Calculation And Understanding of Accounting Ratios (Copy)

Understanding the Role of Accounting Ratios

• Accounting ratios are tools used to assess a business’s financial performance and position.
• They allow comparisons over time, between businesses, or against industry averages.
• Ratios help in decision-making by stakeholders such as owners, investors, managers, banks, and creditors.
• Ratios are classified into:
  • Profitability ratios – assess the ability to generate profit.
  • Liquidity ratios – assess the ability to meet short-term debts.
  • Efficiency ratios – assess how effectively resources are managed.

Profitability Ratios

Gross Margin (Gross Profit Margin)

• Formula:
  Gross Margin = (Gross Profit ÷ Revenue) × 100
• Meaning:
  • Measures how much gross profit is made for every dollar of revenue.
  • Indicates how well the business manages its cost of sales.
• Example:
  Revenue = 80,000
  Cost of Sales = 50,000
  Gross Profit = 80,000 − 50,000 = 30,000
  Gross Margin = (30,000 ÷ 80,000) × 100 = 37.5%
• Interpretation:
  • A higher gross margin means better control over direct costs.
  • A low margin may suggest high purchase prices or low selling prices.

Profit Margin (Net Profit Margin or Profit for the Year Margin)

• Formula:
  Profit Margin = (Profit for the Year ÷ Revenue) × 100
• Meaning:
  • Measures the percentage of revenue that remains as final profit after all expenses.
  • Reflects overall profitability including indirect expenses.
• Example:
  Revenue = 90,000
  Profit for the Year = 12,000
  Profit Margin = (12,000 ÷ 90,000) × 100 = 13.33%
• Interpretation:
  • Higher margins indicate efficient cost management.
  • Falling margins may indicate rising operating or finance costs.

Return on Capital Employed (ROCE)

• Formula:
  ROCE = (Profit from Operations ÷ Capital Employed) × 100
• Where:
  Capital Employed = Total Assets − Current Liabilities
  or
  Capital Employed = Owner’s Capital + Non-current Liabilities
• Meaning:
  • Measures how effectively a business uses its capital to generate profit.
  • Reflects overall business efficiency.
• Example:
  Operating Profit = 25,000
  Capital Employed = 100,000
  ROCE = (25,000 ÷ 100,000) × 100 = 25%
• Interpretation:
  • Higher ROCE indicates better use of capital resources.
  • Compared with interest rates or return on other investments.

Liquidity Ratios

Current Ratio

• Formula:
  Current Ratio = Current Assets ÷ Current Liabilities
• Meaning:
  • Shows whether the business can pay short-term debts using current assets.
  • Ideal range is generally between 1.5 and 2.0.
• Example:
  Current Assets = 30,000
  Current Liabilities = 15,000
  Current Ratio = 30,000 ÷ 15,000 = 2.0
• Interpretation:
  • Below 1.0: risk of liquidity problems.
  • Above 2.0: may indicate excess inventory or inefficient use of resources.

Liquid Ratio (Acid Test Ratio)

• Formula:
  Liquid Ratio = (Current Assets − Inventory) ÷ Current Liabilities
• Meaning:
  • Measures the ability to pay short-term liabilities without relying on inventory.
  • Stricter test of liquidity than current ratio.
• Example:
  Current Assets = 40,000
  Inventory = 10,000
  Current Liabilities = 20,000
  Liquid Ratio = (40,000 − 10,000) ÷ 20,000 = 1.5
• Interpretation:
  • Ratio below 1.0 indicates potential cash flow problems.
  • Higher ratios are safer but may show underutilized resources.

Efficiency Ratios

Rate of Inventory Turnover (Times)

• Formula:
  Inventory Turnover = Cost of Sales ÷ Average Inventory
• Meaning:
  • Indicates how many times inventory is sold and replaced during the year.
  • Measures stock management efficiency.
• Average Inventory Formula:
  Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2
• Example:
  Cost of Sales = 100,000
  Opening Inventory = 12,000
  Closing Inventory = 8,000
  Average Inventory = (12,000 + 8,000) ÷ 2 = 10,000
  Inventory Turnover = 100,000 ÷ 10,000 = 10 times
• Interpretation:
  • Higher turnover means efficient stock usage and fast sales.
  • Low turnover could mean overstocking or slow sales.

Trade Receivables Turnover (Days)

• Formula:
  Trade Receivables Turnover = (Trade Receivables ÷ Credit Sales) × 365
• Meaning:
  • Shows how long it takes customers to pay.
  • Indicates effectiveness of credit control.
• Example:
  Trade Receivables = 12,000
  Credit Sales = 72,000
  Receivables Turnover = (12,000 ÷ 72,000) × 365 = 60.83 days
• Interpretation:
  • Lower days = quicker collection = better liquidity.
  • Longer days = possible risk of bad debts or lenient credit policies.

Trade Payables Turnover (Days)

• Formula:
  Trade Payables Turnover = (Trade Payables ÷ Credit Purchases) × 365
• Meaning:
  • Indicates how long the business takes to pay its suppliers.
  • Reflects supplier relationship and cash flow.
• Example:
  Trade Payables = 15,000
  Credit Purchases = 90,000
  Payables Turnover = (15,000 ÷ 90,000) × 365 = 60.83 days
• Interpretation:
  • Higher days may improve liquidity but strain supplier relations.
  • Very low days may suggest lack of credit terms or over-reliance on cash purchases.

Cross-Analysis of Ratios

• Always use multiple ratios together rather than in isolation.
• For example:
  • Compare gross margin and profit margin to analyze expense control.
  • Combine current ratio with liquid ratio to assess actual liquidity.
  • Use ROCE with inventory turnover to evaluate capital productivity.
• Year-on-year and industry comparison helps judge performance trends.

Common Uses of Ratios

• Owners/Managers: to assess profit trends, liquidity, and financial health.
• Banks: to evaluate loan repayment ability and liquidity before granting credit.
• Investors: to analyze profitability, risk, and return.
• Trade Payables: to assess how soon they will be paid.
• Auditors/Accountants: to detect unusual trends or errors.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course