Chap 10 – Accounting Ratios [CAF – 1]

1-PERFORMANCE RATIOS / PROFITABILITY RATIOS

1.1 Gross Profit ratio

Formula GP ratio = Gross profit x 100 %
Net Sales
Here:
Net Sales = Sales – Sales returns

Comment
Ratio result- “higher” is better

Meaning- It shows the relationship between gross profit and sales and the efficiency
with which a business produces its product.

Reasons for- High ratio Low ratio

•Increase in selling price • Decrease in selling price
•Reduction in purchase cost • Increase in purchase cost
•Lower production costs / economies • Higher production costs
of scale

1.2 Net Profit Ratio

Formula NP ratio = Net profit x 100 %
Net Sales
Here:
Net profit = Profit after tax
Net Sales = Sales – Sales returns

Comments
Ratio result- “higher” is better

Meaning- It shows the overall profitability of business. It shows how efficiently the
business is conducting its operations to ensure higher profits.

Reasons for- High ratio Low ratio

•Higher total gross profit • Lower total gross profit
•Efficient operating expenses • Uncontrolled operating expenses
•Low finance cost • High finance cost

Other profit ratios:

Similarly other profits formulas can be formed for “Operating profit (i.e. PBIT) ratio” and “Profit before tax (i.e.
PBT) ratio” as well.

Cost ratios:
Based on similar concepts (i.e. based on sales) cost ratios can also be formed. For example:
- COS/Sales ratio = COS / Sales x 100 OR (1 – GP ratio)
- Operating expenses/Sale ratio = Operating expense/Sales x 100 OR (1 – Operating profit ratio)

Nasir Abbas FCA 1

 Chap 10 – Accounting Ratios [CAF – 1]

1.3 Return on capital employed (ROCE)

Formula ROCE = PBIT x 100%

Avg. Capital Employed
Here:
PBIT = Operating Profit = Profit before interest (after interest of overdraft) & tax

[As overdraft is not considered as debt for ratio analysis therefore its interest is not included in finance cost for
above formula]

Capital employed = Equity + Borrowings (including current portion of NCL)

Comments
Ratio result- “higher” is better

Meaning- It is considered the best measure of overall profitability of business and

indicates how well the management has used the investment made by
owners and lenders into the business.

Reasons for- High ratio Low ratio

•Higher profitability • Lower profitability
•Efficient funds management • Inefficient funds management
•Repayment of loans • New loans

1.4 Return on equity (ROE)

Formula ROE = PAT – preference dividend x 100%

Avg. Equity
Here:
Preference dividend is on irredeemable preference shares
Equity = Capital and all reserves
Comments
Ratio result- “higher” is better

Meaning- It measures the overall efficiency of a company. This ratio is of great

importance to present and prospective shareholders as well as
management.

Reasons for- High ratio Low ratio

•Lower tax rates • Higher tax rates
•Higher profitability • Lower profitability
•Higher dividends reducing equity • Lower dividends

Nasir Abbas FCA 2

 Chap 10 – Accounting Ratios [CAF – 1]

1.5 Return on assets (ROA)

Formula ROA = PBIT x 100%

Avg. Assets
Here:
Assets = Total assets
OR
= Non current assets
Comments
Ratio result- “higher” is better

Meaning- It measures the overall efficiency of a company in generating profits using

its assets efficiently.

Reasons for- High ratio Low ratio

•Higher profitability • Lower profitability
•Efficient asset management • Inefficient asset management

2-LIQUIDITY/SHORT TERM SOLVENCY RATIOS

2.1 Current ratio

Formula Current ratio = Current assets [x : 1]

Current Liabilities
Here:
Current assets = All current assets including prepayments.
Current Liabilities = All current liabilities including Bank
Overdraft
Comment
Ratio result- “near 2:1” is normal / standard

Meaning- It represents the margin of safety or cushion available to the creditors. It is

an index of the business financial stability.

Reasons for- High ratio Low ratio

•Better liquidity position • Financial difficulty
•Poor recovery control over debtors • Strict recovery from debtors
•Larger inventories • Lower inventories
•Less credit purchases • Longer creditor’s credit periods

2.2 Liquid ratio/acid test ratio/quick ratio

Formula Quick ratio = Current assets –Inventory [x : 1]

Current liabilities
Here:
Current liabilities = All current liabilities including Bank Overdraft.

Nasir Abbas FCA 3

 Chap 10 – Accounting Ratios [CAF – 1]

Comment
Ratio result- “near 1:1” is normal / standard

Meaning- It measures the business’s capacity to pay off current obligations

immediately and is more accurate test of liquidity than the current ratio.

Reasons for- High ratio Low ratio

•Better liquidity position • Financial difficulty
•Longer debtors’ credit period • Shorter debtors’ credit period

3-ACTIVITY/ WORKING CAPITAL RATIOS

3.1 Inventory turnover ratio

Formula Inventory turnover = Cost of sales times

Avg. Inventory
Comment
Ratio result- “higher” is better

Meaning- It measures the velocity of conversion of stock into sales.

Reasons for- High ratio Low ratio

•Efficient inventory management • Inefficient inventory management
•Higher sales • Lower sales

3.2 Inventory period

Formula Inventory period = Avg. Inventory x 365 days

Cost of sales
Note:
Instead of “365”, using “12” will give answer in months and “52” will give answer in
weeks.

