Ratios and Interpretation of Accounts: notes

Profitability Ratios

• Gross profit margin: Gross profit as a percentage of sales. It shows how much is left after paying for goods. Example: Sales $10 000, gross profit $4 000. Margin = 4 000 / 10 000 × 100 = 40%.
• Net profit margin: Net profit as a percentage of sales. It shows what is kept after all expenses. Example: Net profit $1 500 on sales $10 000 gives 15%.
• Mark-up: Gross profit as a percentage of cost of sales. It shows how much the business adds to the cost price. Example: Cost of sales $6 000, gross profit $4 000. Mark-up = 4 000 / 6 000 × 100 = 67%.
• Return on capital employed (ROCE): Net profit as a percentage of capital employed. It shows how well owners' money is earning. Example: Net profit $2 000, capital employed $20 000. ROCE = 10%.

Liquidity Ratios

• Current ratio: Current assets divided by current liabilities. It shows whether the business can pay short-term debts. Example: Current assets $30 000, current liabilities $15 000. Ratio = 2 : 1.
• Acid test ratio: Current assets minus inventory, divided by current liabilities. It removes stock, which is hard to sell quickly. Example: Current assets $30 000, inventory $12 000, current liabilities $15 000. Ratio = 18 000 / 15 000 = 1.2 : 1.

Efficiency Ratios

• Inventory turnover: Cost of sales divided by average inventory. It shows how many times stock is sold in a year. Example: Cost of sales $60 000, average inventory $12 000. Turnover = 5 times.
• Debtors collection period: Debtors divided by credit sales, times 365. It shows how many days customers take to pay. Example: Debtors $5 000, credit sales $73 000. Period = 25 days.
• Creditors payment period: Creditors divided by credit purchases, times 365. It shows how many days the business takes to pay suppliers.

Users and Limits of Ratios

• Users: Owners, banks, suppliers, and managers use ratios to make decisions.
• Limits: Ratios depend on accurate records. They are misleading if figures are old, if businesses use different methods, or if one ratio is judged alone.

Incomplete Records and Single Entry

• Incomplete records: Some books are missing. Accountants rebuild figures using a statement of affairs or by working back from known amounts.
• Single entry: Only one side of each transaction is recorded, usually cash and debtors or creditors. Profit is found by comparing capital at two dates, adjusted for drawings and new capital.