’ assets actually funded by the owners and takes into account all external borrowing including current liabilities.

Actions to improve these ratios

Ensure the initial capital structure is correct and then control the demand for capital (asset

utilisation) while generating and retaining the profits needed for a strong Balance Sheet.

The ultimate control over gearing in business is profit. In most circumstances, a business that

generates high profits and does not put the business in jeopardy by lax controls over current assets

and unjustified spending of fixed assets will not need much in the way of borrowings.

Where it does choose to borrow, it will find it easy to do so.

In contrast, a business that struggles to generate adequate profits is likely to ultimately face cash-

flow difficulties irrespective of the management’s skill in asset utilisation.


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Interest cover ratio


Net Profit before interest/ Interest Example: € Profit before interest 1000 Interest 100

Net profit 900

1000/100 = 10 times

The Interest Cover ratio is expressed as the number of times the Net profit before interest “covers” the interest. It measures the vulnerability of the business to an increase in interest rates. A low level of cover – say 1 to 5 – means that an increase in interest rates would significantly damage profitability. A high level of cover – say 10 or 20 – gives much greater comfort.


Improve profit, reduce gearing and negotiate low interest rates.


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Asset Utilisation

Sales/Total assets


Sales/Total assets Example: P & L for XYZ Ltd - extract € Sales 900 Balance Sheet XYZ Ltd - extract € Fixed assets 380 Current assets 350 730

900/730 = 1.24 times

The Sales to Total Assets ratio shows the efficiency of management in generating sales from all the assets at their disposal - the greater the number, the more efficient the utilisation.


The determinants are effective use of productive assets such as machinery and tight control over

inventory and receivables.

These will be explained in more detail when we deal with the subsidiary ratios of sales to fixed assets

and sales to current assets.

Sales / Fixed assets


Sales/Fixed assets Example: P & L for XYZ Ltd - extract € Sales 900 Balance Sheet XYZ Ltd - extract € Fixed assets 380 Current assets 350 730

900/380 = 2.37 times

The Sales to Fixed Assets ratio is a component of the Sales/Total Assets ratio and indicates the performance in utilising fixed assets to generate sales.


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Verify that acquisition is a better option than renting/hiring and justifies the risk and capital

demanded.

Carry out an appraisal of all fixed assets to see if there are ones that can be sold profitably and

replaced by renting/hiring new ones if necessary.

There can be a lot of fuzzy thinking in business in relation to fixed assets:

“customers are influenced by impressive premises and equipment”

“some assets e.g. property could appreciate in value over time”

These notions may be valid in some situations, but entrepreneurs and managers need to look

dispassionately at decisions on fixed assets and measure them in terms of their return – i.e. sales

generated and hence profitability.

Sales/Current Assets


Sales/ Current assets Example: P & L for XYZ Ltd - extract € Sales 900 Balance Sheet XYZ Ltd - extract € Fixed assets 380 Current assets 350 730

900/350 = 2.57 times

The Sales to Current assets ratio is a component of the Sales/Total assets ratio and indicates the ability of management to generate sales while controlling debtors and inventory.


Increase sales and reduce excess inventory and debtors.


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Debtors days


Debtors/Credit Sales x 365

Example: P & L for XYZ Ltd - extract € Sales 900 Note All sales are on credit. Balance Sheet XYZ Ltd - extract € Fixed assets 380 Current assets Stock 90 Debtors 150 Cash 110 350

150/900 = 60.83 days

This ratio measures performance in collecting amounts receivable from debtors.

Note

If the debtors figure includes VAT (or other turnover taxes), the figure for credit sales should include VAT also, to compare like with like.

The target would be to keep this ratio low, while maintaining levels of customer service consistent with the business’ marketing strategy.


Maintain an effective credit control policy i.e. credit checks on new customers agree payment

terms/maximum credit limits and actively enforce these trading terms.

