Ratio Analysis

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values
taken from an enterprise's financial statements. Ratio analysis is used to interpret in performance
of a business’ operations. The ratio analysis is a useful tool to the users of accounting
information to assist them in making informed judgments and decisions as they identify the
business’ strengths and weaknesses and allow planning for the future. Ratio analysis also assist
management in making comparisons over time.
Users of accounting information are interested in three main aspects of a business. These are; the
profitability, liquidity and efficiency of the business. There are financial ratios available to
satisfy the three aspects of the business.

Profitability Ratios
Profitability measures the ability of the firm to create more value or wealth than the amount
which it started the period with (opening capital). The following ratios are used to calculate the
profitability of the business.
1. Return on Capital Employed (ROCE) - This ratio measures the amount of profit that
has resulted from making use of the firm’s investment in operation. The ratio compares
the net profit generated by the business with opening capital of the business. ROCE is
calculated by the formula:
ROCE= NET PROFIT/ CAPITAL EMPLOYED x100
The result is interpreted as for every $100 of capital employed, the business generated
“x” amount as net profit. A low ROCE is indicative of profits that can be easily turned
into losses with a change in the business fortunes.

2. Gross Profit Margin – This ratio shows the relationship between gross profit and sales
as a percentage. In other words, the ratio measures what proportion of each sales dollar is
to be considered profit. Gross Profit Margin is calculated by the formula:
Gross Profit Percentage = Gross Profit/Sales x 100.
The result is interpreted as for every $100 of sales, the business generated “x” amount as
gross profit.

3. Gross Profit Mark Up – Mark Up is a general term to describe the profit added to the
cost of an item bought for sale. The gross profit mark-up calculates the gross profit as a
percentage of the cost of an item. The Gross Profit Margin is calculated by the formula:
Gross Profit Mark Up= Gross Profit/Cost of Sales x100
The result is interpreted as for every $100 of cost of sales, the business generated “x”
amount of gross profit.
 4. Net Profit Margin – This ratio shows the relationship between net profit as sales as a
percentage. In other words, the ratio indicates the rate at which the business has been
creating wealth. The Net Profit Margin is calculated by the formula:
Net Profit/Sales x 100.
The result is interpreted as for every $100 of sales, the business generated “x” amount as
net profit.

Liquidity Ratios
Liquidity measures the ability of the firm to pay its debts when they are due. Liquidity is tested
by comparing the value of the firm’s current assets with the amount of its current liabilities. Cash
is the most liquid asset and its usefulness lies in the ability to pay the debts of the business. All
other current assets are viewed in terms of how easily they can be turned into cash and become
available to pay current liabilities. Two ratios are used to measure liquidity of a business, they
are, the CURRENT RATIO and the LIQUID RATIO.
1. Current Ratio or Working Capital Ratio – this ratio describes how many times current
assets can pay or cover current liabilities. In the calculation of this ratio, current assets are
always stated as being equal to 1. The current ratio is calculated by the formula:
Current Ratio= Current Assets/ Current Liabilities.
The result is interpreted as current assets can cover current liabilities “x” amount of
times. A current ratio of less than 1:1 indicates an inability of the business to meet its
obligations as they become due.
NB: A current ratio of at least 1.5:1 is acceptable.

2. Liquid Ratio/ Acid Test or Quick Ratio – This ratio compares all current assets other
than stock to current liabilities. The Liquid ratio is calculated by the formula:
Liquid Ratio = Current Assets- Stock/ Current Liabilities.

Efficiency Ratios
Efficiency measures the ability of the firm to utilise and control its resources so as to prevent
waste or loss of those resources. The main efficiency ratio is the Rate of Stock Turnover or Stock
Turn.
Rate of Stock Turnover- this ratio measures the amount of times in a year the average value of
stock is sold. The faster the business sells its stock, the fewer the chances of theft and wastage of
stock. The rate of stockturn is calculated by the formula:
Rate of Stock Turn= Cost of Goods Sold/ Average Stock
NB Average Stock = Opening Stock + Closing Stock/2