Special Accounting Procedures Chapter 5

What ratios I need to know Gross profit margin Net profit margin Gross profit markup Return On Capital Employed (ROCE) Current ratio Acid test ratio (quick ratio) Debtor to sales ratio Creditors to purchases ratio Rate of stock turn over ratio Profitability ratios Liquidity ratios

Gross profit margin Gross profit margin (%) = Gross profit margin Sales X 100 Shows how much gross profit is made for every $ earned

Calculations Sales turnover X 100 42,000 50,000 X 100 ฿ Sales turnover 50,000 Cost of Sales 8,000 Gross profit Expenses Rent 15,000 Utility bills 4,000 Wages 10,000 Net profit Gross profit margin (%) = Sales turnover X 100 42,000 Gross profit margin (%) = 42,000 50,000 X 100 13,000 =84% Analysis For every baht (฿) make from sales, 84% is kept as gross profit

Net profit margin Net profit margin (%) = Net profit margin Net profit Sales turnover X 100 Shows how much Net profit is made for every $ earned

Calculations Sales turnover X 100 5,000 80,000 X 100 ฿ Sales turnover 80,000 Cost of Sales 20,000 Gross profit Expenses Rent 35,000 Utility bills 10,000 Wages 10,000 Net profit Net profit margin (%) = Sales turnover X 100 60,000 Net profit margin (%) = 5,000 80,000 X 100 5,000 =6% Analysis For every baht (฿) make from sales, 6% is kept as Net profit profit

Gross profit markup This ratio shows the percentage of profit to the cost of goods sold. In other words, the amount the owner has ‘marked up’ its products. GP mark up= Gross profit Cost of goods sold X 100 If a product cost £1 and the owner wants a 20% mark up. Then the product will be sold for £1.20

Return On Capital Employed ROCE (%) = Operating profit Capital employed X 100 Shows how successful the managers are at earning a profit from capital used in the business.

Calculations Operating profit Capital employed X 100 ROCE (%) = 10,000 Fixed assets ฿ Land 10,000 Vehicle 5,000 Machines 1,000 Current Assets Debtors 1,000 Cash 500 Stock 2,000 Current Liabilities Creditors 600 Bank loan 800 Net-Current Assets (Working capital) Net assets --------------------------------------------------- Financed by: Profit / Loss 10,000 Share capital 8,100 Capital employed Return on Capital Employed ROCE (%) = Operating profit Capital employed X 100 ROCE (%) = 10,000 18,100 X 100 2,100 =55% Analysis For every baht (฿) invested, the business makes 55% extra. 18,100 18,100

Current ratio Current ratio = Current Ratio Current assets Current liabilities Shows haw many times a business can pay its short term debts with current assets. A good current ratio would be between 1.5 : 1 – 2 : 1 A ratio less than 1 would mean that a business could not pay its short term debts, and could be forced to cease trading. (It has no working capital)

Calculations Current ratio Current assets Current liabilities Fixed assets ฿ Land 10,000 Vehicle 5,000 Machines 1,000 Current Assets Debtors 1,000 Cash 500 Stock 2,000 Current Liabilities Creditors 600 Bank loan 800 Net-Current Assets (Working capital) Net assets --------------------------------------------------- Financed by: Profit / Loss 10,000 Share capital 8,100 Capital employed Current ratio Current ratio = Current assets Current liabilities Current ratio = 3,500 1,400 2,100 =2.5:1 Analysis 2.5:1 means the business can pay it’s short term debts two and a half times. It has high liquidity! 18,100 18,100

Acid test (Quick Ratio) Acid test ratio OR Liquidity ratio Acid test = Current assets – stock Current liabilities Similar to current ratio, however without stock because the nature of some companies may mean it is difficult to sell stock quickly (their stock is not liquid) for example a estate agent / car sales. A good acid test ratio is between 0.5 : 1 – 1 : 1

Calculations Acid test Current assets - stock Current liabilities Fixed assets ฿ Land 10,000 Vehicle 5,000 Machines 1,000 Current Assets Debtors 1,000 Cash 500 Stock 50,000 Current Liabilities Creditors 600 Bank loan 800 Net-Current Assets (Working capital) Net assets --------------------------------------------------- Financed by: Profit / Loss 10,000 Share capital 8,100 Capital employed Acid test Acid test ratio = Current assets - stock Current liabilities Acid test ratio = 1,500 1,400 50,100 =1:1 Analysis 1:1 means the business can JUST pay it’s short term debts. It has virtually no Liquidity! 79,600 18,100

Debtor to Sales ratio Debtors to sales ratio= This ratio assesses how long it takes for debtors to pay what they owe. Debtors to sales ratio= Debtor value Total annual sales X 12 The higher the ratio, the worse the business is at getting its debtors to pay on time. The lower the ratio, the better it is at managing its debtors.

