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Return on capital employed (ROCE) is the ratio which measures the relationship between the size of the profit figure relevant to the size of the business.

The return on capital employed formula is:

ROCE is also known as the primary ratio because it’s often the most important measure of profitability. Once calculated, ROCE should be compared with:

1. previous years’ figures
2. company’s target ROCE
3. the cost of borrowings: if the cost of borrowing is higher than ROCE, further borrowings will reduce earnings per share
4. other companies in the same industry.

Return on capital employed can be calculated in a number of different ways.

The return on shareholders’ equity ratio is more relevant for existing or prospective shareholders than management.

The other commomly used ROCE is:

The overall return ratio is used by managers assessing performance.

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The percentage change in sales: Change in sales as a percentage of sales. This is measured by:

A larger increase might have given some evidence of the type of changes in trading conditions that may have occurred.

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Trading profit margin is affected by more factors than the gross profit margin but it’s equally useful.

A trading profit margin is:

One of he many factors affecting the trading profit margin is depreciation, which is open to considerable subjective judgement.

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What is gross profit percentage? The gross profit percentage is the margin that the company makes on its sales revenue. It’s expected to remain reasonably constant from year to year.

This is the margin that the company makes on its sales revenue. The gross profit percentage formula is:

The comparsion of margins can be very useful but it’s especially important to look at businesses within the same sector. For example, food retailing may have low margins, but a manufacturing industry will have higher margins.

Some business sectors support lower margins than others, but if a company shows lower margins than usual, that suggests scope for improvement.

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Two ratios are used to measure a business’s ability to meet its own short-term liabilities.

The current ratio formula is:

Current ratio = Current assets / Current liabilities

The quick ratio (acid test ratio) formula is:

Quick raito = (Current assets – inventory) /Current liabilities

Two ratios are relevant to consider the nature of the business. And they can be distorted by window dressing. For example, if the current ratio is 1.4 and trade payables are paid just before the year end out of positive cash balances, the raitos improve as shown below:

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The quick ratio is also known as the acid test ratio, becasue it privoeds the acid test of whether the company has sufficient resources (receivables and cash) to settle its current liabilities.

The quick ratio (acid test ratio) formula is:

Quick raito = (Current assets – inventory) /Current liabilities

We know the price of inventory is unstable because of the market condition. The inventory should be eliminated from current assets. Like the current ratio, it need to consider the nature of the business. Norms for the quick ratio range from 1 to 0.7.

In the quick ratio, the asset includes:

1. bank, cash and short-term investments
2. trade receivables.

Excluding prepayments and inventory.

The liabilities would usually include:

1. bank overdraft which is technically repayable on demand
2. trade payables, tax and social security.

Income taxes may be excluded.

Here, we should take care of the status of the bank overdraft. A company with a low quick ratio may actually have no problem in settling accounts payable if sufficient overall overdraft facilities are available.

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When the current liablities fall due, you should caculate whether the current assets meet short-term liablities or not. The current ratio measures the adequacy of current assets to meet short-term liabilities. The current ratio formula is:

Current ratio = Current assets/Current liabilities

Mostly, a current ratio of 2 or higher was regarded as appropriate for most businesses, but companies vary in their level of current ratio depending on the trade, and the current ratio should be looked at what is normal for the business. It’s meaningful in the similar business.

A higher figure is not too good because:

1. high levels of inventory and receiables
2. high cash levels which could be put to better use.

Some important information is often being forgot. We also should consider:

1. availability of further finance
2. seasonal nature of the business
3. long-term liabilities and when they fall due and how they will be financed
4. nature of inventory.

Here, there is another ratio to analyse the financial stability: the qucik ratio. The quick ratio formula is:

Quick raito = (Current assets – inventory) /Current liabilities

The quick ratio provide a better indicator of short-term liquidity.

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The receivables collection period insteads the time to regain the receivables. The longer the receivables collection period is, the worse the business has.

The quickest way to compute the receivables collection period is to use the formula:

For example:

Compared with 20X8 the receivables collection period has worsened in 20X9.

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How to calculate inventory turnover? Firstly, you must know the inventory turnover formulas. Here is the example.

or

Here, we use the days as the tools calculating inventory turnover. For example:

The result of calculating inventory turnover is:

The result of calculating inventory turnover is above. After you’ve calculated the inventory turnover, you should learn to how to analyse it.

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If the inventory turnover increased, it is not possible to analyse that is satisfactory or unsatisfactory, because the nature of the business is unknown. The result of analysing is depended on the nature of the business.
For example, a jeweller will have a low inventory turnover ratio, but a fishmonger selling fresh fish will hope to have a very high inventory turnover ratio. Now, let’s analyse it.

The inventory turnover (inventory turnover ratio) is:

or

An increasing number of days (or a diminishing multiple) implies that inventory is turning over less quickly. This is usually regarded as a bad sign because:

1. lack of demand for the goods
2. poor inventory management
3. ultimately lead to inventory obsolescence and related write-offs.

But sometimes, the increasing number of days will be needed:

1. buying inventory items in larger quantities to take advantage of trade discounts
2. avoid inventory shortages
3. the increase is slight and due to distortion of the ratio caused by comparing a year end inventory figure with cost of sales for the year when that year has been one of increasing growth.

And you should know some manufacturers may consider:

1. reliability of supplies, if the fupplier is unreliable it is prudent to hold more raw materials
2. demand, if demand is erratic it si prudent to hold more finished goods.

So, the result of analysing is depended on the nature of the business.