The financial statements show whether the business has been profitable in a particular accounting period, and comparison with previous years will show if the profit is increasing or decreasing. However the use of accounting ratios can indicate whether the profit is growing, in proportion to the size of the business, as represented by the level of turnover, assets or capital invested in the business. Looking at profit as a percentage of turnover or assets, therefore gives valuable information about the business.
A ratio that is easily taken from the accounts is the gross profit ratio, this being the gross profit as a percentage of turnover. A decline in this ratio from one year to the next could indicate that the direct costs of production are increasing too much, and need to be controlled, or that prices need to be increased. It can also be useful to compare the gross profit percentage with that of other enterprises in the same industry, as this might be an indication of how the company is performing in the context of the market in which it operates.
The net profit margin looks at the net profit as a percentage of turnover. If the net profit margin is declining, this could be a sign that overhead expenses are increasing too rapidly compared to the growth of the business. The enterprise may need to look at the level of general overheads, such as administrative expenses, and look at ways of reducing them. Comparison with the net profit percentage of competitors is also a worthwhile exercise, to gauge the efficiency of the enterprise compared to its competitors.
Another way to gauge how profitably the enterprise is operating, is to look at the Return on Assets (ROA). This measures the net profit as a percentage of the net assets of the enterprise. The ratio looks at how efficiently the enterprise is making use of the assets used in the business, and is therefore one way in which the management performance can be gauged. Ratio analysis of financial statements can, therefore, be used within and outside the enterprise, to give an idea of how well the management is performing, as well as being used by investors to see how the enterprise is developing.
Please continue to page 2, for more information on ratio analysis of financial statements.