Introduction: Accounting Ratios – Your Business Report Card
Welcome to the final section of our Accounting course! You've learned how to prepare the Income Statement and the Statement of Financial Position (SFP). But these statements are just a massive collection of numbers. How do you actually use them to judge if a business is doing well?
That's where Accounting Ratios come in! Ratios are like converting raw exam scores into percentages—they make complicated figures easy to compare and interpret. This chapter is all about turning numbers into meaningful stories and advice.
Don't worry if the formulas look scary at first! We will break them down into simple parts. Remember, in the exam, you need to be able to Calculate and Interpret these ratios.
Part 1: Calculating and Understanding Profitability Ratios
Profitability Ratios measure how successful a business is at earning a profit compared to its sales or the money invested in it. Essentially, how good is the business at turning revenue into cash?
1. Gross Margin (Gross Profit percentage)
This ratio shows the percentage of sales revenue that remains after deducting the Cost of Goods Sold (COGS). It tells us how efficiently the business purchases and prices its goods.
Formula:
\[ \text{Gross Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \]
Interpretation:
- A higher Gross Margin is usually better.
- If the Gross Margin drops, it might mean: Sales prices were too low, or the cost of purchasing inventory increased.
2. Profit Margin (Net Profit percentage)
This ratio shows the percentage of sales revenue that remains after deducting ALL expenses (including operating expenses, but excluding tax and interest, as per the syllabus focus on Profit for the year/Net Profit).
Formula:
\[ \text{Profit Margin} = \frac{\text{Profit for the year}}{\text{Revenue}} \times 100 \]
Interpretation:
- This is the true measure of overall efficiency.
- If the Gross Margin is high but the Profit Margin is low, it suggests the business has poor control over its operating expenses (e.g., rent, wages, electricity).
3. Return on Capital Employed (ROCE)
This is arguably the most important profitability ratio. It measures the profit generated from the total funds invested in the business by the owners and long-term lenders (the Capital Employed).
Think of it like this: If you put money in a bank, you expect interest. ROCE is the ‘interest rate’ the business earns on all its long-term investment.
Formulas:
\[ \text{ROCE} = \frac{\text{Net profit before interest}}{\text{Capital employed}} \times 100 \]
\[ \text{Capital Employed} = \text{Issued Shares} + \text{Reserves} + \text{Non-Current Liabilities} \]
(For a sole trader, Capital Employed is simply the Owner's Equity plus Non-Current Liabilities.)
Interpretation:
- A high ROCE is excellent. It means the business is using its resources effectively.
- The result must be compared to the interest rate banks offer and the profit rates of competitors. If ROCE is lower than the bank interest rate, the owners might as well put their money in the bank!
Key Takeaway (Profitability):
Profitability ratios show how much money the business makes. ROCE is essential because it links profit directly to the investment needed to generate that profit.Part 2: Calculating and Understanding Liquidity and Efficiency Ratios
These ratios assess whether the business can meet its short-term debts (Liquidity) and how efficiently it manages its current assets (Efficiency).
4. Current Ratio (Working Capital Ratio)
This ratio checks if the business has enough current assets (things that will turn to cash soon) to cover its current liabilities (debts due soon).
Formula:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
Interpretation:
- The result is expressed as a ratio (e.g., 2:1).
- An ideal range is often considered 1.5:1 to 2:1. This means for every $1 of debt, the business has $2 of assets to cover it.
- A ratio < 1.0 (e.g., 0.8:1) means the business is facing liquidity problems and may struggle to pay its immediate debts.
- A ratio that is too high (e.g., 4:1) might suggest the business is holding too much idle cash or too much inventory.
5. Liquid Ratio (Acid Test Ratio / Quick Ratio)
This is a stricter test of liquidity. It removes Inventory (stock) from the current assets because inventory can sometimes be slow to sell or difficult to turn into cash quickly.
Formula:
\[ \text{Liquid Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \]
Interpretation:
- An ideal result is often considered 1:1. This means the business can cover its immediate debts without having to rely on selling its slow-moving inventory.
- If the Current Ratio is good (2:1) but the Liquid Ratio is very poor (0.5:1), it signals that the company’s liquidity is trapped mostly in slow-moving stock.
Quick Review: If Current Ratio is 2:1 and Acid Test is 1:1, the business is fine. If Current Ratio is 2:1 and Acid Test is 0.5:1, the business has a huge pile of unsold stock!
6. Rate of Inventory Turnover (Times)
This measures how many times the business sells and replaces its average level of inventory during the year. It measures the efficiency of inventory management.
Formula:
\[ \text{Rate of Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \]
Note: Average Inventory is usually (Opening Inventory + Closing Inventory) / 2. The answer is given in 'times'.
Interpretation:
- A higher number of times is usually better, as it shows inventory is selling fast (less storage cost, lower risk of damage/obsolescence).
- A result that is too high might mean the business is constantly running out of stock (stock-outs), leading to lost sales.
- A result that is low means stock is slow-moving, increasing costs and risk.
7. Trade Receivables Turnover (Days)
This calculates the average number of days it takes for the business to collect cash from its credit customers (trade receivables).
Formula:
\[ \text{Trade Receivables Turnover (days)} = \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \]
Interpretation:
- A shorter collection period is better, as the business gets its cash sooner, improving liquidity.
- If the actual turnover (e.g., 60 days) is much longer than the agreed credit terms (e.g., 30 days), it indicates a problem with debt collection.
