Calculation, Understanding and Interpretation of Accounting Ratios | O Level Accounting 7707 & IGCSE Accounting 0452 | Detailed Free Notes To Score An A Star (A*)

Main Ratios

• Margin
  • The word margin means that you are taking something as a percentage of net sales.
    • Remember, it’s net sales, which means sales – sales returns.
  • If we simply say margin, then we assume it to be gross margin.
    • Gross margin = gross profit/ sales *100
    • Important information
      • Gross margin shows what percentage of the sales was the gross profit.
      • Gross margin (i.e. the percentage) will NOT increase by increasing selling more.
        • Simply because per unit sold, the percentage converted to gross profit after removing the cost will remain the same.
      • Therefore, gross margin can only be increased in two main ways.
        • Either increase the sales price while keeping the cost constant.
        • Or reduce the cost per product while keeping the sale price constant.
        • Or there is an increase in both sale price and cost, but percentage increase in sale price is higher than percentage increase in cost.
        • Or sale price increases and cost price decreases at the same time.
  • Margin tells us exactly what part of the sale is being converted to gross profit after the DIRECT expenses are taken out.
• Profit Margin
  • Also called the net profit margin
  • Net profit margin = Sales/ Net Profit *100
  • In other words, what percentage of sales revenue converted to net income after both direct and indirect (operative expenses) have been removed.
    • If the net income margin has increased since the last period, but the gross profit is the same, it means that the percentage of operative expenses have fallen over the two periods.
    • If gross profit margin has increased over two periods but net profit margin is the same, it means percentage of operative expenses has remained the same, but direct expenses have fallen i.e. cost of goods sold has fallen.
    • Net profit margin is always less than gross profit margin because operative expenses have been taken out.
• Return on Capital Employed
  • Net Profit/ (Owner’s Equity + Long-Term Liabilities) *100
  • It tells us how much return or profit is being generated, in percentage of the total
  • Without a return on capital employed, the business can not survive in the long-term
• Current Ratio
  • In simple terms, a business needs to meet its short-term liabilities. Most new businesses fail because they aren’t able to manage their current liabilities.
  • The current ratio tells us the ratio between current assets and current liabilities. Given that both have a period of up to one year, it gives an idea of a business’s ability to meet its short-term obligations.
  • Current assets/ current liabilities.
  • It is also called working capital ratio.
  • Working capital  = current assets- current liabilities.
  • If the ratio is around 2.1:1, it is the yardstick level, which means it the right ratio for the business to maintain
    • A ratio lower than this means that the business may face difficulties in meeting its short-term liabilities. It means either the business is not generating enough cash, or is making too much investments with little liquidity.
      • Liquidity means a business’s ability to meet its short-term obligations.
    • A ratio higher than this means that the business is hoarding too much cash that it can use instead to pay its liabilities that can help lower its interest expense, or invest somewhere to generate more income.
• Liquid (Acid Test) Or Quick Ratio
  • The ratio is used to determine the ratio between the liquid current assets and current liabilities of the business.
  • For this calculation, we remove inventory from the calculations because it is comparatively illiquid and harder to convert to cash
  • The formulae becomes (current assets – inventory)/ current liabilities
  • Here, we get a better determination of how liquid the business is.
  • The yardstick level for this ratio is around 1.5:1 or even 1:1 is fine in this case.
  • The same goes for higher or lower levels as in current ratio.
  • If the current ratio is very high compared to the liquid ratio, it means a lot of the business’s current assets are piled in inventory, which is relatively illiquid.
• Rate of Inventory Turnover (Times)
  • Inventory turnover means that number of times the inventory was completely sold and then bought in during a particular period.
  • Turnover means one complete cycle of complete purchase and sales.
  • The formulae is (Cost of Goods Sold)/((Opening +Closing Inventory)/2)
  • We can find it in the number of days by dividing the 365/the answer of the above formula
  • It tells us how often inventory needs to be replenished, which means planning can be done accordingly.
  • If the inventory doesn’t turnover quickly, there are chances it can get stolen, damaged, increases the warehousing and storage costs and means that much is not being sold. Therefore, the business needs to determine what the cause is.
    • Sometimes, the cause can be as simple as excessive stock being bought when the demand of the product is not as high.
    • In such cases, less inventory should be bought to allow more cash being available instead of being blocked in a relatively illiquid asset.
  • Usually, a higher inventory ratio and lower inventory days suggest that the business is more efficient.
  • Some industries may naturally have a lower inventory ratio as well.
• Trade Receivables Turnover and Trade Payables Turnover
  • Trade receivables turnover is the number of days, approximately, that debtors take to pay money to your business.
  • Trade payables turnover is the number of days approximately that your business takes to pay the creditors.
  • Trade Receivables Turnover = Trade Receivables/ Credit Sales *365
  • Trade Payables Turnover = Trade Payables / Credit Purchases * 365
  • If the trade payables turnover is lower number of days compared to trade receivables turnover, then the business may face issues in paying its creditors because, on average, creditors will be demanding payments from the business earlier compared to debtors paying the business itself.