Introduction To Accounting Ratios and Interpretation

Introduction to
Accounting Ratios
and Interpretation
What is financial statement analysis?
Financial statement analysis is the process of analyzing a company’s financial

statements for decision-making purposes.
One of the most common ways to analyze financial data is to calculate ratios from the
data in the financial statements.
Uses and Limitations of Financial
Ratios
U ses L im itation s
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understand into transactions m erely
financial relationships. to im prove the ratios.
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quick com parison analysis of the company's
of companies. progress tow ard
nonfinancial goals.
Financial ratios are grouped into the following categories:
1. Profitability ratios
2. Efficiency ratios
3. Liquidity ratios
4. Gearing ratios
5. Investors’ ratios
We will focus on the first THREE categories.

1. Profitability ratios
The Profitability Ratios measure the overall performance of the company in terms of the
total revenue (sales) generated from its operations.
The most common profitability measures include:
 Gross profit margin (GPM)

 Return on assets (ROA)
Gross profit margin (GPM)
GPM tells you about the profitability of your goods and services. It tells you how much it
costs you to produce the product.
Formula
Interpretation: GPM tells investors how much gross profit every dollar of revenue a
company is earning. The higher the GPM the better.
Example: If you sold $10 pens that cost $3 to make, then your GPM on each pen is 70%.
Question
Ali owns a café. In 2020, Ali produced the following profit & loss account. Use the
information below to calculate Ali’s Gross profit margin (GPM).
Revenue $120,000
Cost of good sold $67,000
Gross profit $53,000
Expenses $38,000
Net profit $15,000
Return on assets (ROA)
ROA tells you how profitable a company is relative to its total assets.
Formula
Interpretation: A higher ratio is more favorable to investors because it shows that the
company is more effectively managing its assets to produce greater amounts of net
income.
Question 1:
If a business records net income of $10 million in current operations and owns $50
million worth of total assets as per the financial position.
Calculate return on assets (ROA)?
Question 2:
ABC Company report the following:
Net income: $150,000
Total assets on 1 January 2020: $800,000
Total assets on 31 December 2020: $850,000
Calculate return on assets (ROA)?

Note: You can calculate the average total assets to have more accurate calculation because a company's
total assets can vary over time. (Average total assets is calculated as the sum of the beginning and ending
total assets, divided by two.
2. Efficiency ratios
Efficiency ratios measure the ability of a business to use its assets and liabilities to
generate sales.
The most common efficiency measures include:
 Accounts Receivable Days

 Accounts Payable Days
Accounts Receivable Days (ARD)
ARD measures the number of days that a customer invoice is outstanding before it is
collected.
Formula
Example
Company A has a total of $120,000 in their accounts receivable, along with an annual
sales of $800,000 therefore ARD = (120,000/800,000) x 365 = 55 days.
Interpretation: Company A requires 55 days to collect a typical invoice.

Question
Company A had the following financial results for the year:
Net credit sales of $800,000.

$64,000 in accounts receivables on Jan 1 (beginning of the year).
$72,000 in accounts receivables on Dec 31 (end of the year).
Calculate Account Receivables Days?
Note: You can calculate the average account receivables to have more accurate calculation. (Average
account receivables is calculated as the sum of the beginning and ending total account receivables,
divided by two.
Accounts Payable Days (APD)
APD measures the number of days that a company takes to pay its suppliers.
Formula
Note: in some cases, cost of good sold (COGS) is used in the numerator in place of credit
purchases.
Interpretation: If the number of days increases from one period to the next, this indicates
that the company is paying its suppliers more slowly and may be an indicator of worsening
financial condition. The lower the APD the better.
Question
B Company buys constructions equipment and materials from wholesalers to resell

them at a higher price. During the current year B Company purchased $7,500,000
worth of construction materials from the supplier. According to company’s financial
position, the beginning accounts payable was $800,000 and ending accounts payable
was $884,000.
Calculate Account Payables Days?

3. Liquidity Ratios
Liquidity ratio tells you whether a company’s current assets are enough to cover their
liabilities.
The most common liquidity measures include:
 Working Capital
 Current Ratio
 Quick ratio
Working Capital
Working capital is defined as current assets minus current liabilities. It is a critical
measure for all types of businesses.
Formula
Working Capital = Current assets – Current liabilities
Example
If company current assets are $400 million and current liability is $200 million, then
the working capital will be = 400-200=$200 million
Interpretation
Positive working capital means the company will have enough assets converted into
cash within the next year to pay its current obligations.
Current Ratio (CR)
CR indicates a company’s capacity to repay short-term loans that are due within the next
year using current assets.
Formula
Example
If company current assets are $400 million and current liability is $200 million, then the
ratio will be = $400/$200 = 2 times.
Interpretation: The CR is 2 which means the company’s currents assets are 2 times more
than its current liabilities.
Question 1:
On December 31, 2020, the financial position of ABC company shows the total
current assets of $1,000,000 and the total current liabilities of $400,000.
Calculate current ratio of the company.
Question 2:
If a business holds:
Cash = $15 million
Inventory = $25 million
Short-term debt = $15 million
Accounts payables = $15 million.

Calculate current ratio of the company.
Quick ratio (QR)
QR measures a company’s ability to pay off short-term liabilities with quick assets. The
ratio considers more liquid assets such as cash, account receivables, and short-term
investment. It leaves out current assets such as inventory because it is less liquid.
Formula
Interpretation: A ratio above 1 indicates that a business has enough cash or cash
equivalents to cover its short-term financial obligations and sustain its operations.
Example
Let’s assume ABC company is applying for a loan. The bank asks the company for a
detailed Financial position, so it can compute the quick ratio. The company’s financial
position included the following accounts:
Cash: $20,000
Accounts Receivable: $9,000
Short-term investment: $30,000
Inventory: $5,000
Current Liabilities: $15,000
The bank can compute the company’s quick ratio as follows:

Quick ratio= $20,000 + $9,000 + 30,000/ $15,000 = 4 times.
Interpretation: This company has a quick ratio of 4, which means that it can pay its current
liabilities 4 times over using its most liquid assets.
Questions?

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Introduction to

Financial statement analysis is the process of analyzing a company’s financial

Ratios help users M anagem ent may enter

Ratios provide for Ratios do not help w ith

We will focus on the first THREE categories.

The most common profitability measures include:

 Gross profit margin (GPM)

Calculate return on assets (ROA)?

Calculate return on assets (ROA)?

The most common efficiency measures include:

 Accounts Receivable Days

Interpretation: Company A requires 55 days to collect a typical invoice.

Company A had the following financial results for the year:

Net credit sales of $800,000.

Calculate Account Receivables Days?

B Company buys constructions equipment and materials from wholesalers to resell

Calculate Account Payables Days?

The most common liquidity measures include:

Working Capital = Current assets – Current liabilities

Calculate current ratio of the company.

The bank can compute the company’s quick ratio as follows:

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