Accounting Assignment
Kumeren Govender
Grade 11A
13 July 2010
Term 3
(1) Financial Indicators and possible Ratios
Profitability and
Efficiency
Indicators
Return Indicators
Solvency
Indicators
Liquidity
Indicators
Risk Indicator
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Percentage Gross profit on Sales (turnover)
Percentage Gross profit on Cost of Sales
Percentage Operating profit on sales (turnover)
Percentage Operating Expense on Sales (Turnover)
Percentage Net Profit on Sales (turnover)
Percentage Return on Average owners' equity
Amount earned by each partner
Percentage Return earned by each partner
Net Assets (OE)
Total assets to total liabilities (Solvency ratio)
Net Current assets (net working capital)
Current Ratio
Acid-test Ratio
Turnover rate of stock
Period for which enough stock is on hand
Debtors collection period
Creditors payment period
Debt: Equity ratio (Gearing ratio)
Indicator 1 and 2: Gross profit on Sales and Gross profit on Cost of Sales
The amount that the sales exceed the cost of sales is called the gross profit.
The nature of the business will determine the profit-mark up which determines the gross
profit.
GROSS PROFIT ON SALES= GROSS PROFIT \ SALES x 100
GROSS PROFIT ON COST OF SALES= GROSS PROFIT \ COST OF SALES x 100
The profit mark-up is maintained by the business on all of the sales that occur.
Indicator 3: Operating profit on sales
Operating income subtracted from operating expenses during the accounting period is
called Operating Profit.
OPERATING PROFIT ON SALES= OPERATING PROFIT \ SALES x 100
When the operating profit is calculated as a percentage of sales one can determine
significant conclusions about the influence of the operating expense of the business. This
will determine how efficient the business policy is and what percentage of the gross income
is spent on operating expenses.
Indicator 4: Operating Expense on Sales
OPERATING EXPENSE ON SALES= OPERATING EXPENSE \ SALES x 100
The operating expense is expressed as a percentage of sales so that the owner can compare
these figures for the current year with figures from last year to determine if the operating
expenses have fluctuated.
Indicator 5: Net Profit on Sales
NET PROFIT ON SALES= NET PROFIT \ SALES x 100
Total income subtracted from total expenses gives you the net profit of a business. It is the
operating Income adjusted by Interest expense and income. The indicator of operating
Income to Sales gives us an indication of the operating efficiency of the business.
Indicator 6: Return on average owners’ equity
RETURN ON OWNERS EQUITY = NET PROFIT \ AVERAGE OWNERS EQUITY
x 100
This makes it possible for the owner of the business to determine how lucrative their
investment (capital) in the business is.
Indicator 7: The amount earned by each Partner in a Partnership
AMONT EARNED BY A PARTNER = PARTNERS SALARY+ INTEREST ON CAPITAL+
SHARE OF REMAINING PROFITS OR LOSSES
This is how the portions of the net profit are earned by each partner. Usually the remaining
profit is shared in the ratio to 1:1 but because of difference in salaries etc. the portions of
the whole net profit is different from the 1:1 ratio.
Indicator 8: The Percentage returned earned by each Partner in a Partnership
This indicator is similar to indicator 6. Indicator 6 reflects the profit or loss to a business at a
whole. But when a partnership is formed, each individual partner will want his own personal
return on investment.
RETURN EARNED BY A PARTNER = AMOUNT EARNED BY THE PARTNER \ THE
PARTNER’S AVERAGE EQUILTY X 100
Indicator 9: Net assets (Owners equity)
If the assets in a business exceed the value of the liabilities then the business is solvent. That
means that it is in a position to pay off all its dents.
ASSETS – LIABILITIES =OWNERS’ EQUITY
NET ASSETS=ASSETS- LIABILITIES = OWNERS’ EQUITY
Indicator 10: Solvency Ratio
A. When we evaluate and examine a business, we don’t always look only at the absolute
figures.
An example: Sudhir’s Shoe company may have assets valued at R300 000 and liability of
R150 000. Whereas Nashlin’s bakery stores have assets valued at R450 000 and liability of
R300 000.They both have the same net value of assets.
It is notable to say that Sudhir’s Shoe business is in a safer solvency position that Nashlin’s
bakery stores because its assets exceed its liabilities by 2:1 (i.e. 300 000 : 150 000)
Nashlin’s bakery stores has a solvency ratio of 1,5:1 (i.e. 450 000 : 300 000)
Therefore when the value of Nashlin’s bakery store’s assets drops by 40% it will become
insolvent. (i.e.270 000 : 300 000 { 0,9 : 1} ) But if the assets of Sudhir’s company decrease by
40% they will still be solvent (i.e. 180 000 : 150 000 { 1,2 : 1 }).
The formula to calculate the Solvency Ratio is:
TOTAL ASSETS: TOTAL LIABILITIES
B. There may not be a norm applicable to this ratio
Indicator 11: Net current assets (working capital)
NET CURRENT ASSETS: CURRENT ASSETS –CURRENT LIABILITY
This indicator is used to determine the liquidity of a business. This is important because the
owner needs to know if the business can pay all its debts or not. This can then provide the
owner with information on the financial position of the business.
Indicator 12: Current Ratio
A. Like previously explained in indicator 10, the use of absolute figures may be misleading
therefore we use Ratios. The Current Ratio is used to evaluate liquidity more accurately and
precise.
An Example: Sun Traders and Moon Traders have the same net current assets however
their current liabilities and current assets hugely differ.
