Lesson Notes By Weeks and Term - Senior Secondary 2
Interpretation of account using simple accounting ratio equity II
Interpretation of account using simple accounting ratio equity II
Term: 2nd Term
Week: 11
Class: Senior Secondary School 2
Age: 16 years
Duration: 40 minutes of 2 periods each
Date:
Subject: Financial accounting
Topic:- Interpretation of account using simple accounting ratio equity II
SPECIFIC OBJECTIVES: At the end of the lesson, pupils should be able to
INSTRUCTIONAL TECHNIQUES: Identification, explanation, questions and answers, demonstration, videos from source
INSTRUCTIONAL MATERIALS: Videos, loud speaker, textbook, pictures
INSTRUCTIONAL PROCEDURES
PERIOD 1-2
|
PRESENTATION |
TEACHER’S ACTIVITY |
STUDENT’S ACTIVITY |
|
STEP 1 INTRODUCTION |
The teacher reviews the previous lesson on incomplete records |
Students pay attention |
|
STEP 2 EXPLANATION |
She explains the different accounting ratios
|
Students pay attention and participates |
|
STEP 3 DEMONSTRATION |
She calculates and shows the different examples of accounting ratios |
Students pay attention and participate |
|
STEP 4 NOTE TAKING |
The teacher writes a summarized note on the board |
The students copy the note in their books |
NOTE
ACCOUNTING RATIOS
Types of Ratios
There are actually two ways in which financial ratios can be classified. There is the classical approach, where ratios are classified on the basis of the accounting statement from where they are obtained. The other is a more functional classification, based on the uses of the ratios and the purpose for which they are calculated.
[A] Traditional Classification
Traditional Classification has three types of ratios, namely
1] Profit and Loss Ratios
When both figures are derived from the statement of Profit and Loss A/c we will call it a Profit and Loss Ratio. It can also be known as Income Statement Ratio or Revenue Statement Ratio. One such example is the Gross Profit ratio, which is the ratio of Gross Profit to Sales or Revenue. As you will notice, both these amounts will be derived from the Profit and Loss A/c. Other examples include Operating ratio, Net Profit ratio, Stock Turnover Ratio etc.
2] Balance Sheet Ratios
Just as above, if both the variables are obtained from the balance sheets, it is known as a balance sheet ratio. When such a ratio expresses the relation between two accounts of the balance sheet, we also call them financial ratios (other than accounting ratios).
Take for example Current ratio that compares current assets to current liabilities, both derived from the balance sheet. Other examples include Quick Ratio, Capital Gearing Ratio, Debt-Equity ratio etc.
3] Composite Ratios
A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share etc.
[B] Functional Classification
Then we move onto the functional classification. These help us group the ratios according to the functions they perform in our understanding and analysis of financial statements. This is a more accurate and useful classification of ratios, and hence more commonly used as well. The types of ratios according to the functional classification are
1] Liquidity Ratios
Liquidity Ratios
A firm has assets and liabilities to its name. Some are fixed in nature and then there are current assets and current liabilities. These are short-term in nature and easily convertible into cash. The liquidity ratios deal with the relationship between such current assets and current liabilities.
Liquidity ratios evaluate the firm’s ability to pay its short-term liabilities, i.e. current liabilities. It shows the liquidity levels, i.e. how many of their assets can be quickly converted to cash to pay of their obligations when they become due.
It is not only a measure of how much cash there is but also how easily current assets can be converted to cash or marketable securities. Now let us look at some of the important liquidity ratios.
Current Ratio
The current ratio is also known as the working capital ratio. It will measure the relationship between current assets and current liabilities. It measures the firm’s ability to pay for all its current liabilities, due within the next one year by selling off all their current assets. The formula for is as follows
Current Ratio = Current assets
Current liabilities
Current Assets include,
Current Liabilities include
The ideal current ratio, according to the industry standard is 2:1. That means that a firm should hold at least twice the amount of current assets than it has current liabilities. However, if the ratio is very high it may indicate that certain current assets are lying idle and not being utilized properly. So, maintaining the correct balance between the two is crucial.
