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Accounting for Executive
Week 5 /4/2011 (Fri)
Lecture 5
What’s Inside ?
Learning ObjectivesLearning Objectives
uiz Corner Profitability ratios
Liquidity ratios
Return on capital employed (ROCE)
Management efficiency ratios
emo question
Comparing the financial statements of two companies
Learning ObjectivesLearning Objectives
Classify accounting ratios into three groups.
Calculate ratios for profitability.
Calculate ratios for liquidity.
Calculate ratios for management efficiency.
Interpret final accounts based on accounting ratios.
Explain the limitations of ratio analysis.
After reading this chapter, you will be able to:
Profitability ratios
Liquidity ratiosManagement efficiency ratios
Accounting ratios can be classified into 3 types:
Classifying accounting ratios
Learning Objectives
Profitability ratios
Gross profit ratio
Net profit ratio
Stock turnover rate
Expenses-sales ratio
Return on capital employed
It is also a management efficiency ratio.
Learning Objectives
Cost of goods soldAverage stock
SalesNet profit
Gross profitSales
Gross profit ratio
Net profit ratio
Stock turnover rate
100%
100%
Profitability ratios
(in months)
12 ÷
Cost of goods soldAverage stock
SalesNet profit
Gross profitSales
Gross profit ratio
Net profit ratio
Stock turnover rate
100%
100%
Profitability ratios
(in weeks)
52 ÷
Cost of goods soldAverage stock
SalesNet profit
Gross profitSales
Gross profit ratio
Net profit ratio
Stock turnover rate
100%
100%
Profitability ratios
(in days)
365 ÷
Operating expenses
Expenses-sales ratio
It is also known as _____________________ _______.
It shows how much is spent on operating expenses for every $100 of sales.
Sales 100%
Profitability ratios
expenses as a percentageof sales
uiz Corner
Net profitCapital employed
Return on capital employed
This shows the amount of net profit made for every $100 of capital employed.
The higher the ratio, the more efficiently ______ is utilised and the more ________ the firm is.
100%
Generally, capital employed refers to ____________.
Opening capital + Closing capital2
Profitability ratios
capital
average capital
profitable
However, capital employed can have different meanings under different forms of business ownership.For a sole proprietorship, capital employed could mean:
1. Closing capital
2. Average capital
3. Capital balance + Long-term loans
Profitability ratios
For a limited company, capital employed could mean:
Issued ordinary share capital + Reserves
2. Total shareholders’ funds
3. Total capital employed
1. Ordinary shareholders’ funds
Issued ordinary share capital + Issued preference share capital (preferred stock) + Reserves
Issued ordinary share capital + Issued preference share capital + Reserves + Debentures (bonds)
Profitability ratios
uiz Corner
Current assets – Closing stock
Current liabilities
Current assetsCurrent liabilities
Liquidity ratios
As you have learned in Chapter 1, the liquidity ratios are:
Current ratio
Quick ratio (acid test ratio)
uiz Corner Learning Objectives
Management efficiency ratios
Stock turnover rate
Credit period allowed to trade debtorsCredit period received from trade creditors
This is also a management efficiency ratio because a firm should keep stock at a ___ level while selling goods ______. This ratio indicates how well the firm is managing its sales and stock level.
lowquickly
Learning Objectives
Credit period allowed to trade debtors
DebtorsSales
12
This shows how long it takes our ____________ to pay us.
It is also known as the ____________________ or _________________.
When expressed in months:
The ______ the period allowed, the more _________ is the firm managed.
Management efficiency ratios
trade debtors
debtors collection perioddebtors : sales ratio
efficiently
shorter
Credit period allowed to trade debtors
DebtorsSales
12
When expressed in months:When expressed in weeks:
52
Management efficiency ratios
It is also known as the ____________________ or _________________.
debtors collection perioddebtors : sales ratioThe ______ the period allowed, the more _________ is the firm managed.
efficiently
shorter
This shows how long it takes our ____________ to pay us.
trade debtors
Credit period allowed to trade debtors
DebtorsSales
12
When expressed in months:When expressed in days:
365
Management efficiency ratios
It is also known as the ____________________ or _________________.
debtors collection perioddebtors : sales ratioThe ______ the period allowed, the more _________ is the firm managed.
efficiently
shorter
This shows how long it takes our ____________ to pay us.
trade debtors
This shows how long it takes the firm to pay its _____________.
Credit period received from trade creditors
It is also known as the ______________________ or _____________________.
CreditorsPurchases
12
When expressed in months:
If the firm takes too ____ to pay its creditors, it may lose possible ____________. However, there is no need to pay too ____.
Management efficiency ratios
trade creditors
creditors repayment periodcreditors : purchases
ratiolong
cash discountsearly
Credit period received from trade creditors
CreditorsPurchases
12
When expressed in months:When expressed in weeks:
52
Management efficiency ratios
It is also known as the ______________________ or _____________________.
