PRACTICAL ACCOUNTING
RATIO ANALYSIS
CHRISTOPHER MONGROO
Ratio Analysis
What are ratios?
Ratios are used to interpret financial
information to assess the performance in
several areas
How profitable is the business
Its ability to liquidate assets to cover its
liabilities
Assess its gearing and capital structure
Is used to compare one period’s results against
that of a previous one
Ratio Analysis
About Ratios
Financial ratios provide a means of
summarizing financial information about a
company. It can be categorized as follows:
Profitability ratios
Liquidity ratios
Debt and Gearing ratios
Ratio Analysis
Profitability Ratios
Measures the ability of a business and its
management to generate profit
Return on Capital Employed [ROCE]
measures the % rate of return a business gets
on its capital employed
Formula: Net profit / Total Net Assets x 100
Ratio Analysis
Profitability Ratios
Gross Profit Margin
This is the gross profit (sales less COGS)
expressed as a % of revenue
Measures the level of income a business
generates on its sales i.e. for every $100 of
sales, you made $15 gross profit
Formula: Gross profit / Revenue x 100
Ratio Analysis
Profitability Ratios
Net Profit Margin
This is the net profit after tax (gross profit less
all expenses) expressed as a % of revenue
i.e. for every $100 of sales, you made $10 after
all expenses
Formula: Profit after tax / Revenue x 100
Ratio Analysis
Profitability Ratios
Rate of Inventory Turnover or Stockturn
Measures how well the company is managing
their stock movement i.e. how fast goods are
being sold
Formula: COGS / Average Inventory = x times
Further analyzed into months [12 / Inventory
turnover]
or into days [365 / Inventory turnover]
Ratio Analysis
Profitability Ratios
Return on Sales
This is the operating income of the business
expressed as a percentage of revenue
Operating income aka earnings before interest
and tax [EBIT]
Formula: EBIT / Revenue x 100
Ratio Analysis
Liquidity Ratios
Indicates the entity’s ability to settle its debts
as they fall due
Current Ratio aka Working Capital Ratio
measures the liquidity of a business and its
ability to meet its short term obligations
(liabilities)
Formula: Current Assets / Current Liabilities
e.g. 2:1 means that for every $1 of debt, the
company has $2 available to settle the liability
Ratio Analysis
Liquidity Ratios
Quick Ratio aka Acid Test Ratio
measures the liquidity of a business and its
ability to meet its short term obligations
(liabilities) without factoring in stock
Formula: Current Assets less inventory /
Current Liabilities
Ratio Analysis
Liquidity Ratios
Debtor to Sales Ratio
Assesses how long it takes the debtors to pay
Formula: Debtors / Sales x 12
Giving the # of months (on average)
Ratio Analysis
Liquidity Ratios
Creditor to Purchases Ratio
Assesses how long it takes us to pay our
suppliers
Formula: Creditors / Purchases x 12
Giving the # of months (on average)
Ratio Analysis
Debt and Gearing Ratios
This assesses the financial structure of the
company i.e. where the finance came from
Debt to Equity Ratio
Measure of the company’s financial leverage
regarding its capital structure
Formula: Total Debt / Total Equity x 100
e.g. 50% implies that half of the company’s
financing came from L/T debt borrowing
Ratio Analysis
Debt and Gearing Ratios
Interest Cover Ratio
The number of times the interest payments
can be safely covered by the entity base on the
profits made during the period
Formula: Net profit / Interest expense
Accounting ratio Formula
Gross profit as a percentage of sales Gross Profit / Sales x 100
Net profit as a percentage of sales Net Profit / Sales x 100
Expenses as a percentage of sales Expenses / Sales x 100
Return on Capital Employed Net profit / Capital employed x 100
Inventory turnover COGS / Average Inventory
Current ratio (working capital ratio) Current assets / Current liabilities
Acid test ratio (quick ratio) Current assets - stock / Current liabilities
Accounts receivable turnover ratio Accounts receivable / Sales for the year x 12
Accounts payable turnover ratio Accounts payable / Purchases for the year x 12
Debt to Equity ratio Total Debt / Total Equity x 100
Interest cover ratio Net profit / interest expense
Ratio Analysis
Calculate the ratios below, using the available information:
• Revenue/Sales - $250,000
• Gross Profit - $100,000
• Net Profit - $50,000
• Net Assets/Capital Employed - $1,000,000
• Current Assets - $140,000
• Current Liabilities - $70,000
• Stock/Inventory (amount included within Current Assets) - $77,000
Ratios to calculate
Gross profit as a % of sales
Net profit as a % of sales
Return on capital employed (ROCE)
Current ratio
Acid test ratio
Ratio Analysis
Answer:
Ratios calculated
Gross profit as a % of sales 40%
Net profit as a % of sales 20%
Return on capital employed (ROCE) 5%
Current ratio 2:1
Acid test ratio 0.9:1
Other Accounting terminology
Markup – profit shown as a percentage or
fraction of cost price
Margin – profit shown as a percentage or
fraction of selling price
Stockturn – number of times we sell our
stock in an accounting period
Summary
• Ratio Analysis – definition and purpose
• Ratio categories – profitability, liquidity
and debt/gearing ratios along with
formulas
• Other key accounting terminology –
markup and margin
