# Understanding Ratio Analysis

Expressed as one figure in terms of another, ratio and ratio analysis involves the comparison of ratios to assess any weakness or strength of a company. It is a highly efficient method that provides information about a number of different relationships that are not highlighted in a company’s financial statements. They are also used to assess the overall performance of companies.

Usually, a ratio is evaluated by reference either to the ratios that the company itself has generated in the past (trend analysis) or to ratios currently achieved by other companies in the same industry (inter-company comparison).

So, let’s take a look at the profitability and liquidity ratios that have to be calculated for a company.

# Profitability Ratios

## 1. Gross Profit Margin (Gross Profit Percentage):

The gross profit margin shows the proportion of sales that are being converted into profits before deducting the running expenses of the business. A high gross profit margin means greater trading success and higher profits.

The formula for calculating the gross profit ratio is: gross profit divided by revenue x 100.

Small tip: The gross profit may be further improved by increasing selling price or obtaining cheaper supplies.

## 2. Net profit Margin:

The net profit ratio indicated how well a business is able to control its expenses. A high net profit ratio is an indication of good performance. A net profit percentage of 15 % , for example, shows that out of every \$ 100 sales, the business earns \$ 15 after all operating costs and cost of sales have been covered.

This ratio can be calculated by using either the net profit after interest and before tax. Or, the net profit after tax.

## 3. Return on Capital Employed (ROCE):

The most important profitability ratio is the return on capital employed (ROCE) which states the profit as a percentage of the amount of capital employed.

Here is the formula:

ROCE = Profit Margin x Asset Turnover

Usually, a high-profit margin means a higher selling price and a higher selling price may lead to a decrease in sales and hence generating a lower asset turnover. However, a high asset turnover means that a company is generating a lot of sales but to achieve this it might have to decrease its selling price and hence accept a lower profit margin.

An inverse relationship usually exists between profit margin and asset turnover. For instance, a firm that increases selling price in order to improve its profit margin may suffer a decline in the volume of sales. An improvement in the profit margin may be offset by a worsening asset turnover, leaving ROCE unchanged or even causing it to decline. Thus, a high-profit margin will not on its own lead to an increase in ROCE because the level of sales is also extremely important.

# Liquidity Ratios

Liquidity, as you must know, represents the amount of cash available by a company in order to meet its debts when they fall due. And, it seems like both the Current Ratio and Quick Ratio can give an indication of a company’s liquidation position.

## 1. Current Ratio:

This ratio gives an indication of the company’s liquidity position and helps firms to know whether there are sufficient current assets to pay the current liabilities.

A low ratio usually means firms will have difficulty meeting their short-term obligations. However, a high ratio may indicate that a firm that resources that are not being used efficiently suggesting poor management of receivables (credit) or inventories by the company. Capital is lying idle in the business due to the high level of inventories, trade receivables and cash.

Experts would claim that a ratio between 1.5:1 and 2:1 is reasonable enough.

## 2. Quick Ratio or Acid Test Ratio

Liquid assets are current assets excluding inventories that may soon be converted into cash. Quick ratio shows the proportion of liquid assets (trade receivables and cash) that are available to pay the current liabilities. The acid test ratio should ideally be at least one for companies with slow inventory turnover. However, for firms with a fast inventory turnover, a quick ratio of less than one is acceptable.