Accounting Ratios - Principles of Accounting

Accounting Ratios - Principles Of Accounting
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Principles Of Accounting
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Aims:to explain the importance of the comparison of financial results to demonstrate the calculation of, and explain the usefulness of, the main accounting ratios Accounting ratios are useful measurements with which to identify financial results which need further investigation. There are several results of a business which can be usefully measured using ratios. The main groupings are:Profitability ratios (to measure the profitability of the business) Solvency ratios ( to measure the liquidity position of the business) Use of assets ratios ( to measure the efficiency of the business )
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In all cases, the figures concerned must be compared with other figures from: previous periods of the same business other organizations of carrying on similar business plans and budgets
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dns.he.net Dual Stack: IPv6 and IPv4 Includes Dynamic DNS Support Profitability (performance) ratios These ratios measure the level of profitability of the business. the following are commonly used profitability ratios:-
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1. Gross profit percentage This ratio measures the gross profit as a percentage of sales (i.e. net sales or turn over)
Gross profit percentage (margin) = Gross Profit Net sales
x 100
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2. Net profit percentage This ratio expresses the net profit as a percentage of sales revenue and this ratio is most often used by firms to compare their profit with other firms.
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Net profit percentage = Net profit Net sales 3. Return on capital employed
X 100
This ratio expresses the net profit as a percentage of capital invested Return on capital employed (ROCE) = Capital employed Capital employed can have different meanings. The most widely used formula for capital employed is as follows: Net profit X 100
Capital employed = Capital on the closing date. (Total assets Total liabilities) In the case a limited company, it is the total of the shareholders funds. Liquidity (solvency ratios)
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These ratios measure the ability of a firm to pay its debts as they fall due. 1. Current (working capital ) ratio This ratio compares the current assets with the current liabilities.
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Current ratio = Current liabilities
Current assets
A ratio of 2:1 is considered to be a good standard, but it may vary depending upon the nature of the business and other organizations in the same line of business.
2. Acid test (quick ratio) This ratio tests for insolvency if a business has sufficient liquid resources ( quick assets) to meet its current liabilities. To calculate this ratio, closing stock should be removed from the current assets where the stocks are not likely to be sold very quickly.
Acid test ratio = Current assets closing stock Current liabilities The standard for this ratio is 1:1, a lower ratio indicating insolvency Use of assets (efficiency ratios) 1. Stock turn over (stock turn) ratio
This ratio shows how quickly the business sells its stock how many times the stock turns over in a year.
The rate of stock turn over = Cost of sales Average stock
Where, average stock = Opening stock + closing stock 2 If the rate increases, it may indicate efficiency is improving (sales are increasing) and if it reduces it may mean that the efficiency is deterioting (the business has too much stock because the sales are slowing down) 2. Debtors turn over ratio( Debtors collection period)
This ratio shows how long it is taking to collect debts from customers. The faster cash is collected from debtors, the better the cash flow of the business. It also shows the credit control policy of the business. Debtors collection period = Debtors x 365 days ( or 52 weeks or 12 months) Credit sales 3. Creditors turn over ratio (creditors payments period) This ratio shows how quickly the business pays its creditors. A longer period indicates that the business is taking longer to pay its creditor and hence is holding on to cash which may lead the creditors to refuse to sell to the business.
Creditors payments period = Creditors x 365 days ( or 52 weeks or 12 months) Credit purchases It is also important to compare the creditors payments period with the debtors collection period - ideally, it should take longer to pay creditors than to collect monies from debtors.
Relationship between Mark up and Margin Cost price + profit = Selling price. Cost of sales + profit = Sales
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Advantages of accounting ratios 1. It helps to compare two or more business units. 2. We can compare the results of a business over two periods. 3. On the basis of ratios, the growth or the decline of the business can be understood very easily. 4. To plan for the future. Limitations of accounting ratios 1. Only past events expressed in terms of money alone can be analysed. 2. Different accounting methods give different results that cannot not be compared. 3. No allowance is made for inflation, which makes comparison of results between different periods meaningless. 4. Other non monetary and non financial factors are ignored (eg: staff relations, efficiency of the management, business location, environmental conditions etc) 5. Only like with like items can be compared (similar sized businesses, different periods for the same business, Plans and budgets.
