Ratio Analysis & Communications

Difference between Gross Margin & Markup

1. Gross Margin is the Gross profit as a percentage in relation to revenue

2. Gross Markup is the Gross profit as a percentage in relation to cost of sales

What is ROCE / return on capital employed?

The profit earned or return for every $1 of Capital Employed

This measures profitability

What do you mean by liquidity?

The ability for current assest to meet current liabilities

How to improve gross profit margin?

1. Increase selling prices

2. Find cheaper suppliers / lower purchase price

3. Change sales mix

4. Take advantage of trade discounts / Bargain for more

5. Allow lower rates of trade discounts to customers

These are also the reasons for increased margin. Worsening of margin is the opposite of this

How to increase profit margin

1. Increase in gross profits

2. Greater control over expenses

3. Higher other incomes

If the gross profit is lower than last year then the first point is not applicable

How to Improve ROCE?

1. Increase profits or the business is profitable

2. Employ capital more efficiently

Importance of Current Ratio / Working Capital Ratio

1. Measure the funds available in the short term to meet current liabilities

2. Does not show liquid assets as it includes inventory

3. It measure liquidity as it measure excess current assets over current liabilities

Why is Quick Ratio a better indicator of liquidity?

1. Does not include inventory as it is not a liquid asset

2. Inventory is regarded as two stages from liquidity

Consequences of Poor Liquidity

1. Not enough short term funds to meet short term debts

2. Loss is cash discounts

3. Loss in business opportunities

4. May increase borrowing and interest

Other Ratio that Measure Liquidity

Quick Ratio - The Best

Current Ratio - Good

Trade recievable / payable turnover - useful

Inventory turnover - last used

Advantages of Ratios

1. Allows comparison between businesses

2. Show trends / performances by comparing with past years

3. Can be used to compare with market leader

4. Allows managers to measure performance and set targets / benchmarks

5. Can be compared with industrial averages

6. Gives quick details such as risk and perfomance and efficiency to potential users

Disadvantages / Limitations of Accounting ratios

1. Based on past / historic information

2. Uses only financial information and non-financial items are excluded

3. Doesn't consider seasonality or year ends

4. Doesn't consider inflation

5. Uses subjective data

6. Doesn't give a reason for the cause

7. Doesnt consider state of the asset such as probability of debtor paying

Factors to consider when comparing businesses

1. Must be in the same industry or sell the same products

2. Same size / revenue or capital structures

3. Must be operating at the same accounting policies

4. Must be operating at the same year ends

Limitations of Comparing Businesses

1. Doesn not consider non-financial aspects

2. Not same year ends or seasons

3. Not operating at the same accounting policies

4. May not be in same industry

5. May not be the same size

6. One years of data is not enough to make valid conclusions