An accounting ratio is the comparison of two figures in a set of accounts. Sometimes it may be expressed as a ratio (as in 1:2) and sometimes as a percentage. Some accounting ratios are well known and frequently used, but you are free to calculate and use ratios that are relevant to your particular needs.
Advantages of understanding accounting ratios
A main reason for the production of accounts is the need to provide a historically accurate record, but this is only one reason. Intelligent analysis can get behind the figures and provide greater understanding.
How to use accounting ratios
You will need a set of accounts and you will need to decide which ratios are relevant to your needs. It is often extremely useful to spot trends by calculating the same ratios for several successive periods. Read the notes to the accounts and remember the following points:
* Compare like with like. For example, a change in the balance sheet date or accounting period may distort the figures.
* Seasonal and other special factors may have to be taken into account. For example, a manufacturer of fireworks is likely to carry low stocks in a balance sheet dated 30th November.
* Special factors may be disclosed in the notes or elsewhere. Always read all the accompanying notes.
* Accounting policies are important and should be stated. A different accounting policy may well produce a different figure. In particular, you should look for a change in accounting policy during the year under review. This may distort comparisons and trends.
* Management may distort the figures by action round the balance sheet date. For example, creditors may be paid or not paid, which affects borrowing and the number of creditors days outstanding. Purchases may be suspended in order to reduce stocks.
Return on Capital Employed (ROCE)
Many people consider this to be the key ratio. It is the relationship between profit and the amount of capital invested in a business by its owners. Different definitions of profit may be used and the profit after tax. It is:
10,500/22,500 = 46.7% (previous year is 24.7%)
If profit before tax is used the calculation is:
13,000/22,500 = 57.8% (previous year is 30.5%)
If profit before tax and interest is used, it is:
14,000/22,500 = 62.2% (previous year is 36.8%)
This definition is often used because it enables meaningful comparisons to be made between companies financed in different ways.
By most standards the ratios show a healthy position and one that has improved over the year in question.
Profit to turnover
This is one of the simplest ratios and one of the most commonly used. It is profit expressed as a percentage of turnover in the year. Sometimes profit before tax is used, sometimes profit after tax. Some analysts prefer to deduct interest and other financing charges. The different percentages are:</p> <pre> Current Year Previous Year Profit before tax and interest 28.0%
14.9% Profit before tax 26.0% 12.3% Profit after tax 21.0% 10.0% </pre> <p>Stock turn
This is the number of times that total stock is used (turned over) in the course of a year. Normally, the higher the stock turn the more efficiently the business is being run, though there are dangers in keeping stock too low. Stock turn is normally applied to all stock, rather than just to finished stock. Seasonal factors can distort the ratio, especially if the balance sheet date is not a typical one.
The figure for purchases for resale is needed and the summarised profit and loss account does not give it. However, if during the year, purchases for resale have been 24,000,000 [pounds sterling], the stock turn was
24,000/12,000 = 2.0 or 6 months.
This would probably be considered to be a bad result.
Number of days credit granted:
6,000/50,000 x 365 = 43.8 days.
A potential weakness is that sales over a period of time are being compared with outstanding debts at a fixed date. It is most meaningful when invoicing is done evenly over the period.
Current assets to current liabilities
This compares 18,000 with 15,500 and results in a ratio of 1.2:1 (previous year 1.6:1). It is an extremely important ratio as it shows how assets that may be realised in the short term compare with liabilities that must be paid in the short term. It is possible (and frequently happens) that a business is profitable, but that it runs out of cash.
The purpose of this ratio is to compare the finance provided by banks or other lenders with the amount invested by the shareholders. It is a ratio much used by banks. Generally speaking, lenders do not like to see a ratio of 1: 1 (or some other such proportion) exceeded.
Some people prefer to include overdrafts with long term loans and some prefer to exclude them. If the bank overdraft is excluded, the calculation is:
20,000/22,500 = 0.9:1 (previous year is 1.2:1).
Gearing is said to be high when borrowing is high in relation to shareholders' funds. This can be dangerous but shareholders' returns will be high if the company does well.
Trading profit to sales
This is the gross margin and is:
24,000/50,000 = 48% (previous year 40.4%).
Overheads to sales
This is: 10,000/50,000 = 20% (previous year 25.5%).
Finance for non financial managers in a week, 3rd ed, Roger Mason Chartered Management Institute London: Hodder and Stoughton, 2003
Mastering financial management: demystify finance and transform your financial skills, Stephen Brookson London: Thorogood, 1998
Essentials of management ratios, Philip Ramsden Aldershot: Gower, 1998
How to understand and use company accounts, 4th ed, Roy Warren London: Century Business, 1998
Practical Examples ACME LTD Summarised Profit and Loss Account for the year to 30th September 2001 Current year Previous Year [pounds [pounds sterling]000 sterling]000 Sales 50,000 47,000 Less Cost of Sales 26,000 28,000 Trading Profit 24,000 19,000 Less overheads 10,000 12,000 Profit before Tax and Interest 14,000 7,000 Less Interest 1,000 1,200 Profit Before Tax 13,000 5,800 Less Tax 2,500 1,100 Profit after Tax 10,500 4,700 Dividend 7,000 4,000 Retained Profit 3,500 700 Summarised Balance Sheet at 30th September 2001 30-9-01 [pounds [pounds sterling]000 sterling]000 Fixed Assets 40,000 Current Assets Stock 12,000 Debtors 6,000 18,000 Current Liabilities Creditors 5,000 Bank overdraft 1,000 Taxation liability 2,500 Dividend liability 7,000 15,500 Net Current Assets 2,500 Long Term Loan (20,000) 22,500 Share capital 10,000 Reserves 12,500 22,500 30-9-00 [pounds [pounds sterling]000 sterling]000 Fixed Assets 34,000 Current Assets Stock 11,000 Debtors 8,000 19,000 Current Liabilities Creditors 4,000 Bank overdraft 3,000 Taxation liability 1,100 Dividend liability 4,000 12,100 Net Current Assets 6,900 Long Term Loan (21,900) 19,000 Share capital 10,000 Reserves 9,000 19,000
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|Title Annotation:||Checklist 192|
|Publication:||Chartered Management Institute: Checklists: Managing Information and Finance|
|Date:||Oct 1, 2005|
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