Accounting Ratios
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Semmi Chen, a retired singer, is considering investing $100,000 in company XYZ. She asks for help analyzing XYZ's financial statements to determine if it is a good investment. The assistant provides Semmi with an introduction to financial ratios that can be used to evaluate a company's profitability, efficiency, liquidity, and capital structure based on its financial statements. Key ratios discussed include gross profit margin, net profit margin, rate of stock turnover, current ratio, and return on capital. The assistant offers to calculate these ratios from XYZ's financials and make a recommendation about whether Semmi should invest.
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Accounting Ratios
- 1. 1 Principles of Accounts Analysis and Interpretation of Final Accounts
- 2. 2 Class 4C… Can You Help Semmi Chen?
- 3. 3 Situation Semmi has made lots of money during her singing career. She is thinking of retiring one day from singing and is looking hard at how she can invest her savings wisely. But she wants you to help her make good investment decision. Semmi hears that investing in good companies will earn her more money. She has been recently invited to invest $100,000 in the firm XYZ, which seems to be a promising and profitable firm.
- 4. 4 Can You Help Me? XYZ’s most recent financial statements are HERE. I hear that you are an expert in preparing clear and accurate P&L Statement and Balance Sheet. Can you recommend to me whether I should invest in XYZ firm?”
- 5. 5 First, An Introduction to… Financial Ratios
- 6. 6 Financial Ratios Ratios show important relationships between financial figures. Compare the business’ performance over several financial periods. Compare the business’ performance with that of other business within the same industry.
- 7. 7 Four Uses of Financial Ratios Profitability of the business Gives an indication of the level of returns that the owner is getting: Gross profit margin Mark-up on cost Net profit margin Rate of return on capital
- 8. 8 Level of efficiency of business activity Indicates the way the business uses its assets: Rate of stockturn or Rate of stock turnover Percentage of expenses to turnover Four Uses of Financial Ratios
- 9. 9 Liquidity of the business Indicates the business’ ability to pay its debt and manage its working capital: Working capital Current ratio Quick ratio Four Uses of Financial Ratios
- 10. 10 Capital structure of the business Show the composition of and relationship between equity capital and other long-term sources of finance eg long-term loan: Owner’s equity Capital employed Four Uses of Financial Ratios
- 11. 11 Concept Map Financial Ratios Four types Profitability Efficiency Liquidity Capital structure Mark-up on cost Gross profit margin Net profit margin Rate of return on capital Rate of stockturn Percentage of expenses to turnover Working capital Current ratio Quick ratio Owner's equity Capital employed liabilities Owner's equity Long term Current Beginning Closing Drawings Net profit Gross profit Expenses Turnover/ Net sales COGS Opening stock Closing stock Current assets Cash Bank Debtors Prepayments
- 12. 12 Mark Up on Cost Profit as a % of cost price 100 soldgoodsofCost profitGross upMark ×=
- 13. 13 Application 100 soldgoodsofCost profitGross upMark ×= %44100 $695,000 $305,000 firm)(XYZupMark =×= Cost of goods sold 100% of cost Gross profit 100% of cost 44% of cost Turnover
- 14. 14 Gross Profit Margin Also known as: Gross profit ratio Gross margin Margin As a % of gross profit to turnover 100 Turnover profitGross marginprofitGross ×=
- 15. 15 Application 100 Turnover profitGross marginprofitGross ×= %5.30100 $1,000,000 $305,000 marginprofitGross =×= Turnover (net sales) 100% of turnover 30.5% 100% of turnover COGS Gross profit 69.5%
- 16. 16 Net Profit Margin Also known as Net profit ratio As a % of net profit to turnover 100 Turnover profitNet marginprofitNet ×=
- 17. 17 Application 100 Turnover profitNet marginprofitNet ×= %10100 $1,000,000 $100,000 marginprofitNet =×= Turnover (net sales) 100% of turnover 20.5% Expenses COGS Gross profit 69.5% 10%
- 18. 18 Percentage of Expenses to Turnover As a % of expense per dollar of sale 100 Turnover expensesTotal turnovertoexpenseofPercentage ×=
- 19. 19 Application 100 Turnover expensesTotal turnovertoexpenseofPercentage ×= %5.20100 $1,000,000 $205,000 turnovertoexpenseof PercentagesXYZ' =×= Turnover (net sales) 100% of turnover 20.5% Expenses