MCQ 1. How is mark up shown as a fraction? A. Cost price/ profit C. Profit / cost price B. Profit / selling price D. Cost price / loss 2. How is margin percentage calculated? A. Profit / cost price x 100 C. Profit / selling price B. Profit / selling price D. Loss / selling price. x 100
3. A trader charges 25% profit on cost price. What is this profit called? A. Mark up C. Surplus B. Profit D. Margin
4. A shop keeper is making 25% profit on sale price. What is this profit called? A. Profit C. Mark up 5. Which of the following equations is correct? A. Cost price profit = selling price C. Cost price selling price = profit B. Cost price + profit = selling price D. Selling price + cost price = profit B. Surplus D. margin
6. How is the rate of stock turn over calculated? A. Cost of goods sold / opening stock C. Cost of goods sold / closing stock B. Cost of goods sold / average stock D. Cost of goods sold / sales
7. The following relates to a sole traders business: Average stock Mark up Stock turn over $ 12 600 50% on cost 7 times.
What is the amount of gross profit? A. $ 44 100 B. $ 88 200 C. $ 25 200 D. $ 34 100
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8. A firm sales are $ 150 000, the cost of sales is $ 90 000 and the expenses are $ 45 000. What is the gross profit % to sales? A. 10% B. 30% C. 40% D. 70%
9. A trader supplies the following details: Cost of goods sold Opening stock Closing stock $ 5 600 $ 500 $ 900
What is the rate of stock turn over?
10. K.King gives the following information at 31 $ 600
st
A. 7 times
B. 6 times
C. 8 times
D. 9 times Dec
Stock on 1st Jan
Purchases during the year Average stock during the year
$ 5 400 $ 1 200
What is the amount of closing stock as at 31s Dec? A. $ 3 600 B. $ 1 800 C. $ 600 D. $ 6 000
11. A trader bought goods for $15 000 and then sold 2/3 of them for $ 13 000. What would be his G.P? A. $ 3 000 B. $ 15 000 C. $ 2 000 D. $ 13 000
Assignment questions Q1. From the following information for two firms, Firm A and Firm B calculate
1. The gross profit percentage on sales for each firm. 2. The net profit percentage on sales for each firm. Firm A ($) Sales Gross profit 100 000 20 000 Firm B ($) 100 000 25 000
Q2. Here is a trading account. Sales 50 000 Less Cost of goods sold Opening stock Add Purchases 47 500 Less Closing stock Gross Profit 10 000 37 500 12 500 5 000 42 500
Net profit 5 000 5 000 1. Give one reason why the gross profits of the firms differ?
From the above, calculate :1. The gross profit percentage 2. The stock turn over for the year 3. If debtors are $ 6 250, the credit that is being taken on average 4. If creditors are $ 10 625, the credit that is being received on average 5. If net profit for this business is $ 7 500, the net profit percentage
Q3.
Here is a balance sheet.
Fixed assets Premises Machinery Office equipment 20 500 Current assets Stock Debtors Bank 12 000 4000 2000 13 000 5 000 2 500
18 000 Less Current liabilities
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Creditors Working capital 32 500 Financed by Capital + Net profit 40 000 - Drawings From the above, calculate ;1. Current ratio 2. Acid test ratio 30 000 10 000
6 000 12 000
7 500
32 500
3. Return on capital employed 4. Comment on the figures you have calculated, comparing them with last years balance sheet which showed a current ration of 1.5:1, a liquid ratio of 0.8:1 and a return on capital employed of 20%. Incoming search terms: accounting ratio results accounting ratios Average collection period (debtor days) This ratio is used widely within businesses to measure the calculating closing stock using current asset and liabilities and acid ratio test what would a 2:1 ratio be for net income
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Gross profit percentage (margin) = Gross Profit Net sales

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