Chapter Two

Presentation of Financial
Statements

Course: Financial Analysis and Control

Course Code: BAAC4101
Specialization: Accounting
Department of Business Studies
Financial Ratio Analysis
Contents:
 Overview of financial ratio analysis

 Calculating :

- Profitability ratios

- Efficiency ratios

- Liquidity ratios

- Solvency ratios

- Market ratios

 Limitations of financial ratio analysis

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 Essential Reading (the main textbook)
http://www.sxccal.edu/TwinningProgramme/downloads/MBA-Accounting-Managers-1st
Year.pdf

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 Presentation of Financial Statements
Overview of financial ratio analysis
Meaning of Ratio Analysis:

Ratio analysis is the analysis and interpretation of the figures appearing in the
financial statements (i.e., Profit and Loss Account, Balance Sheet and Cash Flow
statement etc.).

It is a method of comparison of one number against another. It allows the users like
shareholders, investors, creditors and Government etc. to get a better knowledge of
financial statements.

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 Advantages of Ratio Analysis
1. Ratio analysis helps to summarize the financial statement into comparative figures,
thus helping the management to compare and evaluate the financial position of the firm
and the results of their decisions.

2. It simplifies complex accounting statements and financial data into simple ratios of

operating efficiency, financial efficiency, solvency, long-term positions etc.

3. Ratio analysis help identify problem areas and bring the attention of the management
to such areas. Some of the information is lost in the complex accounting statements, and
ratios will help pinpoint such problems.

4. Allows the company to conduct comparisons with other firms, industry standards, intra-
firm comparisons etc. This will help the organization better understand its fiscal position in
the economy. 5
 Limitations of Ratio Analysis
The firm can make some year-end changes to their financial statements, to improve their
ratios. Then the ratios end up being nothing but window dressing.

Ratios ignore the price level changes due to inflation. Many ratios are calculated using
historical costs, and they overlook the changes in price level between the periods. This
does not reflect the correct financial situation.

Accounting ratios completely ignore the qualitative aspects of the firm. They only take into
consideration the monetary aspects (quantitative)

There are no standard definitions of the ratios. So firms may be using different formulas
for the ratios. And finally, accounting ratios do not resolve any financial problems of the
company. They are a means to the end, not the actual solution.

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 Ratio Analysis
The ratios may be divided into these types:

1. Liquidity ratios, focus on the availability of cash for day to day activities.

2. Asset management ratios assess the effective use of the resources.

3. Debt management ratios keep track of debt to be within reasonable limits.

4. Profitability ratios calculates the degree of accounting profits.

5. Market value ratios help investors distinguish between overestimated and

underestimated securities while making investment choices.

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A. Liquidity Ratios:
These ratios focus on the availability of cash to manage the day to day operations
of the company.

1. Current Ratio: This calculates availability of current assets to meet current

liabilities. The formula for calculating current ratio is:

= Current assets/Current liabilities

2. Quick Ratio : It measures the capacity to pay off immediate credit demands.
Formula is : (Current assets - Inventory and Prepaid expenses)/ Current liabilities
i.e. Quick Assets/ Current Liabilities

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 B. Asset management ratios
The asset management ratios evaluate the efficiency of use of the principal assets of a
company.

1. Inventory Turnover: Measures how frequently inventory is turned over during the
year. Formula: Cost of goods sold / Average Inventories

Average Inventories = Inventory in the beginning + Inventory at the end /2

2. Fixed assets turnover: A comprehensive measure of the efficient use of assets is

the fixed assets turnover. This ratio is defined as follows.

Fixed assets turnover = Annual Net sales /Average Net fixed assets

Average Net fixed assets = Fixed Assets in the beginning + Fixed Assets at the end /2
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 B. Asset management ratios
3. Total Assets Turnover: This ratio specifies the extent to which investment in
total assets will result in sales. Formula is : Net sales/ Average Total Assets

Average Total Assets = Total Assets in the beginning + Total Assets at the end / 2

4. Receivables Turnover ratio: This ratio specifies how many times in the period
credit sales have been created and collected. The formula for calculating
Receivables turnover ratio is :

= Total Credit sales/ Average Accounts Receivable

Average Accounts Receivable = Accounts Receivable in the beginning + Accounts

Receivable at the end / 2

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 B. Asset management ratios
5. Days sales outstanding : Day sales outstanding (DSO) is a measure of the average
number of days that it takes a company to collect payment after a sale has been
made.   The formula for measuring day sales outstanding is :

= Average Accounts Receivables /Credit sales per day.