Sun Traders
Current Assets
Moon Traders
100 000
500 000
Current Liabilities
50 000
450 000
Net current Assets
50 000
50 000
By analysing these figures we can easily say that Moon Traders is in a more Unsafe liquidity
position than Sun Traders. If Moon Traders cannot collect capital with respect to 10% of its
current assets including debtors it would be in an illiquid position, while Sun Traders will
safely be liquid.
The formula to calculate Current Ratio is:
CURRENT RATIO = CURRENT ASSETS : CURRENT LIABILITEIS
These ratios points out the difference in the liquidity of the two businesses.
Current Ratio of Sun Traders = 100 000 : 50 000 { 2 : 1 }
Current Ratio of Moon Traders = 500 000 : 450 000 { 1,1 : 1 }
B. Previously many experts felt that the norm for this ratio should be 2:1 to avoid liquidity
problems. But recently investments are much more flexible and capital may be more
available and easy to transfer so the norm rarely applies anymore.
Indicator 13: Acid-Test Ratio
A. The purpose of this ratio is to test the strength and ability of the business to settle its
current debts under poor and abnormal financial conditions. For example when there is a
depression, lack of sales or even a robbery.
The order in which the current assets are categorized in the Balance Sheet is significant in
that Trading Stock is placed first. This is so because this asset is expected to take the longest
time to liquidise or to be turned into money. However debtors are expected to pay within a
short term and hence cash is readily available.
Therefore when we calculate the Acid-Test ratio we ignore Trading stock from the current
assets. The ratio compares only the Trade and other Receivables and cash and cash
equivalents to the current liabilities.
There are two different formulae to calculate the acid-Test ratio but they both give you the
same answer.
ACID-TEST RATIO= (CURRENT ASSET -INVENTORIES): CURRENT LIABILITIES
Note: Inventories is trading stock plus consumables on hand
ACID-TEST RATIO= (RECEIVABLES + CASH): CURRENT LIABILITIES
Note: Receivables - Trade and other Receivables, Cash - cash and cash equivalents
The purpose of this is to compare the assets which can be easily liquidated (Trade Debtors
and Capital) to current liabilities. The experts advise to use the second formula as it avoids
confusion.
The Acid-Test ratio tests the ability of the business to payout its current debts without being
forced to sell its trading stock with pressure from Trade creditors. If a business is forced to
sell its stock it may end up with a massive loss in profit. The ratio 1,5:1 means without
selling stock the business can get hold of R1,5 for every R1 that has to be paid to the current
creditors immediately.
B. Many experts say that the norm for this ratio should be approximately 1:1 to ensure that
the business is safe in case of unexpected situations. However, it is possible that a business
can exist with a low acid-test ratio if the owner gets access cash easily from personal funds
or investments.
As with the current ratio, an acid-test ratio which is too high might be safe but also a
disadvantage to the business in the sense that it could mean extra money could be tied up
with assets which are not bringing a good return.
Indicator 14 and 15: Turnover rate of stock and Period for which enough stock is on hand
This indicator helps to provide with information with the use of the appropriate level of
trading stock required in a business and also to ensure that the trading stock is sold within a
reasonable period of time.
STOCK TURNOVER RATE = COST OF SALES \ AVERAGE STOCK
Average stock is opening stock + closing stock divided by 2.
PERIOD FOR WHICH ENOUGH STOCK IS ON HAND =TRADING STOCK\
COST OF SALES X 365
Fluctuation in stock levels can have a major impact on the capital of the business.
Indicator 16 and 17: Debtors collection period & Creditors payment period
In order to obtain whether a business has managed its capital efficiently it is useful to work
out the period for which stock is on hand, Creditors payments period and Debtors collecting
periods.
DEBTORS COLLECTION PERIOD =DEBTORS\ CREDIT SALES X 365
CREDITORS COLLECTION PERIOD =CREDITORS\ COST OF SALES X 365
Indicator 18: Debt: Equity Ratio
A. The Debt: Equity Ratio provides us with an indication of how a business is financed. The
business will initially require capital to set up the infrastructure. E.g. To purchase fixed
assets and trading stock.
A business can be financed by:
 Capital that is invested by the owner
 Capital that is borrowed from banks and other outside institutions.
Borrowed capital may not always be the best choice to finance new businesses as if the
business suddenly runs at a loss; it may not have enough capital to pay back the loan
especially with the accumulated interest. This could inevitably put the business at a bigger
loss.
However if a business has its capital invested from the owner it may be seen as a low-risk
business as the interest may not be as high as the bank or may not even have to paid back
to the owner.
The purpose of the Debt: Equity ratio indicates the extent to which a business is financed by
borrowed capital and indicates the risk that the business may be in. The ratio also affects
the bottom of the income statement. E.g. Higher loans taken, higher interest must be
payable.
To calculate the Debt: Equity Ratio we using the following formula:
DEBT : EQUITY RATIO = NON-CURRENT LIABILITIES : OWNERS EQUITY
An Example:
Owners’ equity:
Non-Current liabilities:
R1 000 000
R 200 000
The Debt:Equity ratio = 200 000: 1 000 000 = 0,2 : 1
The above business is financed mainly be capital provided by the owner. The long term liabilities are
20% of the equity. This indicates a low risk business.
B. There is no correct or incorrect ratio. The ratio will depend on the nature of the business whether
it may be a multi-million dollar business or a small barber shop. The ratio should be compared to
previous years or to similar businesses.
Kumeren Govender Grade 11A