Topic 5 –
Ratio
Analysis
ATAR Accounting Year 11 Unit 2
What is Ratio Analysis?
In Accounting and Finance, ratios provide a common base for comparison of information about
2 businesses or 1 business over a number of years.
By using ratios, we can compare and evaluate improvements or down turns in areas such as
profitability, liquidity and leverage.
Ratios are used by many internal and external users:
Management: check performance of the business and plan for future activities
Ratio Analysis
 Owners: see how well their investments have performed and to make decisions about
continuing and further investments
 Potential investors: compare businesses and decide where to invest their money
 Creditors, banks and lenders: evaluate risk of lending money by looking at profitability and
liquidity
 Employees: look at long-term viability of the business to advance their careers
PROFITABILITY
Refers to the earning capacity of the business during the period. If a business is profitable then it is generating a
reasonable return from its investment in assets and equities.
One of the main reasons for a business to prepare an Income Statement is to see what the profit or loss figure is for
the reporting period. Profitability requires a comparison between the profit figure and a base figure. These ratios
examine how profitable a business is as well as the reasons for any changes in the profitability.

TO ASSESS PROFITABILITY:
Management can compare its businesses results with industry averages
 Can compare actual figures to budgeted figures
 Can compare to previous years
MEASURES OF PROFITABILITY
We need to learn 4 ratios which measure profitability:
 profit
 gross profit
 expense
 rate of return on assets
Profit Ratio
Shows the percentage of profit that is contained in each $ of sales.
Profit Ratio = Profit
Net sales
One year’s profit ratio can be compared to previous years.
The higher the amount the better – negative result indicates a loss.

An increase in the profit ratio could be caused by:
 profit has risen in proportion to the total sales,
business is selling a greater portion of high-profit items, or high amount of income from a source other than sales
 cost of sales may have decreased, eg discounts
 a reduction in expenses
 expenses may have stayed fixed while income has increased for the period.

A decrease in the profit ratio could be caused by:
expense increases that are not being fully passed on to consumers in the form of increased selling prices or
increased competition causing the business to lower its prices.
 Profit earned decreases in proportion to total sales
 Selling a higher amount of low-profit items
 Cost of sales may have increased
 Fixed expenses are allocated over a lower income amount
Gross Profit Ratio
Shows the percentage of gross profit that is contained in each $ of sales.
Gross Profit = Gross Profit
Net Sales
One year’s gross profit ratio can be compared to previous years. Ideal amount is higher the better.
An increase in the current year’s ratio could be due to:
 an increase in the selling price of the inventory greater than any increase in the purchase price of the inventory
 the purchasing of inventory at a lower price
 cost of sales decreased due to lower freight cost
 method of valuing stock may have changed
 mark-up in selling price of stock
A decrease in the current year’s ratio could be due to:
 a decrease in the selling price of inventory due to;
o new competitors
o price war
o trying to increase market share by decreasing prices
 an increase in the purchase price of inventory greater than any increase in selling price
 cost of sales increased due to freight charges
 valuing of stock changed
 difference between the selling and purchasing price has decreased – lowered the sales price and cost have not
changed.
Expense Ratio
Compares the sales of a business to the total expenses.
Expense Ratio = Operating Expenses
Net Sales
One year’s expense ratio can be compare to previous years.
There is no ideal, preferably ratios should be as low as possible.
An increase in the current year’s ratio could be due to:
 expenses increasing in relation to sales
 the business has become less efficient in spending expenses
 an extraordinary expense has been incurred
A decrease in the current year’s ratio could be due to:
 expenses decreasing in relation to sales
the business has become more efficient and is spending more wisely
Rate of Return on Assets
Measures how efficiently the business uses assets to generate profit.
Rate of Return on Assets Ratio = Profit
Average Total Assets*
*(last year total assets + current year total assets)/2
One year’s rate of return on assets ratio can be compare to previous years.
A positive amount is ideal and the higher the better.
An increase in the rate of return on assets could be due to:
 the business using assets more efficiently to generate a better return
 money invested is being used more efficiently
A decrease in the rate of return on assets could be due to:
 the business using assets less efficiently, to generate a reduced return
needing to reduce the amount of invested assets to ensure they are not idle.
Page 6 Solutions
33 000
= 0.256
129 000
22 000
= 0.183
120 000
39 000
= 0.302
129 000
41 000
= 0.342
120 000
72 000
= 0.558
129 000
63 000
= 0.525
120 000
33 000
= 1.53
21 500
22 000
= 0.77
28 500
Average TA =
$20 000 + $23 000/2
Average TA =
$23 000 + $34 000/2
There is a decrease in the profit ratio which is a
negative, we want this ratio to be as high as
possible. This appears to be due to the
decrease in profit being a greater % than then
decrease in sales.
There is an increase in the expense ratio which
is a negative, we want to keep this ratio as low
as possible. This appears to be due to an
increase in expense and a decrease in sales.
There has been a decrease in the gross profit
ratio, for this ratio the higher the better. This
appears to be because COGS has not changed
yet sales have decreased.
There has been a decrease in the rate of return
on assets which is a negative. This can be due
to the business using assets less efficiently.
LIQUIDITY
Refers to the ability of a business to pay its debts as they fall due. Liquidity is used
to evaluate investment opportunities and indicate how financially stable a business
is. Liquidity ratios might also indicate that questions need to be asked about
business cash flows. The Statement of Financial Position is used as well as the
Cash Flow Statement to measure liquidity.
MEASURES OF LIQUIDITY:
We need to learn 2 ratios which help measure liquidity:
 Current ratio
 Quick Asset ratio
Working Capital or Current Ratio
Measure of the ability of a business to pay its short term debts (current liabilities).
Current Ratio = Current Assets
Current Liabilities
x 100
A current ratio of less than 100% indicates that a business may have difficulty paying its debts.
A current ratio of 100-200% indicates that a business should be able to pay its short term debts.
A current ratio of more than 200% indicates that a business should be able to pay its short term debts and has
extra current assets available.
An increase in the current year’s ratio could be due to:
 Short term asset base is increasing in proportion to short term liabilities
 Inventory might be sold slower
 Debtors taking longer to pay
 Idle cash which could be invested to earn interest of to purchase assets

