Ratio Analysis

Accounts make little sense to Managers and people who don’t have the technical knowledge. This has resulted in the evolvement of a new stream in Accounting known as Management Accounting. 

Ratio analysis is a part of management accounting, whereby complicated accounting information can be presented in a more simplified and presentable manner for laymen in accounting to understand and absorb the information.

A statistics has little value in isolation. The statement ‘a business earned a profit of $100m’ does not make much sense unless it is related to either its sales turnover or its assets.


People who are interested in knowing financial information are known as Stakeholders.

These are

Stakeholders Who are they   Objectives

Owners

They invest capital in the business and get profits from the business

 

Profits, growth of the business

Worker

Employees of the business who give in their time and effort to make a business successful

 

Job security, job satisfaction and a satisfactory level of payment for their efforts

Managers

Employees of the business who manage a business. They lead and control the workers to achieve organisational goals

 

High salaries, Job security, Status and growth of the business

Consumers

These are the people who buy the goods and services of the business.

 

Safe and reliable products, value for money, proper after sales service

Government

Government manages the economy. The government charges a tax from the business and also monitors the working of businesses in the country

 

Successful businesses, employments to be created, more taxes, follow laws

The community

Community is all the people who are directly or indirectly affected by the actions of the business.

 

They expect more jobs, environmental protection, socially responsible products and actions of the business.

 

Stakeholders are interested in getting information about business, in order:

  • To compare the business performance over several financial periods. This is known as Intra-firm comparison.
  • To compare the business performance with that of other businesses within the same industry also known as Inter-firm comparison



Ratios can be broadly classified as:

Profitability ratios

These ratios measure the profit in relation to sales or capital employed.

Gross profit margin

Gross Profit Margin shows the relationship of gross profit and sales turnover.


Gross Profit Margin=
Gross Profit
X 100
Sales turnover

A lower ratio may be the result of the following factors:

  • Decrease in selling price of goods sold
  • Increase in cost of goods sold
  • Over valuation of opening stock or under valuation of closing stock

Net profit margin

It is an index of efficiency and profitability of a business.


Net Profit Margin=
Net Profit
X 100
Sales turnover

Mark up cost refers to profit expressed as a percentage of cost price.


Mark Up=
Gross Profit
X 100
Cost of goods sold

Rate of return on Capital (ROCE)

It shows the return on the investment made by the owner.


Return on Capital employed=
Net Profit
X 100
Capital



These ratios state how efficiently certain areas of the business are performing.

Stock turnover ratio

It indicates the number of times in a year the average stock can be sold off. The more times the stock is sold the more efficient the business.


Stock turnover ratio=
Cost of goods sold
Average stock at cost price

Average Stock is calculated as (Opening stock + Closing stock)/2

Asset turnover ratio

Asset turnover is a measure of how effectively the assets are being used to generate sales. It is one of the ratios that would be considered when interpreting the results of profitability ratio analyses like ROCE.


Asset turnover ratio=
Sales turnover
Total assets-current liabilities

If the asset turnover is high than its competitors, it shows as an over investment in assets.

However, a new firm may have a higher asset turnover ratio than its competitors as the assets are newer and have a higher value. Moreover, some firms may use a lower rate of depreciation than its competitors.

In some cases, firms may purchase assets whereas its competitors firms are leasing assets.

Trade debtor collection period (Debtors days)

This ratio indicates how efficient the company is at controlling its debtors.


Debtors days=
Total Debtors
X 360
Total Sales turnover

Trade creditor payment period (Creditors Days)

This ratio indicates how the company uses short term financing to fund its activities.


Creditors days=
Total Creditors
X 360
Cost of sales

Both these ratios are useful for intra-firm comparison.


Liquidity ratios

It measures the availability of cash and other liquid assets to meet the current liabilities of the firm.

Current Ratio

The current ratio compares total current assets to total current liabilities and is intended to indicate whether there are sufficient short-term assets to meet the short-term liabilities.

Current assets: Current liabilities

The ratio when calculated may be expressed as either a ratio or 1, with current liabilities being set to 1, or as ‘number of times’, representing the relative size of the amount of total current assets compared with total current liabilities.

A ratio of 2:1 or current assets as 2 times is considered to be healthy for a business.

Acid test ratio

It is quite similar to Current ratio. The only difference in the items involved between the two ratios is that the acid test ratio or quick ratio does not include stock.


Acid Test ratio
=
Current assets-Stock
Current liabilities

An acid test ratio 1:1 is considered as healthy. If it is below 1 it suggest the business has insufficient liquid assets to meet their short term liabilities.

 


Candidates should be able to recognise the limitations of accounting statements due to such factors as:

 

historic cost

difficulties of definition

non-financial aspects