Debtor to Sales ratio Business A Business B Total sales $240,000 $180,000 Debtor value $60,000 $30,000 Calculate the debtor to sales ratio. It is important to ensure debtors pay on time because: The longer the debt is owed, the more likely it is to turn into a bad debt The longer the debt is owed, the less working capital the business will have

Creditors to purchases ratio This ratio shows how long on average it takes a business to pay its suppliers Creditors to purchases ratio= Creditor value Annual purchases X 12 Taking longer to pay suppliers could be a good thing or a bad thing depending on the circumstances. If you take a long time to pay, you may lose possible discounting, or gain a bad reputation, in which case the supplier may not sell you goods any more. However, if you do not pay straight away, you keep more money in the business, increasing your working capital.

Creditors to purchases ratio Business A Business B Total purchases $120,000 $90,000 Creditor value $40,000 $22,500 Calculate the creditor to purchases ratio.

Rate of stock turn over ratio Every business should aim to keep their stock low (reduces storage costs) and should aim to sell their stock quickly. The stock turnover ratio measures how successful a business is at ‘managing’ their stock. Cost of goods sold Average stock held Stock turnover ratio= If only the opening and closing stocks are known, the average stock is found by adding opening and closing stock together and dividing them by two. The higher the ratio, the more profitable the business.

Work sheet

Gross profit Mark-up & Margin Can be either a fraction or a percentage Mark-up = Cost price Gross profit Can be either a fraction or a percentage Margin = Selling price

Gross profit Mark-up & Margin Inventory – 1/1/2011 400 Inventory – 31/12/2011 600 Purchases 5,200 A mark-up rate of 20% is applied for sales Find the gross profit and sales revenue figures You know: COGS + GP = Sales COGS +% mark-up = Sales SO.... 20% of 5,000 = 1,000 5,000 + 1,000 = 6,000 (sales) Sales ? Less COGS: - Inventory 1/1/2011 400 - Add purchases 5,200 Less inventory 31/12/2011 (600) 5000 Gross Profit - ? 6,000 SALES COGS GP ________ + 1,000

Gross profit Mark-up & Margin Inventory – 1/1/2011 500 Inventory – 31/12/2011 800 Sales 6,400 A mark-up rate of 25% is applied for sales Find the gross profit and purchases figures You know: COGS + GP = Sales Sales – GP = COGS SO.... Sales – 25% = COGS 6,400 – 1,600 = 4,800 Sales 6,400 Less COGS: - Inventory 1/1/2011 500 - Add purchases ? Less inventory 31/12/2011 800 Gross Profit - ? SALES COGS GP ________ + 5,100 4,800 1,600

Gross profit Mark-up & Margin If the mark-up is known, to find the margin take the numerator to be a numerator of the margin, then plus the denominator plus the numerator for the margin’s denominator. Margin Mark-up 1 4 2 11 1 4+1 2 11 + 2 1 5 2 13

Gross profit Mark-up & Margin If the margin is known, to find the margin take the numerator to be a numerator of the margin, then plus the denominator less the numerator for the margin’s denominator. Mark-up Margin 1 6 3 13 1 6-1 3 13 - 3 1 5 3 10

Gross profit Mark-up & Margin Find the missing fractions: Margin Mark-up 5/12 6/15 7/12 1/4 3/21 1/6 1/9 1/8

Manager’s commission Managers usually get a percentage of the profits as a commission. Assume that profits before the manager’s commission was deducted, amounted to £8,400. The manager was entitled to 5% of the profits. 5% of £8,400 is £420. Therefore the profits remaining would be £7,980. However 5% of £7,980 is £399. What you should do is... % commission 100 + percentage commission X Profit before commission 5 100 + 5 X 8,400 = £400 The profits remaining are £8,000, and £400 is 5% of £8,000. therefore this is now correct