accounting ratios - teleskola.mt€¦ · accounting ratios are very useful in giving the decision...

ACCOUNTING RATIOSGo for Accounting; Third Edition

Pages 229-241

… Preparing the Financial Statements of a business enable us to have a good idea on the performance of a business. However, by simply looking at the ‘Net Profit/Loss’ is not always enough to make sensible management decisions for the future of the business …

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The owner of a business will surely ask the following questions in case a Profit is registered:

- Could the results be improved?- Is the profit a fair return on the amount of money invested

in the business?- Is the business performing

well in all areas?

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On the other hand, the owner of a business will surely ask the following questions in case a Loss is registered:

- Why did the business register a loss?- What could be done to reduce this loss?- How is the business

performing when compared toother similar businesses?

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Accounting ratios and percentages are used to answer the above questions!

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Take a look at the following Financial Statements of Knight Enterprises for the year ended 31st December 2008:

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Take a look at the following Financial Statements of Knight Enterprises for the year ended 31st December 2008:

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… The Income Statement of Knight Enterprises shows that the firm has made a Net Profit of €12,000. Although this figure is important, a closer look is to be given into the Financial Statements to extract more useful information …

… Two important calculations can be made

out of the information found in the Financial

Statements …

WORKING CAPITAL & CAPITAL EMPLOYED

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… It is very important for a business to know if it has enough funds to pay its debts on a day to day basis.

The Working Capital Calculation gives us a clear indication if a business is able to pay its debts on a day to day basis or not.

Working Capital = Current Assets –Current Liabilities

Work out the Working Capital of Knight Enterprises for the year ended 31st December 2008: ______________________________________________________________

______________________________________________________________

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… Insufficient funds to be able to pay debts on a day to day basis may have the following consequences:

1. The business will lose valuable cash discounts. 2. Delaying in paying debts may result in interests.3. Start losing its business reputation.4. Firm may close down in order to be able to pay its

debts.

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… Capital Employed has many definitions. At this stage, we shall consider Capital Employed as the amount of money that the owner has invested and the long-term liabilities which provide more funds for the business to operate in the long-run.

Capital Employed= Capital+ Non-Current Liabilities

Work out the Capital Employed of Knight Enterprises for the year ended 31st December 2008: ______________________________________________________________

______________________________________________________________

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… Now we will consider two sets of accounting ratios. Accounting Ratios are very useful in giving the decision makers of the firm an indication of how the firm is progressing …

LIQUIDITY RATIOS

PROFITABILITY RATIOS

ACCOUNTING RATIOS

Focus on whether the firm is using its assets well and is able to pay the amounts owing as they become due.

Give us information about aspects of how the

firm is running. These ratios will shed light on

how much a firm is being profitable.

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… The following are the Accounting Ratios that we shall study in each and every Category:

LIQUIDITY RATIOS

PROFITABILITY RATIOS

ACCOUNTING RATIOS

1. Current Ratio2. Acid Test Ratio3. Rate of Inventory

Turnover4. Capital Ratio5. Trade Receivable

Ratio6. Trade Payables Ratio

1. Return on Capital Employed

2. Mark Up Ratio3. Gross Profit Ratio4. Net Profit Ratio

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LIQUIDITY RATIOS1

The Working Capital Ratio/Current Ratio

This ratio indicates the ease with which a business can pay its debts as they fall due from its Current Assets.

Current Ratio = Current AssetsCurrent Liabilities

The ratio should always be at least one to one (1:1) or ideally greater than this!

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LIQUIDITY RATIOS1


At the end of 31st December 2015, Knight Enterprises had €47,250 Current Assets and €22,500 Current Liabilities.

Current Ratio = Current AssetsCurrent Liabilities

= €47,250€22,500

= 2.1:1

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LIQUIDITY RATIOS1


Was the Current Ratio’s answer in the seen example, a positive or a negative one?

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LIQUIDITY RATIOS2

The Acid Test Ratio/Quick Assets Ratio

This test is much more stiff in that it tests whether a business is able to pay its current liabilities out of its current assets without selling any of its inventory.

Acid Test Ratio = Current Assets – Closing StockCurrent Liabilities

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LIQUIDITY RATIOS2


At the end of 31st December 2008, Knight Enterprises had Current Assets totalling to €47,250 of which Closing Stock was of €18,000 and

€22,500 Current Liabilities.Current Ratio = Current Assets – Closing Stock

Current Liabilities

= €47,250 – €18,000€22,500

= 1.3:1

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LIQUIDITY RATIOS2


Was the Acid Test Ratio’s answer in the seen example, a positive or a negative one?

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LIQUIDITY RATIOS3

Rate of Inventory Turnover

This ratio shows the number of times in a financial year the inventory is used.

Rate of Inventory Turnover = Cost of SalesAverage Inventory

Note: The Average Inventory is found by adding the Opening Stock and the Closing Stock and dividing by two.

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LIQUIDITY RATIOS2


The Cost of Sales shown in the Income Statement of Knight Enterprises shows a figure of €120,000. The business started the financial year with €12,000 stock and ended with €18,000 closing stock.

Rate of Inventory Turnover = Cost of SalesAverage Stock

= €120,000(€12,000+€18,000/2)

= 8 times

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LIQUIDITY RATIOS3


Do you think that a showroom furniture will have a higher rate of inventory turnover than a green grocer?

