SUBJECT: FINANCIAL ACCOUNTING

CLASS: SS 3

DATE:

TERM: 2nd TERM

WEEK TWO AND THREE

TOPIC: ACCOUNTING RATIOS AND INTERPRETATION OF FINANCIAL STATEMENTS

CONTENT

Introduction
Uses of ratio
Disadvantages of using ratio
Types of ratio – explanation
Illustration

INTRODUCTION

To interpret accounts is to try to gain insight into the information value of financial statements , this can be done through analysis, evaluation ,criticism and comparison and all this is done by the use of accounting ratios. A ratio can be defined as the relationship that exists between two figures.

USES OF RATIO

Ratios are used in preparing industrial averages.
They can be used to interpret financial statements.
They help in comparing performances between and among related organizations.
Ratios help to measure the ability of a given entity to meet its short-term obligations.
They are used in evaluating the performance of companies in the same business

DISADVANTAGES OF USING RATIO

Ratios can easily be affected by inflation
They can be manipulated upon or abused
Different accounting policies affect ratio calculation

TYPES OF RATIO

Profitability and efficiency ratio
Liquidity ratio
Investment ratio

PROFITABILITY AND EFFICIENCY:

Profitability and efficiency ratios measure the effectiveness of the management as shown by the returns obtained on sales and capital invested. This can be broken down into the following.

Net profit%
Gross profit%
Returns on capital employed
Assets turnover ratio
Individual expenses items to sales ratio e.g advertising carriage outwards etc

Formulae:

NP% = NET PROFIT × 100

SALES 1

GP% = GROSS PROFIT × 100

SALES 1

Returns on capital employed ROCE. This measures management ability to utilize effectively the organizations resources.

It is PROFIT × 100

CAPITAL EMPLOYED 1

Where capital employed can be:

a) total asset b) total assets to current liabilities

ASSETS TURNOVER RATIO:

This ratio measures the turnover generated by assets and show how fully a company is utilizing its assets.

Formula: SALES

CAPITAL EMPLOYED

INDIVIDUAL EXPENSE TO SALES:

This helps to reveal the reason for improvement or reduction in the net profit to sales.

Formula: INDIVIDUAL EXPENSES × 100

SALES 1

LIQUIDITY RATIOS:

These ratios help in measuring the ability of an organization to meet its obligations as they fall due.Ratios under this heading are:

Current ratio or working capital ratio
Average stock
Stock to net current assets
Debtors ratio
Creditors ratio

Current ratio or working capital ratio: This ratio indicates the ratio of current assets to current liabilities. It shows the extent the firm can meet up with its short-term creditors. Low ratio implies lack of working capital while high ratio suggests too much of working capital or capital tied up.

Formula: CURRENT ASSETS CA

CURRENT LIABILITIES CL

ACID- TEST/LIQUID RATIO:

This ratio provides measures of the firm’s ability to meet its current liability. Should it fall below 1:1,the firm may have some difficulty in paying its debt.

Formula: CURRENT ASSETS – STOCK OR INVENTORY

CURRENT LIABILTIES

STOCK TURNOVER RATIO:

This is used to measure the number of times stocks are replaced during a given period.

Formula: COST OF GOODS SOLD

AVERAGE STOCK

AVERAGE STOCK: OPENING STOCK + CLOSING STOCK

N.B: Where there is no opening stock,average stock could be calculated by adding closing stock to purchases and dividing by 2

STOCK TO NET ASSET. This ratio is used to express the stock as a percentage of net assets.

Formula: = STOCK × 100

NET ASSET 1

DEBTORS RATIO: Debtors ratio measures the average collection period from debtors. It shows the average credit period given to debtors.

Formula: DEBTORS × 365 DAYS

CREDIT SALES

Long collection dates indicate poor credit policy.

CREDITORS RATIO: This ratio shows the average credit period received from suppliers.

Formula: TRADE CREDITORS × 365 DAYS

CREDIT PURCHASES

INVESTMENT RATIOS : These ratios used by investors to evaluate the return,which they receive from their investments, they cover the following:

Earnings per share ratio
Price earning ratio
Earning yield
Dividend yield
Dividend cover

EARNINGS PER SHARE RATIO: This ratio compares the net earnings attributable to the shares to the number of shares issued.

Formula: PROFIT AFTER TAX(PAT) - LESS PREFERENCE DIVIDEND.

NOS. OF EQUITY SHARE

PRICE EARNING RATIO: This ratio considers the average price of the share to the reported earnings per share.

Formula: MARKET VALUE PER SHARE

EARNINGS PER SHARE

DIVIDEND YIELD: This ratio measures the current actual returns on the shareholders investment.

Formula: DIVIDEND PER SHARE × 100

SHARE PRICE 1

DIVIDEND COVER: This ratio compares the earnings per share to the dividend per share.

Formula: EARNING PER SHARE = EPS

DIVIDEND PER SHARE DPS

Dividend cover is also called payout ratio.

EVALUATION

State three limitations to the use of accounting ratios in evaluating and comparing business organizations
List five uses of accounting ratios.