- 20. 20 Practice Time Mark up on cost Gross margin Net profit margin
- 21. 21 Rate of Stockturn Also known as Rate of stock turnover No. of times in a year the average stock can be sold off
- 22. 22 Rate of stockturn 100 pricecostatstockAverage soldgoodsofCost stockturnofRate ×= stock)closingstockopening( 2 1 pricecostatstockAverage += Where:
- 24. 24 Application(cont…) COGS COGS1x 1x 0.56x Average stock at cost price 1x times56.3 $195,000 $695,000 stockturnofRate sXYZ' ==
- 25. 25 Rate of Stockturn – another formula 100 pricesellingatstockAverage Turnover stockturnofRate ×= Calculating rate of stockturn based on the selling price of goods sold:
- 26. 26 Summary I 100 Turnover expensesTotal turnoverto expensesof% stockAverage COGS stockturn ofRate 100 Turnover NP marginNP 100 Turnover GP marginGP 100 COGS GP costonup-Mark ×= = ×= ×= ×= Total Expenses NP c/d Beg Stock Net Purchases Ending Stock COGS GP c/d Turnover (Net Sales) GP b/d NP b/d Trading & Profit & Loss
- 27. 27 Working Capital Amount of capital used to meet the day-to- day expenses of running a business. sliabilitieCurrent-assetsCurrentcapitalWorking =
- 28. 28 Is working capital of $100,000 adequate or $1,000,000 be adequate or too much? How can we determine how many times current assets are available to pay current liabilities? Think…
- 29. 29 Working Capital Ratio sliabilitieCurrent assetsCurrent ratiocapitalWorking = Indicates the business ability to pay its bills Also known as Current ratio
- 30. 30 Current liabilities Application times2.3 $100,000 $320,000 ratiocapitalWorking sXYZ' == sliabilitieCurrent assetsCurrent ratiocapitalWorking = Current assets 1x 1x 1x 0.2x
- 31. 31 Quick Ratio Also known as: Liquid ratio Acid test ratio sliabilitieCurrent sPrepayment-Stock-assetsCurrent ratioQuick =
- 32. 32 Application times1.1 $100,000 $10,000-$200,000-$320,000 ratioQuick sXYZ' == sliabilitieCurrent sPrepayment-Stock-assetsCurrent ratioQuick = Current liabilities 1x 0.1x Why do we exclude stock & prepayments from current assets in calculating quick ratio?
- 33. 33 Owner’s Equity Also known as Owner’s capital capitalAdditionalDrawing-profitNet periodofbeginningatCapitalequitysOwner' or sLiabilitie-AssetsequitysOwner' + += = What’s XYZ’s Owner’s equity?
- 34. 34 Capital Employed (Net Worth) Is the effective amount of money actually being used in a business, regardless to whom it belongs sliabilitieterm-LongequitysOwner'employedCapital += 000,320,1$000,20$000,300,1$employedCapital sXYZ' =+=
- 35. 35 Rate of Return on Capital Is the net profit as a % of capital at the beginning of the period 100 Capital profitNet capitalonreturnofRate ×= %26.8100 $1,210,000 $100,000 capitalonreturnofRate sXYZ' =×=
- 36. 36 Summary II Current Assets: Cash Bank Debtors Stock Prepayments Fixed Assets Beg Capital Net Profit Ending Cap Liabilities: Long-term Current Balance Sheet 100 Cap profitNet capon returnofRate LTLCapemployedCap Liab-CAFACap CL DBC ratioQuick CL CA ratioWC CL-CAWC ×= += += ++ = = =
- 37. 37 Practice Time Effects of transactions on Working capital Owner’s capital Capital employed
- 38. 38 Stock Valuation Every business will carry out a physical stock-take ie. count the units of goods NOT sold For some firms, physical stock-take is important because: Closing stock may be a main component of current assets. Incorrect valuation will affect the true and fair value of assets of the business.
- 39. 39 Stock valuation (cont…) Incorrect valuation will affect the cost of goods sold, in turn affecting the gross profit and net profit. Since the closing stock of the current year is the opening stock of the subsequent year, incorrect valuation will not only affect the current year profit and value of assets but also the profit of the subsequent year.
- 40. 40 Basis of Stock Valuation Cost or net realisable value (NRV), whichever is LOWER Cost = purchase price + ALL other expenses incurred in bringing the goods to the present location Net realisable value = amount received from the sale of the stock after deducting all expenses that will be incurred in selling the goods
- 41. 41 Concept of Conservatism Closing stock is valued at the LOWER of cost or NRV If closing stock at cost is $50,000 and at NRV is $45,000, what is the appropriate closing stock value which adheres to the concept of conservatism?
