Analyzing
Financial Statements,
Concept and Interpretation
of Ratios 1
Week 5
Revision on the accounting equation
QUESTION
– Which of the following equations is correct?
• ASSETS = LIABILITIES + OWNER’S EQUITY
• LIABILITIES = ASSETS + OWNER’S EQUITY
• OWNER’S EQUITY = ASSETS + LIABILITIES
Revision on the accounting equation
QUESTION
– Which of the following equations is correct?
• ASSETS = LIABILITIES + OWNER’S EQUITY
• LIABILITIES = ASSETS + OWNER’S EQUITY
• OWNER’S EQUITY = ASSETS + LIABILITIES
Revision on the accounting equation
EXERCISE – compute the OWNER’S EQUITY (OE)
| Cash | 9,000 |
| Long-term Assets | 4,000 |
| Accounts receivable due in 2 weeks |
12,000 |
| Notes Payable due in 10 months | 8,000 |
| Long-term Liabilities | 6,000 |
| Inventory | 5,000 |
| Wages Payable | 10,000 |
AssignmentTutorOnline
Revision on the accounting equation
EXERCISE – compute the OWNER’S EQUITY (OE)
| Cash | 9,000 |
| Long-term Assets | 4,000 |
| Accounts receivable due in 2 weeks |
12,000 |
| Notes Payable due in 10 months | 8,000 |
| Long-term Liabilities | 6,000 |
| Inventory | 5,000 |
| Wages Payable | 10,000 |
OE = total assets – total liabilities =
= (CA+NCA) – (CL+NCL) =
= (9,000+12,000+4,000+5,000) –
(8,000+6,000+10,000) =
= 30,000 – 24,000 = 6,000
Learning Outcomes
To identify the role and importance of the accounting ratios for a
company’s financial performance
To list the main types of accounting ratios
To use and analyze the main profitability ratios
To use and analyze the main liquidity ratios
Accounting Ratios
Accounting ratios analysis helps in the identification of the strengths
and weaknesses of a business. Based on the financial reports it
enables the business to measure its efficiency and profitability and
provides a way of determining the relationship between one
accounting variable to another on their financial statements. Over
time a business can assess their performance and pick up on key
indicators on whether improvements or changes are necessary.
Analyzing the relationship between financial data to assess the
performance of the business.
Accounting Ratios – Importance
The use of these ratios can assist a business to better understand:
– How they are tracking – their day-to day-spending and whether they
are experiencing any cash flow issues,
– The amount of staff a business has versus productivity achieved,
– How quickly their stock turns into sale,
– Your customer payments habits versus the terms of payment a
business sets,
– How much money is being made for every £ of sales,
– Pricing of stock – does this need adjusting due to inflation and overall
costs increasing?
Accounting Ratios – Types
Accounting Ratios
Profitability
Ratios
Investment
Ratios
Financial
Efficiency
Ratios
Liquidity Ratios
Themes of Accounting Ratios
Profitability – The relationship between profit and sales revenue, assets
and capital employed
Solvency/liquidity – Considers the stability of the business both in a
long-term and short-term basis respectively
Asset utilisation/Financial Efficiency – The effective and efficient use
of assets
Investment ratios – Examine the returns to shareholders in companies
1. Profitability
Profitability Ratios
Gross Profit
Margin
Operating
Profit Margin
Return on
Capital
Employed
1. Profitability – Gross Profit
Margin Ratio
A) Gross Profit Margin Ratio
The gross profit margin ratio relates the
gross profit of the business to the sales
revenue generated for the same period.
Gross profit represented the difference
between sales revenue and the cost of
sales
Therefore, the ratio is a profitability
measure in buying (or producing) and
selling goods or services before any other
expenses are taken into account.
(Atrill and McLaney, 2017)
1. Profitability – Gross Profit
Margin Ratio
Practice on Gross Profit Margin Ratio (GPMR)
Question 1
Gross Profit = Sales – COGS =
= 102,007 – 39,023 = 62,984
GPMR = (Gross Profit / Sales) *100 =
= (62,984 / 102,007) * 100 = 61,7%
approx.
1. Profitability – Gross Profit
Margin Ratio
Practice on Gross Profit Margin Ratio (GPMR)
Question 2
Gross Profit = Sales – COGS =
= 1,000,000 – 350,000 = 650,000
GPMR = (Gross Profit / Sales) *100 =
= (650,000 / 1,000,000) * 100 = 65%
1. Profitability – Operating Profit
Margin Ratio
B) Operating Profit Margin Ratio
The operating profit margin ratio relates the
operating profit of the business to the sales
revenue generated for the same period.
