32 Crookdale lane
IP32 6TY 14/2/15
Dear Alfresco, I am writing to help you understand how we can analyze ratios in order to measure profitability. I will be using the balance sheet and trade profit and loss account you have provided me in order to help me calculate the ratios for the year ended March 2007. I will also use the other ratios you have provided me to compare them and see how well your business is doing.
Firstly I will complete the table you have given me.
Year ended march 2005
Year ended march 2006
Year ended 2007
Return on capital employed (ROCE)
Debtor payment period
Creditors payment period
Profitability is the ability of a business to earn a profit. There are tree profitability ratios which are Return on capital employed, Gross profit margin and Net profit margin.
I will first look at the three profitability ratios which are Return on Capital Employed, Gross Profit margin and Net Profit margin.
Return on Capital Employed (ROCE) can show Alfresco profitability by putting the operating profit up against the capital employed, this shows how much profit Alfresco is making from his capital employed.
To find out the ROCE ratio you will need an equation which is:
ROCE = Operating Profit X 100 Capital employed
92% = £11,325 £12,325
This means that for every £1 that you put into your business there is a 92% return.
The next ratio I will look at is the gross profit ratio. This is the ratio that will show you how much gross profit you will make in proportion to your sales.
To find out the gross profit ratio you will need to use this equation:
Gross profit Ratio = Gross Profit X 100 Sales
43% = £27,600 X 100 £63,600
This figure means that for every £1 that you have made 43 pence is gross profit and also means that 57 pence goes to expenses. You could try and reduce your expenses in order to maximise your gross profit.
The last profitability ratio is the Net profit ratio. This is just like the Gross profit ratio but this will show your profit after all your expenses have been deducted and what your business will be left over at the end of the financial year.
To find out the Net profit ratio you will need to use this equation:
Net profit Ratio = Net Profit X 100 Sales
18% = 11,325 X 100 63,600
This shows you that after all your expenses are deducted you only make 18 pence net profit for every £1 that you make. This is a low net profit ratio and you should have a look into your expenses as they may be too high and you will need to look into cutting some of them in order to make more net profit as your profit ratio goes from 43% to 18% which is a 25% decrease in your ratios.
The next set of ratios I will look at will be the efficiency ratios.
The first efficiency ratio that I will look at is the stock turnover. This ratio shows how long the company’s money is tied up in stock in days.
To find out this value you will need to use this equation:
Stock turnover = cost of sales Average stock held 4.7 = £35,700 £7550
This shows that it takes you 4.7 days to go over your stock and is also the time period in which your money is tied up.
The next efficiency ratio i will be looking at will the debtor payment period. This is the average time taken for your debtors to pay you their debts. You can find this by using the equation:
Debtor payment period = Debtors X 365 Sales revenue