Business Ratios and Finance: Key Insights

Posted on Feb 19, 2025 in Economy

Profitability Ratios

Profitability ratios compare the profits of a business with its sales revenue.

Profit Margin Ratios

Profit margin ratios are used to assess how successful the management of a business has been at converting sales revenue into gross and net profit.

  • Gross Profit Margin: Compares gross profit with sales turnover (Gross Profit / Sales Revenue * 100). A good indicator of how effectively managers have added value.
  • Net Profit Margin: Compares net profit with sales revenue (Net Profit / Sales Revenue * 100). Comparison of results from previous years indicates if there is any improvement. A good indicator of management’s effectiveness in converting sales revenue to net profit.

Increasing Profit Margins

  • Reducing Direct Costs:
    • Using cheaper materials.
    • Potential drawbacks: Perception of quality might be damaged, quality may be at risk, and employee motivation levels could fall.
  • Increasing Price:
    • Raising prices with no change in variable costs.
    • Potential drawbacks: Profits could fall if customers switch to competitors, and customers may perceive this as profiteering.
  • Reducing Overhead Costs:
    • Cutting rent, promotion, etc.
    • Potential drawbacks: Lower rental costs may mean relocating to a cheaper area. Cutting promotion costs could lead to a decrease in sales.

Liquidity Ratios

Liquidity ratios assess the ability of a firm to pay its short-term debts.

  • Current Ratio: Compares current assets with current liabilities (Current Assets / Current Liabilities). A ratio of over 2 suggests too many funds are tied up.
  • Acid Test Ratio: By eliminating the value of inventories, users of accounts are given a clearer image of a firm’s ability to pay short-term debts (Current Assets – Inventories / Current Liabilities).

Increasing Liquidity

  • Sell off Fixed Assets:
    • Selling land, for example.
    • Potential drawbacks: If assets are sold quickly, they might not be sold for their real value. If assets are still needed, leasing charges may apply.
  • Sell off Inventories:
    • Selling stocks of finished goods at a discount.
    • Potential drawbacks: This will reduce the gross profit margin. Inventories may be needed to meet demand, and customers may doubt the brand’s image.
  • Increase Loans to Inject Cash:
    • Taking out long-term loans.
    • Potential drawbacks: This will increase the gearing ratio and interest costs.

Limitations of Ratio Analysis

  • Provides an incomplete analysis of a company’s financial position.
  • One ratio is of very limited value.

Capital and Revenue Expenditure

Capital Expenditure: The purchase of assets that are expected to last more than one year.

Revenue Expenditure: Spending on all costs and assets other than fixed assets.

Working Capital

Working capital is the capital needed to pay for raw materials, day-to-day running costs, and credit offered to customers. Without sufficient working capital, a business will be illiquid, which could lead to the need to raise finance or even liquidation.

Liquidation: When a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors.

Internal Sources of Finance

Internal sources refer to money raised from the business’s own assets.

  • Profit retained after dividends.
  • Sale of assets.
  • Reductions in working capital.

External Sources of Finance

External sources refer to money raised from outside the business.

  • Bank Overdraft: A bank allows a business to overdraw on its account to an agreed limit. Drawback: High interest rates.
  • Trade Credit: Delaying the payment of bills for goods or services received. Drawback: No discounts for quick payments.
  • Debt Factoring: When a business sells goods on credit, a debtor is created. Claims on debtors can be sold to a debt factor.
  • Hire Purchase: An asset is sold to a company that agrees to pay fixed repayments over an agreed time period.
  • Leasing: Renting equipment or vehicles and paying a leasing charge over a time period.

Long-Term Finance

  • Long-Term Loans: Loans that do not have to be repaid for at least one year.
  • Long-Term Bonds: Bonds issued by companies to raise debt finance.
  • Equity: The sale of shares.