Chapter 4 - Ratio Analysis


Accounting ratios are used to interpret the financial statements so that the strengths and weaknesses of a firm can be determined. Financial analyst uses accounting ratios to diagnose the financial health of an enterprise.  It is used by managers to analyse the profitability and liquidity of a business.

Advantages of ratio analysis

  • It is used to analyse current ratio of a business compared to its past ratios. (Trend analysis)
  • Ratios of a business can be compared against its competitors. (Inter-firm analysis)
  • It is used to analyse the ratios of a business to the average ratios of the industry. (Industry analysis)
  • Accounting ratios help to estimate budgeted figures.
  • It helps users of accounts in understanding the financial statements.

Disadvantages of ratio analysis

  • Financial statements provide historical information and do not reflect current conditions.
  • Different company may apply different accounting policies making it difficult to compare businesses.
  • Seasonal factors may affect financial data.
  • Financial analysts may interpret accounting ratios differently.
  • Accountants may legally present the financial statements in such a way that it shows a better position (Window Dressing)

Accounting ratios can be classified as

  • Profitability ratios
  • Liquidity ratios

Profitability Ratios

Margin

The gross profit margin analyses the relationship between gross profit and net sales. It indicates efficiency of management in converting sales into profit. It measures the percentage of gross profit earned by a business over net sales. The higher is the margin the more profitable is the business.

Margin              =          Gross Profit    × 100                                           

                                        Net sales 

Gross Profit      =          Net sales – Cost of sales 

Net Sales          =          Revenue – Return Inwards (Sales Return) 

Cost of sales    =          Opening inventory + Net Purchases – Closing inventory


Markup

Markup analyses the relationship between gross profit and cost of sales. It represents the percentage added to the cost price of goods to cover expenses. It used by businesses to determine selling price of a product. The higher is the markup the more profitable is the business.

Mark up          =          Gross Profit    × 100

                                     Cost of sales 

NOTE 

Convert Margin to Mark up

   

EXAMPLE 1




EXAMPLE 2


Margin



Markup


Margin


Markup

20%



25%


40%


66.7%









20



25


40

2/3*100=

66.7

100



100


100


100









1


1

1


2

2

2

5


5-1

4


5

5-2

3



















Convert Markup to Margin

   

EXAMPLE 1




EXAMPLE 2



Markup



Margin


Markup



Margin

20%



16.7%


15%



13.04%










20


1/6*100=

16.7


15


3/23*100=

13.04

100



100


100



100










1


1

1


3


3

3

5


5+1

6


20


20+3

23











 

If margin = 20%

Then

Gross Profit           =          20        × Sales

                                           100

Cost of sales          =          80        × Sales

                                            100

If markup = 25%

Then

Gross Profit           =          25        × Cost of sales

                                           100

Gross Profit           =          25        × Sales

                                           125


Expenses to sales ratio

This measures the operating expenses as a percentage of sales. The lower is the ratio the more profitable is the business. A low expense to sales ratio also indicates that management was efficient to control its expenses.

Expenses / Sales ratio           =          Operating Expenses   × 100

                                                                         Net Sales 

                                                   =          Margin – Net profit margin

Net profit margin

The net profit margin measures the profit for the year as a percentage of sales. It indicates management efficiency in converting sales into operating profit. The higher is the net profit margin the more profitable is the business.

Net profit margin      =          Operating profit        × 100

                                                      Net sales

Operating profit          =          Gross Profit – Operating expenses

                                      =          Profit for the year before finance cost (interest)

                                      =          Profit for the year + Interest (Finance cost)


Return on capital employed (ROCE)

This measure the operating profit as a percentage of capital employed. It shows how efficiently management is using total resources available in the business to generate profit. It is the most important profitability ratio. The higher is the ROCE the more profitable is the business.

ROCE                           =          Operating profit        × 100

                                               Capital employed

Capital employed      =          Non current assets + Current assets – Current liabilities

                                     =          Owner’s capital + Non-current liabilities

                                     =          (Capital + Profit – Drawings) + Non-current liabilities

Note - For Company

Capital employed      =          Ordinary share capital + Reserves + Non-current liabilities


Current ratio

This shows whether the business has sufficient financial resources to pay back its short term debts. If the current ratio is greater than 1 the business has a better liquidity position to pay back its current liabilities. If the current ratio is less than 1 then the business is said to be insolvent and may face financial difficulties to do normal trading activities in the near future. The ideal current ratio is 2:1 and it is also known as the Working capital ratio.

Current ratio              =          Current Asset

                                            Current Liabilities

                                    =          Closing inventory + Trade receivables + Bank

                                                                        Trade Payables

Quick ratio

This is a variation of the current ratio. It is calculated and interpreted the same way. The only difference is that closing inventory is ignored in the calculations since it is considered as the least liquid asset (not easily convertible into cash). It is also known as the acid test ratio.

Quick ratio                 =          Current Assets – Closing inventory

                                                            Current Liabilities

                                     =          Trade receivables + Bank

                                                        Trade payables

Rate of inventory turnover

This shows the number of times inventory has been renewed during a financial year. The higher is the inventory turnover the more efficient is the sales department in selling goods. A high rate of inventory turnover also indicates good inventory management and improved profitability and liquidity.

Rate of inv. Turnover   =              Cost of sales

                                                     Average Inventory

Average inventory        =          Opening inventory + Closing inventory 

                                                                             2

Trade receivables turnover

This measures the number of days taken by the debt collection department to collect money from credit customers. It also indicates the days taken by the business to convert sales into cash. A high trade receivable turnover shows that credit customers are paying their debts quickly which in turn is improving the liquidity of the business. It is also referred to as the Trade receivables collection period.

Trade rec. turnover   =          Trade receivables      × 365

                                                    Credit sales

Trade payables turnover

This measures the number of days taken by the business to pay back its credit suppliers. A short trade payables turnover indicates a healthy liquidity position and sound relationship with credit suppliers. It is also knows as Trade payables payment period.

Trade pay. turnover  =          Trade payables          × 365

                                               Credit purchases