If the firm takes too ____ to pay its creditors, it may lose possible ____________. However, there is no need to pay too ____.
creditors repayment periodcreditors : purchases
ratiolong
cash discountsearly
This shows how long it takes the firm to pay its _____________.trade creditors
Credit period received from trade creditors
CreditorsPurchases
12
When expressed in months:When expressed in days:
365
Management efficiency ratios
uiz Corner
It is also known as the ______________________ or _____________________.
If the firm takes too ____ to pay its creditors, it may lose possible ____________. However, there is no need to pay too ____.
creditors repayment periodcreditors : purchases
ratiolong
cash discountsearly
This shows how long it takes the firm to pay its _____________.trade creditors
Accounting ratios can show the _________ between different figures. Thus, the interpretation is _____ and more ________.
Interpretation of final accounts
Final accounts are prepared in _____________. These figures are meaningless unless they are compared and related to ___________.
To analyse final accounts, we always use _________ _____ rather than just looking at the absolute figures.
absolute figures
other figures
accountingratios
relationship faire
robjective
Importance of interpretation:
1. Items in the financial statements can be ________ one another.
2. Performance of the business can be compared between _____ and between ____.
3. It helps identify the _________ of the management.
4. It helps ________ assess their investments.
5. It helps creditors evaluate the ______________ of the firm.
Interpretation of final accounts
related to
years firms
weaknesses
investors
creditworthiness
Learning Objectives
Limitations of ratio analysis
1. Accounting ratios do not reflect the _________ factors of a business.
2. It is based on ___________, and not related to the future trend.
3. Some _______ factors may affect the accuracy of the ratios.
4. It cannot indicate the ______ behind the changes.
5. It is unsuitable for comparison of two companies in _____________.
qualitative
past records
seasonal
reasons
different fields
emo question
emo question
The following are the final accounts of Faster Company and Greater Company:
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
$ $Sales 650,000 1,050,000Less Cost of goods sold:
Opening stock 40,000 20,000Purchases 350,000 670,000
390,000 690,000Less Closing stock 20,000 30,000
370,000 660,000Gross profit 280,000 390,000Less Expenses 80,000 120,000Net profit 200,000 270,000
emo question
(14,000) 120,000686,000 1,070,000
Balance Sheets as at 31 March 20X7Faster Company Greater Company
Fixed Assets $ $Net book value 700,000 950,000Current AssetsStock 15,000 30,000Debtors 25,000 40,000Bank 1,000 120,000
41,000 190,000Less Current Liabilities
Creditors 55,000 70,000
Financed by:Issued share capital 200,000 200,000Retained profits 486,000 870,000
686,000 1,070,000
emo question
Required:
a. Calculate the following ratios for the two companies:i. Gross profit ratio
ii. Net profit ratioiii. Expenses-sales ratioiv. Return on capital
employedv. Stock turnover ratevi. Current ratio
vii. Quick ratioviii.Credit period allowed to trade
debtors (months)
ix. Credit period received from trade creditors (months)
b. Compare the results of the two companies giving possible reasons for the different results.
emo question
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
$ $Sales 650,000 1,050,000Less Cost of goods sold:
Opening stock 40,000 20,000Purchases 350,000 670,000
390,000 690,000Less Closing stock 20,000 30,000
370,000 660,000Gross profit 280,000 390,000Less Expenses 80,000 120,000Net profit 200,000 270,000
i. Gross profit ratio Gross profitSales
100%
$650,000 100%$280,000
$1,050,000 100%$390,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
emo question
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
$ $Sales 650,000 1,050,000Less Cost of goods sold:
Opening stock 40,000 20,000Purchases 350,000 670,000
390,000 690,000Less Closing stock 20,000 30,000
370,000 660,000Gross profit 280,000 390,000Less Expenses 80,000 120,000Net profit 200,000 270,000
ii. Net profit ratioSales
Net profit 100%
$650,000 100%$200,000
$1,050,000 100%$270,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
emo question
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
$ $Sales 650,000 1,050,000Less Cost of goods sold:
Opening stock 40,000 20,000Purchases 350,000 670,000
390,000 690,000Less Closing stock 20,000 30,000
370,000 660,000Gross profit 280,000 390,000Less Expenses 80,000 120,000Net profit 200,000 270,000
iii. Expenses-sales ratioSales
Operating expenses 100%
$650,000 100%$80,000
$1,050,000 100%$120,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
Issued share capital 200,000 200,000
686,000 1,070,000Retained profits 486,000 870,000
