OVERVIEW

1. Introduction to Financial Ratios

2. Types of Ratios- Calculate & Interpret Ratios

A. Introduction to Financial Ratios

 Financial ratios are used to evaluate and compare the financial strength and performance of
companies’ financial statements.
 Ratios are a form of common measure that brings about the same basis of comparison to the
financial statements.
 Ratios are compared from year to year and can also be compared with other businesses.
 The different category of ratios are as follows:
(a) Profitability ratios
(b) Liquidity ratios
(c) Efficiency ratios

B. Types of Ratios

A. PROFITABILITY RATIOS

Profitability ratios measure the financial performance of the business (how profitable is the
business and the returns to investors for their investments).

(i) Gross profit as a percentage of sales (Gross profit margin)

BBFA1043 Chapter 14 Financial Analysis LTJ 2018 1
Gross profit
X 100%
Sales

Purpose: This represents the gross profit before deducting any expenses, for every sale
earned. A higher ratio shows a better financial performance.

(ii) Net profit as a percentage of sales (Net profit margin)

Net profit before tax

X 100%
Sales

Purpose: This represents the net amount of profit for sales earned after deducting the
expenses. A higher ratio shows a better financial performance.

B. LIQUIDITY RATIOS

Liquidity ratios tell us whether the business will be able to pay its creditors, expenses, loans
falling due, etc. at the correct times. Failure to ensure that these payments are covered could
mean that the business would have to be closed down. (How liquid is the business).
 (i) Current ratio

Current assets
Current liabilities

Where it may be expressed as either:

a) ratio to 1 (with current liabilities being set as 1, e.g. 2:1); or
b) ‘number of times’ (relative size of current assets compared with current liabilities, e.g.
2 times)

Purpose: This indicates whether there are sufficient short-term assets to meet short-term
liabilities. A ratio greater than 1 means short-term assets are more than enough to
meet short-term liabilities. A ratio lesser than 1 may mean that the business is
having liquidity problems.

(ii) Acid test (Quick ratio)

Current assets – inventories

Current liabilities

Note: This ratio has the same purpose and is expressed in the similar way as the current
ratio. The difference here is, since inventories may not be able to convert to cash
in a relatively short time, inventories are excluded from current assets in the
calculation of this ratio because it is considered illiquid.

BBFA1043 Chapter 14RATIOS

C. EFFICIENCY Financial Analysis LTJ 2018 2

Efficiency ratios measure how well the business is able to utilise its assets to generate sales and
profits (how efficient is the business).

(i) Inventories turnover (in ‘number of times’)

Cost of goods sold

Average inventories
Where:
Opening inventories + Closing inventories
Average inventories =
2

Purpose: It measures how efficient is the business in maintaining its level of inventories. A
higher ratio shows that inventories are moving fast. A reduction in ratio may
indicate that the business is slowing down. Bigger time is better.

(ii) Inventories turnover (in ‘number of days’)

Average inventories
X 365
Cost of goods sold

Purpose: A lower ratio shows that inventories are moving fast. An increase in ratio may
indicate that the business is slowing down. Smaller is better.
 (iii) Trade Receivables turnover (in number of days)

Trade Receivables
X 365
Sales

Purpose: To ascertain the average period taken by trade receivables to pay up. A higher
ratio shows a longer period to collect payments from trade receivables, hence,
less cash for the business operation. This may potentially bring liquidity
problems for the business. Smaller is better.

(iv) Trade Payables turnover (in number of days)

Trade Payables
X 365
Purchases

Purpose: To ascertain the average period taken to pay trade payables. A higher ratio
shows that the business is able to keep its cash for a longer period before paying
its trade payables. Higher period can also indicate that the business may have
problem paying its suppliers i.e. liquidity problem. To take too long to pay the
suppliers may result in higher purchase price and less/no trade discount.

