0452 · 6.1Calculation and understanding of accounting ratios

Ratio foundations and profit figures

0:00A cycle shop may sell plenty of bicycles while customers still owe money for them. It may also have shelves full of goods when a supplier needs payment. The amount sold therefore cannot answer every question about the business. This video covers the calculation and understanding of accounting ratios. Its ten ratios measure profit percentages, the return on long-term finance, short-term liquidity and turnover in times or days. An accounting ratio expresses the relationship between two accounting figures.

0:26Dividing one figure by another lets us measure an amount relative to a useful starting point. A percentage describes an amount per hundred, while a turnover period expresses time in days. The denominator is the figure underneath the division line, and it determines what the answer measures. Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date.

0:48Every example in this video uses the figures of one business, Rowan Cycles. A limited company is a business owned by shareholders, legally separate from its owners and run by directors. Rowan Cycles is a small limited company that sells bicycles. Revenue is the income a business earns from its main activity, such as selling goods or providing services. For Rowan Cycles, annual revenue is two hundred thousand dollars. Expenses are the costs used up in running the business and earning revenue during a period.

1:15Ratios help separate the amount earned from sales from the amounts used up. Inventory means goods held for resale, while cost of sales is the cost of inventory sold during a period. Rowan Cycles has cost of sales of one hundred and sixty thousand dollars. Its expenses excluding cost of sales and interest are eighteen thousand dollars. Interest is the cost paid for borrowing money. Rowan Cycles has an interest expense of another two thousand dollars.

1:39Gross profit is revenue minus cost of sales. Subtract one hundred and sixty thousand dollars from two hundred thousand dollars. Gross profit is forty thousand dollars. This amount remains before the business deducts its other expenses, so it measures the difference between sales income and cost of sales. Profit for the year is the amount by which revenue exceeds expenses over one financial year. Forty thousand dollars minus eighteen thousand dollars gives twenty-two thousand dollars before interest.

2:05Subtracting two thousand dollars of interest then gives twenty thousand dollars for the year. Keep these amounts separate because the profitability ratios use different stages of the calculation.

Profitability margins and mark-up

2:14Profitability is the ability to earn profit in relation to revenue or resources invested. Gross profit margin measures gross profit as a percentage of revenue. Its formula is gross profit divided by revenue multiplied by one hundred. Revenue belongs underneath because we want to know how much of the sales income remains after cost of sales. Start with gross profit of forty thousand dollars and divide by revenue of two hundred thousand dollars.

2:39Multiply that result by one hundred to express it as a percentage. The gross profit margin is twenty per cent. So Rowan Cycles keeps twenty dollars of gross profit from every hundred dollars of revenue. A higher gross profit margin means more gross profit from each dollar of revenue. When the percentage falls, less of each sales dollar remains after cost of sales. This describes the relationship between two figures, not the total amount earned.

3:03A business can have a lower percentage but a larger total gross profit if its sales are sufficiently greater. Mark-up is gross profit as a percentage of cost of sales, while margin is gross profit as a percentage of revenue. The formula for mark-up is gross profit divided by cost of sales multiplied by one hundred. Here, the starting point is cost of sales. We measure the gross profit added above that cost.

3:25Divide forty thousand dollars by one hundred and sixty thousand dollars. Multiplying the result by one hundred gives a mark-up of twenty-five per cent. Rowan Cycles adds twenty-five dollars of gross profit to every hundred dollars of cost of sales. A higher mark-up means more gross profit relative to cost of sales, and a lower mark-up means less. The gross profit has stayed at forty thousand dollars in both calculations.

3:47Changing the denominator produced twenty per cent for gross profit margin and twenty-five per cent for mark-up. Revenue of two hundred thousand dollars covers cost of sales of one hundred and sixty thousand dollars plus gross profit of forty thousand dollars. That makes the revenue denominator larger, so the margin is always the smaller percentage. Profit margin measures profit for the year as a percentage of revenue. Calculate it as profit for the year divided by revenue multiplied by one hundred.

4:14This calculation goes beyond the buying and selling of goods because the numerator reflects the other expenses too. It measures the percentage of sales income remaining at the end of the annual profit calculation. Use twenty thousand dollars for profit for the year and two hundred thousand dollars for revenue. Divide the annual profit figure by revenue, then multiply by one hundred. The profit margin is ten per cent. A higher result represents more profit for the year from each dollar of revenue, while a lower result represents less.

4:42Rowan Cycles has a gross profit margin of twenty per cent but a profit margin of ten per cent. The difference arises because further expenses are deducted after gross profit. Both calculations use revenue underneath, but their numerators describe different stages. Always select the amount named in the formula before substituting the figures.

