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Learning Outcome
• State the functions of accounting ratios
• Calculate a range of ratios
• Draw logical conclusion from the ratios
• State the limitations associated with ratio
analysis
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Uses of accounting ratios
• Enable comparison of the performance of
the company
• - in different years
• - with its budgets and forecasts
• - with other companies in similar trades
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Uses of accounting ratios
• Provide information of the company in respect of
the liquidity, profitability, use of assets and capital
structure
• Eliminate the effects of the scale and size of
different companies or different years of the same
company so comparison can be provided.
• Appraise the performance of the company, make
predictions for future performance and assist in
future planning
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Accounting ratios and
interpretation
• Liquidity
• - current ratio / working capital ratio
• - acid test ratio / quick ratio / liquid ratio
• - stock turnover rate
• - stock turnover period
• - debtors’ collection period
• - creditors’ payment period
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Liquidity
• Liquidity is a measure of the amount of
funds a company can quickly use to settle
its debts.
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Liquidity – current ratio
• This ratio indicates the ability of a business to
meet its short-term liabilities from its current
assets.
• The norm is 2:1.
• If the ratio is too high, the company may be
holding too many idle short-term assets. (They
may be used in a more profitable way.)
• If the ratio is too low, the company may not have
sufficient funds to meet its short-term liabilities.
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Liquidity – acid test ratio
• This ratio indicates the ability of the business to
meet its short-term liabilities from its quick assets.
• The norm is 1:1.
• If the ratio is too high, the company may be
holding excessive liquid assets.
• If the ratio is too low, the company may have a
liquidity problem / cash flow problem.
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Liquidity – stock turnover rate
• It shows the number of times that a business
can sell its average stock in a period.
• A high ratio means high sales, fast stock
turnover and a low stock level.
• A low ratio means low sales, low stock
turnover and a high stock level. (goods may
become obsolete, high storage cost)
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Liquidity – debtors collection
period
• This ratio measures the debt collection
period of a business.
• A low ratio means debtors pay back their
debts in a short period of time. The
company may have sufficient liquid fund.
• A high ratio indicates a poor credit control
and a high risk of bad debts.
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Liquidity – creditors payment
period
• This shows the length of time taken to pay
the creditors.
• A long payment period may indicate that
the company has a liquidity problem. The
relationship between the company and the
suppliers may be affected.
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Accounting ratio and
interpretation
• Profitability
• - gross profit ratio / gross margin / profit to
sales ratio
• - net profit ratio / net profit margin
• - return on capital employed
• - assets turnover
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Profitability – gross profit ratio
• It shows the gross profit on sales.
• A low ratio means the stock is being sold at
lower prices. It may be a policy to stimulate
sales.
• A high ratio may not result in high gross
profit figure unless a large volume of sales
is achieved.
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Profitability – net profit ratio
• It shows the net profit as a percentage of
sales.
• It gives some ideas of the company’s
pricing policy and cost control.
• A low ratio may be the result of lower
selling prices or higher operating costs.
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Profitability – return on capital
employed
• This ratio shows the profitability of a
business and the management effectiveness
in terms of the use of capital.
• A higher ratio means a higher profitability
and a better management efficiency.
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Capital employed (Sole trader)
• Closing capital
• Average capital
• Capital balance + long term loans
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Capital employed (Partnership)
• Closing balance on fluctuating capital accounts
• Average of opening and closing balances on the
fluctuating capital accounts
• Total of fixed capital accounts plus total of current
accounts
• Average of fixed capital accounts plus total of
current accounts
• Any of the above plus long term loans to the
partnership
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Capital employed
(Limited company)
• - total assets
• - long term suppliers of capital (ordinary
shares + preference shares + reserves +
long-term loans)
• - shareholders’ capital (ordinary shares +
preference shares + reserves)
• - shareholders’ equity (ordinary shares +
reserves)
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Return
• Net profit after tax and preference share
dividends (for ordinary shareholders)
• Net profit after tax + any preference share
dividends + debenture and long-term loan
interest (for all long-term suppliers of
capital)
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Profitability – assets turnover
• This indicates the efficiency of the business
in using its assets to generate revenues.
• A higher ratio means the company is more
efficient to use its assets to generate
revenues. This results in higher profitability.
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Accounting ratios and
interpretation
• Management efficiency
• - stock turnover rate
• - debtors ratio
• - creditors ratio
• - assets turnover
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Management efficiency
• Stock turnover rate measures the efficiency of
sales and stock levels of a company.
• Debtors ratio indicates the credit control of the
company. (lenient credit control?)
• Creditors ratio indicates the ability of the company
to obtain long-term financing.
