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Accounting Ratios - Principles Of Accounting

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http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ Accounting Ratios 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:

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previous periods of the same business other organizations of carrying on similar business



plans and budgets



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Profitability (performance) ratios

QuickBooks 2013 Original

1. Gross profit percentage

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These ratios measure the level of profitability of the business. the following are commonly used profitability ratios:-

This ratio measures the gross profit as a percentage of sales (i.e. net sales or turn over)

Gross profit percentage (margin) = Gross Profit

x 100

Net sales

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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.

Net profit percentage = Net profit

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X 100

Net sales

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3. Return on capital employed This ratio expresses the net profit as a percentage of capital invested Return on capital employed (ROCE) =

Net profit

X 100

Capital employed Capital employed can have different meanings. The most widely used formula for capital employed is as follows:

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)

http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ 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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Accounting Ratios - Principles Of Accounting

Current ratio =

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Current assets

Current liabilities

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.

http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ 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)

/ http://www.principlesofaccounting2.com/ 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…)

/ http://www.principlesofaccounting2.com/ 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

B. Profit / selling price

C. Profit / cost price

D. Cost price / loss

2. How is margin percentage calculated? A. Profit / cost price x 100

B. Profit / selling price

C. 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

B. Profit

C. Surplus

D. Margin

4. A shop keeper is making 25% profit on sale price. What is this profit called? A. Profit

B. Surplus

C. Mark up

D. margin

5. Which of the following equations is correct? A. Cost price – profit = selling price

B. Cost price + profit = selling price

C. Cost price – selling price = profit

D. Selling price + cost price = profit

6. How is the rate of stock turn over calculated? A. Cost of goods sold / opening stock

B. Cost of goods sold / average stock

C. Cost of goods sold / closing stock

D. Cost of goods sold / sales

7. The following relates to a sole trader’s business: Average stock

$ 12 600

Mark up

50% on cost

http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ Stock turn over

7 times.

What is the amount of gross profit? A. $ 44 100

B. $ 88 200

C. $ 25 200

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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

$ 5 600

Opening stock

$ 500

Closing stock

$ 900

What is the rate of stock turn over? A. 7 times

B. 6 times

C. 8 times

D. 9 times

http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ 10. K.King gives the following information at 31

Stock on 1st Jan

$ 600

Purchases during the year

$ 5 400

Average stock during the year

$ 1 200

st

Dec

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. Sales Gross profit

Firm A ($)

Firm B ($)

100 000 20 000

100 000 25 000

Net profit 5 000 5 000 1. Give one reason why the gross profits of the firms differ?

/ http://www.principlesofaccounting2.com/ Q2.

Here is a trading account.

Sales

50 000

Less Cost of goods sold Opening stock

5 000

Add Purchases

42 500

47 500 Less Closing stock

10 000

37 500

Gross Profit

12 500

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

13 000

Machinery

5 000

Office equipment

2 500

20 500 Current assets Stock Debtors

12 000 4000

http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ Bank

2000

18 000

Less Current liabilities

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Accounting Ratios - Principles Of Accounting

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Creditors

6 000

Working capital

12 000

32 500 Financed by Capital + Net profit

30 000 10 000

40 000 - Drawings

7 500

32 500

From the above, calculate ;-

http://principlesofaccounting2.com/ http://principlesofaccounting2.com/ 1. Current ratio 2. Acid test ratio

3. Return on capital employed 4. Comment on the figures you have calculated, comparing them with last year’s 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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