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## FINANCIAL RATIOS

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**FINANCIAL RATIOS**Making sense of Revenue Statements And Balance Sheets**Introduction**• Financial ratios are calculations that help managers examine the performance of the business. • They also assist in determining whether the business is meeting its financial objectives. • Ratios allow comparison over time, with industry averages and with their competitors, they allow for the prediction of trends and assist in planning.**IT IS NOT ENOUGH TO SIMPLY CALCULATE RATIOS YOU MUST**INTERPRET THEM....**To begin...**• You must be familiar with The Accounting Equation • Assets = Liabilities + Owners equity • This equation is the one that ensures that the Balance Sheet actually balances.**The types of ratios**• There are several categories of ratios that businesses use and you need to know which ratio falls under which category**Liquidity**• Liquidity measures how easily a business can meet its current liabilities or short term debts. • It is the relationship between current assets and current liabilities. • Ideally the business should have more current assets than current liabilities to pay their short term debts as they fall due.**How is liquidity measured**• By using the Current Ratio • Current Ratio = current assets current liabilities Generally the industry standard for liquidity is 2:1. This means that for every dollar of liability the business has 2 dollars of assets to pay for it**Worked Example**• Using the Coco’s Coastal Cafe Balance Sheet: • A) Determine the level of current assets and current liabilities • B) Substitute these numbers into the ratio • C) Write a short statement that describes the current ratio of Coco’s Coastal Cafe ( is it good?)**Solvency**• Refers to the long term stability of the business and whether it can meet its total financial obligations as they fall due. • The term used to describe the relationship between debt and equity is gearing. If the business has accumulated more debt than equity it is termed highly geared.**How solvency is measured**• By using the gearing ratio • Gearing Ratio = Total liabilities X 100 Owners Equity Generally the industry standard for small business is 50% and for larger business 100% This means for a small business that for every dollar of equity invested the business has generated 50c of debt.**Worked Example**• Using the Coco’s Coastal Cafe Balance Sheet: • A) Determine the level of total liabilities and owners equity • B) Substitute these numbers into the ratio • C) Write a short statement that describes the gearing ratio of Coco’s Coastal Cafe ( is it good?)**Profitability**• Profitability refers to the businesses ability to make a financial return from their activities. • Profitability can be determined in 3 ways by calculating: * Gross Profit Ratio (GPR) * Net Profit Ratio (NPR) * Return on Owners Equity (ROOE)**Gross Profit Ratio**• This ratio indicates the percentage of each dollar of sales, this is gross profit. It indicates the mark up placed on goods sold. • Generally the higher this percentage the better as this gives the business better opportunities to account for their expenses**GPR**• Gross Profit Ratio = Gross Profit X 100 GPR Sales**Worked Example**• Using the Coco’s Coastal Cafe Revenue Statement: • A) Determine the level of Gross Profit and Sales • B) Substitute these numbers into the ratio • C) Write a short statement that describes the GPR of Coco’s Coastal Cafe ( is it good?)**Net Profit Ratio**• Net Profit Ratio takes into account the expenses of a business and this is how it differs from the GPR. • The Net Profit Ratio (NPR) will be less than the GPR and if expenses were increasing then the NPR would be decreasing. • This ratio measures what percentage of each dollar of sales is net profit. 13-20% is good for retail businesses.**NPR**• Net Profit Ratio = Net Profit X 100 NPR Sales**Worked Examples**• Using the Coco’s Coastal Cafe Revenue Statement: • A) Determine the level of Net Profit and Sales • B) Substitute these numbers into the ratio • C) Write a short statement that describes the NPR of Coco’s Coastal Cafe ( is it good?)**Return on Owners Equity**• This is one of the most important indicators as it shows how much the owners investment and risk in the business is earning. • A high figure is desirable but the trend over time is more significant • A figure below 10% would be a concern as the owner could invest in much less risky areas for a similar return. E.g. bank and property investments**ROOE**• Return on Owners Equity = Net Profit X100 ROOE Owners Equity**Worked Example**• Using Coco’s Coastal Cafe Revenue Statement and Balance Sheet: • A) Determine the level of Net Profit and Owners Equity • B) Substitute these numbers into the ratio • C) Write a short statement that describes the ROOE of Coco’s Coastal Cafe ( is it good?)**Efficiency**• Efficiency means that a business is the maximum returns for the minimum costs. • Efficiency ratios provide a tool to determine how efficiently the business is using its assets and spending to create sales and profits. • There are 2 main efficiency ratios • Expense Ratio • Accounts Receivable Turnover Ratio**Expense Ratio**• This ratio shows the relationship between sales and expenses used to make those sales. • The Expense Ratio needs to be as low as possible so that the business can generate a better NPR. • Strategies are often used to lower the Expense Ratio once it has been determined.**Expense Ratio**• Expense ratio = expenses X 100 sales**Using Coco’s Coastal Cafe Revenue Statement:**• A) Determine the level of Sales and Expenses • B) Substitute these numbers into the ratio • C) Write a short statement that describes the expense ratio of Coco’s Coastal Cafe ( is it good?)**Accounts Receivable Turnover Ratio**• This ratio shows how long it takes for the business to collect money that is owed to them • A long period is a concern as it means the business’s cash flow could be jeopardised. • If a business can collect its debts within 14 days that is excellent but anything up to 60 days is acceptable. The lower the number of days the better.**Accounts Receivable Turnover Ratio**• Accounts Receivable = Accounts Receivable Turnover Ratio Sales /day (sales /day is calculated by dividing the value of sales by 365)**Using Coco’s Coastal Cafe Revenue Statement and Balance**Sheet: • A) Determine the level of Sales and Accounts Receivable • B) Substitute these numbers into the ratio remember to divide the sales by 365!!! • C) Write a short statement that describes the Acc/Rec Turnover Ratio of Coco’s Coastal Cafe ( is it good?)