Accounting Ratios and Interpretation of Financial Statements

Back to: FINANCIAL ACCOUNTING SS3

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In today’s class, we will be talking about accounting ratios and the interpretation of financial statements. Enjoy the class!

Accounting Ratios and Interpretation of Financial Statements

To interpret accounts is to try to gain insight into the information value of financial statements, this can be done through analysis, evaluation, criticism and comparison and all this is done by the use of accounting ratios. A ratio can be defined as the relationship that exists between two figures.

Uses of ratio

1. Ratios are used in preparing industrial averages.
2. They can be used to interpret financial statements.
3. They help in comparing performances between and among related organizations.
4. Ratios help to measure the ability of a given entity to meet its short-term obligations.
5. They are used in evaluating the performance of companies in the same business

The disadvantage of using ratio

1. Ratios can easily be affected by inflation
2. They can be manipulated upon or abused
3. Different accounting policies affect ratio calculation

Types of ratio

1. Profitability and efficiency ratio
2. Liquidity ratio
3. Investment ratio

Profitability and efficiency

Profitability and efficiency ratios measure the effectiveness of the management as shown by the returns obtained on sales and capital invested. This can be broken down into the following.

1. Net profit%
2. Gross profit%
3. Returns on capital employed
4. Assets turnover ratio
5. Individual expenses items to sales ratio e.g. advertising carriage outwards etc

Formulae:

1. NP% = NET PROFIT × 100

.                        SALES          1

2. GP% =  GROSS PROFIT ×  100

.                           SALES                1

3. Returns on capital employed ROCE. This measures management ability to utilize effectively the organizations resources.

It is   PROFIT                  ×   100

CAPITAL EMPLOYED              1

Where capital employed can be:

a) total asset

b) total assets to current liabilities

4. Assets turnover ratio:

This ratio measures the turnover generated by assets and show how fully a company is utilizing its assets.

Formula:           SALES

.                  CAPITAL EMPLOYED

5. Individual expense to sale:

This helps to reveal the reason for improvement or reduction in the net profit to sales.

Formula: INDIVIDUAL EXPENSES × 100

.                          SALES                   1

6. Liquidity ratios:

These ratios help in measuring the ability of an organization to meet its obligations as they fall due. Ratios under this heading are:

• Current ratio or working capital ratio
• Average stock
• Stock to net current assets
• Debtors ratio
• Creditors ratio

1. Current ratio or working capital ratio: This ratio indicates the ratio of current assets to current liabilities. It shows the extent the firm can meet up with its short-term creditors. Low ratio implies lack of working capital while high ratio suggests too much of working capital or capital tied up.

Formula: CURRENT ASSETS                          CA

.              CURRENT LIABILITIES                     CL

2. Acid-test/liquid ratio:

This ratio provides measures of the firm’s ability to meet its current liability. Should it fall below 1:1, the firm may have some difficulty in paying its debt.

Formula: CURRENT ASSETS – STOCK OR INVENTORY

.                                CURRENT LIABILTIES

3. Stock turnover ratio:

This is used to measure the number of times stocks are replaced during a given period.

Formula:         COST OF GOODS SOLD

.                           AVERAGE STOCK

4. AVERAGE STOCK: OPENING STOCK + CLOSING STOCK

.                                                                2

N.B: Where there is no opening stock, average stock could be calculated by adding closing stock to purchases and dividing by 2

5. STOCK TO NET ASSET: This ratio is used to express the stock as a percentage of net assets.

Formula: =          STOCK             × 100

.                      NET ASSET                 1

6. DEBTORS RATIO: Debtors ratio measures the average collection period from debtors. It shows the average credit period given to debtors.

Formula:     DEBTORS           ×   365 DAYS

CREDIT SALES

Long collection dates indicate poor credit policy.

7. CREDITORS RATIO: This ratio shows the average credit period received from suppliers.

Formula: TRADE CREDITORS     × 365 DAYS

.             CREDIT PURCHASES

8. Investment ratios: These ratios used by investors to evaluate the return, which they receive from their investments, they cover the following:
9. Earnings per share ratio
10. Price earnings ratio
11. Earning yield
12. Dividend yield
13. Dividend cover

EARNINGS PER SHARE RATIO: This ratio compares the net earnings attributable to the shares to the number of shares issued.

Formula: PROFIT AFTER TAX (PAT)  –   LESS PREFERENCE DIVIDEND.

.                                  NOS. OF EQUITY SHARE

PRICE EARNING RATIO: This ratio considers the average price of the share to the reported earnings per share.

