Accounting Ratios - Principles of Accounting

7/27/2019 Accounting Ratios - Principles of Accounting

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Current ratio = Current assets

Current liabilities

A ratio of 2:1 is considered to be a good standard, but it may vary depending upon the nature of the

business and other organizations in the same line of business.

2. Acid test (quick ratio)This ratio tests for insolvency if a business has sufficient liquid resources ( quick assets) to meet its

current liabilities. To calculate this ratio, closing stock should be removed from the current assets where

the stocks are not likely to be sold very quickly.

Acid test ratio = Current assets closing stock

Current liabilities

The standard for this ratio is 1:1, a lower ratio indicating insolvency

Use of assets (efficiency ratios)

1. Stock turn over (stock turn) ratio

This ratio shows how quickly the business sells its stock how many times the stock turns over in a

year.

The rate of stock turn over = Cost of sales

Average stock

Where, average stock = Opening stock + closing stock

2

If the rate increases, it may indicate efficiency is improving (sales are increasing) and if it reduces it may

mean that the efficiency is deterioting (the business has too much stock because the sales are slowing

down)

2. Debtors turn over ratio( Debtors collection period)

This ratio shows how long it is taking to collect debts from customers. The faster cash is collected from

debtors, the better the cash flow of the business. It also shows the credit control policy of the business.

Debtors collection period = Debtors x 365 days ( or 52 weeks or 12 months)

Credit sales

3. Creditors turn over ratio (creditors payments period)

This ratio shows how quickly the business pays its creditors. A longer period indicates that the business is

taking longer to pay its creditor and hence is holding on to cash which may lead the creditors to refuse to

sell to the business.

Creditors payments period = Creditors x 365 days ( or 52 weeks or 12 months)

Credit purchases

It is also important to compare the creditors payments period with the debtors collection period - ideally,

it should take longer to pay creditors than to collect monies from debtors.

Relationship between Mark up and Margin

Cost price + profit = Selling price.

Cost of sales + profit = Sales

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Advantages of accounting ratios

Limitations of accounting ratios

MCQ

A. Cost price/ profit B. Profit / selling price

C. Profit / cost price D. Cost price / loss

2. How is margin percentage calculated?

A. Profit / cost price x 100 B. Profit / selling price x 100

C. Profit / selling price D. Loss / selling price.

3. A trader charges 25% profit on cost price. What is this profit called?

A. Mark up B. Profit

C. Surplus D. Margin

4. A shop keeper is making 25% profit on sale price. What is this profit called?

A. Profit B. Surplus

C. Mark up D. margin

5. Which of the following equations is correct?

A. Cost price profit = selling price B. Cost price + profit = selling price

C. Cost price selling price = profit D. Selling price + cost price = profit

6. How is the rate of stock turn over calculated?

A. Cost of goods sold / opening stock B. Cost of goods sold / average stock

C. Cost of goods sold / closing stock D. Cost of goods sold / sales

7. The following relates to a sole traders business:

Average stock $ 12 600

Mark up 50% on cost

Stock turn over 7 times.

What is the amount of gross profit?

A. $ 44 100 B. $ 88 200 C. $ 25 200 D. $ 34 100

1. It helps to compare two or more business units.

2. We can compare the results of a business over two periods.

3. On the basis of ratios, the growth or the decline of the business can be understood very easily.

4. To plan for the future.

1. Only past events expressed in terms of money alone can be analysed.

2. Different accounting methods give different results that cannot not be compared.

3. No allowance is made for inflation, which makes comparison of results between different periods

meaningless.

4. Other non monetary and non financial factors are ignored (eg: staff relations, efficiency of the

management, business location, environmental conditions etc)

5. Only like with like items can be compared (similar sized businesses, different periods for the

same business, Plans and budgets.

1. How is mark up shown as a fraction?


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8. A firm sales are $ 150 000, the cost of sales is $ 90 000 and the expenses are $ 45 000.

What is the gross profit % to sales?

A. 10% B. 30% C. 40% D. 70%

9. A trader supplies the following details:

Cost of goods sold $ 5 600

Opening stock $ 500

Closing stock $ 900

What is the rate of stock turn over?

A. 7 times B. 6 times C. 8 times D. 9 times

10. K.King gives the following information at 31st Dec

Stock on 1st Jan $ 600

Purchases during the year $ 5 400

Average stock during the year $ 1 200

What is the amount of closing stock as at 31s Dec?

A. $ 3 600 B. $ 1 800 C. $ 600 D. $ 6 000

11. A trader bought goods for $15 000 and then sold 2/3 of them for $ 13 000. What would be his G.P?

A. $ 3 000 B. $ 15 000 C. $ 2 000 D. $ 13 000

Assignment questions

Q1. From the following information for two firms, Firm A and Firm B calculate

Q2. Here is a trading account.

Sales 50 000

Less Cost of goods sold

Opening stock 5 000

Add Purchases 42 500

47 500

Less Closing stock 10 000 37 500

Gross Profit 12 500

From the above, calculate :-

Q3. Here is a balance sheet.

Fixed assets

Premises 13 000

Machinery 5 000

Office equipment 2 500

20 500

Current assets

Stock 12 000

Debtors 4000

Bank 2000

18 000

Less Current liabilities

1. The gross profit percentage on sales for each firm.

2. The net profit percentage on sales for each firm.

Firm A ($) Firm B ($)

Sales 100 000 100 000

Gross profit 20 000 25 000

Net profit 5 000 5 000

1. Give one reason why the gross profits of the firms differ?

1. The gross profit percentage

2. The stock turn over for the year

3. If debtors are $ 6 250, the credit that is being taken on average

4. If creditors are $ 10 625, the credit that is being received on average

5. If net profit for this business is $ 7 500, the net profit percentage


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Creditors 6 000

Working capital 12 000

32 500

Financed by

Capital 30 000

+ Net profit 10 000

40 000

- Drawings 7 500 32 500

From the above, calculate ;-

Incoming search terms:

1. Current ratio

2. Acid test ratio

3. Return on capital employed

4. Comment on the figures you have calculated, comparing them with last years balance sheet which

showed a current ration of 1.5:1, a liquid ratio of 0.8:1 and a return on capital employed of 20%.

accounting ratio results

accounting ratios

Average collection period (debtor days) This ratio is used widely within businesses to measure the

calculating closing stock using current asset and liabilities and acid ratio test

what would a 2:1 ratio be for net income

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Accounting Ratios - Principles of Accounting