Observations - Seasonal distortion

Ratios drawn from financial statements at a certain date may be distorted due to seasonal trading

patterns and be different to those calculated at any other time. This is not a major drawback to ratio

analysis, merely something to be aware of.

To illustrate this distortion let’s look at the following situation:

If half your customers pay within 30 days and the other half pay within 60 days, your true Debtors

days ratio is 45 days - irrespective of what the ratios say.

To test the validity of this, let’s take a business where credit sales are €1,000 per month and half the

customers pay after 30 days and the other half pay after 60 days. At the end of the year, the 30-day

customers owe one month’s sales (€500), while the 60-day customers owe two month’s sales

(€1,000).

Amounts receivable from debtors at the year-end are thus €1,500. Annual sales are €12,000. The

Debtor days ratio is calculated as:

Debtors / Credit sales x 360 (we will use the traditional 360 for convenience of calculation in this

illustration)

1,500 / 12,000 x 360 = 45 days.


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But, suppose the sales pattern changes and all the sales are made in the last two months (€6,000 in

each month), with no sales earlier in the year.

At the end of the year, the 30-day customers would again owe one month’s sales (€3,000), while the

60-day customers would owe two month’s sales (€6,000).

The amount receivable at the year-end is now €9,000, while annual sales remain unchanged at

€12,000.

The ratio calculation is now:

9,000/12000 x 360 = 270 days

The business’ credit policy has not changed. All that has changed is the timing of the sales and the

true debtor settlement timing remains at 45 days.

Stock (Inventory) turnover


Inventory/Cost of sales x365 Example: P & L for XYZ Ltd - extract € Sales 900 Cost of sales 500 Gross Profit 400

Balance Sheet XYZ Ltd - extract € Fixed assets 380 Current assets Stock 90 Debtors 150 Cash 110 350

90/500 x 365 = 65.7 days

This ratio is used to indicate the level of investment tied up in inventory. Ideally, this ratio should be minimised. Note: Just like the Debtors days and Creditors days ratios, the Stock Turnover ratio can be affected by seasonal patterns in trading.


The tactics available to improve the Stock Turnover ratio include:

Reducing the minimum re-order value and or average order quantities to create more

frequent re-orders but in smaller quantities. The downside is that purchasing costs may rise,

suppliers may charge more and delivery costs may rise

Negotiate lower prices to reduce the value of inventory


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Progress test 6 – Ratios Question 1: Net Profit margin is calculated as Net Profit divided by ...

a) Overheads b) Cost of Sales c) Purchases d) Sales

Question 2: Gross Profit Margin is Gross Profit divided by ...

a) Sales b) Purchases c) Cost of Sales d) Overheads

Question 3: Return on Capital Employed (ROCE) is Net profit divided by ...

a) Owners’ Equity b) Sales c) Total Liabilities d) Total Assets less Current Liabilities

Question 4: Liquidity ratio is Current Assets divided by ...

a) Owners’ Equity b) Sales c) Total Liabilities d) Current Liabilities

Question 5: Acid Test (Quick) Ratio is Current Assets divided by ...

a) Owners' Equity b) Long Term Liabilities c) Current Liabilities less stock d) Total Assets

Question 6: Interest Cover is Net profit divided by...

a) Total Liabilities b) Sales c) Interest d) Current Liabilities

Question 7: Stock turnover is stock divided by…

a) Cost of Sales b) Owners' Equity c) Total assets d) Sales

Question 8: Asset Turn ratio is Sales divided by...

a) Total Assets b) Cost of Sales c) Current Assets d) Owners' Equity


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Question 9: The "Debt to Equity Ratio" is Long term Loans divided by... a) Owners' Equity b) Total assets c) Total Liabilities d) Sales

Question 10: Debtor days' ratio is Debtors divided by...

a) Owners' Equity b) Sales on credit

c) Sales

d) Cash Sales

Workbook 6 – Ratios · Workbook 6 – Ratios 2 Highlights 1. Learn the sixteen ratios that tell...

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