Balance Sheets as at 31 March 20X7Faster Company Greater Company
Financed by: $ $●●●
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
$ $
Gross profit 280,000 390,000Less Expenses 80,000 120,000Net profit 200,000 270,000
●●●
emo questioniv. Return on capital employed
$686,000 100%$200,000
Capital employedNet profit
100%
$1,070,000 100%$270,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
29.2% 25.2%
emo question
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
$ $Sales 650,000 1,050,000Less Cost of goods sold:
Opening stock 40,000 20,000Purchases 350,000 670,000
390,000 690,000Less Closing stock 20,000 30,000
370,000 660,000Gross profit 280,000 390,000Less Expenses 80,000 120,000Net profit 200,000 270,000
v. Stock turnover rateAverage stock
Cost of goods sold
($40,000 + $20,000) / 2$370,000
($20,000 + $30,000) / 2$660,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
29.2% 25.2%
12.3 times 26.4 times
emo questionvi. Current ratio
Current liabilitiesCurrent assets
emo question
(14,000) 120,000686,000 1,070,000
Balance Sheets as at 31 March 20X7Faster Company Greater Company
Fixed Assets $ $Net book value 700,000 950,000Current AssetsStock 15,000 30,000Debtors 25,000 40,000Bank 1,000 120,000
41,000 190,000Less Current Liabilities
Creditors 55,000 70,000
Financed by:Issued share capital 200,000 200,000Retained profits 486,000 870,000
686,000 1,070,000
$55,000$41,000
$70,000$190,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
29.2% 25.2%
12.3 times 26.4 times
0.75 : 1 2.7 : 1
emo questionvii. Quick ratio
Current liabilitiesCurrent assets – Stock
emo question
(14,000) 120,000686,000 1,070,000
Balance Sheets as at 31 March 20X7Faster Company Greater Company
Fixed Assets $ $Net book value 700,000 950,000Current AssetsStock 15,000 30,000Debtors 25,000 40,000Bank 1,000 120,000
41,000 190,000Less Current Liabilities
Creditors 55,000 70,000
Financed by:Issued share capital 200,000 200,000Retained profits 486,000 870,000
686,000 1,070,000
$55,000$41,000 – $15,000
$70,000$190,000 – $30,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
29.2% 25.2%
12.3 times 26.4 times
0.75 : 1 2.7 : 1
0.47 : 1 2.29 : 1
Balance Sheets as at 31 March 20X7Faster Company Greater Company
$ $Current AssetsStock 15,000 30,000Debtors 25,000 40,000Bank 1,000 120,000
41,000 190,000
●●●
emo questionviii. Credit period allowed to trade debtors
$ $Sales 650,000 1,050,000
Trading and Profit and Loss Accounts for the year ended 31 March 20X7Faster Company Greater Company
●●●
SalesDebtors
12
$650,000 12$25,000
$1,050,000 12$40,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
29.2% 25.2%
12.3 times 26.4 times
0.75 : 1 2.7 : 1
1.47 : 1 2.29 : 1
0.46 months 0.46 months
emo questionix. Credit period received from trade creditors
PurchasesCreditors 12
Less Cost of goods sold:
Faster Company Greater Company$ $
Trading and Profit and Loss Accounts for the year ended 31 March 20X7
Opening stock 40,000 20,000Purchases 350,000 670,000
●●●
●●●
●●●
Balance Sheets as at 31 March 20X7Faster Company Greater Company
$ $
Creditors 55,000 70,000Less Current Liabilities
●●●
$350,000 12$55,000 $670,000
12$70,000
Expenses-sales ratio
Return on capital employed
Gross profit ratio
Net profit ratio
Stock turnover rate
Current ratio
Quick ratio
Faster Company
Credit period allowed to trade debtors
Credit period received from trade creditors
Greater Company
43.1%
emo question
37.1%
30.8% 25.7%
12.3% 11.4%
29.2% 25.2%
12.3 times 26.4 times
0.75 : 1 2.7 : 1
1.47 : 1 2.29 : 1
0.46 months 0.46 months
1.89 months 1.25 months
emo question
Profitability
• Faster Company was more profitable. It achieved a higher gross profit ratio, net profit ratio and return on capital employed.
• Although Greater Company was less profitable, it still performed well in terms of profitability. It achieved a high gross profit ratio of 37.1%, a net profit ratio of 25.7% and a return on capital employed of 25.2%. It also had a very high stock turnover rate.
emo question
Liquidity
• Greater Company performed better in terms of liquidity.
• Faster Company’s current ratio and quick ratio were 0.75 : 1 and 0.47 : 1, respectively. This implies that it had liquidity problems and may have difficulty repaying short-term debts.
emo question
• Both companies managed to collect payments from debtors within one month. They both took only 0.46 months to collect debts. This contributed to their liquidity.
• Both companies took credit periods of similar lengths from their creditors.
Management efficiency• Both Greater Company and Faster
Company had a high stock turnover rate, which contributed to their profitability.
emo question
Although Faster Company was more profitable, Greater Company was the more successful company because it was in a stronger liquidity position as well as being profitable.
Overall comments: