Types of Financial Ratios Liquidity:Liquidity is the ability to pay businesses short-term obligations as they fall due.

Measured by: Current Ratio

(Working capital)Current ratio = Current Assets --------------------Current Liabilities This company has $2.15 of current assets to pay for every dollar of current liabilities Suggested level: 2:1 Non current assets could be sold to increase current assets Factoring to have accounts receivable in cash form Hold a stock take sale to convert inventory into cash Sell and leaseback the building to get large sum of cash. Profitability:Is the earning performance of the business and indicates its capacity to use its resources to maximize profits. Measured by: - Gross profit ratio - Net profit ratio - return on owners equity

Net profit Ratio = Net Profit

-------------Sales

Times 100

Every one dollar of sales gives 43 % worth of net profit (0.43: 1) The higher the ratio the better. A good amount is greater than 10%

Reduce expenses: obtain stock at lower price sack staff move to cheaper premises Find out ways to reduce expenses

Return on owners equity = Net Profit

--------------- Times 100 Owners Equity

For every dollar the owner has put in, the owner receives (whole number) % profit Suggested: Owners would be unhappy with figures below 10% as higher returns could be achieved with little risk in property and financial institutions thus, 20% would be excellent. The higher the ratio the better

reducing expenses improve efficiency increase sales e.g. by expanding product range, changing sales mix look for potential markets and invest.

Grosss Profit Ratio = Gross Profit

-------------Sales

Times 100

This means every one dollar of sales generates a gross profit of 76 % (0.76: 1) Suggested: The higher the better

Raise prices Obtain stock at lower price Increase sales e.g. by promotion Leverage or Gearing or Solvency:It is the proportion of debt and the proportion of equity which is used to finance the activities of a firm.

Measured by: debt to equity ratio

Debt to equity ratio = Total Liabilities --------------------Owners Equity (35) For every one dollar of owners equity the company has borrowed 35 cents Suggested: The higher the ratio the less solvent the business, higher risk. Ratio of 1:1 is sound. The less the ratio the better highly geared can be decreased by lowering the level of liabilities increasing owners contribution to assets (but dividends become smaller)

Efficiency: is the ability of the firm to use its resources effectively in ensuring financial stability and
profitability of the business. Measured by:

1. expense ratio 2. accounts receivable turnover ratio

Expense ratio = Expenses (financial, administrative,selling) ---------------------------------------------------- Times 100 Sales The lower the better. Generally low for each expense around 3% Suggested: varies but rising expenses may call for greater levels of control lower expenses will add to efficiency and profits of a business

Accounts receivable turnover ratio = 365/

Sales ---------------Accounts Receivable

(30.42) It takes an average 30.42 days to turnover its accounts receivables. Suggested: Usually the credit period is 30 days30<40< Is a concern be careful in granting credit, monitor accounts thus, use a credit policy to screen potential debtors to minimize credit risk encourage on time payments: give discounts for early payments and charge high interest for late payments Sample responses
This firm has $3 of current assets for every $1 of current liabilities. The firm has higher than the recommended ratio of 2:1. This indicates that the firm is in a sound financial position and it is liquid and will be able to pay off its short term debts. This firm has 33 cents in external debt for every dollar of internal debt. A ratio of 1:1 indicates a sound financial position so this firm is solvent therefore it will be able to pay off its long term debts This firm has for every one dollar of sales 40% gross profit. This firm may need to search for new suppliers to get cheaper costs of goods and competitors gross profit investigated It takes an average 25 days to turnover its accounts receivable. This is good as the recommended amount is 30 days or 12 times a year. Make sure to continue enforcing strict credit policies. The return on owners equity ratio is 10%. This is not a great amount therefore the owner should consider selling off the business or investing in financial institutions as a change.

Financial statements Cash flow statement (statement of financial position) (Feel free to add on)
Current assets Cash Accounts receivable Inventory Debtors stock Current liabilities accounts payable overdraft creditors term loan

Non current assets Properly, plant or equipment Machinery Intangible assets

Non current liabilities Mortgage Bank loan

Owners equity Capital Retained profits Owners contribution Net profit

Accounting equation ASSETS= LIABIITIES + OWNERS EQUITY

REVENUE STATEMENT $Sales Cogs =opening stock + purchases closing stock Cartage inwards (freight inwards) delivery costs incurred by the business in bringing stock into the business Gross profit=sales-cogs Expenses Selling administrative Commission Stationary Salaries Office salaries Wages Rent Advertising Rates Delivery expenses Telephone Electricity Depreciation on buildings Depreciation on Audit fees items cartage outwards Accountants fees (freight outwards) Insurance the cost of goods security going out of the business financial interest payments lease payments dividends

Selling expenses: those relate to the process of selling the good or service and can be directly traced to the need for sales Administration expenses: costs directly relates to the general running of the business Finance expenses: costs associated with borrowing money from outside people or organizations Net profit= gross profit expenses

Example revenue statement Revenue statement for peters groceries ending 30 June 2008 $ $ Sales Cogs Gross profit Less expenses Selling expenses Electricity Delivery Wages Advertising Administrative expenses Rent Telephone Insurance Financial expenses Interest on loan Lease payments Total expenses 2000 2000 2000 4000 1500 8000 500 500 1000 500 22000 350000 260000 90000

Net profit

68000 Balance sheet for James services period ending 30 June 2008 $ $ Current liabilities $ 44700 Accounts payable 2000 8000 Creditors 2000 15000 Term loan 1800 67700 Total current liabilities Non Current liabilities mortgage 22600 total non current liabilities total liabilities 162000 229000 Total liabilities+owners equity 229700 Owners equity capital Total owners equity 201 300 201300

Current assets Cash Inventory Accounts receivable Total current assets Non Current assets Motor vehicle Plant and equipment

5800

58000 104000

22600 28400

Total non current assets Total assets

Challenge question (this is as hard as it gets) Total assets ($) 400 000 Calculate the Gearing ratio? Total liabilities ($) 700 000