Ahmadhiyya International School
Accounting –RATIOS- reference material-Grade 11(2020)
Analysis of financial statements
After preparation of the financial statements they are to be analyzed for the purpose of
evaluating the performance of a business.
Ratio analysis (accounting ratios)
ratios is one among the different tools used for the
analysis of financial statements.
Accounting ratios
The relation between two figures is known as a ratio. When the ratio is established
between two accounting data, it is called an accounting
accounting ratio. An accounting ratio may be
expressed in three ways.
Ratio analysis is the calculation and comparison of ratios that come from the
information in a business’s financial statements. The ratios are used to examine the
performance of a business over a period of time
a) Pure ratio (e.g. 2:1)
b) Times (e.g. 5 times)
c) Percentage (e.g. 40%)
Uses of accounting ratios: The analysis of accounting statements using ratios allows the
different users of accounting information to assess the strengths and weakn
weaknesses of a
business according to the needs of the individual user group.
Accounting ratios are used:-
1. To analyze and interpret financial statements.
2. To calculate missing figures in financial statements.
3. To make decisions regarding financial and investment policies
4. To frame credit policies regarding purchases and sales
5. To analyze the profitability, liquidity, efficiency, and capital gearing of a business
6. The ratios are used to examine the performance of a business over a period of time
7. Ratios can be used to compare the current year performance of a business with
previous years
ACC-SRN
Ahmadhiyya International School
Accounting –RATIOS- reference material-Grade 11(2020)
Limitations of ratios:
Ratio analysis is a very useful tool, but it has its own limitations
1. Use of Historical Data
All the information used in ratio analysis is based on
o historical numbers only.
2. The Concept of Inflation
Ratio analysis does not account for the inflation factor at all.
3. The Problem of Aggregation
The data from the financial statement for a particular line item that we are using for our
study or comparison may have been aggregated in a different proportion in the past and thus
doing a trend analysis based on this data doesn’t give a true picture.
4. Changes in Operation
A business can go drastic changes in its operations due to certain unexpected needs and
thus using
ing the data of the past and making a judgment based on that does not give a fruitful
conclusion.
5. The Policies of Accounting
When we are doing peer to peer comparison different companies may use different
accounting policies and thus it makes hard to conclude
concl on such cases.
6. No Standard Definition of Ratios
There is no set standard definition of ratios and numbers
numbers to be included in it. Certain firms
may include items when calculating a ratio and few may include others. Thus when it comes
to a comparison of bothoth companies it becomes difficult.
7. Ignorance of the Qualitative Aspect
Ratio analysis ignores the qualitative view of the firm and tends to include only the monetary
aspect.
8. Opportunities for Window Dressing
Some firms may manipulate the numbers to bring about changes to the ratio for displaying a
better picture of the firm. Thus in ratio analysis, there are scopes of window dressing.
9. The Mix of Historical and Actual Numbers
Ratio analysis can be misleading at times because elements from profit and loss st statements
are based on actual cost whereas elements from the balance sheet are based on historical.
Conclusion
Ratio analysis has both advantages and disadvantages of its own and solely depends on the
analyst who is using this and what he/she is using this for. Even then, the advantages clearly
outweigh the disadvantages as for people outside the company this is the only way to get a
better view of the company and understand
understand its financials. Ratio analysis plays a major role in
any kind of fundamental analysis specific to a company.
ACC-SRN
Ahmadhiyya International School
Accounting –RATIOS- reference material-Grade 11(2020)
Classification of accounting ratios
1. Profitability ratios:
These are ratios established on the basis of the profit
p of a business. Usually these are
expressed in percentages and include:
a) Gross profit ratio;; ratio of gross profit to net sales –also
also called (Margin
(Margin)
100
(revenue)
b) Gross profit to cost of sales (MARK-UP) = x 100
c) Net profit ratio:: ratio of net profit to sales(revenue)
sales =
Net profit x 100
Sales
d) Return on capital employed;
employed; indicates the rate of return on investment
= Net profit (before interest ) x 100
Capital employed
e) Expenses ratio:: ratio of expenses to sales. Lower the ratio, the better it is.
