Interpretation Of Accounting Statements Flashcards
Explain the meaning of the term accounting ratios
An accounting ratio is how we express a relationship between two or more items/accounting amount in math terms
Ratio may be expressed as x:z or as a percentage
Why do we need ratios?
For comparing different similar businesses/companies
For comparing different years
Name the 5 different groups that ratios are classified into
Liquidity Efficiency Profitability Solvency Investment
Define liquidity ratios
Measures the ability of a business to meet its short-term debts
Current ratio and acid test ratio are liquidity ratios
Explain the current ratio
Current assets : current liabilities
X:1
Current assets = inventory, debtors, bank (favourable), cash, petty cash, cash float, accrued income, prepaid expenses
Current liabilities = creditors, bank (overdraft), income received in advance, accrued expenses
Good ratio (norm) = 2:1 (up to 3:1)
For every 1 dollar of current liability that the business has, there is 2 dollars worth of current assets to cover for it.
Found in list provided or statement of financial position
Explain the quick/acid test/liquid ratio
Current assets - inventory : current liabilities
Norm: 1:1
For every N$1 of current liabilities, there’s N$1 worth of current assets to cover it, without having to sell al the inventory
Explain the uses of liquidity ratios
Liquidity measures how quickly assets can be turned into cash
The ratios show whether they can meet its short-term commitments
This is normally compared with the previous year’s figures
Below the norm means that the business will struggle to pay short-term debts
Define efficiency ratios
Used to measure how effectively the business uses its assets and liabilities internally
Rate of inventory turnover is the…
Number of times that the inventory of a business is replaced during an accounting period
Explain the rate of inventory turnover
Cost of sales/average inventory
(Average inventory = opening + closing/2)
Answer in times per annum
The more times inventory is replaced per year the better (don’t run out of inventory)
Low rate shows inventory piling, wrong purchases and poor sales
Explain the collection period for debtors
Debtors/credit sales x 365 (or x 12 months)
Answer in days or months
Shorter period = better liquidity (how? - discounts and interest charged on overdue accounts)
The quicker the debtors pay, the quicker you can use the money to pay for current liabilities
Explain the payment period for creditors
Creditors/credit purchases x 365 (or x 12 months)
Answer in days or months
Longer period = better liquidity (disadvantage - miss out on discounts, run risk of being charged with interest)
The longer it takes to pay creditors, the more money the business has to pay day-to-day expenses
What are the uses of efficiency ratios?
Shows how funds are used in the business
If the rate of inventory turnover is too high, it can be a sign that the prices of goods are too low, which makes the ratio higher and the profit lower
The type of business will influence the ratio (fresh products will have higher ratio than other products)
Business has policies for debtors: screen applicants, changing of interest, creditworthiness, bed debts; debtors collection period shows how well the business enforces these policies
Business will have policies for creditors - a shorter period means the business is creditworthy and pays on time
Define the profitability ratios
Measures the ability of the business to generate a profit
Define the term markup
When the gross profit is shown as a % of the cost price
Gross profit/ cost of sales x 100
Define and explain the gross profit margin
When the gross profit is shown as a % of the selling price
Gross profit/ turnover x 100 = …%
Compare with markup, if lower it means the expenses are too high
Shows the amount of gross profit made for each N$100
Define and explain net profit margin
When the net profit is shown as a % of the selling price
Net profit/turnover x 100 = …%
Good ratio depends on the type of business
It shows the operating efficiency of the business and the amount of net profit made for every N$100 of sales after expenses are deducted (shows how well the business controls expenses)
Explain return on capital employed
Shows the amount of profit made for every N$100 invested
Net profit before tax/capital employed x 100 = …%
Ratio should be higher than what the owner can get if they invest the money in a bank
What are the uses of profitability ratios?
To see if the business can make improvements
Identity problems
To check with previous years
Define the solvency ratio
The ability of a business to survive in the long-term
The ratio of the total assets to the total liabilities of a business
A ratio of 40% or more means that investors will be willing to invest in the business
Explain the calculation of the solvency ratio
Total assets : total liabilities
(Total assets = fixed + current + investments)
Good ratio = 2:1
Tests the creditworthiness of the business and shows if the business can meet its total commitments or liabilities
How is working capital calculated?
Current assets less current liabilities
Name 4 ways to improve profitability and working capital
Reduce drawings
Sell surplus fixed assets
Obtain long-term loan
Delay payments to creditors
Discuss the importance of accounting ratios to owners
They will look at all 4 categories
Discuss the importance of accounting ratios to managers
They are more concerned about the internal control/ how they can make their departments more efficient
Financial managers will focus on creditors payment period, debtors collection period and liquidity ratios
Discuss the importance of accounting ratios to trade creditors
Business won’t want to discuss business with each other if there’s a possibility that that one can’t pay it’s financial commitments
Discuss the importance of accounting ratios to lenders
They won’t know if their funds are safe and can be paid back with the agreed interest
Discuss the importance of accounting ratios to employees
Will evaluate before applying to a business for a job
Discuss the importance of accounting ratios to potential investors or partners
Want to be satisfied with their internal control of the business
Interest in profitability
Name the advantages of ratios
Helps understand the business better
Can compare different financial years to find a trend
Problems can be discovered early (liquidity ratios)
Name the disadvantages and limitations of ratios
Person needs knowledge to calculate and interpret ratios
One year’s ratios is irrelevant, needs to be compared with other years
Ratios use historical data - business acts on problems long after the incident
