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Accounting Ratios

Definitions, Types, Analysis, Formulas etc of Accounting Ratios

ACCOUNTING RATIOS
An accounting ratio is a set of figures expressed in terms of another in the sam
e set of
account. Without ratios, financial statements would be largely uninformative to
all but the
very skilled. With ratios, financial statements can be interpreted and usefully
applied to
satisfy the needs of the reader. Ratios by themselves are meaningless unless com
pared to a
benchmark.
Standards of Comparison
Ratios calculated should be compared with the following standards or criteria. S
uch standards
may either be internal or external.
A. Internal Standard (Intra-firm)
1. The company s performance in the previous year s is chosen and
compared with any other year.
2. Actual performance in (Actual ratio) for the year is compared with those
set as objectives at the beginning of the year.

Questions:
i. How far have we achieved our target ratio?
ii. Have we done better (or worse) than we expected?
iii. Trends Whether ratios are steady, gradually going up or gradually going dow
n.
B. External Standards ( Inter-firms)

The performance of the company similar in size or in the same type of business i
s
compared.
Questions
i. Have we done better or worse than them?
ii. How does our ratios (Performance) compare with those of our competitors?

Uses of Ratios
1. Ratios are useful for forecasting likely event in future as past ratio indica
te
trends in

cost, sales, profits, etc (Trends analysis)

2. They are used to measure efficiency by means of inter company and intra compa
ny
comparison.
3. They help to know the ability of the firm to meet it short term obligation. (
liquidity
position)
4. They provide information about the long term solvency of the company.
5. They help to measure the over all performance of the firm by using the profit
ability
ratio.
6. They enable a large volume of data to be conveniently summarised.
7. They facilitate cost and performance control.

This is done because when ratios are calculated they are interpretive to lead to
the
ascertainment of whether things are getting better or worse. This will enable ma
nagement
to take remedial actions.
The relationship between mark-up and margin and how to use the relationship betw
een them
and sales revenue and gross profit to find figures that are missing in the tradi
ng account
Mark-Up and Margin
The relationship between Mark-Up and Margin
Mark-Up: Is the gross profit expressed as a fraction or percentage of the cost p
rice. For
instance the purchase cost, gross profit and selling price of goods and services
may be shown
as: Cost Price + Gross Profit = Selling Price and when shown as a fraction of th
e cost price,
the gross profit is known as mark-up.
Margin: Is the gross profit expressed as a fraction or percentage of sales (sell
ing price).
Since mark-up and margin refer to the same profit there is bound to be a relatio
nship between
them. If one is known the other can be found.
If the mark-up is known, to find the margin take the same numerator of the margi
n then for
the denominator of the margin take the total of the mark-up s denominator plus the
numerator.
Example 1: From mark-up to margin
Fraction Mark-Up Margin
1 1 1 = 1
3 3 3+1 4
2 2 2 = 2
6 6 6+2 8
If the margin is known, to find mark-up, take the same numerator to be that of t
he mark-up,
then for the denominator of the mark-up subtract the margin s numerator from the
denominator.
Example 2: From margin mark-up
Margin Mark-up
1 1 = 1
3 3-1 2
2 2 = 2
11 11-2 9
Calculate margin and mark-up using this example:
Cost Price + Gross Profit = Selling Price
GHC4 + GHC1 = GHC5
Mark-up = Gross Profit as a fraction or as percentage, multiply by 100
Cost Price GHC 1 = 1 or 1 x100 = 25%
4 = 4 4
Margin = Gross Profit as a fraction or as percentage, multiply by 100
Selling Price GHC 1 = 1 or 1 x100 = 20%
5 = 5 5
Example: The closing stock of Marble at 31st Dec 2009 was GHC500 less than the o
pening
stock on Jan 2009. Her average stock amounted to GHC16,000 and purchases for the
year
were GHC18,000. She made a grofit of 20% on turnover within the year. You are re
quired to:
i. Prepare Mabel s trading account for the year ended 31st December 2009
ii. Calculate her rate of stock turnover
i. Trading Account for the year ended 31st December 2009

TRADING PROFIT AND LOSS ACCOUNTS FOR THE YEAR ENDED 31ST DEC 2009
GHC GHC
Opening stock ? Sales ?
Add Purchases 18,000
?
Less Closing stock ?
Cost of sales ?
Gross Profit ?
? ?

