Categories Of Ratio
Some of the category of Accounting ratios are given below:
S
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Profitability Ratios
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Liquidity Ratios
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Efficiency Ratios
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Shareholder Ratios
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Capital Structure Ratio
Profitability Ratio
1. Retrun on Capital Employed(ROCE)
Roce is one of the most important profitability ratio because it help the shareholder to find whether a company make an adequate return on capital employed. The formula of ROCE
Return on capital Employed = Net Profit * 100
Capital employed
For sole trader business we will use the average of the capital account such as
(opening balance+closing balance)/2
Balance Sheets
C D
Non current asset+current asset-Current Liabilities 100000 160000
Capital Accounts
Opening Balance 80000 140000
Add: Net Profit 36000 36000
116000 176000
Less: Drawings (16000) (16000)
100000 160000
therefore,
C D
36000 * 100 =40% 36,000 * 100 =24%
(80,000+100000)/2 1 (140000+160000)/2 1
So Business B has used better capital strucutre,achieving a return of $40 net profit for every $100 invested, whereas D has received only a netprofit of $24 per $100.
2. Gross Profit as Percentage of sales:
The basic formula of Gross Profit is :
Gross profit * 100 =Gross Profit as Percentage of sales
Sales
This formula represent the amount of gross profit for every $100 of sale revenue. If the answer turned out to be 15%,this would mean that for every $100 of sale revenue $15 gross profit was made before any expense made. This ratio is used as a test of the profitability of the sales.Just because sales revenue has increased doesn't,of itself, mean that gross profit will increase.
Income Statement for the year ending Dec 2005 and 2006
2005 2006
$ $ $ $
Sales 7000 8000
Less:Cost of Good Sold
Opening Inventory 500 900
Add:Purchases 6000 7200
6500 8100
Less:Closing Inventory (900) (1100)
(5600) (7000)
Gross Profit 1400 1000
In 2005 the Gross Profit as a percentage of sale was:
1400 * 100 =20%
7000 1
For year 2006 the GP was:
1000 * 100 =12.5%
8000 1
As we can see the revenue/sale had increased but the gross profit had fallen by a relatively greater margin. There are many reason for this fall in the Gross Profit percentage, such as:
1.There might be a greater wasteage or theft of goods.
2.Might be the good sold have cost more, but the selling price for the goods has not risen to the extent.
3.In order to increase sales the entity reduce the selling price of the good.
3. Net Profit as a Percentage of Sales:
The formula of Net profit ratio is:
Net Profit * 100
Sales 1
Net profit expresses the relationship between net profit after taxes and sales.This ratio is a measure of the overall profitability. Net profit is arrived after taking into account both the operating and non operating items of income and expenses.The ratio indicates what portion of the net sales is left for the owners after all expenses have been met. Higher the net profit,higher is the profitability of the business.
Liquidity Ratio:
Discussed earlier about the 'return on capital employed' is used to provide the overall picture of profitability. Thus Profitability is desireable.It must be stressed that "accounting is used,not just to calculate profitability,but also to provide information that indicates whether or not the business will be able to pay its creditors,expenses,loans falling due,etc. at the correct times."(Wood & Sangster:2000)
If the business failed to pay the cover its mean that business is closing down. If the business is paying its debts and they are fall due is known as liquid.It is the company or business responsibility is to aware if a customer is at risk of not repaying the amount due.This is the company responsibility to vetted the new customer credit history to being allowed to trade on credit rather than by cash. For private customers, there are credit rating agencies with extensive records of the credit histories of many individual. For a small charge or fee, a company can receive a credit report whether the new client or customer has good or bad credit rating.
1:Current Ratio:
Current ratio is also known as working capital ratio.Current ratio is the ratio of total current assets to total current liabilities.The formula of Current ratio is:
Current Ratio= Current Asset
Current Liabilities
Current assets are those those which are usually converted into cash or consumed with in short period (say one year).Current Liabilities are required are required to be paid in short period of time (say one year).
"with all ratios,once you have performed the calculation,you need to decide what it tells you.To do so, there is no pointin using a universal guide,such as 'the ratioshould always lie between 1:1 and 2:1.'(wood& sangster:2000)
Interpretation of Current Ratio:
Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities.Higher the current ratio find favour with short-term creditor whereas low current ratio causes alarm or concern to the business.An increase in current ratio improve the business whereas decrease in current ratio deteriorate the business liquidity.As a convention 2:1 is regarded as good ratio because current assets should be almost double than the current liabilities.Current ratio compare the quantity of current assets rather than quality of asset.High current ratio though considerable may prove to be otherwise due to following reasons:
(1).It may be in case of slow moving stocks,these will pile up and will lead to higher ratio.
