C hapter 11: Accounting ratios and the

interpretation of final
accounts
Contents of chapter
This chapter continues an examination of how accounting ratios are calculated, and what can be learnt from
them.

Notes for teachers

Based on my experience over many years as an examiner for various accounting and educational bodies,
1
I can say that:
(i) Most students will try to do the arithmetical part in calculating the ratios, but
(ii) Very few students will give a good answer when asked to comment on the ratios.

It is important that students show all their workings which should be shown as part of the answer.
2

3 Suppose that an answer is worth 4 marks. The answer is:

Gross profit
Gross profit ratio = × 100%
Sales
$6, 000
= × 100% = 10%
$60, 000
1
Suppose the student puts everything as above but calculated the answer as 1%. Possibly 3 2 marks or
even 4 marks will be given.

Suppose he does the workings elsewhere, does not show them and simply states:
Gross profit ratio = 1%
No marks will be given. The examiner cannot guess that the student has only made a mistake in
arithmetic.

In an examination, students should guess how to calculate the ratios, if they cannot remember them or
4
have not heard of them. Marks are not deducted for guessing. In fact, students may give the correct
answers, possibly because their common sense tells them how to do it.

Ensure that students follow the requirements of the descriptive part of the question. If the examiner asks
5
for brief notes, he means a few lines, say about 4 to 5 lines per ratio. He does not mean 2 pages.
Otherwise, he does expect a fairly full answer.

Students should not just say that: ‘The ratio has increased by 2%’ and leave it at that. The student has
6
already done the calculations to show that. Instead, he or she should try to suggest why it might have
changed.

7 Students should have a reasonable amount of practice with the interpretation of ratios.

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 Answers to MCQs and exercises
11.1 C 11.2 B 11.3 C 11.4 C 11.5 B

11.6
Cost of goods sold
(a) Rate of stock turnover =
Average stock
$ $
Cost of goods sold: Stock as at 30.6.20X5 75,000
Add Purchases 218,568
Less Returns outwards 8,568 210,000
285,000
Less Stock as at 30.6.20X6 45,000
240,000
Average stock ($75,000 + $45,000) ÷ 2 = $60,000

$240,000
Stockturn = = 4 times
$60 ,000

Debtors $90,000
(b) × 12 = × 12
Net sales $377,685 − Returns inwards $17,685
$90 ,000
= × 12 = 3 months
$360,000

Current assets
(c) Current ratio =
Current liabilities
$
Current assets: Stock as at 30.6.20X6 45,000
Debtors 90,000
Cash in hand 300
135,300

Current liabilities: Creditors 28,500

Expenses owing 300
Bank overdraft 38,850
67,650

$135,300
Current ratio = =2:1
$67 ,650

$90 ,300
(d) Quick ratio = = 1.33 : 1
$67 ,650

(e) Net sales $360,000 – Cost of goods sold $240,000 = Gross profit $120,000
$120,000
Gross profit ratio = × 100% = 33.33%
$360,000

(f) Gross profit $120,000 – Administrative expenses $19,250 – Expenses owing $300 = $100,450.
$100,450
Net profit ratio = × 100% = $27.9%
$360,000

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11.7X
(a) (i) Gross profit as a percentage of sales:
Gross profit $40,000
= × 100% = 25%
Sales $160,000

(ii) Net profit as a percentage of sales:

Net profit $32,000
= × 100% = 20%
Sales $160,000

(iii) Net profit as a percentage of total capital employed:

Net profit $32,000
= × 100% = 27%
Capital employed $118,000

(iv) Rate of stock turnover:

Cost of sales $120,000
= = 12 times
Average stock $10,000

(v) Current ratio:

Current assets $20,000
= =2:1
Current liabilities $10,000

(vi) Acid test ratio:

Debtors and bank ($8,000 + $2,000)
= =1:1
Current liabilities $10,000
(b) Although K Fung and B Au have the same gross profit as a percentage of sales, B Au’s stock turnover rate is lower.
This would mean a relatively lower gross profit figure for B Au.

B Au’s net profit as a percentage of sales is markedly lower, reduced from 20% to 10%. This implies that B Au has
far higher expenses than K Fung.

For the same amount of total capital employed, K Fung is getting more return on it than B Au, 27% compared
1
with 12 %. This indicates that K Fung’s efficiency in utilising net assets to earn a profit is much higher than that
2
of B Au.

B Au’s liquidity is lower than that of K Fung. It is more obvious when we see their quick asset ratios. They show
that B Au has less ability to meet debts in the short-term than K Fung. But this does not mean that B Au’s liquidity
position is in danger. To determine whether the liquidity ratio is sufficient to meet debts in the short-term, it is
necessary to investigate the standard adopted in the industry.

K Fung is by far the more successful business. It is turning over its stock more frequently and has kept expenses at
a lower level. It is also in a good liquidity position and able to meet its debts.