6. Accounts payable turnover: Accounts payable turnover shows how many times a
company pays off its accounts payable during a period.

Accounts Payable ratio = Net Credit purchases/ Average Accounts payable

Average Accounts payable = Accounts payable in the beginning + Accounts payable

at the end / 2
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 C. Debt management ratios
Debt Management ratios measures the firm's use of debt and ability to avoid
financial distress in the long run. These ratios are also known as Long-Term Solvency
Ratios.

1. Debt to Asset Ratio: The debt to assets ratio shows you how much of your asset
base is financed with debt. The debt to assets ratio is: Total Debt/Total Assets

2. Debt to Equity Ratio : The debt to equity ratio measures how much debt is used
to finance the company in relation to the amount of equity used. Debt to Equity
Ratio is : Total Debt (Liabilities)/Shareholder's Equity

3. Interest Coverage Ratio: This ratio tells the owner of the small business how
well the firm can cover its interest expense on debt. Interest Coverage Ratio is
EBIT/Interest Expense
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 D. Profitability ratios
Ratios to measure the ability of a company to generate profits is called profitability
ratios.

1. Net profit Ratio: It indicates how much of each Omani Riyal of sales is left over
after all expenses. Net profit margin = Net income /Net sales

Net income is defined to be the income after taxes, available to the

stockholders of the company.

2. Gross profit ratio: It indicates how much of each Omani Riyal of sales is left
over after cost of goods sold. Gross income /Net sales.

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 D. Profitability ratios
3. Operating Profit margin ratio: It indicates how much of each Omani Riyal of sales
is left over after all operating expenses. It is the ratio of Operating profit to Net
sales. The ratio is : Operating income / Net sales

4. Return on Total Assets ratio or ROA : The return on assets ratio or ROA measures
how efficiently a company can manage its assets to produce profits during a period.
Return on Assets ratio or ROA is : Net income /Average Total Assets.

5. Return on Equity: Return on Equity measures how efficiently a firm can use the
money from shareholders to generate profits and grow the company. The formula is :
Net income after interest and Tax – Preference Dividend / Shareholder’s equity
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 E. Market value ratios
Market value ratios are used to evaluate the current share price of a publicly-held
company's stock.

1. Earnings per share: This ratio shows the earnings of the company earned in a
particular time period against the number of the company’s shares which are
outstanding. This ratio is used to understand whether investing in it is worth the
money or not.  Net income after interest and Tax – Preference Dividend / Number of
Equity shares.

2. Market Value Per Share : This ratio gives the per share price in the market. The
ratio is : Market value of the shares / Number of shares .

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 E. Market value ratios
3. Price/Earnings Or P-e Ratio: It is used to check whether the shares are over or
underpriced as compared to its earnings potential. P-E ratio = Market price/share
Earnings per share.

4. Dividend yield ratio: This ratio helps in measuring the amount of dividend
distributed in a year against the number of shares outstanding. Dividend yield ratio:
Total dividend paid in a year / Number of shares outstanding.

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 Exercises
Question no. 1. From the data calculate :

(i) Gross Profit Ratio  (ii) Net Profit Ratio   (iii) Return on Total Assets (iv) Inventory Turnover

Sales                            2,520,000        Other Current Assets                           760,000

Cost of sale                  1,920,000        Fixed Assets                                        1,4 40,000

Net profit                     360,000          Net worth                                            1,500,000

Inventory                     800,000          Debt.                                                   900,000

Current Liabilities       600,000

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 Solution to Question no.1

  (i) Gross Profit Ratio = (GP/ Sales) *  100 (600,000 / 25,20,000)*100= 23.8%

Gross Profit = Sales – Cost of Sales (2,520,000 – 19,20,000 = 6,00,000)

(ii) Net Profit Ratio = (NP / Sales)* 100 (( 360,000 / 2,520,000)*100) = 14.28%

(iii) Inventory Turnover Ratio = Cost of goods sold / Average inventory* 100=
1,920,000/800,000= 2.4 times

(iv)Return on Total Assets = Net profit/ Total Assets  = (360,000/3,000,000)*100

= 12%

FA+ CA +inventory [14,40,000 + 7,60,000 + 8,00,000] = 3,000,000

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 Exercises
Question no. 2 :The Balance sheet of Muneer & Co. as on 31.12.2015 shows as
follows:

Liabilities                                RO                      Assets                                                  RO

Equity capital                          100,000          Fixed Assets                           180,000

