2. LESSON OBJECTIVES:
At the end of the lesson, students should be able to :
Demonstrate how to interpret financial statements by calculating and analysing
accounting Ratios:
Profitability Ratios
Liquidity Ratios
Why and How accounts are used
Need of different users of accounts and ratio analysis
How users of accounts use information to make decisions
4. RATIOS MAY BE EXPRESSED :
Proportion/pure
ratio/simple ratio
•It is expressed by simple
division of one number
by other.
•For eg. Current assets =
Rs 1,00,000 and Current
Liabilities = Rs 50,000
•Then the ratio is 2:1
Rate/so many times
It is calculated how
many times a figure is,
in comparison to
another figure
•For eg. Credit sales= Rs
4,00,000 and its trade
receivables = Rs 40,000 at
the end
•So, Trade receivables
turnover ratio = 10 times
(4,00,000/40,000)
Percentage:
•The relation between
two figures is expressed
in hundredth.
•For eg: Capital = Rs
10,00,000 & Profit = Rs
5,00,000
•Then ratio of profit to
capital is 50%.
Fraction
•Say net profit is one-fifth
of capital.
5. The data contained in the financial
statements are used to make some
useful observations about the
performance and financial
strength of the business. This is the
analysis of accounts of a business.
To do so, ratio analysis is employed.
6. Ratio Analysis
Profitability Ratios:
profitability is
the ability of a company
to use its resources to
generate revenues in
excess of its
expenses. These ratios
are used to see how
profitable the business
has been in the year
ended.
Liquidity Ratios:
liquidity is the ability
of the company to pay
back its short-term
debts. It if it doesn’t
have the necessary
working capital to do
so, it will go illiquid
(forced to pay off its
debts by selling assets)
7. PROFITABILITY RATIOS
The three most common performance ratios are:
1. Gross profit margin
2. Profit margin
3. Return on capital employed
1. Gross profit margin: This is calculated by the formula
Gross profit margin (%)= Gross profit / Sales revenue * 100
An outcome of 25% for example, implies that for every $1 of sales revenue, $ 0.25 is earned
as gross profit.
8. 2. Profit margin: This is calculated by the formula
Profit margin (%)= Profit before tax / Sales revenue *100
An outcome of 15% for example, implies that for every $1 of sales revenue, $
0.15 is earned as profit.
3. Return on capital employed(ROCE):
This is calculated by the formula
ROCE(%)= Operating profit / Capital employed * 100
This is how much the business was able to get back from the capital it had
employed.
An outcome of 20% for example, implies that for every $1 of capital it had
employed in the business, $ is earned as operating profit.
9. Class Activity
Using the business data in table 1,
calculate the following accounting ratios to
analyse the business profitability:
i. Gross profit margin,
ii. Profit,
iii. Return on capital employed.
Compare the business performance in 2012
and Based on the results obtained, in which of
the two years was the business more
successful?
12. Class Activity:
Using the business data in table 2
above,
calculate the following accounting
ratios to analyse the business
profitability:
i. Current ratio, ii. Acid test or
Liquid ratio .
Compare the business performance
in 2012 and Based on the ratios
obtained, in which of the two years
was the business more liquid?
14. Uses and users of accounts
• Managers: they will use the accounts to help them keep control over the performance of each
product or each division since they can see which products are profitably performing and
which are not.
• Shareholders :The balance sheet will tell shareholders whether the business was worth more
at the end of the year than at the beginning of the year, and the liquidity ratios will be used to
ascertain how risky it will be to invest in the company
• Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position
and debts of the business. They will only be ready to supply to the business if they will be able
to pay them. If there are liquidity problems, they won’t supply the business as it is risky for
them.
• Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position
and debts of the business. They will only be ready to supply to the business if they will be able
to pay them. If there are liquidity problems, they won’t supply the business as it is risky for
them.
15. Limitations of using accounts and ratio analysis
•Ratios are based on past accounting data and will not indicate how the business will perform
in the future
•Managers will have all accounts, but the external users will only have those published accounts
that contain only the data required by law- they may not get the ‘full-picture’ about the
business’ performance.
•Comparing accounting data over the years can lead to misleading assumptions since the data
will be affected by inflation (rising prices)
•Different companies may use different accounting methods and so will have different ratio
results, making comparisons between companies unreliable.