- 42. 42 Stock-taking and Balance Sheet Date Stock-taking is time consuming and usually takes a few days to complete The work may be carried out before or after Balance Sheet date Meanwhile, business as usual Need to make adjustments to arrive at the value of stock on Balance Sheet date
- 43. 43 Before Balance Sheet Date Date of Stock-take 28 December 2002 $12,345 Balance Sheet Date 31 December 2002 •add purchases •less sales •add returns inwards •less returns outwards Go to question
- 44. 44 After Balance Sheet Date Balance Sheet Date 31 December 2002 Date of Stock-take 7 January 2003 $23,456 •less purchases •add sales •less returns inwards •add returns outwards Go to question
- 45. 45 THE END
Editor's Notes
- Introduction Explain to class that up to this point, the class focus on the recording of financial transactions. In the next 4 lessons, they will be introduced to how they can analyse and interpret the final accounts which they learnt to prepare earlier.
- Explain to class that financial ratios are computed to help users analyse relationships, make comparison over several periods, and with other businesses’ performance in the same industry.
- Explain to class that users usually categorise four major uses of financial ratios; explain that a business exists to make profits, hence the importance of profitability ratios. Tell class briefly the four profitability ratios they are to learn in this course.
- Explain to class that besides knowing the profitability of the business, it is also important to know how efficient the business is run. Explain that they will learn two ratios in this course.
- Explain that it is not enough to have a profitable business; the business must also be liquid enough to pay its debts and bills. Introduce the three liquidity ratios.
- Explain that the fourth use helps the supplier of capital (eg. Banks) assess the level of credit risks of the business. Introduce that they will learn two ratios.
- Explain to class the concept map, briefly mention what they are about to learn and how are these related to their prior knowledge.
- Explain what is mark up on cost and show how the item is computed.
- Show how the mark up for XYZ is computed. Illustrate with the model method (diagrams) how gross profit is a % of COGS. Pose the following: Worked example on board Q: If instead, the mark up is given as 25% and gross profit is $305,000, what would be the cost of goods sold? A: The mark up in dollar amount is equal the gross profit => 25% of COGS = $305,000, then 100% COGS = $1,220,000. Pose the following and have three different students share their answers. Thinking question Q:What products do you see around you where mark up on cost are high? A: cosmetics, perfume, audio & visual equipment, handphones.
- Explain the different names of margin and its formula.
- Show how the margin for XYZ is computed. Illustrate with the model method (diagrams) how gross profit is a % of turnover. Highlight how COGS is related to turnover. Pose question and work out the answer on the board: Worked Example Q:If gross profit margin is 20%, and turnover is $1,000,000, calculate the COGS and mark up. A: COGS = 80% of turnover = $800,000. Mark up on cost = ($1,000,000 - $800,000)/$800,000 x 100% = 25% Ask students to show another manner of solving the question: A: Gross profit = 20% x $1,000,000 = $200,000. Then COGS = $1,000,000 - $200,000 = $800,000. Mark up on cost = $200,000/800,000 x 100% = 25%. Pose to students the following question and wait for response: Thinking Q: What are the ways to increase gross profit margin? A: Increase selling price, reduce cost of goods sold without reducing the quantity sold. Q: Does increasing turnover increase gross profit margin? A: No, since margin is a ratio of gross profit to turnover. If turnover increase 20%, so does gross profit.
- Explain another name for net profit ratio and the formula.
- Show how the net profit margin for XYZ is computed. Illustrate with the model method (diagrams) how net profit, expenses, COGS, and turnover are related. Pose these questions to students and obtain response: Thinking Q:What does a net profit margin of 10% mean in relation to every $1 of sales made? A:Out of every $1 sales, the firm earns $0.10 in net profit. Q:Interpret COGS 69.5% and expenses 20.5%. A:Out of every $1 sales, the cost of goods sold take 69.5 cents and expenses take another 20.5 cents from that sales dollar. Q: What does a firm do which would results in a drop in net profit margin? A: Reduce mark up on cost, increase cost of good sold without increasing quantity sold, reduce quantity sold without proportional decrease in expenses, increase expenses like advertising without proportional increase in sales.
- Explain what this ratio is and the formula.
