These ratios tell us whether a business is making profits -
and if so whether at an acceptable rate. The key ratios are:
|Gross Profit Margin
||[Gross Profit / Revenue] x 100
(expressed as a percentage
||This ratio tells us something
about the business's ability consistently to control its production
costs or to manage the margins its makes on products its buys and
sells. Whilst sales value and volumes may move up and down
significantly, the gross profit margin is usually quite stable (in
percentage terms). However, a small increase (or decrease) in profit
margin, however caused can produce a substantial change in overall
|Operating Profit Margin
||[Operating Profit / Revenue] x
100 (expressed as a percentage)
||Assuming a constant gross
profit margin, the operating profit margin tells us something about a
company's ability to control its other operating costs or overheads.
|Return on capital
||Net profit before tax, interest
and dividends ("EBIT") / total assets (or total assets less
||ROCE is sometimes referred to
as the "primary ratio"; it tells us what returns management
has made on the resources made available to them before making any
distribution of those returns.
These ratios give us an insight into how efficiently the
business is employing those resources invested in fixed assets and working
|Sales /Capital Employed
||Sales / Capital employed
||A measure of total asset
utilisation. Helps to answer the question - what sales are being
generated by each pound's worth of assets invested in the business.
Note, when combined with the return on sales (see above) it generates
the primary ratio - ROCE.
|Sales or Profit / Fixed
||Sales or profit / Fixed Assets
||This ratio is about fixed asset
capacity. A reducing sales or profit being generated from each pound
invested in fixed assets may indicate over-capacty or
||Cost of Sales / Average Stock
||Stock turnover helps answer
questions such as "have we got too much money tied up in
inventory"?. An increasing stock turnover figure or one which is
much larger than the "average" for an industry, may indicate
poor stock management.
|Credit Given /
||(Trade debtors (average, if
possible) / (Sales)) x 365
||The "debtor days"
ratio indicates whether debtors are being allowed excessive credit. A
high figure (more than the industry average) may suggest general
problems with debt collection or the financial position of major
|Credit taken /
||((Trade creditors + accruals) /
(cost of sales + other purchases)) x 365
||A similar calculation to that
for debtors, giving an insight into whether a business i taking full
advantage of trade credit available to it.
Liquidity ratios indicate how capable a business is of
meeting its short-term obligations as they fall due:
||Current Assets / Current
||A simple measure that estimates
whether the business can pay debts due within one year from assets
that it expects to turn into cash within that year. A ratio of less
than one is often a cause for concern, particularly if it persists for
any length of time.
|Quick Ratio (or
||Cash and near cash (short-term
investments + trade debtors)
||Not all assets can be turned
into cash quickly or easily. Some - notably raw materials and other
stocks - must first be turned into final product, then sold and the
cash collected from debtors. The Quick Ratio therefore adjusts the
Current Ratio to eliminate all assets that are not already in cash (or
"near-cash") form. Once again, a ratio of less than one
would start to send out danger signals.
These ratios concentrate on the long-term health of a
business - particularly the effect of the capital/finance structure on the
||Borrowing (all long-term debts
+ normal overdraft) / Net Assets (or Shareholders' Funds)
||Gearing (otherwise known as
"leverage") measures the proportion of assets invested in a
business that are financed by borrowing.. In theory, the higher the
level of borrowing (gearing) the higher are the risks to a business,
since the payment of interest and repayment of debts are not
"optional" in the same way as dividends. However, gearing
can be a financially sound part of a business's capital structure
particularly if the business has strong, predicatable cash flows.
||Operating profit before
interest / Interest
||This measures the ability of
the business to "service" its debt. Are profits sufficient
to be able to pay interest and other finance costs?
There are several ratios commonly used by investors to assess
the performance of a business as an investment:
|Earnings per share
||Earnings (profits) attributable
to ordinary shareholders / Weighted average ordinary shares in issue
during the year
||A requirement of the London
Stock Exchange - an important ratio. EPS measures the overall profit
generated for each share in existence over a particular period.
||Market price of share /
Earnings per Share
||At any time, the P/E ratio is
an indication of how highly the market "rates" or
"values" a business. A P/E ratio is best viewed in the
context of a sector or market average to get a feel for relative value
and stock market pricing.
||(Latest dividend per ordinary
share / current market price of share) x 100
||This is known as the
"payout ratio". It provides a guide as to the ability of a
business to maintain a dividend payment. It also measures the
proportion of earnings that are being retained by the business rather
than distributed as dividends.