Gross Profit Ratio

Gross Profit Ratio

=
Gross Profit %
Sales
Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage

The basic components for the calculation of gross profit ratio are gross profit and net sales. Net sales
means that sales minus sales returns. Gross profit would be the difference between net sales and cost of
goods sold

Gross profit ratio may be indicated to what extent the selling prices
of goods per unit may be reduced without incurring losses on
operations. It reflects efficiency with which a firm produces its
products. As the gross profit is found by deducting cost of goods
sold from net sales, higher the gross profit better it is. There is no
standard GP ratio for evaluation. It may vary from business to
business. However, the gross profit earned should be sufficient to
recover all operating expenses and to build up reserves after
paying all fixed interest  charges and dividends.
 Operating Profit Ratio
Operating Profit Ratio =
Operating Profit
%
Sales
Operating profit ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is
generally expressed in percentage.
Operating profit ratio measures the cost of operations per £ of sales.
The two basic components for the calculation of operating profit ratio are operating cost (cost of
goods sold plus operating expenses) and net sales..

Operating ratio shows the operational efficiency of the business. Lower

operating ratio shows higher operating profit and vice versa. An
operating ratio ranging between 75% and 80% is generally considered
as standard for manufacturing concerns. This ratio is considered to be
a yardstick of operating efficiency but it should be used cautiously
because it may be affected by a number of uncontrollable factors
beyond the control of the firm. Moreover, in some firms, non-operating
expenses from a substantial part of the total expenses and in such
cases operating ratio may give misleading results.
 Return on Investment (ROI)
Return on Investment =
Distributable Profit
Investment
%
The return on investment measures the rate of return that investment managers are able to generate on their
assets
A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a
number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost
of the investment; the result is expressed as a percentage
The calculation for return on investment and, therefore the definition, can be modified to suit the situation - it all
depends on what is considered as the ‘Investment’ = often, share capital is used

Return on investment tells you the percentage return you have made over a specified
period as a result of investing in a business.

Return on Investment (ROI) analysis is one of several commonly used approaches for
evaluating the financial consequences of business investments, decisions, or actions.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit
the user's purposes, and the result can be expressed in many different ways.
 Interest Cover
Operating Profit
Interest Cover =
Interest
This ratio relates the fixed interest charges to the income earned by the business. It indicates whether the
business has earned sufficient profits to pay periodically the interest charges.
Interest cover is a measure of the adequacy of a company's profits relative to interest payments on its debt.
The lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover
interest payments

A value of more than 2 is normally considered reasonably safe, but companies with
very volatile earnings may require an even higher level, whereas companies that
have very stable earnings, such as utilities, may well be very safe at a lower level.
Similarly, cyclical companies may well have a low interest cover but investors who
are confident of recovery may not be overly concerned by the apparent risk.
The interest coverage ratio is very important from the lender's point of view. It
indicates the number of times interest is covered by the profits available to pay
interest charges.
It is an index of the financial strength of an enterprise. A high debt service ratio or
interest coverage ratio assures the lenders a regular and periodical interest income.
But a weakness of the ratio may create some problems to the financial manager in
raising funds from debt sources.
 Earnings Per Share
Distributable Profit
£
Earnings Per Share =
Number Of Shares
Earnings per share (EPS) is calculated by dividing the net profit after taxes by the total number of shares
The portion of a company's profit allocated to each share of stock in the company
Earnings per share serves as an indicator of a company's profitability

Earnings per share is generally considered to be the single most important variable in determining a
share's price
the viability of any business depends on the income it can generate. A money losing business will
eventually go bankrupt, so the only way for long term survival is to make money. Earnings per share
allows us to compare different companies’ power to make money. The higher the earnings per share with
all else equal, the higher each share should be worth.
The earnings per share is a good measure of profitability and when compared with EPS of similar
companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio
calculated for a number of years indicates whether or not the earning power of the company has
increased.
A positive trend of EPS should be visible in order to make sure that the company is finding more ways to
make more money. Otherwise, the company is not growing and thus should be considered only if you are
Return on Capital Employed
(ROCE)
Operating Profit
%
Return on Capital Employed =
Capital Employed
Capital Employed = Share Capital + Reserves + Loans
The prime objective of making investments in any business is to obtain satisfactory return on capital
invested. Hence, the return on capital employed is used as a measure of success of a business in realising
this objective.
Return on capital employed establishes the relationship between the profit and the capital employed. It
indicates the percentage of return on capital employed in the business and it can be used to show the
overall profitability and efficiency of the business.