Quick Ratio
The other important one of the liquidity ratios is Quick Ratio, also known as a liquid ratio or acid test ratio. This ratio will measure a firm’s ability to pay off its current liabilities (minus a few) with only selling off their quick assets.
Now Quick assets are those which can be easily converted to cash with only 90 days notice. Not all current assets are quick assets. Quick assets generally include cash, cash equivalents, and marketable securities. The formula is
Quick Ratio = Quick assets
Current liabilities quick liabilities
Quick Assets = All Current Assets – Stock – Prepaid Expenses
Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit
The ideal quick ratio is considered to be 1:1, so that the firm is able to pay off all quick assets with no liquidity problems, i.e. without selling fixed assets or investments. Since it does not take into consideration stock (which is one of the biggest current assets for most firms) it is a stringent test of liquidity. Many firms believe it is a better test of liquidity than the current ratio since it is more practical.
Absolute Cash Ratio
This is an even more rigorous liquidity ratio than quick ratio. Here we measure the availability of cash and cash equivalents to meet the short-term commitment of the firm. We do not consider all current assets, only cash. Let us see the formula,
Absolute Cash ratio = Cash + Bank balance + Marketable securities
Current liabilities
As you can see, this ratio measures the cash availability of the firm to meet the current liabilities. There is no ideal ratio, it helps the management understand the level of cash availability of the firm and make any changes required.
However, if the ratio is greater than 1 it indicates poor resource management and very high liquidity. And high liquidity may mean low profitability.
Examples
Given Below is the Balance sheet of ABC Co. Analyze the Balance Sheet and Calculate the Current Ratio.
|
Liabilities |
Amount |
Assets |
Amount |
|
Share Capital |
50,000 |
Fixed Asset |
1,24,000 |
|
Preference Share Capital |
30,000 |
Short Term Capital |
10,000 |
|
General Reserve |
40,000 |
Debtors |
95,000 |
|
Debentures |
60,000 |
Stock |
50,000 |
|
Trade Payable |
10,000 |
Cash and Bank |
15,000 |
|
Bank Overdraft |
20,000 |
Discount on Share Issue |
6,000 |
|
Provision for Tax |
40,000 |
||
|
Provision for Depreciation |
20,000 |
||
|
3,00,000 |
3,00,000 |
Solution:
Current Ratio = Current assets
Current liabilities
Current Assets = Debtors + Stock + Cash + Short term Capital = 1,70,000
Current Assets = Trade Payables + Bank Overdraft + Provision for Taxes + Provision for Depreciation = 90,000
Current Ratio = \(\frac{170000}{90000}\) = 1.889 : 1
Q: Calculate Liquid Ratio from the given details.
|
Current Liabilities |
65,000 |
|
Current Assets |
85,000 |
|
Stock |
20,000 |
|
Advance Tax |
5,000 |
|
Prepaid Expense |
10,000 |
Solution:
Quick Ratio = Quick assets
Current Liabilities Quick Liabilities
Quick Assets = All Current Assets – Stock – Prepaid Expenses = 85000 – (20000+5000+10000) = 50,000
Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit = 65,000
Quick Ratio = \(\frac{50000}{65000}\) = 0.77:1
2] Leverage Ratios
Solvency Ratios
Solvency ratios also known as leverage ratios determine an entity’s ability to service its debt. So these ratios calculate if the company can meet its long-term debt. It is important since the investors would like to know about the solvency of the firm to meet their interest payments and to ensure that their investments are safe. Hence solvency ratios compare the levels of debt with equity, fixed assets, earnings of the company etc.
One thing to make note of is the difference between solvency ratios and liquidity ratios. These two are often confused for the other. Liquidity ratios compare current assets with current liabilities, i.e. short-term debt. Whereas solvency ratios analyze the ability to pay long-term debt. Here we will be looking at the four most important solvency ratios. Let us start.
1] Debt to Equity Ratio
The debt to equity ratio measures the relationship between long-term debt of a firm and its total equity. Since both these figures are obtained from the balance sheet itself, this is a balance sheet ratio. Let us take a look at the formula.
Debt to Equity Ratio = Long term debts
Shareholders fund
Long Term Debt = Debentures + Long Term Loans
Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves – Fictitious Assets
The debt-equity ratio holds a lot of significance. Firstly it is a great way for the company to measure its leverage or indebtedness. A low ratio means the firm is more financially secure, but it also means that the equity is diluted.
In contrast, a high ratio indicates a risky business where there are more creditors of the firm than there are investors. In fact, a high debt to equity ratio may deter more investors from investing in the firm, and even deter creditors from lending money.
While there is no industry standard as such it is best to keep this ratio as low as possible. The maximum a company should maintain is the ratio of 2:1, i.e. twice the amount of debt to equity.
2] Debt Ratio
Next, we learn about debt ratio. This ratio measures the long-term debt of a firm in comparison to its total capital employed. Alternatively, instead of capital employed, we can use net fixed assets. So the debt ratio will measure the liabilities (long-term) of a firm as a percent of its long-term assets. The formula is as follows,
Debt Ratio = Long term debt
Capital employed
Or = Long term debts
Net assets
Capital Employed = Long Term Debt + Shareholders Funds
Net Assets = Non-Fictitious Assets – Current Liabilities
This is one of the more important solvency ratios. It indicates the financial leverage of the firm. A low ratio points to a more financially stable business, better for the creditors. A higher ratio points to doubts about the firms long-term financial stability. But a higher ratio helps the management with trading on equity, i.e. earn more income for the shareholders. Again there is no industry standard for this ratio.
3] Proprietary Ratio
The third of the solvency ratios is the proprietary ratio or equity ratio. It expresses the relationship between the proprietor’s funds, i.e. the funds of all the shareholders and the capital employed or the net assets. Like the debt ratio shows us the comparison between debt and capital, this ratio shows the comparison between owners funds and total capital or net assets. The ratio is as follows,
Proprietary Ratio = Shareholders funds
Capital employed
OR
= Shareholders funds
Net assets
A high ratio is a good indication of the financial health of the firm. It means that a larger portion of the total capital comes from equity. Or that a larger portion of net assets is financed by equity rather than debt. One point to note, that when both ratios are calculated with the same denominator, the sum of debt ratio and the proprietary ratio will be 1.
4] Interest Coverage Ratio
All debt has a cost, which we normally term as an interest. Debentures, loans, deposits etc all have an interest cost. This ratio will measure the security of this interest payable on long-term debt. It is the ratio between the profits of a firm available and the interest payable on debt instruments. The formula is,
Interest Coverage Ratio = Net Profit before interest and Tax
Interest on long term debt
EXAMPLES
Q: Calculate Interest Coverage ratio from the following details
Solution:
NPAT = 1,25,000
Tax Rate = 35%
Net Profit before tax = (97500 × 100) ÷ 65
Net Profit Before tax = 1,50,000
Debentures Interest = 6,00,000 × 10% = 60,000
Interest Coverage Ratio = \(\frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-Term Debt}}\) = \(\frac{150000}{60000}\)
Interest Coverage Ratio = 2.5:1
So in the current earnings before interest and tax, the firm can cover the interest cost for 2.5 times.
3] Activity Ratios
Activity Ratios
These ratios basically measure the efficiency with which assets are being utilized or managed. This is why they are also known as productivity ratio, efficiency ratio or more famously as turnover ratios.
These ratios show the relationship between sales and any given asset. It will indicate the ratio between how much a company has invested in one particular type of group of assets and the revenue such asset is producing for the company.
The following are the different kinds of activity ratios that measure the effectiveness of the funds invested and the efficiency of their performance
1] Stock Turnover Ratio
One of the most important of the activity ratios is the stock turnover ratio. This ratio focuses on the relationship between the cost of goods sold and average stock. So it is also known as Inventory Turnover Ratio or Stock Velocity Ratio.
