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
Disadvantages of ratio analysis
Accounting ratios can be classified as
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
Gross Profit = Net sales – Cost of sales
Net Sales = Revenue – Return Inwards (Sales Return)
Cost of sales = Opening inventory + Net Purchases – Closing inventory
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
Convert Margin to Mark up
Convert Markup to Margin
If margin = 20%
Gross Profit = 20 × Sales
Cost of sales = 80 × Sales
If markup = 25%
Gross Profit = 25 × Cost of sales
Gross Profit = 25 × Sales
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
= 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
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 = 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
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
= Closing inventory + Trade receivables + Bank
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
= Trade receivables + Bank
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 = Opening inventory + Closing inventory
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
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