Illustration 1:

BBFA1043ofChapter
Statements 14 Financial
Comprehensive IncomeAnalysis
for the year ended 31 st December 2017 LTJ 2018 3

Company A Company B
RM RM RM RM
Sales 555,000 750,000
Less: Cost of goods sold
Opening inventories 100,000 80,000
Purchases 200,000 320,000
300,000 400,000
Less: Closing inventories (60,000) (240,000) (70,000) (330,000)
Gross Profit 315,000 420,000
Less: Expenditure
Depreciation 5,000 15,000
Wages and salaries 165,000 220,000
Interest charges 5,000 2,000
Other expenses 40,000 (215,000) 33,000 (270,000)
Net profit before tax 100,000 150,000
Less: Tax expense (26,000) (39,000)
Profit for the year 74,000 111,000
 Statements of Financial Position as at 31st December 2017
Company A Company B
RM RM RM RM
Non-current assets (at NBV) 210,000 210,000

Currents assets
Inventories 60,000 70,000
Trade receivables 125,000 100,000
Bank 25,000 12,500
210,000 182,500

Current liabilities
Trade payables (104,000) 106,000 (100,500) 82,000
316,000 292,000
Financed by:
10% Preference shares 15,000 -
Ordinary shares 60,000 72,000
Retained earnings 141,000 180,000
216,000 252,000
Non-current liabilities
5% Debentures 100,000 40,000
316,000 292,000

REQUIRED:
Compute the following ratios and explain the interpretation of these ratios:

(a) Gross profit as a percentage of sales

(b) Net profit as a percentage of sales
(c)BBFA1043
Current Chapter
ratio 14 Financial Analysis LTJ 2018 4
(d) Quick ratio
(e) Inventories turnover times
(f) Inventories turnover days
(g) Trade receivables turnover days
(h) Trade payables turnover days

Solution (Illustration 1)

Company A Company B
(a) Gross profit as a 315,000 x 100% 420,000 x 100%
percentage of sales 555,000 750,000
= 57% = 56%
Interpretation: Company A products are sold at a slightly more profitable
level compared to Company B products.

(b) Net profit as a percentage 100,000 x 100% 150,000 x 100%

of sales 555,000 750,000
= 18% = 20%
Interpretation: Company A achieves a higher net profit margin compared to
Company B, even though gross profit margin is lower. This
may be due to lower amount of expenses incurred by
Company B.
 Company A Company B

(c) Current ratio 210,000 182,500

104,000 100,500
= 2:1 (or 2 times) = 1.8:1 (or 1.8 times)
Interpretation: Both companies have enough current assets to cover their
current liabilities. Therefore both companies do not face
liquidity problem.

(d) Quick ratio 150,000 112,500

104,000 100,500
= 1.4:1 (or 1.4 times) = 1.1:1 (or 1.1 times)
Interpretation: Both companies are still liquid even when excluding
inventories. No liquidity problem foreseen.

(e) Inventories turnover times 240,000 330,000

80,000 75,000
= 3 times = 4.4 times
Interpretation: Company B inventories move faster than Company A
inventories. This means that Company B can sell its goods
faster that A.

(f) Inventories turnover days 80,000 x 365 75,000 x 365

240,000 330,000
= 122 days = 83 days
Interpretation: Company B inventories move faster than Company A.

(g) Trade receivables 125,000 x 365 100,000 x 365

turnover days 555,000
BBFA1043 Chapter 14 Financial Analysis 750,000 LTJ 2018 5
= 82 days = 49 days
Interpretation: Company B’s trade receivables pay a lot faster than Company
A’s trade receivables, probably due to Company B being more
effective in collecting debts. Company A should pay more
attention in its debt collection and credit control measures.

(h) Trade payables turnover 104,000 x 365 100,500 x 365

days 200,000 320,000
= 190 days = 115 days
Interpretation: Company A takes a longer time to pay trade payables
compared to Company B. Company A has to be more prompt
in paying its suppliers to ensure continuation in its supply of
goods and lower purchase price and higher discount from
suppliers.