GCSE Business Studies. Ratios. For first teaching from September 2009 For first award in Summer 2011

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1 GCSE Business Studies Ratios For first teaching from September 2009 For first award in Summer 2011

2 Ratios At the end of this unit students should be able to: Interpret and analyse final accounts and balance sheets to assess the performance of a business using the following ratios: Net profit percentage; Stock turnover rate; Return on capital employed (ROCE); and Working capital ratio. Setting the scene: Pete s Pizza Pete s Pizza has been operating for eight months and business has been very good. Pete has been very busy and the business seems to have made a lot of money. However Pete is not sure how successful the business really is. As the end of the financial year approaches Pete asks his friend Steve, who is an accountant, to prepare a set of final accounts and a balance sheet for Pete s Pizza. Pete has asked Steve to use these accounts to work out how profitable the business is and to compare the performance of Pete s Pizza with one of his other businesses, Smiths Sandwiches. Assessing the performance of a business One of the most obvious ways of assessing the performance of a business is to look at its final accounts and balance sheet to see if it has made a profit. Clearly a business which makes a large profit would be considered to be more successful than a business which made a smaller profit or even a loss. When comparing the profitability of a firm it is necessary to distinguish between gross profit and net profit. Gross profit Gross profit is the difference between the revenue received from selling your product and the cost of sales. Gross Profit = Sales Cost of Goods Sold In the table below we can see that Pete s Pizza had sales revenue of 500,000. The cost of producing the pizzas (the cost of the ingredients) was 252,000, therefore Pete s Pizza made a gross profit of 248,000. It should be noted that gross profit does not include all the other costs and expenses of running a business, for example wages, rent etc.

3 Sales Revenue 500,000 Cost of Goods Sold 252,000 Gross Profit 248,000 Net profit Net profit is the actual amount of profit left over after all other costs, such as wages and electricity, are taken into account. Net profit is calculated by subtracting expenses from gross profit. Net Profit = Gross profit Expenses From the table below we can see that Pete s pizza had total expenses of 99,000. Therefore Pete s net profit is equal to 149,000. Gross Profit 248,000 Less Expenses Wages and Salaries 55,000 Electricity 34,000 Rent and Rates 10,000 99,000 Net Profit 149,000 However even this does not tell us enough about the business to be able to make a true assessment of its performance. To get a much clearer picture of a firm s performance it may be necessary to calculate a number of different ratios. These ratios can be compared with the previous performance of the firm or with the performance of other companies. Ratios Gross profit percentage Gross profit percentage show how much gross profit a firms makes on its sales. It is calculated by the equation Gross profit margin = Gross Profit x 100 Sales Using this equation we can see that Pete s Pizza had a gross profit percentage of 49.6%. ( 248,000/ 500,000 x 100): This means that for every 1 of sales, the firm makes almost 50p in profit. Obviously a firm would like to have a high gross profit margin. The gross profit margin is influenced by many factors including a change in the level of sales and/or a change in the cost of goods sold.

4 Net profit percentage The net profit percentage shows how much net profit a firm makes on its sales. Remember net profit is the actual amount of profit left over after all other costs, such as wages and electricity, are taken into account. Net profit percentage (also known as net profit margin) is calculated by the equation: Net profit percentage = Net Profit x 100 Sales Using this equation we can see that Pete s pizza had a net profit percentage of 29.8%. ( 149,000/ 500,000 x 100): This means that for every 1 of sales, the firm makes almost 30p in profit. Again a firm would wish to have a high net profit percentage. The higher the net profit percentage the more successful the firm is considered to be. Activity: Calculating gross and net profit percentages 1. Use the information in the table below to calculate the gross and net profit percentage for each of the four companies. Company A B C D Sales Revenue 100,00 5,000, ,000 1,600,000 Gross profit 52,000 1,200,000 5, ,000 Net profit 21,00 500,000 2,000 40,000 Gross profit percentage Net profit percentage 2. Which company would you consider to be the most successful? Explain your answer. Stock turnover rate An important issue that all firms must decide upon is the level of stock to hold. If a firm holds too much stock it will take up valuable space that could be put to a better use and it will mean that money is tied up in unsold stock. On the other hand if a firm holds too little stock it may not be able to meet the needs of its customers and therefore it will lose sales. For this reason firms attempt to measure their stock turnover rate. The stock turnover ratio measures the number of times a business is able to sell its average level of stock in a year.

