Accounting Notes > Accounting (Special Edition) Notes

This is an extract of our **Financial Interpretation Ratio Analysis** document, which
we sell as part of our **Accounting (Special Edition) Notes** collection written by the top tier of
Acca students.

* The following is a more accessble plain text extract of the PDF sample above, taken from our Accounting (Special Edition) Notes.
Due to the challenges of extracting text from PDFs, it will have odd formatting:
*

Financial Interpretation - Ratio Analysis http://www.youtube.com/watch?feature=player_embedded&v=jXDzdqc8gPI

Definition Ratio analysis is a fundamental means of examining the health of a company by studying the relationships of key financial variables. In other words Ratio are used to analyze financial statement .They are used to recognised periodical trends of a business and to compare two or more businesses. Why is it important?

Ratios are one of the most important part of the analysis process of a business. Ratios are normally compared to the ratios of other businesses. For e.g gross profit margin is an indicator of a company's profitability, If it is higher than the other business it shows that the business with higher GP margin is more profitable and attractive for investors.

1. 2.

3. 4.

5. Lecture Notes The Ratios are normally classified into following: Profitability ratios Liquidity ratios Efficiency / activity ratios Solvency ratios Investors ratios

Profitability ratios These ratios measures the business ability to generate profits from its resources Following are some of the most commonly used profitability ratios

1) Gross Profit Margin The gross profit margin or net profit margin is calculated as: Gross Profit / Sales x 100 This is the margin that the company makes on its revenues.

*

*

*

Since the ratio is affected by only a small number of variables, a change in GP margin may be due to a change in: selling prices - e.g.because of inflation sales mix - often deliberate purchase price - including carriage or discounts

2) Operating profit margin (net profit) The operating profit margin or net profit margin is calculated as:

1 EBIT / Sales x 100

*

*

If there is a change in the above ratio it should be studied more: Are they in line with changes in GP margin?

Are they in line with changes in revenue? as many costs are fixed in nature, they may not necessarily increase/decrease with a change in revenue.

3) Return on Capital Employed (ROCE) The ROCE is calculated as: ROCE = Profit / Capital employed x 100

*

*

Profit is measured as: operating (trading) profit, or the EBIT, i.e. the profit before taking account of any interest paid on long term finance

*

Capital employed is measured as: equity plus Long term debt

*

*

*

*

ROCE should be compared to: the previous year ROCE a target ROCE the cost of borrowing/

other companies' ROCE in the same industry.

4) Asset Turnover It is calculated as:

= Sales / Capital employed It measures management's efficiency in generating revenue from the net assets at its disposal: Note that this can be further subdivided into:

* noncurrent asset turnover (by making noncurrent assets the denominator) and

* working capital turnover (by making net current assets the denominator).

Relationship between ratios ROCE can be subdivided into profit margin and asset turnover. Profit margin

x Asset turnover

=

ROCE

EBIT

----------- Sales revenue

x Sales revenue

------------ Capital employed

=

EBIT

------------ Capital employed

Two completely different strategies can achieve the same ROCE. 2

*

*

Sell goods at a high profit margin with sales volume remaining low Sell goods at a low profit margin with very high sales volume

Liquidity ratios measures the ability of a firm to meet its short term debts There are two ratios used to measure overall working capital:

1. the current ratio

2. the quick or acid test ratio.

1) Current ratio Current or working capital ratio: Current assets

------------

:1 Current liabilities

*

*

The current ratio measures the adequacy of current assets to meet the liabilities as they fall due. A high or increasing figure may appear safe but should be regarded with suspicion as it may be due to: high levels of inventory and receivables (check working capital management ratios) high cash levels which could be put to better use (e.g. by investing in noncurrent assets).

2) Quick ratio Quick ratio (also known as the liquidity and acid test) ratio: Current assets - inventory

---------------------- : 1 Current liabilities The quick ratio is also known as the acid test ratio because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities.

Activity ratios These ratios measures how efficiently the business is performing its daily activities, such as collection of receivables, inventory handling, payments to suppliers

1) Inventory turnover period Inventory turnover period is defined as: Inventory

-------- x 365 days COS An increasing number of days (or a diminishing multiple) implies that inventory is turning over less quickly which is regarded as a bad sign as it may indicate: 3

*Buy the full version of these notes or essay plans and more in our Accounting (Special Edition) Notes.*