A decrease in the current year’s ratio could be due to:
Short term asset base is decreasing in proportion to short term liabilities
 Inventory might be sold more quickly
Debtors may be paying more promptly
Quick Asset Ratio
Measures the ability of a business to pay its more urgently debts using only its more liquid of current
assets.
Quick Assets Ratio = Current Assets (exc. Inventory and Prepaid Expenses)
Current Liabilities (exc. Bank overdraft)
x 100
A quick asset ratio of less than 100% indicates that a business may have difficulty paying its debts in
an emergency.
A quick asset ratio of 100% or more indicates that a business should be able to pay its short-term
debts.
An increase in the current year’s ratio could be due to:
 Indicates the business might be able to immediately pay all short-term debts
 Debtors, short term investments or cash might have increased
 Creditors might have decreased
A decrease in the current year’s ratio could be due to:
 Indicates the business might not be able to immediately pay all short-term debts
 Debtors, short term investments or cash might have decreased
 Creditors might have increased
118 000
58 000
x 100
= 203.45%
116 000
47 000
x 100
In both years the current ratio is above 200%
which indicates that the business should be
able to pay its short term debts and has extra
assets available.
= 246.81%
52 000
x 100
54 000
42 000
x 100
45 000
= 96.3%
= 93.3%
The quick ratio is under 100% for both years
and is decreasing which indicates that the
business will have trouble paying its debts in
an emergency.
GEARING
Refers to the extent to which the business has borrowed money from outside sources as opposed to
investment by the owner.
Internal Financing – money supplied to the business by the owner, earned from trading or from selling
assets for cash. All within the business. Eg capital
External Financing – money supplied to the business by a loan provider who is paid interest, or trade
creditor who supplied products before being paid. All outside the business. Eg. a loan.
Leverage is the relationship between the debt and the equity of a business. If a business has high
leverage, there is a high level of borrowed external funds compared to internal equity. A low leverage
means that there is a low portion of external debt compared to internally generated equity.
MEASURES OF GEARING:
We need to 1 ratio which is a measure of the extent of gearing:
 Debt to Equity Ratio
Debt to Equity Ratio
Measures the gearing of a business.
Debt to Equity Ratio = Total Liabilities x 100
Equity (end)
Ratio of 100% is ideal as it indicates the business does not rely too heavily on external finance.
A business will usually prefer low leverage, because that means that its providing fund through daily trading and from
the owners.
When more funds are provided from external debt there is a requirement to repay this debt as well as pay interest.
An increase in the current year’s ratio could be due to:
 High level of borrowed external funds
 Liabilities might have increased
 Interest rate pressures might cause problems
A decrease in the current year’s ratio could be due to:
 Low level of borrowed external funds
 Equities might have increased
 Interest rate pressures are less of a concern
Equity = Assets – Liabilities
297 000 – 188 000 = 109 000
188 000
× 100
109 000
167 000
× 100
128 000
= 172%
= 130%
295 000 – 167 000 = 128 000
2018 debt to equity ratio was quite high,
showing that the business is relying quit
heavily on outside finance. 2019 t has
decreased which is a good sign but is still not
below the ideal ratio of 100%.
Limitations of Ratio Analysis:
1. Past performance does not predict future results: historical data to calculate ratios means that the results cannot take into
account possible future changes, either external change such as the business environment, legislative requirements and
the economy, or internal changes such as new management and altered purchasing decisions.
2. Lack of detail: level of detail obtained from ratios is insufficient to make major decisions about and changes to the business.
Ratios are only an indicator of possible concerns or potential bonuses and always require in-depth investigation of the
specific accounts that were used to calculate the ratio.
3. Limited perspective due to one set of financial information: ratios do not allow for seasonal adjustments or results that might
be skewed at the end of the year, adjustments could occur to the fair value of assets and they do not allow for the existence
of abnormal items.
4. The difficulty of making meaningful comparisons: ratio analysis is useful in comparing different businesses as a common
base however it does not allow for difference in other significant areas, such as the environmental policy of two mining
businesses or the quality of product line for two manufacturing companies.
5. Ratios may need to be calculated for a number of years before trend become apparent.
6. Differing accounting policies may affect ratio calculations and comparision.eg cash vs accrual accounting, different methods
of inventory
7. Ratios need to be compared to industry standards to be interpreted
8. Ratios do not identify the causes of problems
Other information to consider:
As financial statements do not necessarily reflect if the business has an excellent customer base, welltrained skilled staff, good quality product or environmental sustainability. Items that are not included in
financial information can still form an important part of performance analysis:
 Customer service
 Health and safety standards
 Quality control procedures
 Sales targets
 Environmental objectives
 Community involvement