B Au, on the other hand, is in a worse position on each factor. It is not only less profitable, but it is also in a less
liquid position to meet its debts as they fall due.

11.8X
(a) K Ltd N Ltd
$200,000 $130,000
(i) = 4:1 Current ratio = 2:1
$50,000 $65,000
$100,000 $62,500 + $3,500
(ii) = 2:1 Quick ratio = 1.1
$50,000 $65,000
$288,000 $187,500
(iii) = 2.6 times Stockturn = 3.0 times
($120,000 + $100,000) ÷ 2 ($60 ,000 + $64 ,000) ÷ 2

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 $60,000 $62,500
(iv) × 12 months = 2 months Credit period allowed × 12 months = 3 months
$360,000 $250,000
to trade debtors

$50,000 $65,000
(v) × 12 months = 2.2 months Credit period received × 12 months = 4.1 months
$268,000 $191,500
from trade creditors

$72,000 $62,500
(vi) × 100% = 20% Gross profit as a percentage of sales × 100% = 25%
$360,000 $250,000
$43,200 $35,000
(vii) × 100% = 12% Net profit as a percentage of sales × 100% = 14%
$360,000 $250,000
$43,200 $35,000
(viii) × 100% = 12.3% Rate of return on shareholders’ funds × 100% = 13.7%
$350,000 $255,000

(b) N Ltd gives a higher return to shareholders, see (viii) above.

K Ltd’s current ratio is higher than N Ltd’s. This indicates that K Ltd is in a better liquidity position.

N Ltd’s stock turnover is higher than that of K Ltd. This shows that N Ltd’s sales performance is better.

The gross profit percentage of N Ltd is 5% higher than that of K Ltd. This may be due to better purchasing and
selling methods. The overhead level of N Ltd is also lower than that of K Ltd. The tight control of overheads will
lead to higher profitability. Therefore, N Ltd’s net profit margin is 2% higher than that of K Ltd.

11.9
Workings
Net profit
W1: = 25%
Capital
$21000
,
∴ Capital = = $84 ,000
25%
Cost of goods sold $403,200
W2: = 12 times or = 12
Average stock Average stock
Stock is, therefore, $33,600 (i.e. divide $403,200 by 12). This is an average figure for both opening and closing
stocks.

$504,000
W3: Monthly sales = = $42,000
12
∴ Debtors = $42,000 × 2
= $84,000

W4: We can now reconstruct the trading account. Missing figure of purchases needed to balance trading account is
found to be $403,200.
$403,200
Monthly purchases = = $33,600
12
∴ Creditors = $33,600 × 2 = $67,200.

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 W5: Given current ratio is 2 : 1,
Total current assets = $67,200 × 2
= $134,400

Florence
Balance Sheet as at 31 December 20X4
$ $
Fixed Assets as at 1.1.20X4 26,460
Less Depreciation to date (balancing figure) 2,940 23,520
Current Assets
Stock (W2) 33,600
Debtors (W3) 84,000
Cash at bank (balancing figure) 16,800
134,400 (W5)
Less Current Liabilities
Creditors (W4) 67,200
Net current assets 67,200
90,720
Financed by:
Capital
Balance as at 1.1.20X4 (W1) 84,000
Add Net profit for the year 21,000
105,000
Less Drawings 14,280
90,720

11.10

(a) Cash Book (Bank)

$ $
(1) Error in carry forward ($21,600 – $21,146) 454 Balance b/f 393,265
(5) Debtor paid direct 4,375 (2) Dishonoured cheque 4,450
Balance c/f 400,000 (4) Cheque post-dated* 3,900
(6) Bank overdraft interest 2,900
(7) Rent 314
404,829 404,829

*Post-dated cheques should not be entered in the cash book until the date on the cheque has arrived.

(b) C Han
Bank Reconciliation Statement as at 31 December 20X5
$
Bank overdraft as per cash book (400,000)
Add (3) Unpresented cheques 24,750
(375,250)
Less (8) Banking not on bank statement 37,500
Overdraft balance as per bank statement (412,750)

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 (c) C Han
Balance Sheet as at 31 December 20X5
Fixed Assets $ $ $
Computer, cost less depreciation (W4) 1,500,000
Car, cost less depreciation (W9) 265,000
(W8) 1,765,000
Current Assets
Stock (W2) 300,000
Debtors (W3) 500,000
Cash (W7) 75,000
(W5i) 875,000
Less Current Liabilities
Creditors (W6) 225,000
Bank overdraft 400,000 (W6) 625,000 (W5ii)
Net current assets 250,000
2,015,000
Capital 2,500,000
Add Net profit (W1) 330,000
2,830,000
Less Drawings (W11) 815,000
(W10) 2,015,000

Net profit
(W1) = 11%, Net profit = $3,000,000 × 11% = $330,000
Sales

(W2) Cost of sales to clients $3,000,000 – ($3,000,000 × 40%) = $1,800,000

Cost of sales
Stockturn = =6
Average stock
Therefore 1800
, ,000 = 6, so average stock is $300,000.
?

