Mr Roshan Khalawan

Tel: 5 7640922

Ratio Analysis
Work example 1:

Sales revenue $ 201 000

Sales return $ 1 000
Opening inventory $ 20 000
Purchases $ 110 000
Closing inventory $ 40 000
Total expenses $ 50 000
Trade receivable $ 100 000
Trade payable $ 15 000
Capital at start $ 300 000
Drawings $ 20 000
Loan from bank $ 100 000 (long term)

Required: Prepare I/S

 Turnover (net revenue) = sales revenue – sales returns

 Cost of sales = opening inventory + net purchases – closing inventory

 Gross profit = Turnover – cost of sales

 Profit for the year = gross profit + total incomes– total expenses

Note: In ratio, sales means turnover (net revenue)

 Gross profit as a percentage of sales or

Gross profit margin = gross profit x 100
turnover

 Gross profit mark- up or

Gross profit as a percentage of cost or
Gross profit as a percentage of cost of sales = gross profit x 100
Cost of sales

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 Mr Roshan Khalawan
Tel: 5 7640922

 Gross profit as a percentage of opening capital = gross profit x 100

Opening capital

 Expenses as percentage of sales = Total expenses x 100

Turnover

Average Inventory = (Opening inventory + Closing inventory)

2

1. Rate of Inventory Turnover = Cost of sales = (answer given in times)

Average Inventory

The rate of inventory represents the number of times the average inventory has been sold
during the year. The ratio shows how rapidly inventory is being sold. Generally, a high rate of
inventory turn or a lower inventory turnover is indicative of good inventory management and
improved liquidity. Rate of inventory can be improved by reducing the level of inventory,
generating more sales through aggressive marketing and replacement of inventory only when
needed (just in time purchasing).

Possible reasons for improvement in rate of Possible reasons for deterioration in rate of
inventory turn inventory turn
Increase in sales volume as a result of Decrease in sales volume as a result of fierce
aggressive marketing campaign competition
Keeping low level of inventory by using just in Maintaining high level of inventory
time purchasing technique
Getting rid of obsolete inventory

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 Mr Roshan Khalawan
Tel: 5 7640922

1. Profit Margin = Profit for the year X 100

Net Revenue

A high profit margin is an indication of good performance. It also highlights management

efficiency in controlling expenses.

Possible reasons for improvement in Possible reasons for deterioration in

profit margin
Increase in selling price
Decrease in purchase price
Decrease in freight and custom duty
Higher trade discount on bulk buying
Overvaluation of closing inventory
Decrease in expenses
Increase in sales volume
Increase in other operating income such as
rental income and interest income
profit margin
Decrease in selling price
Increase in purchase price
Increase in freight and custom duty
Lower or loss trade discount on bulk buying
Undervaluation of closing inventory
Increase in expenses
Decrease in sales volume
Decrease in other operating income such as
rental income and interest income

2. Return on Capital Employed = Profit for the year before deducting X 100
interest
Capital employed

Return on capital employed is the ultimate test of profitability for a business. It relates profits
to total investment in the business.

Possible reasons for improvement in Possible reasons for deterioration in

return on capital employed return on capital employed
Increase in sales price or sales volume Decrease in sales price or sales volume
Decrease in purchase price Increase in purchase price
Increase in other operating income such as Decrease in other operating income such as
rental income and interest income rental income and interest income
Decrease in expenses Increase in expenses

Liquidity Ratios

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 Mr Roshan Khalawan
Tel: 5 7640922

Liquidity or solvency refers to the ability of a business to pay its debts as and when required.
Common indicators of liquidity are the current ratio, quick ratio, cash and cash equivalent and
the ability of the business to raise funds when required.

2. Current Ratio/ Working Capital Ratio = Current Assets = x:y

Current Liabilities
The current ratio relates the total current assets to the total current liabilities. It shows how
much dollars of current assets the business has to pay for each dollar of short-term debts. The
higher the ratio, the better is the liquidity position. As a general rule, a current ratio of 2:1 is
considered to represent a satisfactory financial condition. A ratio of less than 1 is often a cause
for concern, particularly if it persists for a long time.

Possible reasons for improvement in Possible reasons for deterioration in

current ratio current ratio
Increase in sales volume or selling at higher Decrease in sales volume or selling at lower
margin margin
Sales of surplus non-current assets Large investment in non-current assets
Reduction in drawings or introduction of High drawings
capital in cash

3. Liquid Ratio/ Acid Test Ratio/ Quick Ratio = Current Assets excluding inventory = x: y
Current Liabilities
As a general rule, a business having a liquid ratio of 1:1 is believed to be solvent and a ratio of
less than 1 would start to send out danger signals.

Possible reasons for improvement in Possible reasons for deterioration in

quick ratio quick ratio
Increase in sales volume or selling at higher Decrease in sales volume or selling at lower
margin margin
Sales of surplus non-current assets Large investment in non-current assets
Reduction in drawings or introduction of High drawings
capital in cash
Liquidation of inventory Large investment in inventory

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 Mr Roshan Khalawan
Tel: 5 7640922

Example
The following income statement and statement of financial position information has been
extracted from the books of Paula on 31 December 2015.