• Assets turnover shows the efficiency of the
business in using its assets to generate revenues.
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Accounting ratios and
interpretation
• Long-term solvency and stability
• - debt ratio
• - gearing ratio
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Debt Ratio
• Debt ratio
• Total debts
• = ---------------------- X 100%
• Total assets
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Long-term solvency – debt ratio
• Debt ratio shows the total amount of
liabilities to total assets.
• If the debt ratio is too high (more than 50%),
it is difficult to obtain further financing and
it also has a heavy burden of interest
expense.
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Gearing ratio
• Gearing ratio
• Prior charge capital
• = --------------------------------------- X 100%
• Total capital
• Prior charge capital = preference shares + long
term loans
• Total capital = ordinary share capital + reserves +
preference shares + long term loans
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Long-term solvency – gearing
ratio
• It is concerned with the company’s long-term
capital structure.
• A high gearing ratio indicates a high portion of
funds is obtained from borrowings. It may lead to
long-term insolvency. It is difficult to obtain
further financing and has to bear a high interest
burden.
• Ordinary shareholders may not get any dividends
in bad times as very little profit is left over for
them
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Gearing ratio (P.648 – P. 649)
• High geared company • Low geared company
• Investment is more • The risk of investment
risky is relatively lower
• Larger dividends will • It is more certain to
be available in good have dividends.
times
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Changing the gearing
• To reduce gearing • To increase gearing
• By issuing new • By issuing debentures
ordinary shares • By buying back
• By redeeming ordinary shares in
debentures issue
• By retaining profits • By issuing new
preference shares
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Accounting ratio and
interpretation
• Investment appraisal
• - earnings per share
• - price earning ratio
• - dividend cover
• - dividend yield
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Earnings per share
• Earnings per share (EPS)
• Net profit after tax and preference dividends
• = ------------------------------------------------------
• No. of ordinary shares issued
• (ranked for dividends)
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Investment appraisal – earning
per share
• It shows the profit in dollars associated with
each ordinary share.
• A higher earnings per share indicates the
investors may have higher confidence in the
company. It is more profitable to invest in
the shares.
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Price / earning ratio
• Price / earning ratio
• Market price per share
• = -----------------------------------------
• Earnings per share
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Investment appraisal – price
earning ratio
• This ratio indicates the number of years
required to earn the amount invested in the
shares.
• A high ratio indicates investors have strong
confidence in the company.
• An unreasonably high ratio may be the
result of speculation in the stock market.
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Dividend cover
• Dividend cover
• Net profit after tax and preference dividends
• = -------------------------------------------------------
• Ordinary dividends paid and proposed
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Investment appraisal – dividend
cover
• It shows the amount of profit that has been
distributed as dividends.
• A low ratio means a large amount of profits has
been retained as reserves which can help to
finance the operations of the company.
• A high ratio means a large amount of profits has
been distributed as dividends. The dividend
payment is vulnerable unless the company
becomes more profitable.
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Dividend yield
• Dividend yield
• Dividend per share for the year
• = -------------------------------------------- X 100%
• Current market price of the share
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Investment appraisal – dividend
yield
• This ratio measures the rate of return
obtained from dividends on an investment
in shares.
• A high dividend yield may imply the
company is more successful and efficient. It
is more profitable to invest in these shares.
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Other ratios (P. 649)
• The company will be able to pay interest on the
loan when it falls due. (short-term liquidity)
• - current ratio and acid test ratio
• It will be able to repay the loan on maturity. (long-
term solvency)
• - operating profit / loan interest
• - total external liabilities
• - shareholders’ fund / total assets
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Examples of interested group
(P.641)
• Profitability
• - shareholders
• - management
• - employees
• - creditors
• - competitors
• - potential investors
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Examples of interested group
• Liquidity
• - shareholders
• - suppliers
• - creditors
• - competitors
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Examples of interested group
• Management efficiency
• - shareholders
• - potential purchasers
• - competitors
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Examples of interested group
• Investment appraisal
• - shareholders
• - potential investors
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Examples of interested group
• Capital structure
• - shareholders
• - lenders
• - creditors
• - potential investors
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Limitations of ratio analysis
• Different definitions of capital employed
may cause confusion.
• Changes in price level will affect the
comparability of the ratios between two
financial periods.
• Changes in external environment will affect
the comparison.
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Limitations of ratio analysis
• Differences in management and background of
various businesses may affect the comparison.
• Different accounting definitions, methods,
techniques and policies used by various businesses
may affect the comparability.
• It is difficult to set up a proper standard for good
performance.
• Short term fluctuations may not be reflected.
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