Ratios (AQA A-Level Business): Revision Notes
Ratios
Financial ratios are powerful tools that transform raw data from balance sheets and income statements into meaningful numbers that are easy to understand and compare. They allow you to assess a company's performance over time and benchmark it against competitors in the same industry.
What are liquidity ratios?
Liquidity ratios reveal how much money a business has available to pay its bills when they fall due. These ratios are crucial for understanding a company's short-term financial health.
Understanding liquidity and working capital
A firm needs sufficient working capital to maintain healthy liquidity. Without adequate working capital, a business faces poor liquidity, meaning it cannot use its assets to pay for essential expenses when needed.
Understanding Liquidity Levels
Liquidity refers to how easily an asset can be converted into cash and used to purchase goods or services. Different assets have varying levels of liquidity:
- Cash is highly liquid (it's already money)
- Non-current assets such as factories and buildings are not liquid (they cannot be quickly converted to cash)
- Stocks (inventories) and debtors (receivables) fall somewhere in between
The current ratio
The main liquidity ratio you need to understand is the current ratio (also called the working capital ratio). This ratio measures how solvent a business is by comparing what it owns in the short term to what it owes in the short term.
Current Ratio Formula:
The current ratio compares current assets (resources the business can access within one year) to current liabilities (debts due within one year).
Worked Example: Calculating the Current Ratio
A business has $30,000 of current assets and $32,000 of current liabilities.
This result means that for every $1 of liabilities, the company only has $0.9375 (or 93.75p) of assets. This situation is concerning because there aren't enough assets to cover the liabilities.
Interpreting the current ratio
A business that lacks enough current assets to pay its liabilities when they are due is insolvent. When insolvency occurs, the business must either:
- Quickly find money to pay creditors
- Cease trading (stop operating)
- Enter liquidation (sell assets to pay debts)
Ideal Current Ratio Values
A current ratio between 1.5 and 2 is generally considered ideal. Below 1.5 suggests potential liquidity problems and difficulty meeting current liabilities.
However, these benchmarks come with important caveats. In reality, a business probably cannot sell all its stock immediately, and it would need additional capital to replace that stock. The current ratio should be viewed as higher than the raw number suggests to account for these practical limitations.
How to improve liquidity
Liquidity can be enhanced through several strategies:
- Decreasing stock levels - reducing the amount of inventory held
- Speeding up collection of debts owed by customers
- Slowing down payments to creditors such as suppliers (though this must be managed carefully)
What are profitability ratios?
Profitability ratios measure a company's ability to generate profit relative to various factors. They show managers and investors how well the business is performing financially.
Return on capital employed (ROCE)
The most important profitability ratio is Return on Capital Employed, commonly known by its acronym ROCE. This metric is considered the best way of analysing profitability and is expressed as a percentage.
ROCE Formula:
ROCE tells you how much money is made by the business compared to how much money has been invested into the business. In simpler terms, it measures the return generated from the capital that has been employed (used) in the business.
The operating profit figure comes from the income statement, while total equity and non-current liabilities are found on the balance sheet. Together, total equity and non-current liabilities represent the capital employed in the business.
Interpreting ROCE
The principle is straightforward: the higher the ROCE, the better the business is performing. A higher ROCE indicates that the business is generating more profit from the money invested in it.
ROCE is particularly important because it allows comparison with the Bank of England interest rate at the time. This comparison tells investors whether they would be better off putting their money in the bank (earning interest) or investing in the business.
How to improve ROCE
ROCE can be enhanced through two main strategies:
- Paying off debt - reducing non-current liabilities decreases the denominator in the formula, increasing the overall percentage
- Making the business more efficient - improving operations to increase operating profit, which directly increases the numerator
ROCE is just one measure of return on investment. Another important metric is the average rate of return, which provides additional perspective on investment performance.
What are efficiency ratios?
Efficiency ratios (also called performance ratios) demonstrate how efficiently a firm is operating. These ratios help managers and shareholders assess how well the business is using its resources.
There are three important efficiency ratios you need to understand:
- Inventory turnover ratio (stock turnover ratio)
- Payables days ratio (creditor days ratio)
- Receivables days ratio (debtor days ratio)
These ratios reveal how efficiently the business is managing its assets and how effectively managers are controlling stock, creditors, and debtors.
Inventory turnover ratio
The inventory turnover ratio (also called stock turnover ratio) compares the cost of all the sales a business makes over the year to the cost of the average stock held during that period.
Inventory Turnover Formula:
To calculate this ratio correctly, you need to know the cost price of everything the business has sold (not the selling price). This is what the products cost the firm to produce or purchase. Stock is valued at cost price on financial statements, so you need the cost of sales figure (not revenue) for consistency.
