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By Ala Mohamed Wahra

15/3/2009

Financial Accounting Ratios

1

What is a Ratio?

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A ratio is an expression which compares quantities relative to each other. The most common examples involve two quantities. In mathematical terms, they are represented by separating each quantity with a colon, for example the ratio 2:3, which is read as the ratio "two to three". Ratios may also be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as

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**What are the Accounting Ratios?
**

• They are Tools which used for analyzing the financial performs of the business. • It is a ratio of two selected numerical values taken from an enterprise's financial statements.

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**Why Do We Need Accounting Ratios?
**

• They are the starting point for further analysis for the firm. • They help to highlights the financial strengths and weakness of a firm. NOTE: [very important] Accounting ratios should be very carefully handled, they are extremely useful if used and interpreted appropriately, and very misleading otherwise.

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**ACCOUNTING RATIOS CLASSIFICATION
**

A)Profitability Ratios. B) D)Liquidity Ratios. E) C) Efficiency Ratios.

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A) PROFITABILITY RATIOS

Profitability ratios express the profit made in relation to other key figures in the financial statements or business resources. there are 3 formulas to calculates this:

A.1) Gross profit margin [Gross profit as a percentage of sales]. A.2) Cost of sales as a percentage of sales. A.3) Net profit margin [Net profit 15/3/2009 Financial Accounting Ratios margin as a percentage of sales].

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**A.1) GROSS PROFIT MARGIN [Gross Profit as a Percentage of Sales]
**

Gross profit Margin=(gross profit/sales)x 100

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This represents the amount of gross profit for every $100 of sales revenue. For example if the answer turn to be 15%, this would mean for $100 of sales revenue $15gross profit was made before any expenses

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**A.2) Cost of Sales as a Percentage of Sales
**

C.O.S.A.P.O.S= (cost of sales/sales)x100

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This one here shows the cost of sales for every $100 of sales revenue. For example if the answer 64.38%, it means that every $100 of sales revenue it costs $64.38 to make. The materials that are used to produce and techniques of production can have an

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**A.3) NET PROFIT MARGIN [Net Profit as a Percentage of Sales]
**

Net Profit Margin= (net profit/sales)x100

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This shows the amount of net profit for every $100 of sales revenue. For example if the answer 5.53%, it means that for every $100 of sales revenue the firm gains $5.53. This ratio is mainly affected by the operating expenses that is incurred by the firm. Other effects could be economic conditions, customer service, the type

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**Example of these people are: • Shareholders. • Management. • Employees. • Creditors. • Competitors. • Potential Investors.
**

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Which people uses or need the information of Profitability Ratios?

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B) LIQUIDITY RATIOS

These ratios shows or relate to the cash position in an organization and hence its ability to pay liabilities when due. There are 3 calculations for this: B.1) Working capital. B.2) Current ratio. B.3) Quick ratio [Quick asset]

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B.1) WORKING CAPITAL

Working Capital= Current assets – Current liabilities This shows the net current assets. It shows the amount of money in which firm have to pay to its short-term liabilities. For example, if the answer is $10,000, it means that amount of money is going to be used by the company to pay its short-term liabilities.

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B.2) CURRENT RATIO

Current Ratio = Current Assets/Current Liabilities

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This one here shows how the working capital is sufficed to the daily expenses of the firm. For example if the answer is 2.22 (2.22 : 1), it means the firm can cover more than twice of the original daily expenses.

Financial Accounting Ratios

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VERY IMPORTANT !!!

It is not likely to have a large rate of current ratio because it is risky. If a company have a large amount of the money that is over 5 times a day, it can be stolen, damaged, and may be taken by unauthorized personals. Therefore, it is better to have a low rate of current ratio.

Financial Accounting Ratios 14

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**B.3) QUICK RATIO [QUICK ASSET]
**

Quick Ratio = (Current Assets – Closing Stock)/ Current Liabilities This shows the ability to pay. For example if the answer is 1.11 or [1.11 : 1], it means that any firm is able to pay all their expenses. In the other hand, if the firm got o.44 or [o.44 : 1] it means that particular firm won’t be able to pay all its expenses, but only part of it.

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**How do we relate the Liquidity Ratios together?
**

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Let us take an example of you as a student. You have a pocket money of RM20 for today, and that pocket money is your [working capital]. You must know if that pocket money is enough or sufficient for today’s expenses like your lunch, transport, and etc. it is called [current ratio], and also must be sure that you will be able to pay for those expenses. We call that [Quick ratio].

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**An example of those people: • Shareholders. • Suppliers. • Creditors. • Competitors. •
**

Which people uses or need the information of Liquidity Ratios?

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C) EFFICIENCY RATIOS

This type of ratios examine the productive or timely ways in which various resources of the business are managed. The following calculations consider important aspects of resource management: C.1) Stock turnover period/days. C.2) Debtors collection period. C.3) Creditors payment period.

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**C.1) STOCK TURNOVER PERIOD / DAYS
**

S.T.O = (Average Stock / cost of sales) x 365 days Average stock = (Opening stock + Closing stock) / 2 This means the numbers of times stock is sold in an accounting period. It measures how efficient a business is at maintaining an appropriate level of stock. For example if the answer is 2 times, it means that a company is selling their stocks very slowly. Stocks are piling up in the stores and not being sold. This could lead to a LIQUIDITY CRISIS. If the answer is 3 or 4 times, the 15/3/2009 Financial Accounting Ratios 19 company is selling their stocks quickly and

**C.2) DEBTORS COLLECTION PERIOD
**

**D.C.P = (Debtors / Credit Sales) x 365 days
**

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This ratio shows how long it takes for a debtor to pay back their debts to the business. An example if the answer is 114 days, it means the firm allows so much time for its debtor to pay back and that’s not right. It means there is no proper credit control system within the firm. While if the answer is 24 days,

Financial Accounting Ratios 20

**C.3) CREDITORS PAYMENT PERIOD
**

C.P.P = (Creditors / Credit Purchase) x 365 days

This shows how long it takes for the business to pay its creditors.

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Financial Accounting Ratios

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**An example of these people: • Shareholders. • Potential Purchasers. • Competitors.
**

Which people uses or need the information of Efficiency Ratios?

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Financial Accounting Ratios

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**Advantages of Accounting Ratios analyze
**

• Simplifies financial statements. • Helps in planning. • Help in investment decisions. •

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**Limitations of Accounting Ratios
**

• Limitations of financial statements. • Limited use of single ratios. • Problems of price level changes.

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- What are accounting ratios?
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