Ratio Analysis

• Ratio analysis is used to determine a firm’s performance and financial stability
• Profitability ratios, such as gross, operating, and net profit margins, measure a business’s effectiveness at making a profit relative to its size
• Return on capital employed shows the percentage return expected from all the investment in the company
• Liquidity ratios, including the current ratio and acid test ratio, assess a business’s short-term financial stability
• Current ratio compares total current assets to total current liabilities
• Ideal current ratio is greater than 1, with a range of 1.5 to 2 considered safe
• Acid test ratio measures a business’s ability to meet short-term liabilities quickly and easily
• Acid test ratio excludes stock from current assets
• Return on capital employed should be significantly higher than bank interest rates
• A decrease in return on capital employed between years may be a cause for concern
• The acid test ratio measures a business’s ability to pay short-term liabilities
• A ratio of around one to one is ideal for the acid test ratio
• A low acid test ratio indicates severe liquidity problems
• The gearing ratio shows the proportion of a business funded by long-term borrowing
• A gearing ratio above 50% is a concern as it makes the business vulnerable to changes in interest rates

Ratio analysis is a method used to assess a firm’s financial performance and stability by analyzing its financial accounts. It is also useful for evaluating investment decisions. The seven ratios discussed in this video include profitability ratios (gross, operating, and net profit margins), return on capital employed, liquidity ratios (current ratio and acid test ratio), and gearing ratio. Profitability ratios, such as profit margins, are calculated by dividing profit by revenue and expressing it as a percentage. These ratios allow for comparisons between businesses of different sizes and stages of development. Return on capital employed measures the percentage return generated from the total investment in the company. It is calculated by dividing operating profit by total capital employed. Liquidity ratios assess a company’s ability to meet short-term financial obligations. The current ratio is calculated by dividing current assets by current liabilities, while the acid test ratio subtracts stock from current assets before dividing by current liabilities. These ratios indicate the stability of a company’s short-term financial position. It is important to note that there is no specific target figure for return on capital employed, but it should be higher than the interest earned from putting money in the bank. A higher return is generally preferred. The current ratio should ideally be greater than 1, indicating more current assets than liabilities. A range of 1.5 to 2 is considered safe. The acid test ratio, which excludes stock, provides a more short-term liquidity measure. Overall, ratio analysis provides valuable insights into a company’s financial performance, stability, and ability to meet its obligations. It helps in making informed investment decisions and comparing businesses of different sizes and stages of development.