1. Chapter 10 Introduction to Ratio Analysis

2. Introduction
A major purpose of accounting is to provide useful information to make informed decisions. One way to assist with this is to examine financial ratios. A financial ratio matches two or more pieces of monetary data and presents them in the form of a percentage, proportion, or in relation to a period of time (e.g. per month, per quarter, per year).

3. Profitability Ratios
These measure the firm’s potential to obtain and maintain revenues that exceed expenses.
Examples include:
Gross mark-up
Gross margin
Net profit margin
Return on capital employed

4. Liquidity Ratios
These measure the firm’s ability to meet its short term debts as they arise.
Examples include:
Current ratio
Acid-Test ratio
Debtors’ turnover
Creditors’ turnover
Rate of stockturn

5. Stock Turnover (Turnover) Ratio
Cost of sales ÷ Average stock, where Average stock=
(Opening stock + Closing stock) ÷ 2
Measures the speed at which merchandise is sold. It may be shown in “times” or “days”.

6. Current (Working Capital) Ratio
Current assets ÷ Current liabilities
A test of the ability to pay short term debts as they arise.

7. Acid-test (Quick) Ratio
Current assets (less closing stock) ÷ Current liabilities A better test of the ability to pay short term debts as they arise.

8. Debtors’ Turnover Ratio
Closing debtors (before provision for bad debts) ÷ Net sales Demonstrates how quickly money has been received from debtors.

9. Creditors’ Turnover Ratio
Closing creditors ÷ Net purchases The speed at which creditors are being paid the amount owed to them.

10. Gross Margin Ratio
Gross profit ÷ Net sales The value of gross profit being earned from every dollar of sales.

11. Gross Mark-up Ratio
Gross profit ÷ Cost of sales The value of gross profit being generated from every dollar spent on getting the items in a state suitable for sales.

12. Net Profit Ratio
Net profit (before interest and tax) ÷Net sales x 100 The value of net profit being earned from every dollar of sales.

13. Return On Capital Employed (ROCE)
Net profit (before interest and tax) ÷ Capital employed x 100 For an unincorporated business, the capital employed = (Opening Capital + Closing Capital)÷2 This percentage is the overall test of management's ability to efficiently utilise its scarce resources.