Definitions, Types, Analysis, Formulas etc of Accounting Ratios

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ACCOUNTING RATIOS An accounting ratio is a set of figures expressed in terms of another in the same set of account. Without ratios, financial statements would be largely uninformative to all but the very skilled. With ratios, financial statements can be interpreted and usefully applied to satisfy the needs of the reader. Ratios by themselves are meaningless unless compared to a benchmark. Standards of Comparison Ratios calculated should be compared with the following standards or criteria. Such standards may either be internal or external. A. Internal Standard (Intra-firm) 1. The companys performance in the previous years is chosen and compared with any other year. 2. Actual performance in (Actual ratio) for the year is compared with those set as objectives at the beginning of the year. Questions: i. ii. iii. How far have we achieved our target ratio? Have we done better (or worse) than we expected? Trends Whether ratios are steady, gradually going up or gradually going down. B. External Standards ( Inter-firms) The performance of the company similar in size or in the same type of business is compared. Questions i. ii. Have we done better or worse than them? How does our ratios (Performance) compare with those of our competitors?

Uses of Ratios 1. Ratios are useful for forecasting likely event in future as past ratio indicate trends in cost, sales, profits, etc (Trends analysis)

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2. They are used to measure efficiency by means of inter company and intra company comparison. 3. They help to know the ability of the firm to meet it short term obligation. (liquidity position) 4. They provide information about the long term solvency of the company. 5. They help to measure the over all performance of the firm by using the profitability ratio. 6. They enable a large volume of data to be conveniently summarised. 7. They facilitate cost and performance control. This is done because when ratios are calculated they are interpretive to lead to the ascertainment of whether things are getting better or worse. This will enable management to take remedial actions.
The relationship between mark-up and margin and how to use the relationship between them and sales revenue and gross profit to find figures that are missing in the trading account

Mark-Up and Margin The relationship between Mark-Up and Margin Mark-Up: Is the gross profit expressed as a fraction or percentage of the cost price. For instance the purchase cost, gross profit and selling price of goods and services may be shown as: Cost Price + Gross Profit = Selling Price and when shown as a fraction of the cost price, the gross profit is known as mark-up. Margin: Is the gross profit expressed as a fraction or percentage of sales (selling price). Since mark-up and margin refer to the same profit there is bound to be a relationship between them. If one is known the other can be found. If the mark-up is known, to find the margin take the same numerator of the margin then for the denominator of the margin take the total of the mark-ups denominator plus the numerator. Example 1: From mark-up to margin Fraction 1 3 2 6 Mark-Up 1 3 2 6 Margin 1=1 3+1 4 2 =2 6+2 8

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If the margin is known, to find mark-up, take the same numerator to be that of the mark-up, then for the denominator of the mark-up subtract the margins numerator from the denominator. Example 2: From margin mark-up Margin 1 3 2 11 Mark-up 1 =1 3-1 2

2 =2 11-2 9

Calculate margin and mark-up using this example: Cost Price + Gross Profit = Selling Price GHC4 + GHC1 = GHC5

Mark-up = Gross Profit as a fraction or as percentage, multiply by 100 Cost Price GHC 1 = 1 or 1 x100 = 25% 4=4 4

Margin = Gross Profit as a fraction or as percentage, multiply by 100 Selling Price GHC 1 = 1 or 1 x100 = 20% 5=5 5

Example: The closing stock of Marble at 31st Dec 2009 was GHC500 less than the opening stock on Jan 2009. Her average stock amounted to GHC16,000 and purchases for the year were GHC18,000. She made a grofit of 20% on turnover within the year. You are required to: i. ii. Prepare Mabels trading account for the year ended 31st December 2009 Calculate her rate of stock turnover

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i.

Trading Account for the year ended 31st December 2009

TRADING PROFIT AND LOSS ACCOUNTS FOR THE YEAR ENDED 31ST DEC 2009 GHC Opening stock Add Purchases ? 18,000 ? Less Closing stock Cost of sales Gross Profit ? ? ? ? ? Sales GHC ?

Workings To find opening stock and closing stocks Take x to represent opening stock Therefore: Closing stock = x- 500 Average stock = opening stock + closing stock 2 16,000 = x + x-500 2 32,000 32,000 16,250 = 2x 500 = 2x =x

Therefore x = 16,250 If x (opening stock) = 16,250 then closing stock will be less by 500 15,750 (16250 500) =

ii.

Calculation of sales Method 1 ( Sales Method)

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Cost price + Profit 80 + 20

= Sales (100) = 100

If cost of sales (80) = 18,500 Therefore: Profit = 20 x 18,500 80 = 4,625 Therefore: Sales =C + P

=18,500 + 4,625 = 23,135 OR If C (80) = 18,500

Therefore: S (100) = 100 x 18,500 80 = 23,125 Method 2 (Mark-up & Margin) Margin = (20%) 1/5 1 = 1/4 Therefore: Mark-up (Profit) = 1/4 x 18,500 = 4,625 Rate of turnover = Cost of Sales = 18,500 Average stock = 16,000 = 1.16 times

TRADING PROFIT AND LOSS ACCOUNTS FOR THE YEAR ENDED 31ST DEC 2009 GHC GHC

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Opening stock Add Purchases

16,250 18,000 34,250

Sales

23,125

Less Closing stock Cost of sales Gross Profit

15,750 18,500 4,625 23,125 23,125

Types of Ratios I. II. III. IV. V. Profitability Ratios Liquidity / Solvency Ratios Activity / Asset used (Efficiency) Ratios Capital Ratios Investment Ratios

I.