Return on capital employed ratio is considered to be the best measure of

profitability in order to assess the overall performance of the business. It indicates
how well the management has used the investment made by owners and creditors
into the business. It is commonly used as a basis for various managerial decisions.
As the primary objective of business is to earn profit, higher the return on capital
employed, the more efficient the firm is in using its funds. The ratio can be found
for a number of years so as to find a trend as to whether the profitability of the
company is improving or otherwise.
 Financial Gearing =
Gearing
Debt :
Equity
Debt = Long-term loans + Short-term loans + Overdraft
Equity = Total Shareholder Equity
Gearing is the relationship between different types of funding of a business
Gearing compares the shareholder’s equity (or capital) to borrowed funds. Gearing is a measure of financial
leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's
funds. 
Gearing, called leverage in the US and some other countries, essentially measures the extent to which a
company is funded by debt

The higher a company's degree of leverage, the more the company is considered risky - a

highly geared company is one where there is a high proportion of debt to equity, and can be
considered a risky investment as there is a higher likelihood of the company being unable to
pay its large debts. As for most ratios, an acceptable level is determined by its comparison to
ratios of companies in the same industry. 
A high level of debt is a cause for concern, but it does accelerate profit growth as well as
declines. Companies with more stable operating profits can safely take on higher levels of
debt, so what is acceptable depends on the business.
 Current Ratio
Current Ratio
=
Current Assets :
Current Liabilities
The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations
It is a measure of general liquidity and is most widely used to make the analysis for short term financial
position or liquidity of a firm. It is calculated by dividing the total of the current assets by total of the current
liabilities.
This ratio is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion
available to the creditors

A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current
obligations in time and when they become due. On the other hand, a relatively low current ratio
represents that the liquidity position of the firm is not good and the firm shall not be able to pay its
current liabilities in time without facing difficulties. An increase in the current ratio represents
improvement in the liquidity position of the firm while a decrease in the current ratio represents that
there has been a deterioration in the liquidity position of the firm. A ratio equal to or near 2 : 1 is
considered as a standard or normal or satisfactory. The idea of having double the current assets as
compared to current liabilities is to provide for the delays and losses in the realization of current assets.
However, the rule of 2 :1 should not be blindly used while making interpretation of the ratio. Firms
having less than 2 : 1 ratio may be having a better liquidity than even firms having more than 2 : 1 ratio.
This is because of the reason that current ratio measures the quantity of the current assets and not the
quality of the current assets. If a firm's current assets include debtors which are not recoverable or
stocks which are slow-moving or obsolete, the current ratio may be high but it does not represent a
good liquidity position.
 Acid-test Ratio or Liquid Ratio
Current Assets - Stock
:
Acid-test Ratio =
Current Liabilities
Liquid ratio or Acid Test Ratio or "Quick Ratio is the ratio of liquid assets to current liabilities. The true
liquidity refers to the ability of a firm to pay its short term obligations as and when they become due.
A stringent test that indicates whether a firm has enough short-term assets to cover its immediate
liabilities without selling inventory – as stock is considered the least liquid of current assets.
The acid-test ratio can be far more true than the current ratio, primarily because the current ratio
allows for the inclusion of inventory assets.
The acid test ratio is very useful in measuring the liquidity position of a firm. It measures the firm's capacity to pay
off current obligations immediately and is more rigorous test of liquidity than the current ratio. It is used as a
complementary ratio to the current ratio. Liquid ratio is more rigorous test of liquidity than the current ratio
because it eliminates inventories and prepaid expenses as a part of current assets. Usually a high liquid ratios an
indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other
hand a low liquidity ratio represents that the firm's liquidity position is not good. As a convention, generally, a
quick ratio of "one to one" (1:1) is considered to be satisfactory.
Although liquidity ratio is more rigorous test of liquidity than the current ratio, it should be used cautiously and 1:1
standard should not be used blindly. A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position
of the firm if all the debtors cannot be realized and cash is needed immediately to meet the current obligations. In
the same manner, a low liquid ratio does not necessarily mean a bad liquidity position as inventories are not
absolutely non-liquid. Hence, a firm having a high liquidity ratio may not have a satisfactory liquidity position if it
has slow-paying debtors. On the other hand, A firm having a low liquid ratio may have a good liquidity position if it
has a fast moving inventories. Though this ratio is definitely an improvement over current ratio, the interpretation
of this ratio also suffers from similar limitations as of current ratio.
 Depreciation
‘Straight-line’ depreciation = Cost of asset – Residual value
Useful life
= Amount to be depreciated per year
Depreciation is a method which spreads the cost of a non-current (fixed) asset over its
useful life based on the matching principle when recording non-current (fixed) assets in
accrual accounting
A non-current (fixed) asset is a ‘long term’ asset with a life of generally more than 1
year – the company controls and gets future benefit from these non-current (fixed)
assets beyond the scope of the current financial year
The cost of a non-current (fixed) asset should be written off over its useful life – this is
depreciation (for tangible assets) or amortisation (for intangible assets) which is a non-
cash expense
Depreciation is required due to the fact that expensing a non-current (fixed) asset for
solely the financial year within which it was bought would severely distort the profits for
the year – this is not fair to charge the full price of the non-current (fixed) asset as an
expense in the year of purchase as it will be used over future years to generate income
for the business (taking into account the matching principle)
 The Business Cycle
• The term business cycle (or economic cycle) refers to economy-
wide fluctuations in production or economic activity over several
months or years.

•These fluctuations occur

around a long-term growth
trend, and typically involve
shifts over time between
periods of relatively rapid
economic growth (expansion or
boom), and periods of relative
stagnation or decline
(contraction or recession)
Limitations of Ratios and Formulae
when Analysing Financial Data and
Reports

• It is important not to rely on any one

financial measure, but to use it in
conjunction with statement analysis and
other measures.