Accounting Ratios

Introduction
There are a number of ratios used to analyse and interpret the performance of a business. They are valuable means of comparing the performance of your business. These ratios can be classified as trading account ratios, profit and loss ratios and balance sheet ratios. In this topic we will examine each of these ratios.

Objectives
Upon completion of this lesson you will be able to:
1. identify ratios that can be used to analyse the performance of your business;
2. calculate ratios based on the end of year financial statements;
3. state the formulas to be used when calculating accounting ratios; and
4. calculate and analyse ratios on profitability, liquidity and efficiency to assess a business’s performance.

Interpretation of accounts
In order to assess the performance of business, financial information is recorded, classified and communicated to the different users of accounting information. The financial information can be evaluated by the use of accounting ratios. Ratios provide a valuable means of comparing the performance of a business

• From one year to the next
• With other similar businesses

They enable changes in important aspects of a business’s performance to be pinpointed and quantified. If ratios are calculated every year, it is possible to see whether any significant trends are becoming apparent. (David, A., et al 2011)
An important factor in a business is to ensure that it operates at a profit and that it can pay its creditors and expenses when they become due. The ability for a business to pay its debts when they become due is known as liquidity and the ability to make a profit is known as profitability.

We will have a look at the profitability and liquidity ratios and which part of the financial statement should be used to calculate these ratios.

Trading Account Ratios
Accounting ratios that uses the information from your trading account can be classified as trading account ratios. These ratios are
1. Margin which is gross profit is shown as a percentage of selling price

Gross Profit x 100
Selling Price

2. Mark-up is gross profit shown as a percentage of cost price

Gross Profit x 100
Cost Price

3. Rate of stock turnover or stock turn measures quickly a business sells its goods without losing its profitability.

Cost of goods sold = stock turnover
Average stock

Average stock =	Opening stock + Closing Stock
	2

4. Gross profit as percentage of sales this measures the amount of gross profit from ever $100 of sales

Gross Profit x 100
Sales

The gross profit as a percentage of sales and rate of stock turnover ratios are ratios that measures the profitability of a business.

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Example 4.1

A business’s trading account include the following information
Trading Account
For the year ended 31 December 2010
	$	$
Sales		240,000
Opening Stock	16,000
Add Purchases	178,000
	194000
Less Closing Stock	14,000	180,000
Gross Profit		60,000

Margin	Gross Profit x 100 Selling Price	60,000 x 100 240,000	25%
Mark-up	Gross Profit x 100 Cost Price	60,000 x 100 180,000	33 1/3 %
Rate of Stock Turnover	Cost of goods sold  Average stock	180,000 15,000	12 times
Gross Profit as a percentage of Sales	Gross Profit x 100 Sales	60,000 240,000	25 %

Profit and Loss Account Ratios
Accounting ratios classified as profit and loss account ratios are

1. Net profit as a percentage of sales this shows how much net profit has been made for every $100 of sales.

Net Profit x 100
Sales

This ratio takes into account the expenses incurred and shows the amount of profit remaining. Changes in this ratio can be linked to

• Changes in the gross profit/sales percentage
• Changes in the expenses.

2. Expenses to sales ratio

Expenses x 100
Sale

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Example 4.2

A business’s total sales for the year ended 31 December 2010 was $400,000. Its Profit and Loss included the following information.

	$	$
Gross Profit		140,000
General expenses	24,000
Wages	82,000	106,000
Profit		34,000

Net Profit as Percentage of sales	Net Profit x 100 Sales	34,000 x 100 400,000	8.5%
Expenses as Percentage of Sales	Expenses x 100 Sales	106,000 x 100 400,000	26.5%

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Balance Sheet Ratios
Manager uses different information to determine the performance of the business. The ratios that analyse the balance sheet are
1. Current ratio





This shows the relationship between the current assets and the current liabilities. It determines the amount of money the business has to pay its debts as they become due. The ability of a business to pay its debts when they become due is called liquidity. The business will have liquidity problems if this ratio is below 2:1.

2. Acid Test Ratio


The acid test ratio also measures the liquidity of a business since it measures the amount of liquid assets it has to pay its current liabilities

3. Return on Capital Employed


This ratio compares the amount of profit made in relation to the amount of money invested into the business.

4. Debtors Ratio


The debtor’s ratio measures how long the debtors take to pay what they owe to the business.

5. Creditors Ratio


This measures how long it takes the business to pay the debts owed to its suppliers within a year.

J. Richardson Retail Store Balance Sheet as at 31 December 2011 is as follows:
J. Richardson Retail Store
Balance Sheet
As at 31 December 2011
Fixed Assets	$	$
Equipment at cost	10,000
Less Depreciation to date	8,000	2,000
Current Assets
Stock	1,500
Debtors	2,5000
Bank	5,000
	45,000
Less Current Liabilities
Creditors	5,000	40,000
		42,000
Financed by:
Capital		38,000
Add Net Profit		10,000
		48,000
Less Drawings		6,000
		42,000
The following information is also available
Sales $80,000
Purchases $50,000
Net Profit $10,000

Current ratio	Current Assets Current liabilities	45,000 5,000	9:1
Acid Test Ratio	Current Assets – Stock Current Liabilities	30,000 5,000	6:1
Return on Capital Employed	_Profit x 100 Capital Invested	10,000 x 100 (38,000 + 42,000)÷2	25%
Debtors Ratio	Debtors x 12 Sales	25,000 x 12 80,000	3.75 months
Creditors Ratio	Creditors x 12  Purchases	5,000__ x 12 50,000	1.2 months

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Topic Summary
You have completed the examination of your financial records with the use of accounting ratios. You would have learnt that ratios shows and identifies different performances of your business. You can now compare how your business performs from one period to the next and with similar businesses. They inform you and guide you to make necessary changes to improve your business performance.