ACCOUNTING RATIOS

By
Ala Mohamed Wahra

15/3/2009 Financial Accounting Ratios 1

 What is a Ratio?
A ratio is an expression which


compares quantities relative to each

other. The most common examples
involve two quantities. In
mathematical terms, they are
represented by separating each
quantity with a colon, for example
the ratio 2:3, which is read as the
ratio "two to three". Ratios may also
be expressed as a decimal value,
such as 0.10, or given as an
equivalent percent value, such as
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 What are the Accounting
Ratios?
• They are Tools which used for
analyzing the financial performs of
the business.
• It is a ratio of two selected numerical
values taken from an enterprise's
financial statements.

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 Why Do We Need
Accounting Ratios?
• They are the starting point for further
analysis for the firm.
• They help to highlights the financial
strengths and weakness of a firm.
NOTE: [very important]

 Accounting ratios should be very

carefully handled, they are extremely
useful if used and interpreted
appropriately, and very misleading
otherwise.
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 ACCOUNTING RATIOS
CLASSIFICATION


A)Profitability Ratios.
B)
D)Liquidity Ratios.
E)
C) Efficiency Ratios.

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 A) PROFITABILITY RATIOS
 Profitability ratios express the profit
made in relation to other key figures
in the financial statements or
business resources. there are 3
formulas to calculates this:
 A.1) Gross profit margin [Gross profit
as a percentage of sales].
 A.2) Cost of sales as a percentage of

sales.
 A.3) Net profit margin [Net profit

15/3/2009 margin asFinancial

a percentage
Accounting Ratios of sales]. 6
A.1) GROSS PROFIT MARGIN
[Gross Profit as a Percentage

of Sales]
 Gross profit Margin=(gross
profit/sales)x 100


This represents the amount of gross



profit for every $100 of sales

revenue. For example if the answer
turn to be 15%, this would mean for
$100 of sales revenue $15gross
profit was made before any expenses
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 A.2) Cost of Sales as a
Percentage of Sales


 C.O.S.A.P.O.S= (cost of
sales/sales)x100


This one here shows the cost of sales for



every $100 of sales revenue. For

example if the answer 64.38%, it
means that every $100 of sales
revenue it costs $64.38 to make. The
materials that are used to produce and
techniques of production can have an
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 A.3) NET PROFIT MARGIN
[Net Profit as a Percentage of

Sales]
 Net Profit Margin= (net
profit/sales)x100


This shows the amount of net profit for



every $100 of sales revenue. For

example if the answer 5.53%, it means
that for every $100 of sales revenue
the firm gains $5.53. This ratio is
mainly affected by the operating
expenses that is incurred by the firm.
Other effects could be economic
conditions, customer service, the type
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 Which people uses or need
the information of
Profitability Ratios?
Example of these people are:


• Shareholders.
• Management.
• Employees.
• Creditors.
• Competitors.
• Potential Investors.

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 B) LIQUIDITY RATIOS
These ratios shows or relate to the
cash position in an organization and
hence its ability to pay liabilities
when due. There are 3 calculations
for this:
B.1) Working capital.

B.2) Current ratio.

B.3) Quick ratio [Quick asset]

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 B.1) WORKING CAPITAL


 Working Capital= Current assets –

Current liabilities
This shows the net current assets. It

shows the amount of money in which

firm have to pay to its short-term
liabilities. For example, if the answer
is $10,000, it means that amount of
money is going to be used by the
company to pay its short-term
liabilities.
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 B.2) CURRENT RATIO


 Current Ratio = Current Assets/Current

Liabilities


This one here shows how the working



capital is sufficed to the daily

expenses of the firm. For example if
the answer is 2.22 (2.22 : 1), it
means the firm can cover more than
twice of the original daily expenses.
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 VERY IMPORTANT !!!
It is not likely to have a large rate


of current ratio because it is

risky. If a company have a large
amount of the money that is over 5
times a day, it can be stolen,
damaged, and may be taken by
unauthorized personals. Therefore, it
is better to have a low rate of current
ratio.
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 B.3) QUICK RATIO [QUICK
ASSET]


Quick Ratio = (Current Assets –



Closing Stock)/ Current Liabilities

This shows the ability to pay. For
example if the answer is 1.11 or
[1.11 : 1], it means that any firm is
able to pay all their expenses. In the
other hand, if the firm got o.44 or
[o.44 : 1] it means that particular
firm won’t be able to pay all its
expenses, but only part of it.
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 How do we relate the
Liquidity Ratios together?
Let us take an example of you as a


student. You have a pocket money of

RM20 for today, and that pocket
money is your [working capital]. You
must know if that pocket money is
enough or sufficient for today’s
expenses like your lunch, transport,
and etc. it is called [current ratio],
and also must be sure that you will
be able to pay for those expenses.
We call that [Quick ratio].
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 Which people uses or need
the information of Liquidity
Ratios?
An example of those people:


• Shareholders.
• Suppliers.
• Creditors.
• Competitors.
•

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 C) EFFICIENCY RATIOS
This type of ratios examine the
productive or timely ways in which
various resources of the business are
managed. The following calculations
consider important aspects of
resource management:
C.1) Stock turnover period/days.

C.2) Debtors collection period.

C.3) Creditors payment period.

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C.1) STOCK TURNOVER PERIOD /
DAYS
 S.T.O = (Average Stock / cost of sales) x 365
days
 Average stock = (Opening stock + Closing
stock) / 2
This means the numbers of times stock is sold

in an accounting period. It measures how

efficient a business is at maintaining an
appropriate level of stock. For example if
the answer is 2 times, it means that a
company is selling their stocks very slowly.
Stocks are piling up in the stores and not
being sold. This could lead to a LIQUIDITY
CRISIS. If the answer
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is 3 or 4 times, the
Financial Accounting Ratios 19
company is selling their stocks quickly and
C.2) DEBTORS COLLECTION
PERIOD


 D.C.P = (Debtors / Credit Sales) x 365

days


This ratio shows how long it takes for a



debtor to pay back their debts to the

business. An example if the answer is
114 days, it means the firm allows so
much time for its debtor to pay back
and that’s not right. It means there is
no proper credit control system within
the firm. While if the answer is 24 days,
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 C.3) CREDITORS PAYMENT
PERIOD


 C.P.P = (Creditors / Credit Purchase) x

365 days


This shows how long it takes for the



business to pay its creditors.

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 Which people uses or need
the information of Efficiency
Ratios?
An example of these people:


• Shareholders.
• Potential Purchasers.
• Competitors.

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 Advantages of Accounting
Ratios analyze
• Simplifies financial statements.
• Helps in planning.
• Help in investment decisions.
•

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 Limitations of Accounting
Ratios
• Limitations of financial statements.
• Limited use of single ratios.
• Problems of price level changes.

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