Financial ratios offer a way to analyse a company’s performance and financial health. Using past examples from NCFE, Plegg’s Deli, we’ll look at the 4 financial ratios.
Financial ratios are calculated from a company’s financial statements. They provide insights into profitability, liquidity, and efficiency, transforming the raw financial data into meaningful metrics for analysis used by business owners and investors and other stakeholders.
Remember for the exam:
Profitability Ratios
Profitability ratios gauge a company’s ability to generate profits relative to its revenue, assets, equity, or other financial metrics. Key ratios include:
Net profit margin (%)
Net Profit Margin is calculated using the income statement. This ratio measures the percentage of profit a company earns from its total revenue. A higher percentage indicates a company retains more profit from each pound of revenue.
\[\text{Net Profit Margin} = \left( \frac{\text{Net Profit}}{\text{Total Revenue}} \right) \times 100\]
Example
To Calculate the net profit for Plegg’s Deli in 2017 you would do
(net profit divided by sales revenue) x100
(46,000 / 230,000) x 100 = 20% NPM
Can you work out the NPM for 2018 and 2019?
Return On Capital Employed (ROCE %)
To calculate ROCE you need the Income Statement and Balance Sheet. ROCE provides insight into how efficiently a company uses its capital to generate profits. A higher percentage means the company is using its capital more efficiently.
\[\text{ROCE} = \left( \frac{\text{Net Profit}}{\text{Capital Employed}} \right) \times 100\]
\[\text{Capital Employed} = \text{Total Assets} – \text{Total Current Liabilities}\]
Use the Profit Before Interest and Tax if available, if not use net profit.
Example
To calculate the ROCE in 2018 for Pleggs Deli, we need to do two calculations: 1 – Capital Employed & 2 ROCE.
Capital Employed
Fixed assets + Current assets = Total Assets
222,000 + 2,500 = 224,500
Total Assets – Current Liabilities = Capital Employed
224,500 – 2,000 = 222,500
ROCE
Earnings Before Interest and Tax (net profit) / capital employed = ROCE
(52,000 / 222,500) x 100 = 23.37% Return on Capital Employed
Using the most recent balance sheet (2018), can you calculate what the ROCE would be for 2017 and 2019?
Liquidity Ratios
Liquidity ratios measure a company’s ability to cover its short-term obligations. Key ratios include:
Current Ratio (_:1)
This ratio indicates a company’s ability to pay off its short-term liabilities with its short-term assets. A value above 1 suggests the company can comfortably cover its short-term debts.
\[\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}\]
When writing the result, we always write it with “:1” at the end. So, if your result is 1.25, you write it as “1.25:1”. This means for every 1 in liabilities you owe, you have 1.25 in assets.
Example
To calculate the current ratio for Plegg’s Deli in 2018, you would do:
Current Assets / Current Liabilities
2500 / 2000= 1.25:1
You always display the ratio :1, this represents that for every £1 of current liabilities, Plegg’s has £1.25 in current assets.
Acid-Test Ratio (or Quick Ratio _:1)
The acid-test ratio is a stricter measure that excludes inventories (stock to sell), determining if a company can settle its short-term debts without relying on inventory sales. A value above 1 is considered healthy.
\[\text{Acid-Test Ratio} = \frac{\text{Current assets less inventory (stock)}}{\text{Current Liabilities}}\]
Example
(Current assets – inventory) / Current Liabilities = Acid-Test Ratio
(£2,500−£2,000) / £2,000 = 0.25:1
This means that for every £1 of current liabilities, Plegg’s Deli has £0.25 in liquid assets (excluding inventory) available to cover those liabilities. A ratio below 1 might indicate potential liquidity issues, but a business will always look at the industry average before drawing any conclusions. For example, supermarkets have lots of stock so their acid ratio is usually very low.
Tasks
- Calculate the Net Profit Margin for PLEGG’S DELI in 2017 and 2019.
- Using the 2019 data, determine PLEGG’S DELI’s ROCE.
- Compute the Current Ratio for PLEGG’S DELI in 2017.
- Determine the Acid-Test Ratio for PLEGG’S DELI in 2019.