- Show how this ratio for XYZ is computed. Illustrate with the model method (diagrams) how expenses is related to turnover. Pose question on board and work out answer on board: Worked Example Q:If gross profit is $250,000, gross margin is 20%, and expenses is $100,000, calculate the turnover, net profit margin, and % of expense to turnover ratio. A: turnover = $250,000 x 100%/20% = $1,250,000. Net profit margin = net profit/turnover = $(250,000-100,000)/1,250,000 x 100% = 12% % of expense to turnover ratio = 100,000/1,250,000 x 100% = 8%
- Have students pair up and work on worksheet_margin_markup.doc (20 min) Have students shout out the answer as teacher work out the question on board.
- Explain what is rate of stockturn.
- Show how the rate of stockturn for XYZ is computed. Illustrate with the model method (diagrams) how this ratio is related to COGS.
- Pose this question and get student response: Thinking Q:Is a higher stockturn better than a lower stockturn rate? A:Depends. Too low means that stocks are not moving, which can lead to increase storage costs and obsolescence. Too high could mean that the firm may not have enough stocks to fulfill customers’ orders, which could lead to customers going elsewhere.
- Explain that there is another formula for rate of stockturn; explain that the previous formula based on cost is more usually used.
- Explain how these ratios can be calculated from the Trading and P&L account.
- Explain to class what is working capital.
- Pose the question on slide and ask 2 students for their response.
- Explain how working capital ratio is calculated.
- Show how the working capital ratio for XYZ is computed. Illustrate with the model method (diagrams) how current assets is related to current liabilities.
- Explain what is quick ratio and its purpose - to provide a better indicator for liquidity.
- Show how the quick ratio for XYZ is computed. Illustrate with the model method (diagrams) how current liability is related to the quick ratio. Pose the thinking question in slide and get students’ response.
- Briefly recap what is owners’ equity and get students to tell answer what’s XYZ’s owner’s equity.
- Explain what is capital employed, and alert students that there are various definitions, but for the purpose of the syllabus, they need only learn this particular definition. Pose following question: Thinking Q:Why would knowing the capital employed and the owner’s equity be helpful to (i) owner, and (ii) lending bank? A:(i) how much he can “leverage” to take advantage of the lower cost of borrowing. (ii) for the bank to assess the risk of lending to the firm.
- Explain how rate of return on capital is computed. Pose following question and get students’ response. Thinking Q:What is the current bank fixed deposits rate? Would you recommend to Allan to invest in XYZ Dotcom? A:1-2%. Depends. Although 8.26% is better than that earned from fixed deposits, XYZ is a riskier investment than fixed deposits. Allan may not even get back his capital invested if the future business is bad. Q:When looking at these ratios, which is more important – those ratios that focus on the future or those ratios based on past financial data? A:What is past is past. It is more helpful to Allan to have ratios that focus on the future. By computing ratios based on past data, we only have a gauge of how the firm performed. These information must be supplemented with other information about the future.
- Explain that these ratios can be computed using the Balance Sheet.
- Have students work in pairs on worksheet_balance sheet analysis.doc (20 min). Have students shout out answers as teacher work out the question on board.
- Explain to class that for some firms, stock is a major item of its current assets. Therefore, its valuation has implications on whether the accounts show a true and fair picture of the business. Explain what is a stock take and its importance.
- Explain the basis of stock valuation. Pose question and get students’ response. Thinking: Q:What is the difference the expenses in determining cost and that in determining net realisable value? A:The former refers to the cost incurred in preparing the goods to be sold, and the latter, refers to the selling price less out all expenses incurred in selling it.
- Work question on slide on the board and have student answer the question. Pose the following question and get students’ response. Thinking Q:What happens to the $5,000? A:the loss is recognised before the goods are sold. => closing stock is $45,000, instead of $50,000, resulting in a higher COGS in the trading & P&L statement.
- Explain that stock take takes several days and may be carried out before or after Balance Sheet date.
- Refer to text book POA Loh/Ng pp 603 Work out on the board: Computation of Stock as at 31 December 2002 Stock as at 28 Dec 200212,345 Add: Purchases1,300 Returns inwards 96 1,396 13,741 Less: Sales2,000 Returns outwards 200 Error – stock overstated 80 2,280 Stock as at 31 Dec 200211,461
- Refer to text book POA Loh/Ng pp 603 Work out on the board: Computation of Stock as at 31 December 2002 Stock as at 7 Jan 200323,456 Add: Sales3,104 Error – stock undercast 150 3,254 26,710 Less: Purchases1,875 Returns inwards 300_ 2,175 Stock as at 31 Dec 200224,535