Profitability Ratios

These are ratios used in measuring the economic efficiency of the business. The main purpose of these ratios is to measure the profit made by a business within a year. Profitability ratios can assist owners to: a. enquire further b. support, chastised or fire management(to sack management) c. expand, maintain or close down the enterprise. There are two types of profitability ratios a. Profitability in relation to sales. b. Profitability in relation to investment. a. Profitability in relation to sales

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These indicate efficiency of internal operation and importance for intra and inter company comparison. They comprise the following: i. ii. Gross Profit Ratio (Gross Profit to Sales) Net Profit Ratio (Net Profit to Sales)

Gross Profit Ratio (Gross Profit to Sales): This ratio expresses the proportion of selling price which represent gross profit. It is calculated as follows: Gross Profit Ratio = Gross Profit x 100 Net Sale This ratio helps the user to ascertain the pricing policy of the firm and also helps to ascertain the efficiency of the firm. Net Profit Ratio (Net Profit to Sales): This ratio measures the efficiency of all operations of a company. It shows how close a company is to making losses. It is measured as follows: Net Profit Ratio = Net Profit (after tax) x100 Net Sales b. Profitability in relation to investments These ratios which come under this indicates the earning power of the funds invested in the firm. They are important for inter firm comparison and includes the following: i. Net Profit to Fixed Asset: This ratio is of importance to companies that depend on fixed assets for generation of income. It enables the user to know whether the fixed assets are being efficiently utilised or not. Every low ratio could mean that fixed assets are being under utilised and vice versa. It is measured as follows: Net Profit to Fixed asset = Net Profit x 100 Fixed Asset

ii. Return on Capital Employed (ROCE): This is also known as the primary ratio because it enables the analyst to access the ultimate objective of the business. The efficiency of the management can be ascertained by marching

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the net profit (usually before tax) against long term funds invested in the business. The result can then be compared with companies in the same industry. It is calculated as follows: ROCE = Net profit (before tax) x 100 Capital employed Capital employed = Shareholders equity + Long term Liabilities Shareholders equity = Equity (Ordinary) Shares + Reserves or Surplus

iii. Capital Turnover Ratio: This reveals the number of times that capital invested into the business have been used over the period. It is define as the ratio on sales to capital employed. It is calculated as follows: Capital Turnover Ratio = Sales x100 Capital employ iv. Net Equity Income to Equity Capital: This means the net profit after charging loan interest and taxation less preference dividend. It is calculated as follows: Net Equity Income Equity Capital

II.

Liquidity / Solvency Ratios:

Refers to the ability of the business to pay its debt as they fall due. They are meant to measure the firms ability to meet its short term obligation. The solvency of the business can be tested by calculating the following: a. Working Capital b. Working / Current Ratio c. Liquidity Ratio d. Acid Test / Quick Ratio

a. Working Capital This is the excess of the total current asset over total current total liabilities. It measures the amount of funds that the business has available for meeting day to day expenses. It is calculated as follows:
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Working Capital = CA CL (Current Asset Current Liability) A positive Working Capital (WC) indicates that the business is solvent; where as a negative WC shows that the business is insolvent. A negative WC may be as a result of Capitalization or over trading. b. Current Ratio This is also referred to as the Working Capital ratio. It is calculated as follows: Current Ratio = Current Asset Current Liability It is the numerical relationship of CA to CL and it indicates whether the business is to meet its CL as they fall due. The minimum Working Capital ratio of any business should be 1:1. This means that the business is just able to pay its CL. However a 2:1 ratio is considered a satisfactory one. c. Liquidity Ratio This is the ratio of current asset (excluding stock) to current liabilities. It gives a sharper focus on the assets which are more readily convertible into cash. It is calculated as follows: Liquidity ratio = Current Assets Stock Current Liabilities d. Acid Test / Quick Ratio This reveals the readiness of the business to pay its immediate debt and demand. A satisfactory ratio is 1:1. It is calculated as follow: Acid Test Ratio = Current Asset (Stock + Prepayment) Current Liabilities AT=CAS+P CL

III.

Activity / Asset used (Efficiency) Ratios

Activity or efficiency ratios show how efficiently the assets of an organisation have been used to attain it major objective. Ratios which fall under this are: a. b. Stock Turnover Ratio Debtors/Sales Ratio
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c.

