Accounting Ratios

Financial statements, ie final accounts and Balance Sheet are prepared to provide information to
interested parties such as the owners, creditors, employees, bankers etc. However, information presented
in absolute numbers in isolation is meaningless and not useful unless it is compared and related to other
figures. Hence, each component in the financial statements has to be analysed and interpreted.

To analyse means to separate or to break down things into different elements or components so that a
relationship can be established.

To interpret is to explain the meaning of these components in a simpler term so that it is easily
understood.

Analysis of final accounts involves the computation of ratios and percentages.

Importance of Analysis and Interpretation:

1. Items in the financial statements can be related to one another.

2. Performance of the business can be compared between years and between firms.
3. Helps to identify the weaknesses of the management.
4. Helps investors to assess their investments.
5. Helps creditors to evaluate the credit worthiness of the firm.

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from
an enterprise’s financial statements. Often used in accounting, there are many standard ratios used to try to
evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used
by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s
creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various
companies.
Financial ratios quantify many aspects of a business and are an integral part of the financial statement
analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio
measures.
Financial ratios allow for comparisons:
-between companies
-between industries
-between different time periods for one company
-between a single company and its industry average
Ratios generally hold no meaning unless they are benchmarked against something else, like past
performance or another company. Thus, the ratios of firms in different industries, which face different
risks, capital requirements, and competition, are usually hard to compare.
Profitability ratios

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Profitability ratios measure the earning ability of the business. The ratios are calculated based on items
from the Income Statement ( T&P&L).

1. Mark up:

It indicates the amount of gross profit to be added to the cost of goods sold in order to determine the
selling price.

Formula:

Eg.

It indicates that..............................................................................................................................

..........................................................................................................................................................

..........................................................................................................................................................

..........................................................................................................................................................

2. Gross Profit Margin:

It indicates the gross profit earned for each dollar of sales.

Formula:

Eg.

It indicates that................................................................................................................... .........

..........................................................................................................................................................

..........................................................................................................................................................

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 3. Rate of Stockturnover/ Rate of Turnover:
This refers to the number of times the average stock is replaced or sold in an accounting period.

A low rate of turnover indicates excessive stock is held by the business, slow moving stock or a longer
time taken to sell the stock.

A high rate of turnover indicates a satisfactory level of stock held, fast moving stock or a shorter time
needed to sell the stock.

Formula:

Eg.

It indicates that......................................................................................................
............................................................................................................................. ......................................................
............................................................................................................................. ......................................................
......................................................................................................................................

The Average stock is calculated as ( opening stock + closing stock ) ÷ 2

4. Percentage of Net Profit to Turnover/ Net Profit as a Percentage of Turnover.

It shows how many cents of profits is earned for each dollar of sales.

Formula:

Eg.

It means for…………………………………………………………………………………………………………………

……………………………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………

5. Expenses as a Percentage of Turnover/Percentage of Expenses to Turnover.

It shows the amount of expenses incurred for each dollar of sales.

Formula:

Eg.

3
It indicates that………………………………………………………………………………………………………….

……………………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………

LIQUIDITY RATIOS:

This ratio measures the business’ ability to pay its debts when they fall due. The figures from the Balance
Sheet are used for these ratios.

1. Owners’ Equity:

Owner’s equity or capital is the difference between the total assets and total liabilities of the business. It is
the net worth of the business. It can be obtained in two (2) ways:

a).

b).

Profit and additional capital…………………………………. Owner’s equity.

Loss and drawings ……………………………………………….. Owner’s equity.

2. Capital employed:

Capital employed is basically the effective capital that is being used in the business. The average of the
capital account for the year i.e. (opening capital + closing capital) ÷ 2 may be used as capital employed.

3. Rate of Return on Capital Employed(ROCE)

The ROCE shows the relationship between the net profit earned and the capital at the beginning of the
year. It measures the net profit earned for each dollar invested.

Formula:

Eg.

It indicates that.........................................................................................................................................

4
............................................................................................................................. ......................................................
............................................................................................................................. ......................................................

4. Working Capital Ratio/ Current Ratio:

It measures the ability of the business to pay its debts when they fall due.

Formula:

Eg.

It indicates that......................................................................................................................................................

............................................................................................................................. ......................................................

...................................................................................................................................................................................

The ideal ratio is 2:1. A current ratio that is too high indicates that the resources of a
business are tied up in stock, debtors and cash that lie idle in the bank instead of
putting them into more productive use.

5. Quick Ratio or Liquid Ratio or Acid- Test Ratio.

It measures the ability of the business to pay its debts when they fall due without selling its stock.

Quick or liquid assets are those current assets that are in the form of cash and those that can be converted
into cash within a very short period. They do not include stock.

A business is said to be ‘liquid’ when it is able to pay its debts on time. It is equally important that the
business collect from debtors their outstanding amounts on time.

Formula:

Eg.

It shows that................................................................................................................ ............................

5
............................................................................................................................. ......................................................

...................................................................................................................................................................................

6. Debtors to Sales ratio:

This ratio assesses how long it takes for debtors to pay what they owe.

Formula:

Eg.

……………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………………………………………………………

…………………………………………………………………………………………………………………………………………..

7. Creditors to purchases ratio:

This ratio shows how long it takes a business (on average) to pay its suppliers.

Formula:

Eg.

……………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………………………………………………………