(2).It may be due to slow collection of trade debts which lead to higher ratio.
On the other hand if the ratio is low, it may be the following reason:
(1).Might be company donot have enough funds to pay its obligation.
(2).It might be the case where the company trading level beyond the capacity of the business.
2.Acid-Test Ratio:
Acid-test ratio is also known as quick ratio.The term quick asset includes all the current assets less inventories and prepaid expenses.Inventory,by nature cannot be converted into ready cash immediately.The formula of Acid-Test Ratio is
Acid Test Ratio= Current Assets-Inventory
Current Liabilities
InterPretation of Acid Test Ratio:
Acid-Test ratio eliminate the inventory and prepaid expenses for matching against the current liabilities therefore it is a rigorous test of liquidity as compared to current ratio.When we analysis a company and we use both current ratio and Acid-Test ratio it gives a clearer picture of business liquidity.Rule of thumb for acid test ratio is 1:1 i.e., if business liquid asset is 100% of its liabilities it is considered to be having fairly good financial position but care must be taken place.
Example:
D E
$ $ $ $
Non-Current Assets 40,000 70,000 Current Assets
Inventory 30,000 50,000
Bank 15,000 1,000
Account Receivable 45,000 9,000
90,000 60,000
Total Assets 130,000 130,000
Current Liabilities:Account Payable (30,000) (30,000)
Net Assets 100,000 100,000
Capital
OPening Capital 80,000 80,000
Add:Net Profit 36,000 36,000
116,000 116,000
Less Drawing (16000) (16000)
100,000 100,000
The sale figure for both the comapanies are $144,000.Gross Profit of D & E are identical at $48,000.
Current Ratio
D=90,000 =3
30,000
E=60,000 =2
30,000
Acid Test Ratio
D=60,000 =2
30,000
E=10,000 =0.33
30,000
Commentary
The above ratio shows the picture that E may be in trouble,because it will probably find it difficult for the company to pay its current liabilities on time.It doesn't matter how profitable the business is ,unless it is adequately liquid it may fail.
Capital Structure Ratio:
Gearing:
If you want to judge the company longterm financial soundness then it can be judge by its longterm creditors by testing its ability to pay interest charges regularly and its ability to repay the principal as per schedule.The longterm company financial standing can be judge by capital structure ratio.The relationship of equity shares (Ordinary Shares) to other forms of longterm financiing (longterm loans plus preference shares) can be extremely important. Analysts are, therefore,keen to ascertain a ratio to expree this relationship. There are many ways to calculate this ratio but widely use is as below:
Gearing= Long-Term Loans+Preference Shares * 100
Ordinary Share Capital+Reserves+Preference Shares +Long-Term Liabilities
The formula sometime abbreviated as:
Prior Charge Capital * 100
Total Capital
Now Look at the example:
A Ltd B Ltd
$ $
10% loan notes 20,000 200,000
10% Preference Shares 40,000 100,000
Ordinary Shares 200,000 40,000
Reserves 140,000 60,000
400,000 400,000
Gearing Ratios:
ALtd: 20,000+40,000 * 100 =15%(low gearing)
20,000+40,000+200,000+140,000
B Ltd: 200,000+100,000 * 100 =75%(High Gearing)
200,000+100,000+40,000+60,000
A company with high percentage gearing ratio is called High geared company and a company with low percentage gearing ratio is called Low geared ratio.If the company has higher rate of debt(i.e. long-term loans and preference shares) it means that company is in bad times and very little left over for ordinary shareholders after payment of interest on the debt items and also preference dividend. In low gearing ratio the ordinary shareholder enjoy higher return. This mean people investing in ordinary shares in a high geared company are taking high risk with their money then those who invested in low geared company.In above example company A is low geared and company B is High geared company.It depened on the investor which company to choose for investment the risk averse person go for Company A and the Risk taker going to invest in Company B.
Changing the gearing of a company:
Changing of gearing might be due to the following reason:
To reduce gearing
1).By issuing ordinary shares
2).By redeeming loan notes
3).By retaining Profits.
To Increase Gearing
1).By issuing loan notes.
2).By buying back ordinary shares in issue.
3).By issuing preference shares.