Essential Accounting Ratios and Financial Analysis Metrics

Accounting Notes

Profitability Ratios

These measures indicate how much profit a business has generated. When analyzing these, always compare figures over time to determine growth or decline.

• Gross Profit (GP) %: Measures the amount of GP made on sales. Analyze whether the figure has increased or decreased and explain the impact on the business. Consider factors like the quantity of sales, bulk purchasing, and supplier relationships.
• Operating Profit (OP) %: Measures the amount of OP made on sales after deducting administration and distribution expenses. An increase is a positive sign of expense control, while a decrease suggests rising costs.
• Return on Capital Employed (ROCE) %: Evaluates the success of a business in generating satisfactory profit from invested capital. Shareholders monitor this closely to decide whether to invest.
• Asset Turnover: Measures how effectively sales are generated relative to the capital employed in the business.

Liquidity Ratios

These measure a business's ability to meet short-term debts by generating sufficient cash.

• Current Ratio: Measures how many times current assets cover current liabilities. A standard benchmark is 2:1.

Efficiency Ratios

These focus on how well a business utilizes its resources, emphasizing spending and saving in the right areas.

• Trade Receivables Collection Period (Days): Measures how long it takes for debtors to pay their bills. A period of 36.5 days is generally considered healthy, though lower is often better.
• Trade Payables Payment Period: Measures how long it takes for a business to pay its creditors for goods purchased on credit. There are varying perspectives on whether to pay immediately or delay payment for cash flow management.

Investment Ratios

These measure how appealing a business is to potential investors who seek a good rate of return on their shares.

• Gearing: Measures the proportion of fixed-interest capital relative to total capital. A result over 50% may indicate financial risk.
• Interest Cover: Assesses whether the business can comfortably pay its interest charges on debt.

Cash Flow Statement

This statement tracks the movement of cash inflows and outflows within the bank accounts over a specific accounting period.