Subject: Principles of Accounts Title:Accounting Ratio and Interpretation of Accounts
Author : Fok Pui Yan Student No: 98114640
Target Audience : Form 5 students Purposes of using the slides : for lecturing
Content1.Introduction 2. Profitability ratios-- Gross Profit Margin -- Net Profit Margin -- Return on Capital Employed3. Liquidity ratios-- Current Ratio -- Acid test Ratio4. Activity ratios-- Stock Turnover -- Credit Period Allowed to Debtors -- Credit Period Received from Creditors
Accounting Ratios AND The Interpretation Of Accounts The Evaluation Of Financial Performanceinvolves a series of techniques that can be used to help identify the strengths and weaknesses of a firm.
Financial Ratios:- • which use data from a firm’s balance sheet, income statement, and certain market data, often are used when evaluating the financial performance of a firm.
Financial Ratios measure how effectively a firm’s management generates profits. A. Profitability ratios indicate a firm’s ability to meet its short-term financial obligations. B. Liquidity ratios indicate how efficiently a firm is using its assets to generate sales C. Activity ratios
Content Profitability ratios • Profitability is the ability of an entity to earn profits. This ability to earn profits depends upon the effectiveness and efficiency of operations as well as resources available to the enterprise.
(I) Gross Profit Margin/Gross Profit to Sales Ratio • It shows how much gross profit has been made for every $100 of sales • Sales margins vary widely between different industries but tend to be similar within industries
Equation: **Gross Profit = Sales- Cost of Goods Sold **Cost of Goods Sold = (Opening Stock + Purchases - closing Stock)
(II) Net Profit Margin/Net Profit to Sales • It shows how much net profit has been made for every $100 of sales • It indicate the relative efficiency of the business after taking into account all revenues and expenses. • The difference between gross profit margin and net profit margin would indicate the efficiency of expenses control.
Equation: ** Net Profit = Gross Profit + Revenue -Expenses
(II) Return on Capital Employed (ROCE) / Return on Assets Employed • It is an important ratio and is often known as the primary ratio • It is a measure of the overall profitability of the business • It shows the percentage return on the capital invested in the business. It shows how much profit has been earned for every $100 invested
(II) Return on Capital Employed (ROCE) / Return on Assets Employed • It indicates how efficiently management is using the business resources to earn profits • There is a variety of methods used to calculate ROCE. It is important, in order that the results can be used for comparative purposes, that the same method of calculation is used over time or when comparing the results of different businesses.
Equation: I. For Sole Proprietorship and Partnerships Company ** Average Capital = (Opening Capital + Closing Capital)/2
Equation: II. For Limited Company ** Total Share Capital = (Ordinary Shares + Preference shares + Reserves)
Content Liquidity ratios • These are the ratios which can help to assess the ability of a firm to meet its current liabilities.
(I) Current Ratio / Working Capital Ratio • This ratio indicates the ability of a business to meet its short-term liabilities out of its current assets • The The idea behind the current ratio is that a company should have enough current assets to generate sufficient cash to meet its future commitments and pay off its current liabilities. A Ratio of 2 is the norm for most companies.
(I) Current Ratio / Working Capital Ratio • If the ratio is too high (e.g. 5:1), the company may be holding too many idle short-term assets. (e.g. debtors and stocks that earn little or no income) • If the ratio is too low (e.g. 0.5:1, which is less than 1), it may indicate that the company may face liquidity problems and may not able to meet its debts when they fall due.
(II) Acid Test Ratio / Quick Ratio / Liquidity Ratio • This ratio indicates the ability of a business to meet its short-term liabilities out of its quick assets. Quick assets can be converted into cash quickly. They consist of all the current assets except "STOCK”. • The rule of thumb for the Quick Ratio is 1:1
(I) Current Ratio / Working Capital Ratio • If the ratio is too high, the company may be holding excessive liquid assets. • If the ratio is too low, the company may have a liquidity problem.
Content Activity ratios • These are the ratios which can help to assess the management efficiency of a company.
(I) Stock Turnover Ratio • This ratio shows the number of time the average stock is being sold in a period. This measures the efficiency of the sales and stock levels of a company. • A high ratio means high sales, fast stock turnover and a low stock level. • A low stock turnover ratio means the business is slowing down or with a high stock level. On the other hand, it may involve more storage expenses and stock insurance.
(I) Stock Turnover Ratio • Differences across stocks, companies, and industries are too great to allow a general statement as to what is a good stock turnover. For example, a firm selling food should have a higher turnover than a firm selling furniture or jewelry. However for each business or each department within a business, there is a reasonable turnover rate. A turnover lower than this rate could mean that stock is not being managed properly. In such cases, an investigation should be undertaken to determine the causes of the lower turnover rate.
Equation: ** Cost of goods sold = (Opening stock + Purchases - Closing Stock) **Average Stock = (Opening stock + Closing Stock)/2
(I) Credit Periods Allowed to Debtors • This ratio is used to appraise the company performance in its debt collection ability. • It is a rough measure of the average length of time it takes for a company to collect trade debts from debtors.
(I) Credit Periods Allowed to Debtors • The shorter the collection period the better. • If debtor days are increasing year on year, this is indicative of a poorly managed credit control function. The longer a debt is owed, the more likely it will become bad debts.
Equation: OR OR
(III) Credit Period Received from Creditors • This ratio shows how long it takes a firm on average to pay its creditors. • Within reason, where cash discounts are not offered, it is better to extent the settlement period for as long as possible. In this way, the business benefits from the cheapest form of finance.
(III) Credit Period Received from Creditors • Most of the companies want to obtain a long credit period from their creditors because their creditors would not charge them interest during the credit period. • (Its seems the longer the period, the better.) But you should bear in mind that the company needs to keep good relations with its suppliers or otherwise, suppliers may refuse to supply again.
Equation: OR OR
When evaluating a firm's performance based on its balance sheet, income statement, and a series of financial ratios, a good financial analyst must be aware of the accounting techniques used by the firm and mindful of the quality of the firm's earnings and its balance sheet. -END-