It basically counts the number of times a stock rotates (completes a cycle) in one given accounting period and the sales it effects in the same period. So it calculates the speed with which the company converts stock (lying about) to sales, i.e. revenue. The formula for the ratio is as follows,
Quick Ratio = COGSAverageStock
COGS = Sales – Gross Profit
Average Stock = OpeningStock+ClosingStock2
From a managerial standpoint, this is an important ratio to calculate. It allows them to figure out their inventory reordering schedule, by indicating when all the stock will run out. It also helps them analyze how efficiently the stock and its reordering is being managed by the purchasing department.
2] Debtors Turnover Ratio
This ratio measures the efficiency with which Accounts Receivable are being managed, hence it is also known as ‘Accounts Receivable Turnover ratio’. The ratio shows the equation between credit sales (cash sales are not taken into consideration) and the average debtors of a firm. The formula is as below
Debtors Turnover ratio = CreditSalesAverageDebtors OR
Debtors Turnover ratio = CreditSalesDebtors+BillsReceivable
And with a slight modification, we also derive the average collection period. This will indicate the average number of days/weeks/months in which the payment from the debtor is collected by a firm. The formula for this formula is as below,
Average Collection Period = Numberofdays/weeks/monthsDebtorsT/ORatio
Both of these ratios are significant in managing the debtors and bills receivables of a company. Not only do they calculate the velocity with which debtors pay up, they help shape the credit policy of the firm as well.
3] Creditors Turnover Ratio
This ratio shows the relation between credit purchases (cash purchases are ignored in this context) and the average creditors of a company at any given time of the accounting year. This ratio is also the ‘accounts payable turnover ratio’. While calculating the net purchases we will minus any purchase return. The formula is as below,
Creditors Turnover ratio = CreditPurchasesAverageCreditors OR
Creditors Turnover ratio = CreditPurchasesCreditors+BillsPayable
Average Creditors = OpeningCreditors+ClosingCreditors2
Now using the same ratio, we can also calculate the average payment period in the number of days/weeks/months. We only have to modify the ratio a little, and remember this will be expressed as a function of time (days, moths etc)
Average Payment Period = Numberofdays/weeks/monthsCreditorsT/ORatio
Again creditors turnover ratio has great importance. It calculates the velocity with which creditors are paid off during the year. It helps the management judge how efficiently the accounts payables are being handled.
4] Working Capital Turnover Ratio
This one of the activity ratios will measure the efficiency with which the firm is using their Working Capital to support their sale volumes. So any excess of current assets over the current liabilities of a firm is their working capital. The formula for the ratio is
Working Capital Turnover ratio = TotalSalesWorkingCapital
Working Capital = Current Assets – Current Liabilities
A high Working Capital Turnover ratio means that the working capital is being very efficiently utilized. But sometimes it could mean that the creditors of the company are excessive (bringing down the working capital) and this could be a problem in the future. Conversely, a low ratio could mean that there are too many debtors or a very big inventory which is not an efficient use of resources.
EXAMPLES:
Calculate Debtors Turnover Ratio and Average Collection Period (in days) from the following.
Total Sales – 6,00,000
Cash Sales – 20% of Total sales
Trades Receivable at beginning of the year- 80,000
Trades Receivable at the end of the year- 1,60,000
Solution: From the given information
Credit Sales = 80% of Total Sales = 80% of 6,00,000 = 4,80,000
Average Debtors = OpeningDebtors+ClosingDebtors2
= 80,000+1,60,0002 = 1,20,000
Debtors Turnover ratio = CreditSalesAverageDebtors
= 480000120000
= 4 times
Average Collection Period = Numberofdays/weeks/monthsDebtorsT/ORatio
= 3654
= 91.25 days = 92 days
4] Profitability Ratios
The management of a company cannot wait for the year to end to analyze their financial performance and their profits. This must be done year round. These profitability ratios help the management determine an entity’s ability to use its assets and create earnings. The most useful comparisons for these ratios is to the performance of the previous years.
Profitability ratios are both revenue statement ratios and balance sheet ratios. They compare the revenue of a firm to different types of expense accounts within the Profit and Loss Statement. And then some profitability ratios also compare revenue to aspects of the balance sheet such as assets and equity.
There are a variety of profitability ratios calculated with the help of the Income Statement and the Balance Sheet. Here we will be focusing on the most important ones that are used regularly to analyze the profitability of various entities.