Return on capital employed

5:00The next profitability ratio, return on capital employed or R O C E, needs the long-term finance used by a company. Capital employed is the total of issued shares, reserves and non-current liabilities. Rowan Cycles takes each of these three figures from its statement of financial position. Each share has a nominal value, which is the stated value assigned to it. Issued share capital is the nominal value of the shares actually issued to shareholders.

5:25Rowan Cycles has issued shares with a total nominal value of thirty-five thousand dollars. Reserves are the general reserve and retained earnings kept in the company. Rowan Cycles has reserves of seventeen thousand dollars. Non-current liabilities are amounts due for payment after more than twelve months. The company owes twenty-eight thousand dollars on a long-term loan, so that is its non-current liability. The interest expense of two thousand dollars is the cost of this loan.

5:49The formula is capital employed equals issued shares plus reserves plus non-current liabilities. Thirty-five thousand dollars plus seventeen thousand dollars plus twenty-eight thousand dollars gives eighty thousand dollars. This combines finance from shareholders with borrowing repayable after more than twelve months. The ratio measures the return generated on that combined amount. Return on capital employed measures profit for the year before interest as a percentage of capital employed. Its formula is profit for the year before interest divided by capital employed multiplied by one hundred.

6:21The lenders of the long-term loan receive interest, and their loan is part of capital employed. Using profit before interest therefore matches the return with finance from both shareholders and lenders. We already calculated profit for the year before interest as twenty-two thousand dollars. Divide it by capital employed of eighty thousand dollars, then multiply by one hundred. R O C E is twenty-seven point five per cent. A higher percentage represents a greater annual return before interest on the finance employed, while a lower one represents a smaller return.

6:51When a question gives only profit for the year, add back the interest expense to obtain the required numerator. For Rowan Cycles, twenty thousand dollars plus two thousand dollars gives twenty-two thousand dollars. Use issued shares plus reserves plus non-current liabilities for the denominator. Profit margin is a separate ratio, with revenue as its denominator.

Current and acid test ratios

7:12Liquidity is the ability to meet short-term debts when they fall due. Rowan Cycles must be able to pay its suppliers when payment is due. Liquidity ratios compare short-term resources with the debts that must be paid soon. Assets are resources owned or controlled by a business that bring future benefit. Rowan Cycles' bicycles waiting for customers are among its assets. Current assets are assets expected to be turned into cash or used up within twelve months.

7:36Rowan Cycles has current assets of thirty thousand dollars, including closing inventory of nineteen thousand dollars. Liabilities are amounts the business owes to others, while current liabilities are amounts due for payment within twelve months. Rowan Cycles has current liabilities of ten thousand dollars. We need the inventory figure separately because the two liquidity ratios treat it differently. The current ratio, also called the working capital ratio, compares current assets with current liabilities.

8:02Calculate it as current assets divided by current liabilities, and present the answer as a ratio. The result shows how many dollars of current assets the business has for each dollar due within twelve months. The answer is always written as a number to one. Thirty thousand dollars divided by ten thousand dollars gives a current ratio of three to one. Rowan Cycles has three dollars of current assets for each dollar of current liabilities.

8:24Those resources include inventory and amounts that have not yet become cash. A higher current ratio represents more current assets relative to current liabilities. A lower value indicates fewer such resources for each dollar due. However, not every current asset is money that can be spent today. A bicycle still on the shelf must be sold before the business can receive money from its sale. The acid test ratio, also called the liquid ratio, compares current assets excluding inventory with current liabilities.

8:53Its formula is current assets minus inventory, divided by current liabilities. Inventory is excluded because selling goods may take time, and collection from a customer may take longer still. This gives a narrower measure of the resources available to meet short-term debts. Subtract inventory of nineteen thousand dollars from current assets of thirty thousand dollars. Current assets excluding inventory are eleven thousand dollars. Dividing this amount by current liabilities of ten thousand dollars gives an acid test ratio of one point one to one.

9:22A higher acid test ratio represents more resources excluding inventory for each dollar of current liabilities. A lower one means the business depends more on selling inventory to pay its debts. The gap between Rowan Cycles' two liquidity ratios comes entirely from excluding inventory. Current liabilities remain ten thousand dollars in both calculations.

Inventory and trade turnover

9:43Efficiency ratios measure how quickly inventory is sold or trade amounts are settled. Inventory turnover uses the amount of inventory held across the whole year. Opening inventory is the value of goods held for resale at the start of a financial period. The goods remaining at its end are called closing inventory. Rowan Cycles began the year with thirteen thousand dollars of inventory and ended with nineteen thousand dollars. Average inventory usually equals opening inventory plus closing inventory, divided by two.

10:10Thirteen thousand dollars plus nineteen thousand dollars gives thirty-two thousand dollars. Divide by two to obtain average inventory of sixteen thousand dollars. Using both the opening and the closing figure gives a better estimate of the amount held during the year. The rate of inventory turnover measures how many times average inventory is sold and replaced during a period. Calculate it as cost of sales divided by average inventory. Both figures are measured at cost, so they are on a consistent basis.

10:35Revenue would include the gross profit added above that cost. Divide cost of sales of one hundred and sixty thousand dollars by average inventory of sixteen thousand dollars. The rate of inventory turnover is ten times. Over the year, Rowan Cycles sold goods costing ten times its average inventory. This describes the value sold relative to the average amount held, not the number of individual bicycles. A higher rate means average inventory is sold and replaced more frequently.

11:01When the rate is lower, goods move through the business more slowly. The same relationship can be expressed as the average number of days inventory is held. That version reverses the division, because it measures a length of time. Inventory turnover in days measures the average time inventory is held before sale. Its formula is average inventory divided by cost of sales multiplied by three hundred and sixty-five days. The division finds the fraction of the year's cost of sales represented by average inventory.

11:28Multiplication converts that fraction into days. Average inventory of sixteen thousand dollars is divided by cost of sales of one hundred and sixty thousand dollars. Multiply the result by three hundred and sixty-five days. Inventory turnover is thirty-six point five days. A lower number of days represents a shorter average holding period, while a higher figure represents a longer period. These two answers describe the same movement of inventory. More turnovers during a year correspond to fewer days per turnover.

11:56For Rowan Cycles, three hundred and sixty-five days divided by ten turnovers gives the same thirty-six point five days. When a division does not end exactly, keep full calculator precision and round only the final answer to two decimal places. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services. Rowan Cycles has trade receivables of six thousand dollars. Credit sales are sales for which customers pay later.

12:20Its annual credit sales were one hundred and forty-six thousand dollars. These figures connect the amount still owed with the sales that created customer debts. Trade receivables turnover in days measures the average time credit customers take to pay. Calculate it as trade receivables divided by credit sales multiplied by three hundred and sixty-five days. Cash sales leave no amount awaiting collection from customers. That is why the denominator is credit sales, the sales that created the amounts owed.

12:45Divide trade receivables of six thousand dollars by credit sales of one hundred and forty-six thousand dollars. Multiply by three hundred and sixty-five days to obtain fifteen days. This is an average collection period, so some customers pay sooner and others later. A higher result means slower average collection, while a lower result means faster collection. Trade payables are amounts owed to credit suppliers that the business has not yet paid.

13:09Rowan Cycles has trade payables of nine thousand dollars. Buying on credit means receiving something now and agreeing to pay for it later. Credit purchases are goods bought for resale with payment due later. Rowan Cycles made credit purchases of one hundred and fifty thousand dollars in the year. Trade payables turnover in days measures the average time the business takes to pay its credit suppliers. Its formula is trade payables divided by credit purchases multiplied by three hundred and sixty-five days.

13:35This matches the unpaid supplier amounts with the purchases that created them. Cost of sales measures goods sold, so credit purchases is the required denominator here. Nine thousand dollars divided by one hundred and fifty thousand dollars is the first step. Multiply the result by three hundred and sixty-five days without rounding the intermediate answer. Trade payables turnover is twenty-one point nine days. A higher figure represents a longer average payment period, while a lower value indicates that the business pays suppliers sooner.

Exam technique and recap

14:02Paper one contains forty multiple-choice questions, and Paper two contains five compulsory structured questions. Calculate means work out from given figures, while state means express in clear terms. In a calculation, show the specified formula, substitute the relevant amounts and finish with the correct unit. This also makes the denominator choice visible in your working. Consider a question that asks you to calculate the profit margin and state why it differs from the gross profit margin.

14:29Twenty thousand dollars divided by two hundred thousand dollars, multiplied by one hundred, gives ten per cent. Further expenses are deducted after gross profit to obtain profit for the year. That reason earns the mark because it names what separates the two numerators. Each ratio needs the starting amount named in its formula. Use revenue for both margin calculations and cost of sales for mark-up. Return on capital employed requires profit for the year before interest.

14:54For the acid test ratio, subtract inventory before division, and present both liquidity answers to one. Match inventory at cost with cost of sales, and use average inventory in both inventory turnover calculations. Customer collection uses credit sales, while supplier payment uses credit purchases. Percentages, times, days and ratios describe different relationships, so include the correct unit. Round the final answer to two decimal places while retaining full precision during the working.

15:21Profitability ratios measure amounts earned relative to revenue, cost of sales or capital employed. Liquidity ratios compare short-term resources with amounts due, with the acid test excluding inventory. Efficiency ratios describe how frequently goods are sold and how long collection or payment takes. Choosing the correct denominator is what gives each accounting ratio its particular meaning.