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Profitability, Solvency and Performance Ratios

Once the accounts have been done, and are ready to be published. A number of people might want to compare them with other companies operating in the same financial sector. How do they do this?

The answer is to use profitability, solvency and performance ratios. These are quite simple formulae which help to create a picture of the company. This worksheet identifies the name of the ratio, the formula, where we should be looking in the accounts and what it means. These ratios are not by themselves the answer to all questions, but an indicator of areas requiring further examination.

Try some out! Have a go with the figures from Pepe's Pizza Parlour.

Please note: The / symbol means divide by.

Profitability

How successful a company is depends upon its profitability. The key ways in which we work out these are called the Return on Capital Employed and the Gross and Net Profit Margins.

Return on Capital Employed (ROCE)

This is expressed in percentage terms and is often called "return on owner's equity". It represents the profit earned from the money invested in the business by it's owner. It can be worked out by the following equation:

(Net Profit (before Interest and tax) / Capital Employed) x 100

So a company generating a net profit of £250,000 before deduction of interest and tax which has an opening balance on it's capital account £1M would have a Return on Capital of 25%.

Gross and Net Profit Margins

These are the most commonly used profitability ratios. They express the comparison between sales and profit in percentage terms, and are worked out by the following equations:

(Gross Profit Margin = Gross Profit /Sales) x 100

(Net Profit Margin = Net Profit / Sales) x 100

So, if the company which generated a net profit of £250.000 had achieved sales of £750.000 the profit margin would be 33%.

Solvency

The solvency or liquidity of a company tells us whether a company can pay its debts. We work how solvent companies are by using the Liquidity Ratios.

Liquid Ratio (or Acid test)

This ratio is calculated as follows:

Liquid assets / Current liabilities.

Liquid assets are those assets which can be turned into cash quickly such as debtors, cash and short term investments such as bank deposits. Stock is not considered a liquid asset. Current liabilities are those liabilities which must be paid shortly such as creditors and bank overdrafts. A bank overdrafts is considered to be a current liability because it can be recalled without notice. The ideal ratio should be around 1:1.
If, for example, a company had liquid assets of £60,000, and debts of £40,000 the ratio would be:

60,000 / 40,000 : 1

Expressed as 1.5 : 1

This means that the company has more assets (1.5) than liabilities (1). This company is solvent but may not be managing it's money very well.
If the figures were reversed then the ratio would change as follows:

40,000 / 60,000 : 1

Expressed as 0.66 : 1

This would mean that the company is in serious trouble since it would not have sufficient funds to meet its liabilities.

Current or Working Capital ratio

This is the other test of a companies liquidity. It takes a longer term view of the company's position since unlike the Acid test it includes stock and work in progress ( this is termed Current assets). This is due to the fact that it is deemed that both of these will at sometime be turned into debts and eventually into cash. The ratio is worked out as follows:

Current assets / Current liabilities

therefore a company with current assets of £80,000 with the current liabilities of £40,000 would equate as follows:

80,000 / 40,000 = 2

and would be expressed as 2 : 1.

There is no "ideal" ratio but a figure of 2:1 is often quoted. Most businesses operate with a ratio lower than this but it is important to maintain a healthy figure because bank overdrafts can in theory be recalled without notice at any time.

Performance

These ratios provide information on how well a business is being run.

Rate of Stock turnover

Businesses try to have as high a rate of stock turnover as possible. The rates can be expressed in two ways.

(Average stock / Cost of goods sold) x either 12, 52 or 365

This tells a business how long on average an item remains in stock. The figure can be expressed in terms of months, weeks or days. For Pepe's Pizza Parlour, this would result in the following:

4,750 / 39,500 x 365 = 44 days (on average)

Cost of goods sold / Average stock

This tells a business how many times in each year the stock rotates. For Pepe's Pizza Parlour, this would result in the following:

39,500 / 4,750 = 8.3. i.e. The stock is cleared 8.3 times a year.

Note! In both cases the average stock can be calculated from the Trading and Profit and Loss account by:

Opening stock + Closing stock / 2.
For Pepe's Pizza Parlour this is 4,000 + 5,500 / 2 = 4,750.

Debtors collection period

Most businesses sell goods on credit. Credit is usually given for periods of 30, 60 or 90 days. No business wishes to extend the credit period given and so it is important to monitor just how long customers are taking to pay for credit sales. The following ratio can be used:

Debtors / Average daily sales (Sales divided by 365)

Creditors payment period

It is important for a business to monitor how long it takes to pay it's creditors. Persistent late payment may result in a supplier cutting off credit facilities! The following ratio can be used:

Creditors / Average daily purchases (Purchases divided by 365)

Gearing (income gearing)

Gearing is the name given to the ratio which measures how much of a company's profits are taken up by interest payments. It is expressed as a percentage, and is worked out by:

(Interest / Profit) x 100

Therefore a company with interest payments of £35,000 whilst earning £50,000 would have the following gearing ratio:

(35,000 / 50,000) x 100 = 70%

This company would be susceptible to changes in the interest rate. Whereas a company with a gearing ratio of 40% could absorb any increases in the interest rate with greater ease.

A Test paper based upon these ratios is available. (You will need to print off a copy of Pepe's Trading and profit and Loss Account and Pepe's Balance Sheet if you wish to do this test paper)

Go to Pepe's Trading and Profit and Loss Account (to print)

Go to Pepe's Balance Sheet (to print)

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