5 The stock turnover rate is calculated using the following formula: Stock turnover rate = Cost of goods sold Average stock Where the cost of goods sold is calculated by adding opening stock to purchases and subtracting the closing stock. Cost of Goods Sold = Opening Stock + Purchases Closing Stock And where the average stock is calculated by adding the opening stock to the closing stock and dividing by 2. Average stock = opening stock + closing stock 2 For example if a firm had an opening stock of 5000 and a closing stock of 4000 and had purchases of then its stock turnover rate would be calculated as follows: Step 1: Calculate cost of goods sold using the formula: Cost of Goods Sold = Opening Stock + Purchases Closing Stock = Step 2: Calculate the average stock using the formula: Average stock = opening stock + closing stock = 4500 Step 3: Calculate the stock turnover rate using the formula: Stock turnover rate = Cost of goods sold Average stock = 4.9 This means that the firm sells out of its stock approximately 5 times a year.

6 Activity: Calculating the stock turnover rate Use the information in the table below and the equations provided above to calculate: The cost of goods sold The average stock The stock turnover rate Opening Stock 6,000 Purchases 256,000 Closing Stock 10,000 Cost of Goods Sold Average stock Stock turnover rate Return on capital employed A fourth ratio which is useful when looking at how well a company has performed is the return on capital employed (ROCE). This calculation shows the net profit which the owner makes on the capital he has invested in the business. Calculating the ROCE allows the owner to compare this return with what he could have earned by placing his money in a bank or by investing it in some other business. The ROCE is calculated by the following equation ROCE = Net profit x 100 Capital employed For example if the capital invested in Pete s Pizza is 200,000 then the ROCE is equal to 74.5%. ( 149,000/ 200,000 x100). This means that Pete is making almost 75% profit on his investment.

7 Activity: Calculating the ROCE 1. Use the information in the table below to calculate the ROCE for each of the 3 firms in the table. Firm A B C Net profit ( m) Capital employed ( m) ROCE 2. If you were considering investing in one of these 3 companies which one would you chose. Explain your answer. Working capital ratio This ratio which is also known as the current ratio shows the relationship between businesses current assets and current liabilities. It is seen as a measure of the firm s ability to pay its current debts. It is calculated using the equation: Working capital ratio = Current assets Current liabilities For example if we assume that Pete s Pizza had current assets of 100,000 and current liabilities of 50,000 we would calculate its current ratio to be 2:1. 100,000 = 2 :1 50,000 Although different businesses will have different acceptable ratios, as a rule of thumb a ratio of 2:1 is considered to be good. This means that the business has 2 worth of current assets for every 1 worth of current liabilities. If the ratio is any lower, the business may find it difficult to meet its current liabilities. However, too high a ratio may indicate that the business is holding too much current assets. For example they may have too much cash which is not earning them a return or stock levels may be too high which is costly.

8 Activity: Business ratios Use the information in the table below to calculate and compare the following ratios for Firm A and Firm B: Net profit percentage Gross profit percentage Return on capital employed Working capital ratio Firm A Firm B Sales Gross Profit Net profit Current Assets Current Liabilities Capital Knowledge Review/ Key terms Gross profit is the difference between the revenue received from selling your product and the cost of sales. Net profit is the actual amount of profit left over after all costs have been taken into account. Net profit is calculated by subtracting expenses from gross profit. Net profit percentage shows how much net profit a firms makes on its sales. It is calculated by the equation: Net profit percentage = net profit / Sales x 100. The stock turnover ratio measures the number of times a business is able to sell its average level of stock in a year. It is calculated using the formula: Stock turnover rate = cost of goods sold / average stock. Return on capital employed shows the net profit which the owner makes on the capital he has invested in the business. It is calculated by the equation; ROCE = Net profit / Capital employed x 100. Working capital ratio also known as the current ratio this shows the relationship between businesses current assets and current liabilities. It is calculated using the equation: Working capital ratio = Current assets / Current liabilities. Revision questions 1. Explain the difference between gross profit and net profit. 2. Calculate the gross profit margin for a firm whose sales are 40,000 and gross profits are 22, Calculate the net profit margin for the firm above if expenses are 12, Explain why an entrepreneur would want to calculate the ROCE for a particular business. 5. Give 2 disadvantages to a firm of holding too much stock.

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