For manufacturing business inventory period is analyzed as:

Raw material inventory period = Avg. RM inventory/Material consumed x 365

Work in process inventory period = Avg. WIP inventory/COGM x 365

Finished goods inventory period = Avg. FG inventory/Cost of sales x 365

Comment
Ratio result- “lower” is better

Meaning- It measures the period for which goods remain in stock before getting sold.

Nasir Abbas FCA 4

 Chap 10 – Accounting Ratios [CAF – 1]

Reasons for- High ratio Low ratio

•Inefficient inventory management • Efficient inventory management
•Lower sales • Higher sales

3.3 Debtors turnover ratio

Formula Debtors turnover = Credit sales times

Avg. Debtors
Note:
If Credit sales are not given in question then use“Total sales”

Comment
Ratio result- “higher” is better

Meaning- It measures the velocity of debt collection of the business.

Reasons for- High ratio Low ratio

•Better control over debtors • Poor control over debtors
•Shorter credit periods • Longer credit periods
•More discounts offered • Less discounts offered

3.4 Debtors collection period

Formula Debtors collection period = Average debtors x 365 days

Credit sales

Note:
- If Credit sales are not given in question then use “Total sales”
- Instead of “365”, using “12” will give answer in months and “52” will give answer in
weeks.

Comment
Ratio result- “Lower” is better but should be within credit period allowed

Meaning- It indicates the number of days for which a business has to wait before its
debtors are converted into cash.

Reasons for- High ratio Low ratio

•Inefficient collection • Efficient collection
•Longer credit periods • Shorter credit periods
•Less discounts offered • More discounts offered

Nasir Abbas FCA 5

 Chap 10 – Accounting Ratios [CAF – 1]

3.5 Creditors turnover ratio

Formula Creditors turnover ratio = Credit purchases times

Avg. Creditors
Note:
If Credit purchases are not given in the question then use“Total Purchases”
If Purchases are not given then use “Cost of sales”

Comment
Ratio result- Generally “higher” is better as it shows credit worthiness, however higher
ratio may indicate that credit period is not fully availed.

Meaning- It measures the velocity of paying to creditors of the business.

Reasons for- High ratio Low ratio

•Timely payment to suppliers • Late payment to suppliers
•Credit worthiness • Less credit worthiness
•More discounts availed • Less discounts availed

3.6 Creditors payment period

Formula Payment period = Average creditors x 365 days

Credit purchases
Notes:
- If credit purchases is not given in question then use “Total Purchases” or “Cost of sales”
- Instead of “365”, using “12” will give answer in months and “52” will give answer in
weeks.

Comment
Ratio result- Generally “lower” is better as it shows credit worthiness, however it
should be closer to credit period allowed.

Meaning- It indicates the number of days of credit period enjoyed by the business in
paying creditors.

Reasons for- High ratio Low ratio

•Late payment to suppliers •Timely payment to suppliers
•Less credit worthiness •Credit worthiness
•Less discounts availed •More discounts availed

3.7 Assets turnover ratio

Formula Assets turnover = Sales times

Avg. Assets
Here:
Sales = Sales – sales return
Assets = Non-current assets OR Capital employed OR Total assets

Nasir Abbas FCA 6

 Chap 10 – Accounting Ratios [CAF – 1]

Comments
Ratio result- “higher” is better

Meaning- It measures the efficiency and profit earning capacity of business assets. It
indicates how well the assets are utilized to generate revenue.

Reasons for- High ratio Low ratio

•Efficient utilization of assets • Inefficient use of assets
•High productivity of assets • Low productivity

3.8 Working capital cycle / Cash operating cycle

Formula
Working capital cycle= [Inventory period + debtors collection period – creditors period]

Comments
Ratio result- “Lower” is better

Meaning- It reflects the period of one operating cycle from time suppliers are paid to
the time cash is received from customers.

Reasons for- High ratio Low ratio

•Low inventory turnover • High inventory turnover
•Poor control over debtors • Better control over debtors
•Timely payment to suppliers • Late payment to suppliers

4- LONG TERM SOLVENCY / LEVERAGE RATIOS / DEBT RATIOS

4.1 Debt to assets ratio / Gearing ratio

Formula Debt to asset ratio = Debt x 100 %
Capital employed
Here:
Debt = Borrowings (including current portion)
Capital employed = Equity + Debt
Comments
Ratio result- It depends upon nature of business that which ratio is better

Meaning- It measures the portion of total finance of a business, relating to outsiders.

Reasons for- High ratio Low ratio

•High amount of debts • Lower debt
•Less ability to pay off debts • Better solvency position

4.2 Debt Equity Ratio / Gearing ratio

Formula Debt Equity ratio = Debt [x : y or in %]

Equity

Nasir Abbas FCA 7

 Chap 10 – Accounting Ratios [CAF – 1]

Comment
Ratio result- Generally “1:1” is standard, however, it largely varies from business to
business.

Meaning- It indicates the relationship between external finance and internal finance.

Reasons for- High ratio Low ratio

•Higher debts •Lower debts
•Less risk shared by owners •More risk shared by owners
•Less solvent business •Better solvency position

4.3 Interest cover / Debt service ratio

Formula Interest cover = PBIT times
Interest
Here:
PBIT= Operating Profit = Profit before interest and tax
Interest = finance cost for the year

Comment
Ratio result- “higher” is better

Meaning- It indicates whether the business earned sufficient profits to pay

periodically the interest charges.

Reasons for- High ratio Low ratio

•Higher profitability • Lower profitability
•Less use of debts • More use of debts
•Ability to take further debts • Less credit worthiness

Nasir Abbas FCA 8