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Ratios
Ratio analysis is a method of evaluating the financial information presented in accounts
There are six main types of ratios: profitability, liquidity, efficiency, gearing, investment and cash flow.
Profitability ratios
These ratios seek to establish how profitable a business is. The profitability ratios are: Return on capital
employed, gross profit ratio and net profit ratio.
Efficiency ratios
These ratios look at how effectively a business is operating they are primarily concerned with the
efficient use of assets. The main efficiency ratios are debtor’s collection period, creditors collection
period, stock turnover and asset turnover
Liquidity ratios
Liquidity ratios are derived from the balance sheet and seek to test how easily a firm can pay its debts.
Loan creditors such as bankers who have loaned money to the business are particularly interested in
these ratios. The liquidity ratios are current ratio and acid test or quick ratio.
Gearing ratios
Gearing ratios are also derived from the balance sheet. Gearing effectively represent the relationship
between ordinary shareholders ‘funds and the debt capital of a company.
Limitations of ratios
Ratios must be used in contest this means that they should be used to compare businesses that are
similar
Ratios must be calculated on a consistent and comparable basis and international comparisons must be
made with care
Ratio analysis
Three reasons why ratios are important
They provide a quick and easily digestible snapshot of an organization’s performance
Ratios provide a good yardstick by which it is possible to compare one company with another or
compare the same company over time.
Ratio analysis takes account of size. One company may make more absolute profit than another, if size is
taken into account the company might not be performing well.

Interpretation of Accounts: Ratio Analysis

Accounting ratios are calculated by expressing one figure as a ratio or percentage of another with the
objective of disclosing significant relationship and trends that are not immediately evident from the
examination of individual balances appearing in the accounts.
Commonly used ratios
Profitability ratios
a) Return on capital employed (ROCE) =Net profit × 100
Capital employed( equity and loan)

or ROCE = Net Profit

Net Assets
This ratio considers how effectively a company uses its capital employed. Capital employed covers
ordinary share capital plus reserves plus long term loan. The calculated figure indicates the return which
the business earns on the capital.
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b) Gross Profit Ratio = Gross Profit × 100

Sales
c) Net profit ratio = Net profit × 100
Sales
Liquidity Ratios
The two main measures of liquidity are the current ratio and acid test ratio
a) Current Ratio = Current assets
Current liabilities
This ratio compares assets which will become liquid within 12 months with liabilities which will be due
for payment in the same period.

b) Acid test or (quick assets) ratio = Current assets – Inventory

Current liabilities
The ratio measures liquidity of the business without having to sell the stock as stock might take a while
to sell.
Current ratios tries to find out whether there are enough current assets to cover current liabilities
Efficiency Ratios
Efficiency ratios look at how effectively a business is operating. They are primarily concerned with the
effective use of assets.

a) Stock Turnover ratio = cost of sales

Average stock

Or average stock× 365 days

sales
This ratio measures the speed with which stock move through the business

b) Debtors Collection Period = trade receivables

Credit sales

Or Average receivables × 365

Credit sales
Measures how long customers take to pay debts. The shorter the period the better for the company

c) Creditors collection/Payment period = Average Trade payables × 365

Credit purchases
Measures how long a business take to pay creditors. The longer the period, the longer the business has
money in the bank.
d) Asset turnover ratio = Sale
Total assets
The ratio compares sales to total assets.
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Question 1 ( 30 marks)
The following financial statements are for Maru Store for the year ended 31 December 2019.

Income statement for the period ended 31 December 2019

Pula Pula

Sales 500 000

Opening stock 25 000

Purchases 305 000

330 000

Less closing stock 30 000

Cost of sales 300 000

Gross profit 200 000

Operating cost (60 000)

Finance cost (24 000)

Profit before tax 116 000

Taxation 0

Profit for the year 116 000

Retained profit b/f 160 000

Retained profit c/d 276 000

Maru Store Statement of financial position (balance sheet) as at 31 December 2019

Pula Pula

Property plant and equipment 540 000

Current assets

Inventory 25 000

Receivables 62 500
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Bank 12 000 99 500

Total assets 639 500

Share capital and liabilities

Share capital 125 625

Retained profits 256 000

381 625

Non- current liabilities

Debentures 200 000

Current liabilities

Payables 37 875

Proposed dividends 20 000 57 875

Total capital and liabilities 639 500

A) Required to calculate the following ratios:

a) Gross profit ratio
b) Net profit ratio
c) Current ratio
d) Acid test ratio
e) Credit collection period (days)
f) Stock turnover
g) Debtors/Trade receivables collection period
h) Return on capital employed
i) Debt Ratio

(2 marks each)

B)

a. The industry current ratio is 3 and acid test ratio is 2. How does this company compare
with the industry in terms of liquidity? (4 marks)

b. Comment on the trade payable and trade receivable period of this company with the
industry trade payable of 30 days. (4 marks)
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c) What does the acid test ratio measure? (4 marks)

