Chapter 10
Introduction to
Ratio Analysis
Introduction
A major purpose of accounting is to provide
useful information to make informed
decisions. One way to assist with this is to
examine financial ratios. A financial ratio
matches two or more pieces of monetary data
and presents them in the form of a
percentage, proportion, or in relation to a
period of time (e.g. per month, per quarter,
per year).
Profitability Ratios
These measure the firm’s potential to obtain
and maintain revenues that exceed
expenses.
Examples include:
–
–
–
–
Gross mark-up
Gross margin
Net profit margin
Return on capital employed
Liquidity Ratios
These measure the firm’s ability to meet its
short term debts as they arise.
Examples include:
–
–
–
–
–
Current ratio
Acid-Test ratio
Debtors’ turnover
Creditors’ turnover
Rate of stockturn
Stock Turnover
(Turnover) Ratio
Cost of sales ÷ Average stock,
where Average stock=
(Opening stock + Closing stock) ÷ 2
Measures the speed at which merchandise is
sold. It may be shown in “times” or “days”.
Current
(Working Capital) Ratio
Current assets ÷ Current liabilities
A test of the ability to pay short term debts as
they arise.
Acid-test (Quick) Ratio
Current assets (less closing stock) ÷ Current
liabilities
A better test of the ability to pay short term
debts as they arise.
Debtors’ Turnover Ratio
Closing debtors (before provision for bad
debts) ÷ Net sales
Demonstrates how quickly money has been
received from debtors.
Creditors’ Turnover Ratio
Closing creditors ÷ Net purchases
The speed at which creditors are being paid the
amount owed to them.
Gross Margin Ratio
Gross profit ÷ Net sales
The value of gross profit being earned from
every dollar of sales.
Gross Mark-up Ratio
Gross profit ÷ Cost of sales
The value of gross profit being generated from
every dollar spent on getting the items in a
state suitable for sales.
Net Profit Ratio
Net profit (before interest and tax) ÷Net sales
x 100
The value of net profit being earned from every
dollar of sales.
Return On
Capital Employed (ROCE)
Net profit (before interest and tax) ÷ Capital
employed x 100
For an unincorporated business, the capital
employed = (Opening Capital + Closing
Capital)÷2
This percentage is the overall test of
management's ability to efficiently utilise its
scarce resources.