Formula: MARKET VALUE PER SHARE

.                EARNINGS PER SHARE

DIVIDEND YIELD: This ratio measures the current actual returns on the shareholders investment.

Formula: DIVIDEND PER SHARE ×   100

.                  SHARE PRICE                  1

DIVIDEND COVER: This ratio compares the earnings per share to the dividend per share.

Formula: EARNING PER SHARE   = EPS

DIVIDEND PER SHARE     DPS

Dividend cover is also called payout ratio.

Evaluation

1. State three limitations to the use of accounting ratios in evaluating and comparing business organizations
2. List five uses of accounting ratios.

Illustration

The following was extracted from the books of capital ltd for two years, 31/12/001/002.

You are required to calculate the following ratios.

1. Gross profit ii. Net profit iii. Expenses as a % of sales iv. Stock turnover v. Current ratio vi. Acid – test ratio vii. Rate of returns on capital employed viii. Creditors /Purchases ratio ix. Debtors/sales ratio ix. Average stocks

Solutions:

1. GP% =  GP              × 100

.                      SALES             1

2001 = 15,000    ×    100     =    25%

.              60,000            1

2002  = 18,000    ×    100   = 20%

90,000          1

1. NET PROFIT% =    NP         ×    100

SALES              1

2001   =  7,500   ×   100     =  12.5%

60,000       1

2002   =  11,250      ×    100   =12.5%

90,000             1

• EXPENSES AS A % OF SALES =    ×    100

SALES           1

2001  =   7,500    ×   100    =   12.5%

60,000          1

2002  =     6,750     ×    100   = 7.5 %

90,000            1

1. STOCK TURNOVER = COST OF GOODS SOLD

AVERAGE STOCK

2001        45,000                       =     45,000       = 3TIMES

(18750 + 11,250)¹/₂                15,000

2002          72,000                     =   72,000        =  4.8 TIMES

(16,875 + 13,125)¹/₂             15,000

1. CURRENT RATIO =                CURRENT ASSETS

CURRENT LIABILITIES

2001     =    33,750     =  9   = 9:1

3,750          1

2002   =   30,000      = 4  =   4:1

7,500         1

1. ACID TEST RATIO =   CURRENT ASSET – STOCK

CURRENT LIABILITIES

2001  =   33,750  –  11,250

3,750

=   22,500    =   6  =  6:1

3,750          1

2002    =  30,000 – 13,125  =   1,687   =  225

7,500              7,500        10

= 2.25

• RETURNS ON CAPITAL EMPLOYED

=    NP                                           ×           100

CAPITAL EMPLOYED                               1

N.B:  Capital employed is total assets less current liabilities.

2001    =     7,500    ×    100  = 23.8%

31,500            1

2002  =   11.250     ×   100   = 34%

33,000          1

• CREDITORS/PURCHASES RATIO = CREDITORS

PURCHASES

2001 =  3,750     ×    365 DAYS       365 DAYS OR (12 MOS.)

37,500

=  36.5 DAYS OR 1.2 MONTHS

2002 =   7.500    ×   365 DAYS

68,250

=  40.11 DAYS OR 1.3 MONTHS

1. DEBTORS/SALES RATIO = DEBTORS    ×  365 DAYS

SALES

2001  =       18750   ×   365 DAYS

60,000

=  114 DAYS OR 3-8 MONTHS

2002  =  15,000  ×   365 DAYS

90,000

= 60-8 DAYS OR 2 MONTHS

1. AVERAGE STOCK = (OPENING STOCK + CLOSING STOCK) ½

2001 = 18750 + 11250   = 15000

2

2002  =  16,875 + 13,125   = 15000

2

Evaluation

1. What is the formula for stock turnover
2. What is the other name for stock turnover?

General evaluation

1. What is depreciation
2. Explain the following methods of calculating depreciation (i) straight line  (ii) reducing balance     (iii) sum of the years’ digit
3. What is the difference between depreciation and amortization
4. State ten uses of the general journal
5. Explain the principle of double entry system

Reading assignment

Essential Financial Accounting page 308-317

Weekend assignment

1. Which of the following formulae is for the average stock?( a) (sales – returns)1/2 ( b) (opening stock + purchases)1/2  (c) (opening stock + closing stock)÷ 2  (d) net profit/2 + opening stock
2. When a current asset is less than current liability it means (a) over trading (b) under trading (c) optimum trading    (d) counter trading

Theory

1. Explain a) debtors /sales ratio b) creditors/purchases ratio
2. What will be revealed to a business when the above ratios are compared?

In our next class, we will be talking about Public Sector Accounting.  We hope you enjoyed the class.

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