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Accounting ratios.doc

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ACCO 240
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Accounting Ratios A ratio is an accounting item expressed in terms of another accounting item; e.g net profit margin expresses the net profit as a percentage of sales. Ratios are often used in accounting, and there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios. What ratios to calculate? 1. Profitability ratios: ratios which indicate (i) the profit margin in sales and (ii) the long term efficiency of the company in generating profits from the funds at the firm’s disposal. 2. Liquidity ratios: ratios which assess the ability of the company to meet its short term debts as and when they fall due. 3. Efficiency or working capital ratios: ratios which examine the extent to which management is efficient at reducing the need for working capital. 4. Gearing ratios: ratios which highlight the extent of the financial risk borne by the owners or shareholders of a business. The greater the proportion of debt capital, the greater will be the financial risk. 5. Shareholders’ investment ratios: these are ratios which help equity shareholders and investors to assess the worth and viability of an investment in ordinary shares. A. PROFITABILITY RATIOS The business must be profitable if it is to survive in the long term i.e. for the foreseeable future. Profitability is the result of many managerial policies and decisions. Profitability ratios measure the efficiency of the business in generating profits. Profits Before Interest and Tax (PBIT) 1. Return on total assets (ROTA): x 100% Total assets Total assets = FA + CA = Long term capital + short term capital [ Owner's equity + Long term loans] Current liabilities ROTA reflects the profits earned before interest and tax (i.e. before remunerating providers of capital) on all the assets employed, irrespective of how they are financed. ROTA therefore measures the efficiency with which profits are generated from total capital at the disposal of the business, irrespective of the source of the capital. 2. Net profit margin = Net Profit x 100% Sales 3. Net Profit mark-up = Net Profit x 100% Cost of sales 4. Return on Capital employed (ROCE) = Profits before interest and tax (PBIT) x 100% Capital employed B. LIQUIDITY RATIOS Managers must ensure the short-term survival of the business. In so doing, their attention is inevitably drawn to liquidity. Is the company able to meet its short term maturing obligations? Current assets 1. Current ratio (or liquidity ratio) =Current liabilitie s • Since current assets are cash or assets expected to be turned into cash within the next 12 months, and current liabilities are those that should be paid within the next 12 months, a business should presumably be in a good position to meet its current obligations if current assets exceed current liabilities by a reasonable margin having regard to the nature of the business. Traditionally the satisfactory norm was 2:1. • However, a reasonable norm depends on the nature of the business. If the business carries lots of stocks and debtors, it is normal that the business will REQUIRE more working capital so that its current ratio may be 2:1 or even 3:1. However, if a business has rapid stock turnover and few debtors because it sells mainly for cash (e.g. a supermarket), then it can afford to have a lower liquidity ratio (say 1:1) because its REQUIREMENT for working capital is much less. • Therefore, the level of working capital, indicated by the current ratio, must be compared with the working capital requirement. An abnormally high liquid ratio could mean that the need for working capital is high because stock is remaining in store a long time before being sold and/or because debtors are taking too much time to settle their accounts. This is why the currant ratio must be assessed in relation to working capital or efficiency ratios. Current assets - stocks 2. Quick or Acid test ratio = Current liabilitie s • Analysts recognise that current assets include inventory which is sometimes slow moving and not so readily realisable into cash as implied by the current ratio. • The quick ratio therefore removes inventory from the calculation, thus providing a more rigourous (hence the term acid test) test of the company's ability to pay its short-term obligations. cash and cash equivalent 3. Cash ratio = Current liabilitie s This is the ultimate test of liquidity as it tests whether the firm currently has enough cash to meet its current liabilities. Interpretation: If liquidity ratios are too low, this may indicate liquidity problems and the need to raise further finance. If the ratios are too high, this could indicate poor working capital management with stock and debtor levels too high. C. WORKING CAPITAL OR EFFICIENCY RATIOS 1. i. Stock turnover (in days) = Closing stock (or average stock) x 365days Cost of sales The stock turnover period shows the average number of days the stock stays in store before being sold. ii. Rate of stockturn = Cost of sales = …. times Closing stock (average stock) The rate of stockturn measures the number of times, on average, when goods are bought and sold. Interpretation • It is desirable to have a low stock turnover but a high rate of stockturn. This would imply that goods are being bought and sold rapidly. • On the other hand, a low rate of stock turnover (i.e. stocks remain in store a long time before being sold) and a high stock turnover may indicate poor stock control or even obsolescence. Closing debtors (or average debtors) 2. Debtors collection (in days) = x 365 days Credit sales Debtors collection represents the average time taken for debtors to settle their accounts. Interpretation • The higher the collection period, the greater the investment in debtors and the greater the need for working capital. • A high collection period could indicate poor credit control i.e. the credit worthiness of customers are not properly evaluated. • The collection period should be compared with the past and with industry trading terms. 3. Creditors payment period (in days) = Trade creditors (or average creditors)x 365 days Credit purchases This ratio shows the average time taken by the business to pay its trade creditors. Interpretation • An increase in the creditors collection period could indicate that the business is finding difficulty paying its creditors or that it has obtained more favourable credit terms. • An increase in the credit collection period represents a source of funds and reduces the need for working capital. 4. Cash cycle The cash cycle represents the length of time between paying creditors for the goods and receiving cash from debtors from the sale of goods. The cash cycle (in days) is equal to: Stock turnover period X days + Debtor collection period X days - Creditor payment period (X) days Cash cycle X days Interpretation:
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