Income statement for the year ended 31 December 2015

$ $
Revenue 605 000
Less revenue returns (5 000)
Net revenue 600 000
Less cost of sales
Opening inventory 25 000
Purchases 530 000
Less closing inventory (75 000)
Cost of sales (480 000)
Gross profit 120 000
- Wages and salaries 35 000
- Rent 16 000
- Sundry expenses 13 000 (64 000)
Profit before interest 56 000
Less interest on loan (8 000)
Profit for the year 48 000

Statement of financial position at 31 December 2015

$ $
Assets
Non-current assets
Property 200 000
Current assets
- Inventory 75 000
- Trade receivables 45 000
- Other receivables 10 000
Bank 65 000 195 000

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 Mr Roshan Khalawan
Tel: 5 7640922

Total assets 395 000

$ $
Equity and liabilities
Equity
- Capital at start 200 000
- Add profit 48 000
- Less drawings (18 000) 230 000

Non-current liabilities
8 % Loan (repayable 2024) 100 000
Current liabilities
- Trade payables 50 000
- Other payables 15 000 65 000
Total equity and liabilities 395 000

REQUIRED

(a) Calculate the following:

i. Gross profit mark-up
ii. Gross profit margin
iii. Percentage of profit for the year to sales ratio
iv. Rate of inventory turn
v. Capital employed on 1 January 2015
vi. Return on capital employed (ROCE) – using capital employed on 1 January 2015
vii. Working capital ratio (Current ratio)
viii. Quick ratio

Answer
Ratio
Gross profit mark-up
Gross profit margin
Percentage of profit for the year
to sales ratio
Average inventory
Rate of inventory turn
Capital employed
Return on capital employed
Formula
Gross profit ÷ Cost of sales x 100
Gross profit ÷ Net Revenue
Profit for the year ÷ Net Revenue x
100
(Opening inventory + Closing
inventory) ÷ 2
Cost of sales ÷ Average inventory
Owners capital + Long term loan
Profit before interest ÷ capital
employed
Workings
12 000 ÷ 480 000 x 100 = 25 %
120 000 ÷ 600 000 x 100 = 20 %
48 000 ÷ 600 000 x 100 = 8 %
(25 000 + 75 000) ÷ 2 = 50 000
480 000 ÷ 50 000 = 9.6 times
200 000 + 100 00 = 300 000
56 000 ÷ 300 000 x 100 = 18.67 %

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 Mr Roshan Khalawan
Tel: 5 7640922

Working capital ratio Current assets ÷ Current liabilities (45 000 + 65 000 + 75 000 + 10 000)
÷ (50 000 + 15 000) = 3:1
Quick ratio Current assets excluding inventory ÷ (45 000 + 65 000 + 10 000) ÷ (50 000
current liabilities + 15 000) = 1.85:1
Working capital management
Working capital being the excess of current assets over current liabilities is often described as
the lifeblood of a business. This is simply because a business will not be able to carry out its
activities without adequate working capital. Therefore, working capital is vital for the existence
and continuity of a business and hence a sound management is essential.

Working capital (net current assets) = Current Assets – Current Liabilities

When current liabilities exceed current assets, the term being used is net current liabilities.

Ways to increase working capital

1. Selling of surplus non-current assets
2. Introduction of additional capital by the owner(s)
3. Obtain a long-term loan
4. Liquidation of inventory at a low profit

Disadvantages of inadequate working capital

1. The business may not be able to fulfill orders and hence lose its customers.
2. The business may not be able to pay its debts.
3. The reputation of the business will suffer when it cannot satisfy customers and pay its
debts.
4. The business would not be able to obtain attractive credit terms from suppliers or loan
from banks with a bad reputation.
5. The business will not be able to implement its plans and achieve its aims.
6. Management inefficiencies will arise when plans cannot be executed.
7. There will be no growth or worse there may be reduction in the activities of the
business.

Disadvantages of excessive working capital

1. There will be unnecessary accumulation of inventory leading to higher storage costs.
2. Large inventory also increases the risk of pilferage, waste and theft.
3. Higher risk of bad debts due to larger trade receivables.
4. Too much cash in hand or at bank is a waste of resources since they are non-productive.
Excessive working capital sometimes leads to management complacency resulting in
managerial inefficiency.

7
 Mr Roshan Khalawan
Tel: 5 7640922

Homework:

Sales revenue $ 102 000

Sales return $ 2 000
Opening inventory $ 10 000
Purchases $ 70 000
Closing inventory $ 20 000
Total expenses $ 12 000
Trade receivable $ 50 000
Trade payable $ 10 000
Capital at start $ 200 000
Drawings $ 40 000
Loan from bank $ 100 000

Required:
(a) Prepare I/S
(b) Calculate all ratios same as example one and also write the formula for each ratio.

Part 2

Gross profit margin: Gross profit is based on turnover

 Mark-up: Gross profit is based on COS

Note: Table (I/S) will be used only when gross profit margin or mark-up has been given in terms of
percentage (%).