Question 2

The income statement and balance sheet for Rama Ltd for the year ended 31 March 2007 are given
below
Income statement for the year ended 31 March 2007
Pula
Revenue 551 000
Cost of sales (379 100)
Gross profit 171 900
Distribution expenses (27 000)
Administration expenses (63 000)
Profit from operation 81 900
Finance charge (6 500)
Profit before tax 75 400
Tax (7 540)
Profit for the year 67 860

Balance sheet as at 31 March 2007

Pula
Assets:
Non-current assets:
Property, plant and 661 500
Equipment
Current assets:
Inventory 72 000
Trade receivables 49 400
Bank balance 5 000
Total current assets 126 400
Total assets 787 900
Equity and liabilities
Share capital and reserve
Share Capital 320 000
Share premium 120 000
General reserve 200 860
640 860
Non-current liability 65 000
Current liabilities
Trade payables 36 000
Taxation 7 540
Dividends 32 000
Interest on borrowings 6 500
Total current liabilities 82 040
Total equity and liabilities 787 900
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Calculate the following ratios: Current ratio, acid test/ quick ratio, return on capital employed, stock
turnover, debtor days, debt ratio.

Question 2
The income statements of Bana Ltd and Tawana Ltd for the year ended 30 June 2006 are as follows:
Income statement for Bana Ltd Tawana Ltd
Pula Pula Pula Pula
Sales 325 000 208 000
Less cost of sales:
Opening stock 117 000 39 000
Purchases 273 000 156 000
390 000 195 000
Less closing stock 143 000 247 000 65 000 130 000
78 000 78 000
Less expenses 45 500 36 400
Net profit 32 500 41 600
Less appropriations::
General reserve 2 600 2 600
Dividend 25 000 27 600 20 000 22 600
Retained profit for the year 4 900 19 000

Balance sheet as at 30/6/06 Bana Ltd Tawana Ltd

Pula Pula Pula Pula
Fixed assets:
Plant and machinery at cost 26 000 6 500
Less accumulated depreciation 10 400 15 600 2 600 3 900
Motor vehicle 39 000 26 000
Less accumulated depreciation 15 600 23 400 9 100 16 900
39 000 20 800
Current assets
stock 143 000 65 000
debtors 81 250 26 000
Cash at bank 9 750 234 000 13 000 104 000
Total assets 273 000 124 800
Equity and liabilities
Share capital 130 000 65 000
Reserves 9 100 15 600
Profit and loss 16 900 23 400
156 000 104 000
Current Liabilities
Creditors 117 000 20 800
Total equity and liability 273 000 124 800
Calculate the following ratios for each of the two companies:
Gross profit, net profit, return on capital employed, Expenses as a percentage of sales, creditor’s
collection period, Stock turnover; Aid test ratio, current ratio; debtors collection period, debt ratio.
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Comment on the performance of the two companies.

Question 2 ( 30 marks)

1) Gross profit ratio = Gross profit × 100

Sales

200 000 ×100 = 40 %

500 000

2) Net profit ratio = Net profit×100

Sales

116 000× 100 =23%

500 000

3) Current ratio = Current assets

Current liabilities

99 500 = 1.7

57 875

4) Acid test ratio =current assets- stock

Current liabilities

(99 500- 25 000)= 1 .29

57 75
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5) Creditors collection period = average creditors × 365

Credit purchases

37 875 × 365 000 =45 days

305 000

6) Stock turnover= Cost of sales

Average stock

300 000 = 10.9 times

27 500

7) Debtors/Trade receivables collection period = Average Trade receivables × 365

Sales
62 500 × 365 days = 46 days
500 000

8) Return on capital employed = Net profit× 100

Capital employed

116 000 × 100 × = 30 4 %

381 625

9) Debt ratio = total debt/total assets 257 875 ×100 = 40%

639 500
(2 marks each = 18)
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B)
a) The industry liquidity ratios are just a little higher than those of the company but this
should not be a course for concern because the company can still pay its debts when
they fall due if it maintains the same position in future. ( 4marks)

b. The payables collection period for the company is a little bit higher than that of the industry.
this should be a concern to management that they are not paying their debts as quickly
as their counterparts in the industry and might damage their reputation as bad payers.

( 4 marks)

b) Acid test ratio measures the ability of a business to pay its short term debts using its
current assets without having to rely on cash received from sale of inventory. Inventory
can take long from the time of sale to the time the money is received from such sale. If a
business relies heavily from raising money from inventory it might run into problems if
debtors do not pay on time. ( 4 marks)
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Question 2

1) Gross profit ratio = gross profit × 100

sales

200 000 ×100 = 40 %

500 000

2) Net profit ratio = net profit×100

Sales

116 000× 100 =23%

500 000

3) Current ratio = current assets

Current liabilities

99 500 = 1.7

57 875

4) acid test ratio =current assets- stock

Current liabilities

(99 500- 25 000)= 1 .29

57 75

5) Creditors collection period = average creditors × 365

Credit purchases
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37 875 × 365 000 =45 days

305 000

6) Stock turnover= Average stock × 365

Turnover

25 000 ×365 = 18 days

500 000

(2 marks each = 12)

The industry liquidity ratios are just a little higher than those of the company but this should not be a
course for concern because the company can still pay its debts when they fall due if it maintains the
same position in future. ( 3marks)