#4358 - Ratio Analysis - Accounting

Profitability

1. Gross Profit Margin = GP / Sales x 100

2. Gross Profit Markup = GP / CGS x 100

3. Net Profit Margin = NP / Sales x 100

4. Net Profit Markup = NP / CGS x 100

5. ROCE = PBIT / *Capital Employed x 100

*Capital Employed = Ord. shares + Pref. shares + Reserves + Long term debts

Liquidity

1. Current ratio = CA / CL

2. Quick ratio = (CA – inventories) / CL

Efficiency

1. Inventory turnover rate = CGS / average inventory (answer in times)

2. Debtor collection period = Average debtors / Credit Sales x 365 days

3. Creditors ratio = Average Creditors / Credit purchase x 365 days

Investors

1. Earnings per share (EPS) = (PAT – Pref.dividends) / no. of Ord. Shareholders

2. P/E ratio = MV / EPS

3. Dividend Yield = DPS / MV

4. Dividend Cover = (PAT – Pref.dividends) / Ord. Dividend paid and proposed

5. Gearing = (Long term Loans + Pref. Shares) / Capital Employed

Or Prior charge capital / Total Capital

Abbreviations

CA = current assets GP = Gross Profit NP = net Profit

CL = current liabilities EPS = earnings per share CGS = cost of goods sold

P/E = price to earnings ratio PAT = Profit after Tax MV = market value per share

DPS = Dividend per Share PBIT = Profit before interest and Tax

Drawbacks & limitations of ratio analysis

Ratio analysis is widely used in practice in business. Teams of investment analysts pour over the historical and forecast financial information of quoted companies using ratio analysis as part of their toolkit of methods for assessing financial performance. Venture capitalists and banker use the ratios featured here and others when they consider investing in, or loaning to businesses.

The main strength of ratio analysis is that it encourages a systematic approach to analyzing performance.

However, it is also important to remember some of the drawbacks of ratio analysis

• Ratios deal mainly in numbers – they don’t address issues like product quality, customer service, employee morale and so on (though those factors play an important role in financial performance)

• Ratios largely look at the past, not the future. However, investment analysts will make assumptions about future performance using ratios

• Ratios are most useful when they are used to compare performance over a long period of time or against comparable businesses and an industry – this information is not always available

• Financial information can be “massaged” in several ways to make the figures used for ratios more attractive. For example, many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.

Practice Bank

1. A debtor collection ratio of 12:1 means that:

   1. in any given month, twelve debtors are expected to pay in full.

   2. the average debtor takes about one month to pay.

   3. debtors are about twelve times as big as creditors.

   4. one-twelfth of debtors will turn out to be bad debts.

2. Given inventory of $24,000, other current assets of $12,000 and current liabilities of $20,000, the acid test (quick ratio) will be:

A 0.6 B 1.2 C 1.8 D 1.6

3. A company makes a profit of $5,000 before tax and after all interest totaling $1,200 has been charged. The capital of the company is made up of $35,000 ordinary shares, $35,000 preference shares, $25,000 debentures and $30,000 reserves. The return on capital employed for this company before tax is:

A 6.5% B 4.0% C 4.96% D 6.2%

4. Return on capital employed for a company will increase if:

   1. Sales volume decreases with no change in margins.

   2. Sales volume decreases and margins decrease.

   3. Sales volume doesn't change but margins decrease.

   4. Sales volume increases with no change in margins.

5. The PE ratio is calculated as follows:

   1. Profit of the company attributable to ordinary shareholders divided by the total earnings for the year.

   2. Profit of the company divided by sales earnings.

   3. Price of ordinary share on the market divided by total earnings of the company.

   4. Price of ordinary share on the market divided by earnings per share.

Financial Interpretation/ Ratio analysis Theory (Q/A)

Questions:

1. Give 5 users of accounting information.

2. What is the formula to find out the GP%?

3. What would be the reason for the increase in GP%? Give 2 reasons

4. What would be the reason for decrease in the GP%? Give 2 reasons.

5. What is the formula to find out NP %?

6. Give two problems of inter firm comparison.

7. What is meant by liquidity?

8. What is meant by working capital?

9. What does current Ratio measure?

10. What is the standard current Ratio for a business?

11. What are the effects of not having enough working capital?

12. Quote 4 ways of improving working capital.

13. What is the other name of Quick ratio?

14. What is the formula to find out Quick Ratio?

15. What is the standard quick ratio?

16. What is the formula to calculate stock turnover ratio?

17. In what way knowing the rate of stock turnover will be useful to the businessmen.

18. What is the other name of debtor’s ratios?

19. Give 3 ways of improving the collection period from debtors.

20. Give 3 ways of reducing the risk of bad debts.

Answers:

Ans. # 1: 1. Owner. 2. Bank 3. Business manager. 4. Creditor 5. Auditor

Ans. # 2: GP /Sales x 100

Ans. # 3: (a) Selling goods at higher prices.

(b) Buying the goods at cheaper prices.

Ans. # 4: (a) Selling goods at higher prices.

(b) Offering Trade discounts.

(c) Not passing on increase prices.

Ans. # 5: NP/ Sales x 100

Ans. # 6: 1. All businesses are not same in all sense.

2. Different businesses follow different accounting policies.

3. One business may not be of the same size like the other.

Ans. # 7: It is the ability of the business to convert its assets in to cash and to pay its debts

Ans. # 8: It is the money required to meet its everyday expenses.

Ans. # 9: It measures the ability of the business to meet its current liability as they fall due.

Ans. # 10: It is somewhere between 1.5 to 2:1.

Ans. # 11: (i) Problems in meeting debts as they fall due.

(ii) Inability to take advantage of cash discount.

(iii) Difficulty in obtaining further supplies.

Ans. # 12:...