Calculation and understanding of accounting ratios

Profitability ratios measure a business's ability to generate profit from its sales. The Gross Profit Margin shows the profit made on the goods sold, before considering other expenses. It tells you how much profit is generated for every $1 of revenue from the core trading activity. The Profit Margin (or Net Profit Margin) is a more comprehensive measure. It shows the percentage of revenue that is left after ALL expenses, including overheads like rent and salaries, have been deducted. A large difference between the gross and profit margins can indicate high operating expenses.

Return on Capital Employed (ROCE) is a crucial profitability ratio that measures how effectively a business is using its long-term funds to generate profits. It shows the profit generated for every $100 of capital invested in the business. 'Capital Employed' represents the total long-term capital from both owners (equity) and lenders (non-current liabilities). A higher ROCE is desirable as it indicates more efficient use of capital. It is often compared with the previous year's ROCE or the interest rates available from a bank to judge performance.

Liquidity ratios assess a business's ability to meet its short-term debts (current liabilities) as they become due. The Current Ratio compares all current assets with all current liabilities. A commonly accepted 'safe' ratio is between 1.5:1 and 2:1, meaning the business has $1.50 to $2.00 of current assets for every $1 of current liabilities. The Liquid Ratio, also known as the Acid Test Ratio, is a stricter test. It removes inventory from current assets because inventory can be difficult to sell quickly. A ratio of 1:1 is often considered ideal, showing the business can pay its immediate debts without relying on selling stock.

The Rate of Inventory Turnover is an efficiency ratio that measures how many times a business sells and replaces its inventory over a specific period, usually a year. It indicates how efficiently the business is managing its stock. A high turnover rate is generally good, suggesting strong sales and less money tied up in inventory. However, a rate that is too high might lead to stock-outs and lost sales. A low turnover rate can indicate poor sales, obsolescence, or over-stocking. To get a more accurate picture, we use average inventory in the calculation.

These efficiency ratios focus on the management of credit with customers and suppliers. The Trade Receivables Turnover (in days) calculates the average number of days it takes for a business to collect cash from its credit customers. A lower number is better, as it means cash is coming into the business more quickly. The Trade Payables Turnover (in days) calculates the average number of days a business takes to pay its credit suppliers. A higher number can be beneficial as it means the business holds onto its cash for longer, improving its cash flow. However, paying too late can damage relationships with suppliers and risk losing credit facilities. Ideally, a business should collect from receivables faster than it pays its payables.