Expenses ratio = Expenses x 100
Sales
Capital and Capital employed
Capital refers to the fund invested by the owner. It is called owner’s equity. The total fund
invested in the business is called capital employed.. It is the total of owned capital and
borrowed capital by means of Debentures or long-term
long loans.
Capital employed = Owned fund + Borrowed fund OR
Capital employed= Owners’ equity + non-Current
non Liabilities OR
Capital employed= Total assets – Current Liabilities
2. Liquidity or solvency ratios
These ratios are established to check the solvency position or the firm’s ability to pay
its creditors/trade payables.. These ratios are expressed as pure ratio.
a) Current ratio
The relation between current assets and current liabilities
Current assets are assets held for a short period of time with easy convertibility in to cash.
(Cash, Bank, Trade receivables, Inventory, prepaid expenses etc)
ACC-SRN
Ahmadhiyya International School
Accounting –RATIOS- reference material-Grade 11(2020)
Current liabilities are payments to be made within a short period of time(less
time(less than one year)
– Trade payables,, unpaid expenses, bank overdraft,
overdraft short term loans etc. (2:1
2:1 is ideal for any
concern)
Current ratio = Current assets
Current liabilities
b) Liquid or Acid test ratio.
It is the proportion of liquid assets to current liabilities. Assets which can be converted
into cash most easily are called liquid assets. It is the total off current assets excluding
inventory. (1:1 is ideal for any concern)
Acid test ratio = Liquid assets (or current assets- inventory)
Current liabilities
3. Efficiency ratios
These ratios are used to evaluate the operational efficiency of a business.
a) Stock or Inventory turnover ratio
ra
It indicates the number of times
times a business converts its inventory into sales. It is
expressed in times. Higher the number the better it is.
Inventor turnover = Cost of goods sold
Average stock
Cost
st of goods sold = opening inventory + purchases-
purchases closing inventory
Or Sales Revenue – gross profit
Or Average inventory x inventory turnover
Average inventory = opening inventory + closing inventory
2
b) Trade Receivables turnover (Debt
( collection period)
It indicates the number of days with in which a business collects the amount of credit
sales from its debtors. It is expressed in days. (Shorter the period, the better it is)
Trade receivables turnover ratio = Trade Receivables x 365
Credit sales
c) Trade payables turnover
It indicates the length of time taken by a business to pay its creditors for goods
supplied. Longer the period the better it is. It is
i expressed in days.
Trade payables turnover ratio = Trade payables x 365
Credit purchases
ACC-SRN
Ahmadhiyya International School
Accounting –RATIOS- reference material-Grade 11(2020)
d) Ratio of non-current
current assets to Revenue
Re (Assets usage ratio)
Revenue
Non-current assets
This ratio establishes
lishes relation between
betwe net revenue and total non-current
current assets. ((Non-
current assets at their carrying value)
Relationship between Trade receivables collection period, Trade payables payment
period and Liquidity
The longer the trade receivables collection period, the worse it will affect the cash flow,
since it takes longer time to collect cash from trade receivables. This reveals poor credit
control – customers are allowed to purchase goods on credit without the business ensuring
prompt payment.
A long trade payable payment period has a positive impact on the cash flow, but it
reveals to suppliers that the business has a liquidity problem and as a result, it may not
supply goods on credit anymore. This can lead to an even poorer liquidity result because
purchases of inventory may need to be in cash.
In short, if the trade receivable collection period is shorter than the trade payable
payment period, it will have a positive impact on liquidity. The business also need to bear in
mind that the trade payable payment period should not be too long because this ensure that
suppliers continue to supply the purchases made by the business on credit rather than
insisting on cash.
Exam hint:
In the examination, calculate the ratios to two decimel places unless your are
told differently. As well as describing what has happened to the ratio, explain
whether it has improved or worsened
Always write down the formula you are using and show all workings
ACC-SRN