Operating profit is the profit before interest
and taxation and it represented the profit
from trading operations before interest
payable is taken into account.
It is normally the most appropriate measure
of operational performance.
(Atrill and McLaney, 2017)
1. Profitability – Operating Profit
Margin Ratio
Practice on Operating Profit Margin Ratio (OPMR)
| Question 1 | Gross Profit = Sales – COGS = = 1,000,000 – 500,000 = 500,000 |
Operating Profit = Gross Profit – Operating
Expenses = 500,000 – 15,000 – 100,000 –
25,000 = 360,000
OPMR = (Operating Profit / Sales) *100 =
= (360,000 / 1,000,000) * 100 = 36%
1. Profitability – Operating Profit
Margin Ratio
Practice on Operating Profit Margin Ratio (OPMR)
Question 2 Gross Profit = Sales – Production Cost =
= 150,000 – 30,000 = 120,000
Operating Profit = Gross Profit – Operating
Expenses = 120,000 – 60,000 = 60,000
OPMR = (Operating Profit / Sales) *100 =
= (60,000 / 150,000) * 100 = 40%
1. Profitability – Return on
Capital Employed
C) Return on Capital Employed (ROCE)
The return on capital employed ratio expresses the
relationship between the operating profit generated
during a specific period and the capital employed
The capital employed is defined as the total assets
minus current liabilities
It is considered by many as a primary measure of
profitability as it compared inputs (capital invested)
with outputs (operating profit) in order to show the
effectiveness with which funds have been deployed
(Atrill and McLaney, 2017)
1. Profitability – Return on
Capital Employed
Practice on ROCE
Operating Profit = 90,000 – 40,000 = 50,000
Capital Employed = (CA+NCA) – CL =
1,000,000 – 500,000 = 500,000
ROCE = (OP / CAPITAL EMPLOYED) * 100 =
(50,000 / 500,000) * 100 = 10%
| Element | Value |
| Gross Profit | 90,000 |
| Current Liabilities |
500,000 |
| Non-current liabilities |
100,000 |
| Current assets | 300,000 |
| Non-current assets |
700,000 |
| Sales | 110,000 |
| Operating expenses |
40,000 |
Exercise on all three ratios of
profitability
Calculate the GPMR, OPMR, ROCE
GPMR = (400 / 1000) * 100 = 40%
OPMR = (200 / 1000) * 100 = 20%
Can we calculate ROCE?
(NO, because we don’t know how much are
the current liabilities, even though we know
how much are the total liabilities: 1000-
700=300)
2. Liquidity Ratios – current ratio
The current ratio is a liquidity ratio that measures a
company’s ability to pay short-term obligations or
those due within one year.
The higher the current ratio, the more liquid the
business is considered to be. As liquidity is vital to the
company’s survival, a higher current ratio might be
considered to be preferable to a lower one.
(Atrill and McLaney, 2017)
2. Liquidity Ratios – acid-test ratio
The acid-test ratio, also commonly known as the quick
ratio, is very similar to the current ratio, but it represents
a more strict test of liquidity.
For a lot of businesses, stock cannot be converted into
cash quickly. For this reason, it is usually better to
exclude this particular asset from this ratio.
The minimum level for this ratio is usually regarded as
1.0 times, however for a lot of highly successful
companies, it is not unusual for this ratio to be below 1.0
and at the same time not causing any liquidity issues.
(Atrill and McLaney, 2017)
2. Liquidity Ratios
EXERCISE ON CURRENT AND ACID-TEST RATIOS
| Cash | 9,000 |
| Long-term Assets | 4,000 |
| Accounts receivable due in 2 weeks |
12,000 |
| Notes Payable due in 10 months |
8,000 |
| Long-term Liabilities | 6,000 |
| Inventory | 5,000 |
| Wages Payable | 10,000 |
CALCULATE BOTH RATIOS
2. Liquidity Ratios
Current ratio = CA / CL = (9,000+5,000+12,000)
/ (10,000+8,000) = 26,000 / 18,000 = 1.44
approx.
Acid-test ratio = LA (liquid assets) / CL =
(9,000+12,000) / 18,000 = 21,000 / 18,000 =
1.17 approx.
EXERCISE ON CURRENT AND ACID-TEST RATIOS
| Cash | 9,000 |
| Long-term Assets | 4,000 |
| Accounts receivable due in 2 weeks |
12,000 |
| Notes Payable due in 10 months |
8,000 |
| Long-term Liabilities | 6,000 |
| Inventory | 5,000 |
| Wages Payable | 10,000 |
CALCULATE BOTH RATIOS
Next week…
The final two categories:
3. Financial Efficiency ratios
4. Investment ratios
Thank You
Any Questions ?
