Profitability Ratios - Examines profits in relation to other figures, such as sales revenue. Stakeholders use these ratios to scrutinise the financial performance of the business. The two main ratios used are the Gross Profit Margin (GPM), and Net Profit Margin (NPM).
Gross Profit Margin - Value of gross profit as a percentage of sales revenue, it measures the significance of direct costs on the profitability of a product.
Net Profit Margin - Value of net profit as a percentage of sales revenue, it measures the significance of direct and indirect costs on the profitability of a product.
The difference between the GPM and NPM of a business will detail the significance of overhead costs on the profitability of a product.
Efficiency Ratios - Examines how well a firm’s resources have been used, such as the amount of profit generated from the available resources of the business. The main ratio used is the return on capital employed.
Return on Capital Employed - Measures the financial performance of a business as a percentage of the amount of capital employed. Capital employed is the sum of all sources of finance, such as shareholders’ funds, retained profits and long-term liabilities.
Liquidity Ratios - Measures the ability of a firm to pay its short-term liabilities, such as by comparing working capital to short-term debts. The main two ratios used are the current ratio and acid test ratio.
Current Ratio - Measures the firm’s current assets against its liabilities, to reveal whether the firm has adequate liquid assets to cover short-term debts.
Acid Test Ratio - Measures the firm’s current assets less unsold stocks, against its liabilities. Unlike the current ratio, the acid test ratio considers unsold stocks to not be easily converted into cash.
Employees and Trade Unions - Use ratios to assess whether a pay rise or bonuses are deserved if there is a marked improvement in financial performance.
Managers and Directors - Assess whether the firm has reached its financial and efficiency targets, enabling them to identify areas of improvement in the business.
Financiers and Suppliers - Assess ability of firms to pay on time before negotiating a deal.
Shareholders and Potential Investors - Use ratios to assess the return of their investment, and whether investing in the business is financially worthwhile.
Historical Accounts - Ratios measure historical data, and do not forecast the performance of the business in the future.
Window Dressing - No standardised way to report ratio analysis, so businesses often find unethical ways to improve the statistics and make the business appear more financially stable and successful as in reality.