You will find cost of sales on the income statement and the stock held on the balance sheet. Sometimes you might see 'cost of sales' written as 'cost of goods sold' instead.
Worked Example: Calculating Inventory Turnover
A business has sales costing $160,000 and average stock held costing $8,000.
As a ratio, this would be 20:1.
Interpreting inventory turnover
This ratio reveals how many times during the year the business sold all its stock. In the example above, the business sold its entire stock 20 times. Put another way, a fruit and vegetable seller might sell their entire stock every day, giving a stock turnover ratio of 365.
A property developer who takes 4 months to renovate and sell each house would have a ratio of 3, indicating just-in-time (JIT) production and a very high ratio.
When analysing this ratio, you need to determine whether the business has enough stock to fulfil orders, but not too much stock that ties up funds unnecessarily. Holding twice the stock needed might not be an efficient use of capital.
The ideal turnover ratio depends on the type of business, but companies generally aim for higher values than in previous years or compared to their competitors.
How to improve inventory turnover
The inventory turnover ratio can be enhanced by:
- Holding less stock - reducing inventory levels
- Increasing sales - selling more products
However, these improvements are easier said than done and require careful management.
Aged stock analysis
Aged stock analysis helps managers ensure that old stock gets sold before it becomes obsolete and unsaleable. This process lists all stock in age order, allowing managers to discount old stock and reduce orders for slow-selling items. This analysis supports effective inventory management and prevents waste.
Payables days ratio
The payables days ratio (also called creditor days ratio) compares the amount the business owes to its creditors to the cost of all the sales a business makes over the year.
Payables Days Formula:
Payables appear as a current liability on the balance sheet, while cost of sales is found on the income statement.
Worked Example: Calculating Payables Days
A business has payables of $300 and sales that cost $7,000.
Interpreting payables days
This figure represents the number of days the firm takes to pay for goods it purchases on credit from suppliers. In the example above, the business takes approximately 16 days to pay its suppliers.
It's valuable to establish a trend over a period of time and use this trend to analyse the efficiency of the firm:
- An upward trend might suggest the firm is experiencing difficulties paying its suppliers
- While this might seem acceptable initially, if suppliers become concerned and demand immediate payment, it becomes a serious problem
Using payables days to manage cash flow
A business can use this ratio strategically to maximise its cash flow. For example, if the business above had an agreed credit period of 30 days with suppliers, it could take up to 2 weeks longer to pay its debts, since it currently only takes about 16 days. This delay would improve cash flow by keeping money in the business for longer.
Receivables days ratio
The receivables days ratio (also called debtor days ratio) compares the amount owed to a business by its debtors to the total sales revenue for the year.
Receivables Days Formula:
You'll find receivables on the balance sheet as a current asset, while sales revenue appears on the income statement.
Worked Example: Calculating Receivables Days
A business has receivables of $1,500 and sales revenue of $50,000.
Interpreting receivables days
'Receivables days' represents the number of days that the business has to wait to be paid for goods it supplies on credit to customers. In other words, it shows how long debtors take to pay their bills.
It's best to have low receivables days because this helps with cash flow and working capital. When customers pay quickly, money comes into the business faster, improving liquidity.
What makes a good receivables days ratio depends on the type of business:
- Retailers tend to get paid straight away (same day) when customers buy items
- Medium-sized businesses usually take 70-90 days to receive invoice payments
Analysing receivables days trends
You can compare receivables days ratios with previous months or years to look for trends:
- An upward trend might indicate that the business has offered longer credit terms to attract more customers
- However, if not carefully monitored, rising receivables days may signal cash flow problems
Managing receivables
Aged receivables analysis enables managers to control receivables days effectively. This process lists unpaid accounts in order of how long they've been outstanding. The accounts that are most overdue are targeted first for repayment, ensuring the business collects money owed as efficiently as possible.
Links between efficiency ratios
Both inventory turnover and receivables days are measures of activity — they tell you how effectively a business is using its resources to generate revenue. These ratios work together to give a complete picture of operational efficiency.
Key Points to Remember:
- Liquidity ratios measure a firm's ability to pay short-term debts; the current ratio should ideally be between 1.5 and 2
- ROCE (Return on Capital Employed) is the key profitability ratio - higher percentages indicate better performance and can be compared with interest rates
- Inventory turnover shows how many times per year stock is sold; higher ratios generally indicate efficiency but the ideal depends on business type
- Payables days reveals how long a business takes to pay suppliers; this can be managed strategically to improve cash flow
- Receivables days shows how long customers take to pay; lower values are better for maintaining healthy cash flow and working capital