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LIQUIDITY RATIOS4

Capital Ratio / Rate of Non-Current Liabilities to Capital Employed

This ratio is used to find out whether a business is financed mainly by its owners or whether outside sources of finance are the main providers of money.

Capital Ratio = Non-Current Liabilities x 100%Capital Employed

Note: Capital Employed is found by adding Capital to Non-Current Liabilities

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LIQUIDITY RATIOS4

Capital Ratio / Ratio of Non-Current Liabilities to Capital Employed

Non-Current Liabilities as at 31st December 2008 amount to €30,000 whilst that Capital as at the same date amount to €122,250.

Capital Ratio = Non-Current Liabilities x 100%Capital Employed

= €30,000(€122,250 + €30,000)

= 19.7%

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LIQUIDITY RATIOS4

Capital Ratio / Ratio of Non-Current Liabilities to Capital Employed

Long-term loans provided are less than 20% of the total funds invested in Knight Enterprises.

Is this good?

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LIQUIDITY RATIOS5

Trade Receivables Ratio / Debt Collection Period

This ratio measures the efficiency of a business in collecting the amount of money owed to it by trade receivables.

Debt Collection Period = Trade Receivables x 365 daysNet Sales

Remember that any money tied up outside the business is money that the business cannot use for its own purposes.

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LIQUIDITY RATIOS5


Trade Receivables of Knight Enterprises amount to €15,000 at the end of 2008. Moreover, the Net Sales figure shown in the Income Statement for the year ended 31st December 2008 amounts to €150,000.

Debt Collection Period = Trade Receivables x 365 daysNet Sales

= €15,000 x 365 days€150,000

= 36.5 days

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LIQUIDITY RATIOS5


Ideally the time taken by a business’ trade receivable to pay should be as short as possible!

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LIQUIDITY RATIOS6

Trade Payables Ratio

This ratio calculates how long a business takes to pay its trade payables.

Trade Payables Ratio= Trade Payables x 365 daysPurchases

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LIQUIDITY RATIOS6


Trade Payables of Knight Enterprises amount to €22,500 at the end of 2008. Moreover, the purchases figure shown in the Income Statement for the year ended 31st December 2008 amounts to €126,000.

Trade Payables Ratio = Trade Payables x 365 daysPurchases

= €22,500 x 365 days€126,000

= 65.17 days

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LIQUIDITY RATIOS6


Ideally the time taken by a business to pay its trade payables should be as long as is practical.

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LIQUIDITY RATIOS6


Compare the Debt Collection Period of Knight Enterprises with its Trade Payables Ratio.

What do you comment?

COMPARE

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PROFITABILITY RATIOS1

Return on Capital Employed (R.O.C.E)

It is of great importance for a business man to know whether he is receiving a fair amount of Net Profit when compared with the money he has invested in the business.

Return on Capital Employed = Net Profit x 100%Capital Employed

A business man may compare the R.O.C.E with, for example, merely leaving his money in a bank deposit account and receiving interests!

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The Net Profit registered by Knight Enterprises for the year ended 31st

December 2008 is of €12,000. Capital Employed is found to be €152,250.

R.O.C.E = Net Profit x 100%Capital Employed

= €12,000 x 100%€152,250

= 7.9%

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LIQUIDITY RATIOS1


Would have the owner of Knight Enterprises been wiser if he had invested his money in a savings account yielding 3% interests per annum?

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Mark Up Ratio

This ratio is used to determine the selling price when the cost of goods is known.

Mark Up Ratio = Gross Profit x 100%Cost of Sales

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Mark Up Ratio

The Gross Profit registered by Knight Enterprises for the year ended 31st

December 2008 is of €30,000 whilst that the Cost of Sales is found to be €120,000.

Mark Up Ratio = Gross Profit x 100%Cost of Sales

= €30,000 x 100%€120,000

= 25%

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LIQUIDITY RATIOS2

Mark Up Ratio

Imagine that one of the products sold by Knight Enterprises has a Cost Price of €100. Using a 25% mark up, how much will be the selling price of this product?

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Gross Profit Ratio

This ratio indicates the amount of gross profit made on the amount of Sales.

Gross Profit Ratio = Gross Profit x 100%Sales

The Gross Profit Ratio should be consistently similar from year to year. Businesses operating in the same trade should have similar Gross Profit Ratios too!

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Gross Profit Ratio / Margin

The Gross Profit registered by Knight Enterprises for the year ended 31st

December 2008 is of €30,000 whilst Net Sales are found to be €150,000.

Gross Profit Ratio = Gross Profit x 100%Net Sales

= €30,000 x 100%€150,000

= 20%

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Net Profit Ratio

This ratio indicates the amount of net profit made on the amount of Sales.

Net Profit Ratio = Net Profit x 100%Sales

The Net Profit Ratio may not be the same from year to year since the expenses of the business may vary from one year to another.

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Net Profit Ratio

The Net Profit registered by Knight Enterprises for the year ended 31st

December 2008 is of €12,000 whilst Net Sales are found to be €150,000.

Net Profit Ratio = Net Profit x 100%Net Sales

= €12,000 x 100%€150,000

= 8%

accounting ratios - teleskola.mt€¦ · accounting ratios are very useful in giving the decision...

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