Accounting Ratios
S4 Accounting
RATIO ANALYSIS
Ratio analysis is the process of determining and
interpreting numerical relationship based on
financial statements. It is the technique of
interpretation of financial statements with the help
of accounting ratios derived from the balance
sheet and profit and loss account.
Basis Of Comparision
Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance – improvement, deterioration
or constancy – over the years.
Interfirm Comparison involves comparing the ratios of a
firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firm’s
performance in relation to its competitors.
Comparison with standards or industry average
Ways To Interpret Accounting
Ratios
Single absolute ratio.
Group ratio.
Historical comparision.
Inter-firm comparision.
Projected ratios.
Profitability Ratios
These ratios are calculated
using the Profit & Loss:
Gross Profit as a Percentage of Net Sales
Net Profit as a Percentage of Net Sales
Rate of Stock Turnover
Gross Profit as a Percentage of Net Sales
The GP Percentage is used to calculate
what the gross profit is in relation to the
sales of a business.
The GP Percentage on turnover is
calculated using the formula:
Gross Profit x 100
Net Sales
(Remember sales - sales returns = net
sales).
Reasons for gross profit DECREASE?
Cash losses: theft or wrong amounts being
rung up on the till.
Stock losses: theft of stock by employees
or passing of stock to friends.
Expenses: Utilities can increase such as
gas and electricity prices.
Mark downs: Reductions in selling price.
Damaged or almost out of date goods.
Gross profit to INCREASE.
The gross profit can
increase. A rise in the
gross profit percentage is
almost always due to
increased efficiency.
Rate of Stock Turnover
The Rate of Stock Turnover is very
important. When a company turns over
stock - profit is made.
Stock has turned over when it has been
sold and replaced with new stock.
The higher a company turns over stock the
greater the profits should be.
Stock Turnover is always expressed as a
number followed by the word times.
If your Rate of Stock Turnover is 4 times
then the company would have turned the
stock over every 3 months.
We calculate the Rate of Stock Turnover
with the following formula:
Cost of Goods Sold
Average Stock *
* To calculate Average Stock
Opening Stock + Closing Stock
Net Profit as a Percentage of Net Sales
The Net Profit Percentage indicates how
well a business has controlled their
overheads.
The Net Profit is calculated by deducting
the total expenses from the gross profit.
We calculate the Net Profit Percentage of
Net Sales with the following formula:
Net Profit x 100
Turnover
If there is little difference
between the gross and net
profit percentages this
indicates that the business
has been able to control its
overheads efficiently.
Balance Sheet Ratios
Return on Capital Invested
Working (Current) Capital Ratio
Return on Capital Invested
The most important ratio calculated by the
owner of a business.
Return on Capital Invested compares
profit earned in the year with the capital
invested in the business.
A good Return on Capital is essential to
any business.
Poor returns on capital should make the
owners or partners think whether
continuing with the business is a good
idea.
To calculate the Return on Capital
Invested we use the formula:
Net Profit
x 100
Capital at Start
Working (Current) Capital Ratio
The Working Capital Ratio or Current
Ratio focuses on the relationship between
a businesses current assets and current
liabilities.
The formula to calculate this ratio is:
Current Assets
Current Liabilities
A business must never run short of
working capital.
This is a very popular cause for business
failures.
If a business has a ratio of less than 1:1
then in effect it is insolvent.
Low ratio indicates a lack of working
capital.
High ratio indicated there may be too
much working capital. Too much money
tied up in stock or other assets.
Price Earning Ratio
It shows how many times the annual earnings the
present shareholders are willing to pay to get a share.
This ratio helps investors to know the effect of earnings
per share on the market price of the share. This ratio
when calculated for several years can be used as term
analysis for predicting future price earning ratios and
therefore, future stock prices.
Average market price per share
Price earning ratio=
Earning per share
Earning Per Share
This ratio indicates the earning per equity share. It
establishes the relationship between net profit available
for equity shareholders and the number of equity shares.
Net profit available for equity share holders
Earning per share =
Number of equity shares