Accounting Ratios and its Interpretation
You can monitor your business's performance with tools called key accounting ratios, which help
you to interpret financial information about your company. The more you know about how your
business is performing, the easier it will be for you to make informed decisions about how to manage
and grow your business.
Now we need to examine in more detail how these accounting statements can be used to assess a
business’ performance and progress. There are two stages in this process:
1 Analysis This is the detailed examination of various aspects of a business’ performance. To make
comparisons (with other businesses or for the same business over a period of time) easier and more
meaningful, the results are expressed as percentages or ratios, e.g. the percentage of gross profit to
sales, or the working capital ratio.
2 Interpretation Here the results of analysis are used to judge a business’ performance. This is done
by making comparisons
a with other similar businesses, usually within the same year, e.g. was the gross profit to sales
percentage last year better or worse than the average for the trade or industry?
b for the same business over a number of years, e.g. has the trend of the gross profit percentage to
sales over the last five years been up or down?
We will also examine the extent to which analysis and interpretation are useful tools for owners and
others in making and assessing business decisions.
We will learn how to calculate various ratios measuring profitability and liquidity. We will then
consider in section D how ratio analysis can help us to judge a business’ performance and lead to
action for its improvement.
Group Ratio Formula
Liquidity ratios Current ratio Current Assets : Current
Liabilities
Quick ratios (also called Acid Current Assets – Stock :
test ratios) Current
Liabilities
Efficiency ratios Rate of stock turn/turnover Cost of sales ÷
Average stock 1
Collection period debtors (Debtors ÷
Credit Sales) × (365 days ÷1)
or
(Debtors÷
Credit Sales) ×
(12 months ÷
1)
Payment period creditors (Creditors ÷
Credit purchases) ×
(365 days ÷
1) or
(Creditors ÷
Credit purchases) ×
(12 months ÷
1)
, Profitability ratios Percentage of gross profit to (Gross profit ÷
sales Turnover) × (100 ÷ 1)
Percentage of net profit to (Net profit ÷
sales Turnover) × (100 ÷ 1)
Net profit as percentage of (Net Income ÷
Capital Owner’s equity 2) × ( 100 ÷ 1)
Employed (also called Return
on Owner’s
Equity
Investment ratios Earnings per share (Net income after tax ÷ No. of
(NSSCH) issued shares) ×
(100c ÷ 1)
Price/Earnings ratio Stock market price ÷
Earnings per share
1 Average Stock = (Opening stock + closing stock) ÷ 2
2 Owner’s Equity = Capital at the beginning of the year
Accounting ratios: liquidity
Liquidity Ratios:
Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the liquidity of the
company as on a particular day i.e the day that the Balance Sheet was prepared. These ratios are
important in measuring the ability of a company to meet both its short term and long term
obligations. Liquidity Ratios are used to measure the short-term solvency of a company. They show
the ability of the company to quickly convert its assets into cash to pay its short-term debts. The
higher the ratios, the more liquid the company and the less likely the company experience financial
distress in short-term basis.
Ratio Answer form Use for/comment on
Current ratio x:1 • To check liquidity – ability to
pay short-term debts
• the norm is 2 : 1
• Compare with previous year
Quick ratio x:1 • To check investment in stock
• To check liquidity – ability to
pay short-term debts
• The norm is 1 : 1
• Compare with previous year
Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total
Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the
'working capital' relationship of current assets available to meet the company's current obligations.
You can monitor your business's performance with tools called key accounting ratios, which help
you to interpret financial information about your company. The more you know about how your
business is performing, the easier it will be for you to make informed decisions about how to manage
and grow your business.
Now we need to examine in more detail how these accounting statements can be used to assess a
business’ performance and progress. There are two stages in this process:
1 Analysis This is the detailed examination of various aspects of a business’ performance. To make
comparisons (with other businesses or for the same business over a period of time) easier and more
meaningful, the results are expressed as percentages or ratios, e.g. the percentage of gross profit to
sales, or the working capital ratio.
2 Interpretation Here the results of analysis are used to judge a business’ performance. This is done
by making comparisons
a with other similar businesses, usually within the same year, e.g. was the gross profit to sales
percentage last year better or worse than the average for the trade or industry?
b for the same business over a number of years, e.g. has the trend of the gross profit percentage to
sales over the last five years been up or down?
We will also examine the extent to which analysis and interpretation are useful tools for owners and
others in making and assessing business decisions.
We will learn how to calculate various ratios measuring profitability and liquidity. We will then
consider in section D how ratio analysis can help us to judge a business’ performance and lead to
action for its improvement.
Group Ratio Formula
Liquidity ratios Current ratio Current Assets : Current
Liabilities
Quick ratios (also called Acid Current Assets – Stock :
test ratios) Current
Liabilities
Efficiency ratios Rate of stock turn/turnover Cost of sales ÷
Average stock 1
Collection period debtors (Debtors ÷
Credit Sales) × (365 days ÷1)
or
(Debtors÷
Credit Sales) ×
(12 months ÷
1)
Payment period creditors (Creditors ÷
Credit purchases) ×
(365 days ÷
1) or
(Creditors ÷
Credit purchases) ×
(12 months ÷
1)
, Profitability ratios Percentage of gross profit to (Gross profit ÷
sales Turnover) × (100 ÷ 1)
Percentage of net profit to (Net profit ÷
sales Turnover) × (100 ÷ 1)
Net profit as percentage of (Net Income ÷
Capital Owner’s equity 2) × ( 100 ÷ 1)
Employed (also called Return
on Owner’s
Equity
Investment ratios Earnings per share (Net income after tax ÷ No. of
(NSSCH) issued shares) ×
(100c ÷ 1)
Price/Earnings ratio Stock market price ÷
Earnings per share
1 Average Stock = (Opening stock + closing stock) ÷ 2
2 Owner’s Equity = Capital at the beginning of the year
Accounting ratios: liquidity
Liquidity Ratios:
Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the liquidity of the
company as on a particular day i.e the day that the Balance Sheet was prepared. These ratios are
important in measuring the ability of a company to meet both its short term and long term
obligations. Liquidity Ratios are used to measure the short-term solvency of a company. They show
the ability of the company to quickly convert its assets into cash to pay its short-term debts. The
higher the ratios, the more liquid the company and the less likely the company experience financial
distress in short-term basis.
Ratio Answer form Use for/comment on
Current ratio x:1 • To check liquidity – ability to
pay short-term debts
• the norm is 2 : 1
• Compare with previous year
Quick ratio x:1 • To check investment in stock
• To check liquidity – ability to
pay short-term debts
• The norm is 1 : 1
• Compare with previous year
Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total
Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the
'working capital' relationship of current assets available to meet the company's current obligations.