Workings
To find opening stock and closing stocks
Take x to represent opening stock
Therefore: Closing stock = x- 500
Average stock = opening stock + closing stock
2
16,000 = x + x-500
2
32,000 = 2x 500
32,000 = 2x
16,250 = x
Therefore x = 16,250
If x (opening stock) = 16,250 then closing stock will be less by 500 (16250 500)
=
15,750

ii. Calculation of sales Method 1 ( Sales Method)

Cost price + Profit = Sales (100)
80 + 20 = 100
If cost of sales (80) = 18,500
Therefore: Profit = 20 x 18,500
80
= 4,625
Therefore: Sales = C + P
=18,500 + 4,625
= 23,135
OR
If C (80) = 18,500
Therefore: S (100) = 100 x 18,500
80
= 23,125
Method 2 (Mark-up & Margin)
Margin = (20%) 1/5 1 = 1/4
Therefore: Mark-up (Profit) = 1/4 x 18,500
= 4,625
Rate of turnover = Cost of Sales = 18,500
Average stock = 16,000
= 1.16 times

TRADING PROFIT AND LOSS ACCOUNTS FOR THE YEAR ENDED 31ST DEC 2009
GHC GHC
Opening stock 16,250 Sales 23,125
Add Purchases 18,000
34,250
Less Closing stock 15,750
Cost of sales 18,500
Gross Profit 4,625
23,125 23,125

Types of Ratios
I. Profitability Ratios
II. Liquidity / Solvency Ratios
III. Activity / Asset used (Efficiency) Ratios
IV. Capital Ratios
V. Investment Ratios

I. Profitability Ratios

These are ratios used in measuring the economic efficiency of the business. The
main
purpose of these ratios is to measure the profit made by a business within a yea
r.
Profitability ratios can assist owners to:
a. enquire further
b. support, chastised or fire management(to sack management)
c. expand, maintain or close down the enterprise.

There are two types of profitability ratios

a. Profitability in relation to sales.
b. Profitability in relation to investment.
a. Profitability in relation to sales
These indicate efficiency of internal operation and importance for intra and int
er company
comparison. They comprise the following:
i. Gross Profit Ratio (Gross Profit to Sales)
ii. Net Profit Ratio (Net Profit to Sales)

Gross Profit Ratio (Gross Profit to Sales):

This ratio expresses the proportion of selling price which represent gross profi
t. It is
calculated as follows:
Gross Profit Ratio = Gross Profit x 100
Net Sale
This ratio helps the user to ascertain the pricing policy of the firm and also h
elps to ascertain
the efficiency of the firm.
Net Profit Ratio (Net Profit to Sales):
This ratio measures the efficiency of all operations of a company. It shows how
close a
company is to making losses. It is measured as follows:
Net Profit Ratio = Net Profit (after tax) x100
Net Sales
b. Profitability in relation to investments

These ratios which come under this indicates the earning power of the funds inve
sted in the
firm. They are important for inter firm comparison and includes the following:
i. Net Profit to Fixed Asset:
This ratio is of importance to companies that depend on fixed assets for generat
ion of income.
It enables the user to know whether the fixed assets are being efficiently utili
sed or not. Every
low ratio could mean that fixed assets are being under utilised and vice versa.
It is measured
as follows:
Net Profit to Fixed asset = Net Profit x 100
Fixed Asset

ii. Return on Capital Employed (ROCE):

This is also known as the primary ratio because it enables the analyst to access
the ultimate
objective of the business. The efficiency of the management can be ascertained b
y marching
the net profit (usually before tax) against long term funds invested in the busi
ness. The result
can then be compared with companies in the same industry. It is calculated as fo
llows:
ROCE = Net profit (before tax) x 100
Capital employed
. Capital employed = Shareholders equity + Long term Liabilities
. Shareholders equity = Equity (Ordinary) Shares + Reserves or Surplus

iii. Capital Turnover Ratio:

This reveals the number of times that capital invested into the business have be
en used over
the period. It is define as the ratio on sales to capital employed. It is calcul
ated as follows:
Capital Turnover Ratio = Sales x100
Capital employ
iv. Net Equity Income to Equity Capital:
This means the net profit after charging loan interest and taxation less prefere
nce dividend.
It is calculated as follows:
Net Equity Income
Equity Capital

II. Liquidity / Solvency Ratios:

Refers to the ability of the business to pay it s debt as they fall due. They are
meant to
measure the firm s ability to meet its short term obligation. The solvency of the
business can
be tested by calculating the following:
a. Working Capital
b. Working / Current Ratio
c. Liquidity Ratio
d. Acid Test / Quick Ratio

a. Working Capital

This is the excess of the total current asset over total current total liabiliti
es. It measures the
amount of funds that the business has available for meeting day to day expenses.
 It is
calculated as follows:
Working Capital = CA CL (Current Asset Current Liability)
A positive Working Capital (WC) indicates that the business is solvent; where as
a negative
WC shows that the business is insolvent. A negative WC may be as a result of Cap
italization
or over trading.
b. Current Ratio

This is also referred to as the Working Capital ratio. It is calculated as follo

ws:
Current Ratio = Current Asset
Current Liability
It is the numerical relationship of CA to CL and it indicates whether the busine
ss is to meet
its CL as they fall due.
The minimum Working Capital ratio of any business should be 1:1. This means that
the
business is just able to pay its CL. However a 2:1 ratio is considered a satisfa
ctory one.
c. Liquidity Ratio
This is the ratio of current asset (excluding stock) to current liabilities. It
gives a sharper
focus on the assets which are more readily convertible into cash. It is calculat
ed as follows:
Liquidity ratio = Current Assets Stock
Current Liabilities
d. Acid Test / Quick Ratio
This reveals the readiness of the business to pay its immediate debt and demand.
A
satisfactory ratio is 1:1. It is calculated as follow:
Acid Test Ratio = Current Asset (Stock + Prepayment)
Current Liabilities
A T = C A S + P
C L

III. Activity / Asset used (Efficiency) Ratios

Activity or efficiency ratios show how efficiently the assets of an organisation

have been
used to attain it major objective. Ratios which fall under this are:
a. Stock Turnover Ratio
b. Debtors/Sales Ratio
c. Creditors/Purchases Ratio

a. Stock Turnover Ratio

Stock turnover measures how efficient a business is at maintaining an appropriat
e level of
stock. When it is not being as efficient as it used to be, or is being less effi
cient than its
competitors, this may indicate that control over stock level is being undermined
. A reduction
in stock turnover can mean that the business is slowing down. Stock may be pilin
g up and not
being sold. This could lead to liquidity crises, as money may be taken out of th
e bank simply
to increase stocks which are not then sold quickly enough. It is calculated as f
ollows for two
companies for comparison:
Cost of Sales Opening Stock + Closing Stock
Average Stock Where Average Stock = 2

b. Debtors/Sales Ratio
The resources tied up in debtors is an important ratio subject. Money tied up un
necessarily in
debtors is unproductive money. The relationship is often translated into the len
gth of time a
debtor takes to pay. The debtor/sales ratio can be calculated for two companies
as:
Debtors/Sales = Debtors
Sales x 12 months
c. Creditors/ Purchases Ratio
This ratio like stock turn over and debtors/sales ratio can be classified as liq
uidity or
efficiency ratio. It is also often translated into length of time we take to pay
our creditors.
This turns out to be:
Creditors/ Purchases Ratio = Creditors
Purchases x 12 months
IV. Capital Ratio

These are ratios that explain the relationship between various types of capital
and a limited
liability company.
a. Gearing Ratio:

This compares equity capital with fixed capital obligation, fixed capital consis
ts of preference
shares and debentures. A ratio of more than 1 or 100% is interpreted as high gea
ring while
the ratio of less than 1 or 100% is considered as low gearing.
A high geared company has a high proportion of debt capital and low proportion o
f equity
capital i.e. it has a large amount of interest to pay; while a low geared compan
y on the other
hand is low proportion debt capital and a high proportion of equity capital, i.e
. it has a small
amount of interest to pay. It is calculated as:
Gearing = Fixed Capital (Preference Shares + Long-term Liability
Equity Capital (Ordinary Shares + Reserve) x 100
b. Capital Employed to Fixed Asset Ratio:
This reveals that part of fixed assets which were financed by the owners of the
company. A
ratio of less than 1 is a sign of weakness because, it is expected that the owne
r of the business
must provide funds for the acquisition of the assets. It is calculated as:
Capital Employed to Fixed Asset Ratio = Capital Employed
Fixed Assets
c. Fixed Assets to Capital Employed:
This reveals the distribution of capital employed among fixed assets and workin
g capital. It
is calculated as:
Fixed Assets to Capital Employed = Fixed Assets
Capital Employed
d. Debt Equity Ratio:

This is the shareholder s equity compared with the total liabilities. It also show
s the
proportion of the shareholders ownership in assets. It is calculated as:
Debt Equity Ratio = Shareholder Equity or Total Debt
Total Liabilities Shareholder s Equity

OR Long-term Liabilities
Shareholders Equity

e. Debt Asset Ratio: Calculated as follow

Total Debt
Total Assets
f. Equity Asset Ratio: Calculated as

Shareholders Equity
Total Assets
V. Investment (Shareholder)Ratio

These are ratios that help equity shareholders (ordinary Shares) and other inves
tors to
assess the value and quality of an investment in the ordinary shares of company.

a. Net Equity Income to Equity Capital:

Net equity income means that net profit after charging loan interest and taxatio
n less
preference dividend and distribution to any outside interest. The figure is the
amount
attributable to ordinary shareholders and it is compared to the ordinary shares
issued
plus reserves. This is useful when considering profitability of ordinary shareho
lders. It
is calculated as follows.
Net Equity Income
Equity Capital
b. Return on shareholders Fund:

This shows the profitability of shareholders funds invested into the business.
Shareholders fund refers to total share capital plus reserves. It is calculated
as:
Net Profit after tax
Shareholders Fund x 100

c. Earning per share ( EPS):

This ratio reflects the profitability of a concern from one point of view of equ
ity
shareholders in terms of each share held by them. In other wards it gives the
shareholder (or prospective shareholder) a chance to compare one year s earnings
with another in terms easily understood. Many people consider EPS to be the most
important ratio that can be calculated from the financial statement. It is measu
red as
follows:
Earning per share (EPS) = Net profit after interest and preference dividends
Number of ordinary shares issued
d. Dividend per share:

This ratio informs the ordinary shareholder of the dividend payable or paid per
share
held. It can help forecast the dividend to expert, It is measured as follows:
Total ordinary dividend payable
Total number of ordinary share
e. Dividend Cover:

This ratio shows what proportion on ordinary activities for the year that is ava
ilable
for distribution to shareholders has been paid or proposed and what proportion w
ill be
retained in business to finance further growth. Usually, the dividend is describ
ed as
being so many times covered by profits made. A dividend of two times would indic
ate
that the company has paid 50% of its distributable profit as dividend and retain
ed 50%
in the business to help finance further operations.
Dividend Cover = Net profit after interest and preference dividends
Ordinary dividends paid and proposed
f. Earning Yield:

This ratio indicates the expected rate of return of the investors from the busin
ess.
Equity dividend per share
Price per share
g. Dividend yield:

This measures the return to a shareholder on the amount of his investment. It is

calculated as follows: Gross dividend per share
Market price per share
h. Price earning ratio:

This is the ratio of a company s current share price to the earning per share. It
represents the amount investors are willing to pay for each cedi of firm s earning
s. It
is measured as: Market price per share
Earning per share
Limitations of Ratios
1. The reliability of accounting ratio depends upon the reliability of accountin
g data.
2. Price level changes/inflation affects the comparison of accounting ratio.
3. Different procedures followed by different firms for determining certain acco
unting
values makes accounting ratios non comparable.
4. The problem of inconsistent accounting practises followed by a firm from peri
od to
period may make ratios incomparable.
5. Ratios sometimes give a misleading picture.
6. Different concepts are used for determining a particular ratio.
7. There are also problem of definition: There should be careful definition of t
erms used.

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