ILLUSTRATION:

The following was extracted from the books of capital ltd for two years, 31/12/001/002.

2001				2002
	â¦	â¦	â¦		â¦
Sales		60,000			90,000
Less
cost of sales
Opening stock	18,750		16,875
Add purchases	37,500		68,250
	56,250		85,125
Less closing stock	11,250	45,000	13,125		72,000
Gross profit		15,000			18,000
Less expenses		7.500			6,750
Net profit		7,500			11,250

Balance sheet
Fixed asset
Motor car		15,000			10,500
Current asset
Stock	11,250		13,125
Debtors	18,750		15,000
Bank	3,750		1,875
		33,750			30,000
Less current liability
Creditors	3,750	30,000	7,500		22,500
		31,500			33,000
Financed by:
Capitals		28,500			27,000
Add net profit		7,500			11,250
		36,000			38,250
Less drawing		4,500			5,250
		31,500			33,000

You are required to calculate the following ratios.

Gross profit ii. Net profit iii. Expenses as a % of sales iv. Stock turnover v. Current ratio vi. Acid – test ratio vii. Rate of returns on capital employed viii. Creditors /Purchases ratio ix. Debtors/sales ratio ix. Average stocks

Solutions:

GP% = GP × 100

SALES 1

2001 = 15,000 × 100 = 25%

60,000 1

2002 = 18,000 × 100 = 20%

90,000 1

NET PROFIT% = NP × 100

SALES 1

2001 = 7,500 × 100 = 12.5%

60,000 1

2002 = 11,250 × 100 =12.5%

90,000 1

EXPENSES AS A % OF SALES = EXPS. × 100

SALES 1

2001 = 7,500 × 100 = 12.5%

60,000 1

2002 = 6,750 × 100 = 7.5 %

90,000 1

STOCK TURNOVER = COST OF GOODS SOLD

AVERAGE STOCK

2001 45,000 = 45,000 = 3TIMES

(18750 + 11,250)1/2 15,000

2002 72,000 = 72,000 = 4.8 TIMES

(16,875 + 13,125)1/2 15,000

CURRENT RATIO = CURRENT ASSETS

CURRENT LIABILITIES

2001 = 33,750 = 9 = 9:1

3,750 1

2002 = 30,000 = 4 = 4:1

7,500 1

ACID TEST RATIO = CURRENT ASSET – STOCK

CURRENT LIABILITIES

2001 = 33,750 - 11,250

3,750

= 22,500 = 6 = 6:1

3,750 1

2002 = 30,000 – 13,125 = 1,687 = 225

7,500 7,500 10

= 2.25

RETURNS ON CAPITAL EMPLOYED

= NP × 100

CAPITAL EMPLOYED 1

N.B: Capital employed is total assets less current liabilities.

2001 = 7,500 × 100 = 23.8%

31,500 1

2002 = 11.250 × 100 = 34%

33,000 1

CREDITORS/PURCHASES RATIO = CREDITORS

PURCHASES

2001 = 3,750 × 365 DAYS 365 DAYS OR (12 MOS.)

37,500

= 36.5 DAYS OR 1.2 MONTHS

2002 = 7.500 × 365 DAYS

68,250

= 40.11 DAYS OR 1.3 MONTHS

DEBTORS/SALES RATIO = DEBTORS × 365 DAYS

SALES

2001 = 18750 × 365 DAYS

60,000

= 114 DAYS OR 3-8 MONTHS

2002 = 15,000 × 365 DAYS

90,000

= 60-8 DAYS OR 2 MONTHS

AVERAGE STOCK = (OPENING STOCK + CLOSING STOCK) ½

2001 = 18750 + 11250 = 15000

2002 = 16,875 + 13,125 = 15000

EVALUATION

What is the formula for stock turnover
What is the other name for stock turnover

GENERAL EVALUATION/REVISION QUESTIONS

What is depreciation
Explain the following methods of calculating depreciation (i) staight line (ii) reducing balance (iii) sum of the years digit
What is the difference between depreciation and amortization
State ten uses of the general journal
Explain the principle of double entry system

READING ASSIGNMENT

Essential Financial Accounting page 308-317

WEEKEND ASSIGNMENT

Which of the following formulae is for average stock?( a) (sales – returns)1/2 ( b) (opening stock + purchases)1/2 (c) (opening stock + closing stock)÷ 2 (d) net profit/2 + opening stock

What is the formula for stock turnover?

(a) cost of goods sold (b ) sales – returns ( c)sales ÷ returns (d) profit + sales - returns

average stock inwards

ROCE is calculated thus

(a) NP × 100 (b) SALES × 100 ( c) NP × 100 (d) GP + NP/SALES

SALES PURCHASES NET ASSETS

Acid – test ratio is obtained by (a) current assets – stock ( b) total assets – stock

current liabilities current liability

When current asset is less than current liability it means (a) over trading (b) under trading (c) optimum

trading (d) counter trading

THEORY

Explain a) debtors /sales ratio b) creditors/purchases ratio
What will be revealed to a business when the above ratios are compared?

Lesson Notes By Weeks and Term - Senior Secondary School 3