Financial Accounting, SS 3, Week 4
Topic: Interpretation of Accounts Using Simple Ratio
Content:
- Definition of Ratio
- Profitability ratio
- Liquidity ratio
- Investment ratio
Definition of Ratio
Ratio can be defined as the relationship that exists between two figures. Accounting ratio are used in the interpretation of financial statements and they provide means by which various items in the final accounts are compared to other other items. It will be considered under the following headings:
- Profitability ratio
- Liquidity ratio
- Investment ratio
Profitability Ratio
The profitability ratio measures the profit earned over the period and capital employed at the end of the year,this will show the effectiveness of the management team.
Gross profit percentage: this is the relationship between profit and selling price.
Gross profit/sales x 100%
Net profit percentage: this shows whether or not the expenses of running the business are in proportion to the amount of trade.
Net profit after tax/sales x100%
Return on capital employed: this is the yardstick employed to measure the efficiency of the management in utilizing the assets of the business.
Profit/capital employed x100%
Where capital employed = total assets-current liabilities.
Turnover ratio: this is the ratio that shows the company has been able to utilize its asset to generate sales. A low rate shows that company is not generating sufficient volume of business for the size of investment,this may be due to inefficiency in production planning and control
Liquidity Ratio
This ratio measures the extent to which the business can meet its short term obligations or pay its debt as they fall due.a business that cannot meet its obligation is insolvent
Current ratio or working ratio :it indicates the strength of the working capital and the degree of solvency of the business,the ratio shows the extent to which the claim of creditors can be quickly met.
Current ratio=current asset/current liabilities
Liquidity or acid test ratio:this is a better test of the short-term solvency of the business because of the length of time often necessary to convert stocks into cash.
Current assets-stock/current liabilities
Rate of stock turnover: the ratio shows the number of times stock is turned over within the period.the average stock must be taken to be opening stock plus closing stock divided by two
Rate of stock turnover =cost of goods sold/average stock
Stock on current assets: this shows the importance of stock as a percentage of current asset.
Stock/current asset x 100%
Debtor ratio:this ratio relates debtor to sales to the average period of credit given to debtors.a long collection period shows a poor credit control system within the organization.
Debtors/credit sales x365days
Creditor ratio: the ratio shows the average credit period taken from suppliers.
Creditors/credit purchases x 365days
Investment Ratio
The investment ratio is used by investors in evaluating the share of quoted companies as potential investment.
Price earning ratio:this expresses the market price of the shares as the number of years of its current earnings.
Quoted price of one share/earning per share
A high price earning ratio means that investors expect the profits of the company grow.
Dividend yield: this is an indication of the yield an ordinary shareholder would receive if the profit were divided .
Dividend per share/share price x100%
Dividend cover:this is known as pay out ratio,it compares the earnings per share to the dividend per share and indicates the extent to which earnings are being retained or ploughed back into the business
Profit after tax/total dividend OR
earnings per share/dividend per share.
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