Explain the following statement: “Ratio analysis can help in measuring business performance and setting objectives/goals”
Ratios are calculated from an organisation’s financial statements and are an effective business tool in measuring its performance. By comparing the ratios to those of the previous year it is possible to determine whether a business is doing better this year than last year.
It is important not to simply calculate as many ratios as possible, but to identify those most relevant to your business.
There are many different ratios that can be calculated and which can be grouped together into
Five main categories:
By carefully selecting the most suitable ratios business owners and managers can use theresults to gain a better understanding of how their organisation is performing. The same ratioscan also be used to set future targets.
For example, a business may be experiencing cash flow problems. The business owner believes that his customers are taking too long to settle their accounts. By calculating their debtors days and recording the results, it will be possible not only to establish what the current position is, but also to set targets for the future. This may be to reduce the debtor days from thirty five to twenty five days. A reduction in debtor days will help ease cash flow and reduce the risk of bad debts.
An organisation should select a number of ratios which provide key information about its performance. These are known as Key Results Indicators. Whilst these will vary from business to business some of the most common are listed below:
• Gross Profit Margin
• Net Profit Margin
• Trading Overheads as percentage of Turnover
• Debtor & Creditor Days
• Current Ratio
• Debt to Equity
• Return on Capital Employed