RATIO ANALYSIS (Analysis of Financial Statements).pptx

Ratio Analysis

1. RATIO ANALYSIS Profitability and Liquidity Ratio Analysis

2. LESSON OBJECTIVES: At the end of the lesson, students should be able to : Demonstrate how to interpret financial statements by calculating and analysing accounting Ratios: Profitability Ratios Liquidity Ratios Why and How accounts are used Need of different users of accounts and ratio analysis How users of accounts use information to make decisions

3. MEANING Relationship between two figures, expressed in arithmetical terms is called a ratio.

4. RATIOS MAY BE EXPRESSED :

5. The data contained in the financial statements are used to  make some useful observations about the performance and financial strength  of the business. This is the analysis of accounts of a business. To do so, ratio analysis is employed.

6. Ratio Analysis Profitability Ratios : profitability is the  ability of a company to use its resources to generate revenues in excess of its expenses.  These ratios are used to see how profitable the business has been in the year ended. Liquidity Ratios : liquidity is the  ability of the company to pay back its short-term debts.  It if it doesn’t have the necessary working capital to do so, it will go illiquid (forced to pay off its debts by selling assets)

7. PROFITABILITY RATIOS The three most common performance ratios are: 1. Gross profit margin 2. Profit margin 3. Return on capital employed 1. Gross profit margin: This is calculated by the formula Gross profit margin (%)= Gross profit / Sales revenue * 100 An outcome of 25% for example, implies that for every $1 of sales revenue, $ 0.25 is earned as gross profit.

8. 2. Profit margin: This is calculated by the formula Profit margin (%)= Profit before tax / Sales revenue *100 An outcome of 15% for example, implies that for every $1 of sales revenue, $ 0.15 is earned as profit.  3. Return on capital employed(ROCE): This is calculated by the formula ROCE(%)= Operating profit / Capital employed * 100 This is how much the business was able to get back from the capital it had employed. An outcome of 20% for example, implies that for every $1 of capital it had employed in the business, $ is earned as operating profit.

9. Class Activity Using the business data in table 1, calculate the following accounting ratios to analyse the business profitability: Gross profit margin, Profit, Return on capital employed. Compare the business performance in 2012 and Based on the results obtained, in which of the two years was the business more successful?

10. ANSWERS TO CLASS ACTIVITY

11. LIQUIDITY RATIOS Two common liquidity ratios are: Current ratio and Acid test or liquid ratio

12. Class Activity: Using the business data in table 2 above, calculate the following accounting ratios to analyse the business profitability: Current ratio, ii. Acid test or Liquid ratio . Compare the business performance in 2012 and Based on the ratios obtained, in which of the two years was the business more liquid?

13. SOLUTION to ACTIVITY 2

14. Uses and users of accounts Managers : they will use the accounts to help them keep control over the performance of each product or each division since they can see which products are profitably performing and which are not. Shareholders : The balance sheet will tell shareholders whether the business was worth more at the end of the year than at the beginning of the year, and the liquidity ratios will be used to ascertain how risky it will be to invest in the company Creditors : The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position and debts of the business. They will only be ready to supply to the business if they will be able to pay them.  If there are liquidity problems, they won’t supply  the business as it is risky for them. Creditors : The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position and debts of the business. They will only be ready to supply to the business if they will be able to pay them.  If there are liquidity problems, they won’t supply  the business as it is risky for them.

15. Limitations of using accounts and ratio analysis Ratios are  based on past accounting data  and will not indicate how the business will perform in the future Managers will have all accounts, but the external users will only have those published accounts that contain only the data required by law- they may not get the ‘full-picture’ about the business’ performance. Comparing accounting data over the years can lead to misleading assumptions since the  data will be affected by inflation  (rising prices) Different companies may use different accounting methods  and so will have different ratio results, making comparisons between companies unreliable.