Creditors/Purchases Ratio

a. Stock Turnover Ratio Stock turnover measures how efficient a business is at maintaining an appropriate level of stock. When it is not being as efficient as it used to be, or is being less efficient than its competitors, this may indicate that control over stock level is being undermined. A reduction in stock turnover can mean that the business is slowing down. Stock may be piling up and not being sold. This could lead to liquidity crises, as money may be taken out of the bank simply to increase stocks which are not then sold quickly enough. It is calculated as follows for two companies for comparison: Cost of Sales Average Stock Where Average Stock = Opening Stock + Closing Stock 2

b. Debtors/Sales Ratio The resources tied up in debtors is an important ratio subject. Money tied up unnecessarily in debtors is unproductive money. The relationship is often translated into the length of time a debtor takes to pay. The debtor/sales ratio can be calculated for two companies as: Debtors/Sales = Debtors Sales x 12 months

c. Creditors/ Purchases Ratio This ratio like stock turn over and debtors/sales ratio can be classified as liquidity or efficiency ratio. It is also often translated into length of time we take to pay our creditors. This turns out to be: Creditors/ Purchases Ratio = Creditors Purchases x 12 months IV. Capital Ratio

These are ratios that explain the relationship between various types of capital and a limited liability company. a. Gearing Ratio: This compares equity capital with fixed capital obligation, fixed capital consists of preference shares and debentures. A ratio of more than 1 or 100% is interpreted as high gearing while the ratio of less than 1 or 100% is considered as low gearing.

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A high geared company has a high proportion of debt capital and low proportion of equity capital i.e. it has a large amount of interest to pay; while a low geared company on the other hand is low proportion debt capital and a high proportion of equity capital, i.e. it has a small amount of interest to pay. It is calculated as: Gearing = Fixed Capital (Preference Shares + Long-term Liability Equity Capital (Ordinary Shares + Reserve) b. Capital Employed to Fixed Asset Ratio: This reveals that part of fixed assets which were financed by the owners of the company. A ratio of less than 1 is a sign of weakness because, it is expected that the owner of the business must provide funds for the acquisition of the assets. It is calculated as: Capital Employed to Fixed Asset Ratio = Capital Employed Fixed Assets c. Fixed Assets to Capital Employed: This reveals the distribution of capital employed among fixed assets and working capital. It is calculated as: Fixed Assets to Capital Employed = Fixed Assets Capital Employed d. Debt Equity Ratio: This is the shareholders equity compared with the total liabilities. It also shows the proportion of the shareholders ownership in assets. It is calculated as: Debt Equity Ratio = Shareholder Equity or Total Debt Total Liabilities Shareholders Equity x 100

OR

Long-term Liabilities Shareholders Equity

e. Debt Asset Ratio: Calculated as follow Total Debt Total Assets

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f. Equity Asset Ratio: Calculated as Shareholders Equity Total Assets V. Investment (Shareholder)Ratio These are ratios that help equity shareholders (ordinary Shares) and other investors to assess the value and quality of an investment in the ordinary shares of company. a. Net Equity Income to Equity Capital: Net equity income means that net profit after charging loan interest and taxation less preference dividend and distribution to any outside interest. The figure is the amount attributable to ordinary shareholders and it is compared to the ordinary shares issued plus reserves. This is useful when considering profitability of ordinary shareholders. It is calculated as follows. Net Equity Income Equity Capital b. Return on shareholders Fund: This shows the profitability of shareholders funds invested into the business. Shareholders fund refers to total share capital plus reserves. It is calculated as: Net Profit after tax Shareholders Fund x 100

c. Earning per share ( EPS): This ratio reflects the profitability of a concern from one point of view of equity shareholders in terms of each share held by them. In other wards it gives the shareholder (or prospective shareholder) a chance to compare one years earnings with another in terms easily understood. Many people consider EPS to be the most important ratio that can be calculated from the financial statement. It is measured as follows: Earning per share (EPS) = Net profit after interest and preference dividends Number of ordinary shares issued

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d. Dividend per share: This ratio informs the ordinary shareholder of the dividend payable or paid per share held. It can help forecast the dividend to expert, It is measured as follows: Total ordinary dividend payable Total number of ordinary share e. Dividend Cover: This ratio shows what proportion on ordinary activities for the year that is available for distribution to shareholders has been paid or proposed and what proportion will be retained in business to finance further growth. Usually, the dividend is described as being so many times covered by profits made. A dividend of two times would indicate that the company has paid 50% of its distributable profit as dividend and retained 50% in the business to help finance further operations. Dividend Cover = Net profit after interest and preference dividends Ordinary dividends paid and proposed f. Earning Yield: This ratio indicates the expected rate of return of the investors from the business. Equity dividend per share Price per share g. Dividend yield: This measures the return to a shareholder on the amount of his investment. It is calculated as follows: Gross dividend per share Market price per share h. Price earning ratio: This is the ratio of a companys current share price to the earning per share. It represents the amount investors are willing to pay for each cedi of firms earnings. It is measured as: Market price per share Earning per share Limitations of Ratios 1. The reliability of accounting ratio depends upon the reliability of accounting data. 2. Price level changes/inflation affects the comparison of accounting ratio.

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3. Different procedures followed by different firms for determining certain accounting values makes accounting ratios non comparable. 4. The problem of inconsistent accounting practises followed by a firm from period to period may make ratios incomparable. 5. Ratios sometimes give a misleading picture. 6. Different concepts are used for determining a particular ratio. 7. There are also problem of definition: There should be careful definition of terms used.
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