15% Preference shares           50,000         Stores                                      25,000

12% Debentures                      50,000          Debtors                                   55,000

Retained Earnings                   20,000           Bills Receivable                      3,000

Creditors                                 45,000             Bank                                         

2,000

265,000                                                            265,000

Calculate (i)Debt – Equity Ratio, (ii)Current Ratio, and (iii)Liquid ratio. 19

 Solution to Question no.2
(i) Debt – Equity Ratio = Debt / Equity Ratio(shareholders funds) = 50,000/
1,70,000 = ·29

Long-term Debt = Debentures (= 50,000)

Shareholder’s Fund = Equity + Preference + Retained Earnings( = 1,00,000 +

50,000 + 20,000)

(ii) Current Ratio = Current Assets / Current Liabilities (85,000/45,000 =1.89: 1)

Current Assets = Stores + Debtors + BR + Bank= 25,000 + 55,000 + 3,000 +

2,000 = 85,000

Current Liabilities= Creditors =45,000

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 Solution to Question no.2
(iii) Liquid ratio= Liquid Assets / Current Liabilities (= 60,000 / 45,000   = 1.33)

Liquid Assets = Current Assets – Stock and Prepaid expenses( 85,000 -25000
=60,000

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 Exercises
Question no.3 From the following information of Rahim & Co. for the year 31st Dec.
2018 :
RO RO
To Opening Stock 60,000 By Sales 400,000
To Purchase 275,000 By Closing Stock 75,000
To Wages 25,000
To Gross Profit c/d 115,000
475,000 475,000
To Administrative Expenses 45,000 By Gross Profit b/d 115,000
To Selling and Distribution Expenses 10,000 By Interest on Investment 10,000
To Office Expenses 5,000
To Non Operating Expenses 15,000
To Net Profit 50,000
125,000 125,000
You are required to calculate : (i) Gross Profit Ratio. (ii) Operating Profit Ratio. (iii)
Net Profit Ratio. 22
 Exercises
Question no.4 Calculate the Earning Per Share from the following data : Net Profit
After tax RO. 200,000. 10 % Preference share capital (RO. 10 each) RO. 200,000,
Equity share capital (RO. 10 each) RO. 200,000.

Solution:

Earning Per Equity Share = Net Profit After Tax - Preference Dividend / No. of
Equity Shares( 180,000/ 20,000 = RO 9 per share)

Net Profit After Tax - Preference Dividend= 200,000 – 20,000(Preference

dividend)= 180,000, Number of Equity shares = 200,000/10 = 20,000

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Exercises
Question no. 5 Calculate the following ratio on the basis of following information:
(i) Gross Profit Ratio (ii) Current Ratio (iii) Acid Test Ratio (iv) Inventory Turnover
Ratio (v) Fixed Assets Turnover Ratio

Gross Profit- RO 50,000, Net sales- RO 100,000 , Inventory - RO15,000, Trade

Receivables- RO 27,500, Cash and Cash Equivalents -RO 17,500 Current
Liabilities- RO 40,000, Land & Building -RO 50,000, Plant & Machinery -RO
30,000, Furniture -RO 20,000, Cost of Goods sold- RO 50,000

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Solution to Question no.5
(i) Gross profit ratio = Gross income /Net sales = 50,000/ 100,000X100 =50%

(ii) Current ratio= Total current assets/Total current liabilities= 60,000 / 40,000 =
1.5 : 1

Total current Assets = 15,000 + 27,500 + 17,500 = 60,000

(iii) Inventory Turnover ratio = Cost of goods sold / Average Inventories

= 50,000/ 15,000 = 3.33 times

(iv) Fixed assets turnover= Annual Net sales /Average Net fixed assets =
100,000/ 100,000 = 1: 1

Fixed Assets =50,000+ 30,000 +20,000 =100,000

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 Reference
1. http://
www.accountingnotes.net/accounting/ratio-analysis-accounting/ratio-analysis-
problems-and-solutions-accounting/13433

2. http
://content.inflibnet.ac.in/data-server/eacharya-documents/53e0c6cbe413016f2
34436f6_INFIEP_18/3/SA/18-3-SA-V1-S1__
solved_problems_ra.pdf

3. https
://www.toppr.com/guides/accountancy/accounting-ratios/meaning-objectives-a
dvantages-and-limitations-of-ratio-analysis/
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VERSION HISTORY

Version No Date Approved Changes incorporated

01 Sem. (I) 2019/2020

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