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.

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