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Financial Ratios: Analysis Suite

Understanding Liquidity

Core Definition

Liquidity means the ability of a business to meet its short-term financial obligations, such as paying suppliers and employees.

Current Ratio

Current Assets ÷ Current Liabilities
Measures whether a business has enough short-term assets to cover its short-term debts. A ratio of 2:1 is typically seen as healthy.

Acid Test Ratio (Quick Ratio)

(Current Assets - Inventory) ÷ Current Liabilities
Evaluates liquidity excluding inventory, which may not be easily convertible to cash quickly. A ratio above 1 generally indicates strong liquidity.

Improving Liquidity Strategies

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Cash Inflow Focus: Businesses can improve liquidity by speeding up receivables collection or increasing short-term borrowing.
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Working Capital Management: Businesses can improve liquidity by reducing inventory levels or negotiating longer credit terms with suppliers.

Profitability Metrics

The Goal of Returns

Profitability shows how effectively a business generates profit from its resources. We measure the return generated relative to invested capital and sales.

Return on Capital Employed (ROCE)

Operating Profit ÷ Capital Employed × 100
Indicates how well the business is generating returns from the capital invested (where capital employed equals equity plus non-current liabilities).

Margin Definitions

Key profitability indicators used to assess performance against sales revenue.

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Gross Profit Margin

Gross Profit ÷ Revenue × 100. Illustrates efficiency in production or purchasing after covering direct costs.
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Profit Margin (Net)

Net Profit ÷ Revenue × 100. Shows the percentage of revenue retained as profit after all expenses.

Profit Enhancement Tips

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Strategy Summary: Increasing sales prices, reducing cost of sales through cheaper suppliers or improved production, cutting overheads, or targeting more profitable product lines can help.

Financial Efficiency Assessment

Resource Management

These ratios assess how well the business manages its resources and working capital. Efficient use of assets drives performance.

Working Capital Turnover

Tracking how quickly assets convert or liabilities are settled defines efficiency.

1

Rate of Inventory Turnover

Cost of Sales ÷ Average Inventory. Measures how quickly inventory is sold and replaced.
2

Trade Receivables Turnover (Days)

(Trade Receivables ÷ Revenue) × 365. Shows the average number of days customers take to pay.
3

Trade Payables Turnover (Days)

(Trade Payables ÷ Cost of Sales) × 365. Indicates how long the business takes to pay suppliers.

Efficiency Improvement Dialogue

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What key actions improve financial efficiency?
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Reducing inventory levels, tightening credit control, and negotiating favorable payment terms with suppliers can enhance efficiency.

Gearing Ratio Calculation

Non-Current Liabilities ÷ Capital Employed × 100
Measures the proportion of long-term debt relative to capital employed.

Gearing Risk vs. Return

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High Gearing: Means higher financial risk due to fixed interest payments but may enhance returns on equity.
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Low Gearing: Suggests financial stability but may limit growth opportunities. Improving gearing methods include repaying debt or issuing more equity.

Shareholder Investment Metrics

These ratios provide insight into returns received and market perception by shareholders.

1

Dividend Yield

Dividend per Share ÷ Market Price per Share × 100. Shows the return on investment based on dividends.
2

Dividend Cover

Earnings per Share ÷ Dividend per Share. Indicates how comfortably dividends can be paid from profits.
3

Price/Earnings (P/E) Ratio

Market price per share divided by earnings per share. Reflects market expectations about growth and value.

Boosting Shareholder Value

Investor Confidence

Improving investor return involves increasing profits, maintaining a consistent dividend policy, and preserving investor confidence.
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Financial Ratios Deck
Question
Liquidity

What does liquidity measure in a business?

Answer
Definition

The ability to meet short-term financial obligations.

Question
Current Ratio Calculation

How is the Current Ratio calculated?

Answer
Formula

Current Assets ÷ Current Liabilities.

Question
Current Ratio 2:1 Meaning

What does a Current Ratio of 2:1 indicate?

Answer
Interpretation

The business has twice as many current assets as current liabilities, which is typically healthy.

Question
Acid Test Ratio Calculation

How is the Acid Test Ratio (Quick Ratio) calculated?

Answer
Formula

(Current Assets - Inventory) ÷ Current Liabilities.

Question
Inventory in Acid Test Ratio

Why exclude inventory in the Acid Test Ratio?

Answer
Reason

Inventory may not be easily convertible to cash quickly.

Question
Return on Capital Employed (ROCE)

What is Return on Capital Employed (ROCE)?

Answer
Formula

Operating Profit ÷ Capital Employed × 100.

Question
Gross Profit Margin

How do you calculate Gross Profit Margin?

Answer
Formula

Gross Profit ÷ Revenue × 100.

Question
Profit Margin Meaning

What does Profit Margin show?

Answer
Meaning

Percentage of revenue remaining as profit after all expenses.

Question
Rate of Inventory Turnover

How is Rate of Inventory Turnover calculated?

Answer
Formula

Cost of Sales ÷ Average Inventory.

Question
Trade Receivables Turnover (Days)

How to calculate Trade Receivables Turnover (Days)?

Answer
Formula

(Trade Receivables ÷ Revenue) × 365.

Question
High Gearing Ratio

What does a high Gearing Ratio indicate?

Answer
Implication

Higher financial risk due to more debt compared to capital employed.

Question
Dividend Yield Calculation

How is Dividend Yield calculated?

Answer
Formula

Dividend per Share ÷ Market Price per Share × 100.

Question
Dividend Cover Meaning

What does Dividend Cover indicate?

Answer
Meaning

How comfortably dividends can be paid from earnings.

Question
Improving Profitability

How to improve profitability?

Answer
Methods

Increase sales prices, reduce costs, cut overheads, or target profitable products.

Question
Improving Liquidity

What methods improve liquidity?

Answer
Methods

Speed up receivables, reduce inventory, negotiate longer credit terms, increase borrowing.

Question
Improving Financial Efficiency

How can financial efficiency be improved?

Answer
Methods

Reduce inventory, tighten credit control, negotiate better supplier terms.

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📊 Financial Ratios Quiz

1. What does the Current Ratio measure?

The Current Ratio assesses if a business has enough current assets to cover current liabilities.

2. Which formula correctly calculates the Acid Test Ratio?

The Acid Test Ratio excludes inventory to focus on quick assets.

3. A high Rate of Inventory Turnover indicates:

High turnover means inventory is sold and replaced quickly.

4. What is a typical healthy Current Ratio?

A ratio of 2:1 implies twice as many current assets as liabilities.

5. How is Gearing Ratio calculated?

Gearing measures the proportion of long-term debts.

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