Did you know? The longer the cash is stuck with the customer, the less cash the business has to pay its own bills!
8. Trade Payables Turnover (Days)
This calculates the average number of days the business takes to pay its own credit suppliers (trade payables).
Formula:
\[ \text{Trade Payables Turnover (days)} = \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \]
Interpretation:
- Businesses prefer a longer payment period (better for their cash flow).
- However, if the period is too long, the business might damage its reputation with suppliers, leading to losing trade discounts or having credit restricted.
- Ideally, the payment period should be shorter than or similar to the receivables period, but not so long that suppliers are angered.
Key Takeaway (Liquidity & Efficiency):
Liquidity ratios (Current and Acid Test) check short-term financial health. Efficiency ratios (Turnovers) check how quickly assets (like stock and debts) are managed.Part 3: Interpretation, Comparison, and Recommendations (6.2)
Calculating ratios is only half the battle; the syllabus requires you to interpret them and make recommendations.
Comparing Results (Trends)
Ratios are only useful when compared. A business must compare its current results with:
- Previous Years' Results: This shows the business trend. Is profitability improving or declining over time?
- Inter-firm Comparison: Comparing results with competitors or industry averages (Section 6.3).
- Industry Standards: Comparing against ‘ideal’ standards (like 2:1 for Current Ratio).
The Significance of Profit Margins
It is vital to understand the difference between Gross Margin and Profit Margin.
If Gross Margin increases, it means the pricing strategy or purchasing costs have improved.
If Profit Margin decreases while Gross Margin increases, it means the cost of running the business (operating expenses) has risen disproportionately (e.g., rent tripled, or management salaries doubled). The business needs to focus on cutting overheads!
Making Recommendations: Improving Performance
1. Improving Profitability (Gross Margin & Profit Margin):
- Increase Revenue: Run marketing campaigns, find new markets, increase sales prices (if possible).
- Reduce Cost of Goods Sold: Negotiate better discounts with suppliers, buy in bulk, or use cheaper suppliers.
- Reduce Operating Expenses: Cut unnecessary spending, reduce salaries, switch to cheaper utility providers.
2. Improving Working Capital (Liquidity Ratios):
The goal is to increase the Current and Acid Test Ratios to ensure short-term survival.
- Reduce Inventory: Improve stock control to reduce average inventory levels (improves Acid Test and Inventory Turnover).
- Speed up Receivables: Offer cash discounts for early payment, or enforce stricter credit control policies.
- Review Payables: Negotiate longer credit periods with suppliers (but be careful not to damage relationships).
- Convert Non-Current Assets to Cash: Sell unused machinery or buildings.
Inter-firm Comparison (6.3)
Comparing your business ratios with a competitor can be very helpful, but there are problems:
- Different Accounting Policies: One firm might use Straight Line depreciation, another Reducing Balance, making ROCE comparisons unfair.
- Different Year Ends: Data might be from different economic periods.
- Size Difference: Comparing a local sole trader to a multinational limited company is misleading.
- Different Product Mix: Two companies may operate in the same industry but focus on different products (e.g., high-end luxury vs. budget items).
Part 4: Who Needs Accounting Information? (6.4)
Different parties are interested in the financial statements for different reasons. They use ratios to help them make decisions.
1. Owners (Shareholders or Proprietor)
Focus: ROCE, Profit Margin, overall growth.
Decision: Is the business profitable? Should they invest more money or sell their shares?
2. Managers
Focus: All ratios (especially efficiency and control of expenses).
Decision: Which areas of the business need improvement? Are we managing stock correctly? Should we hire more debt collectors?
3. Trade Payables (Suppliers)
Focus: Current Ratio, Liquid Ratio, Trade Payables Turnover.
Decision: Is the business likely to pay its debts on time? Should they offer credit terms or demand cash?
4. Banks and Lenders
Focus: ROCE, Current Ratio, Liquid Ratio.
Decision: Is the business stable enough to repay a loan? Is the return on investment (ROCE) healthy?
5. Investors (Potential Shareholders)
Focus: ROCE, Profit Margin, trends over several years.
Decision: Is this a good company to invest money in for future returns?
6. Club Members
Focus: Income and Expenditure results, accumulated fund.
Decision: Are the subscription fees being used wisely? Is the club financially healthy?
7. Government and Tax Authorities
Focus: Profit for the year, Revenue.
Decision: Calculating the correct amount of tax the business owes.
Part 5: Limitations of Accounting Statements (6.5)
Ratios give us great insights, but they are not perfect. It is crucial to recognise the limitations of relying solely on financial statements.
1. Historic Cost
The figures in the financial statements are usually based on the historic cost principle (assets are recorded at their original purchase price).
Limitation: The Statement of Financial Position might show a building bought 50 years ago at a very low cost. This figure doesn't reflect the building's current market value, making the total assets figure misleading.
2. Difficulties of Definition
Sometimes, definitions can be ambiguous, or different firms define items differently. For example, what one company classifies as a 'non-current asset' another might classify differently, which can distort ratios like ROCE.
3. Non-Financial Aspects
Ratios only deal with numbers. They ignore crucial factors that affect a business's true health and future success:
- Staff Morale: Are the employees happy and productive?
- Customer Loyalty: How strong is the customer base?
- Product Quality: Is the product superior to competitors'?
- Market Changes: Is a new competitor or technology about to disrupt the industry?
Example: A ratio might show high short-term profit (good), but if the product quality is terrible (non-financial aspect), the business will fail soon (bad).