Gross Profit Ratio
This ratio simply compares the gross profit of a company to its net sales. Both of these figures are obtained from the Income Statement. The ratio is also known as Margin ratio or the Rate of Gross Profit. The ratio is represented as a percentage of sales.
This ratio basically signifies the basic profitability of the firm. This is why it is one of the most important profitability ratios. It shows the margin in the selling price before the company will incur losses from operations. The formula is
Gross Profit Ratio = Gross ProfitsNet Revenue from Operations × 100
Net Revenue from Operations = Net Sales = Sales – Sale Returns
Gross Profit = Sales – Cost of Sales
Operating Ratio
The second one of the profitability ratios is the operating ratio. This ratio measures the equation between the cost of operating activities and the net sales, or revenue from operations. This ratio expresses the cost of goods sold as a percentage of the net sales.
Operating ratio also takes into account operating expenses such as administration and office expenses, selling and distribution costs, salaries paid, depreciation expenses etc. Also, it ignores the non-operating incomes such as interests, commisions, dividends etc.
Operating Ratio = COGS + Operating ExpensesNet Revenue from Operations × 100
This ratio can actually help ascertain the efficiency of the organization along with its profitability. There is no standard ratio, but a trend analysis must be done on year on year basis to check the progress of the firm.
Net Profit Ratio
Unlike the operating ratio, the net profit ratio includes the total revenue of the firm. It takes into account both the operating income as well as the non-operating income. Then it compares net profit to these incomes. This ratio too is represented as a percentage. The formula for Net Profit ratio is,
Net Profit Ratio = Net ProfitNet Revenue × 100
Net Profit = Net Profit after Tax (NPAT)
this ratio helps measure the overall profitability of the firm. It indicates the portion of the net revenue that is available to the proprietors. It also reflects on the efficiency of the business and is a very important ratio for investors and financiers.
Return on Capital Employed
This ratio is one of the important ones of the profitability ratios. It measures the overall efficiency of the utilization of the firm’s funds. The ratio explores the relationship between the total income/profit earned by a firm and the total capital employed by the firm, or the total investment made. The formula is as follows,
Return on Capital Employed = PBITCapital Employed × 100
PBIT = Profit Before Income and Tax
This ratio measures the efficiency with which the capital is being utilized and it indicates the productivity of the capital employed. It is a good tool to measure the overall profitability of the firm as well.
Earnings Per Share
This ratio represents the profit or the earnings of a company in the context of one share. It represents the earnings of a firm whether or not dividends were actually declared on such shares. The formula for this ratio is
Earnings Per Share (EPS) = Profit available to Equity ShareholdersNumber of equity Shareholders × 100
Profit available to Equity Shareholders = NPAT – Preference Dividend
This is an important ratio for the shareholders, it helps them decide whether to hold onto the shares or sell them. It also is a good indicator of the dividends to be declared and/or bonus issues.
EXAMPLES
Q: Firm ABC and Co. have a Gross Profit ratio of 20%. It has credit revenue of 10,00,000 and cash revenue is 20% of the total revenue. The indirect expenses of ABC & Co. added up to 1,50,000. Please find the Net Profit ratio for the firm.
Sol:
Credit revenue = 10,00,000 = 80% of Total Revenue
Cash Revenue = 1000000 × 20/80 = 2,50,000
Total Revenue = 12,50,000
Gross Profit ratio = 20% of Total Revenue = 2,50,000
Net Profit = Gross Profit – Indirect expenses = 250000 – 150000 = 1,00,000
Net Profit Ratio = Net ProfitNet Revenue × 100 = 1000001250000 × 100 = 8%
5] Coverage Ratios
Shows the equation between profit in hand and the claims of outside stakeholders. These are stakeholders that are required by the law to be paid, even in case of liquidation. So these types of ratios ensure that there is enough to cover these payments to such outsiders. Some examples of coverage ratios are Dividend Payout Ratio, Debt Service ratio etc.
EVALUATION: 1. List and explain the types of ratios
CLASSWORK: As in evaluation
CONCLUSION: The teacher commends the students positively