Debtors $3, 000, 000 × 2

(W3) × 12 = 2 months, ∴ Debtors = = $500,000
Sales 12

(W4) Cost $2,000,000 – Depreciation ($2,000,000 × 25%) = $1,500,000

(W5) Current assets – Current liabilities = Net current assets

$1.4 – $1 = $0.4

(i) Current assets – Current liabilities = $250,000 (given)

1.4
∴ Current assets = $250,000 ×
0.4
= $875,000

(ii) $875,000 – Current liabilities = $250,000

Current liabilities = $875,000 – $250,000
= $625,000

(W6) Current liabilities = Creditors + Bank overdraft

Bank overdraft = $400,000 (as per cash book)
Current liabilities = $625,000 (as per W5ii)
∴ Creditors = $625,000 – $400,000
= $225,000

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 (W7) This is the missing figure to make current assets equal $875,000. Therefore cash is $75,000.

Net profit
(W8) × 100% = 12.5%
Total assets
330,000 100
Therefore × 100% = 12.5%, and total assets = × $330,000 = $2,640,000.
? 12.5
i.e. Total assets $2,640,000 – Current assets $875,000 = Fixed assets $1,765,000.

(W9) Missing figure to balance is: Fixed assets (NBV) $1,765,000 – Computer (NBV) $1,500,000 = Van (NBV) $265,000.

(W10) To make balance sheet totals agree, the capital balance as at 31 Dec 20X5 must be $2,015,000.

(W11) Missing figure to balance is: Capital $2,500,000 + Net profit $330,000 – Capital employed $2,015,000
= Drawings $815,000.

11.11X
(a) Business S and Business T
Trading and Profit and Loss Accounts for the year ended 31 December 20X6
Business S Business T
$ $ $ $
Sales (W1) 672,000 1,067,500
Less Cost of goods sold 560,000 854,000 (W2)
Gross profit 112,000 213,500
Less Administrative expenses 56,000 (W3) 80,500 (W4)
Selling and distribution expenses 21,000 77,000 49,000 129,500
Net profit 35,000 84,000

W1: Calculated cost of goods sold plus mark-up: S 20%, T 25%

W2: $840,000 + Amendment for stock overvalued $14,000 = $854,000
W3: ($70,000 – $14,000) = $56,000
W4: ($84,000 – $3,500) = $80,500

(b) Comparative assessment

Business S Business T

(i) Gross profit ratio 16.67% 20%

$35,000 $84,000
(ii) Net profit ratio × 100% = 5.21% × 100% = 7.87%
$672,000 $1,067,500
$560,000 $854,000
(iii) Stock turnover rate = 10 times = 13.56 times
$56,000 $63,000 *
* $70,000 + at close ($70,000 − $14 ,000)
2
= $63,000
(iv) Return on capital employed (based on owner’s capital):
Business S Business T
$35,000 $84,000
× 100% = 12.5% × 100% = 17.14%
$280,000 $490,000

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 (v) Return on capital employed (based on the purchase price):
Business S Business T
$35,000 $84,000
× 100% = 13.16% × 100% = 15%
$266,000 $560,000

All ratios are favourable to Business T. If the profitability ratios remain the same, then Business T would be a
better investment/buy.
But (1) Would it be possible to improve the gross profit of Business S as compared to Business T?
(2) Could the stockturn of Business S be improved?

(c) (i) We need to know the current assets and current liabilities in detail.
(ii) • Do they belong to similar types of business?
• What type of business is each of them?
• Is there any competition from other businesses?
• Would prefer several years’ accounts to gauge trends.
• What is the quality of staff, and would they continue to work for Dai?
• What are the norms of the industry with regard to the above-mentioned accounting ratios?

11.12X
(a) Mr Lai
Trading and profit and loss account for the year ended 31 March 20X2
$ $
12
Sales ($31,250 × ) 125,000
3
Less Cost of goods sold:
Opening stock 30,000
Add Purchases 52,500
82,500
Less Closing stock ($28,125 × 2 – $31,250 – $5,000) 20,000 62,500
Gross profit 62,500
Less Operating expenses (balancing figure) 37,500
Net profit ($125,000 × 20%) 25,000

Mr Lai
Balance Sheet as at 31 March 20X2
$ $ $
$125,000
Fixed Assets ( ) 31,250
4

Current Assets
Stock ($28,125 × 2 – $31,250 – $5,000) 20,000
Debtors 31,250
Cash in hand 5,000
56,250
Less Current Liabilities
Creditors ( $52,500 × 2) 8,750
12
Bills payable 19,375 28,125
Net current assets 28,125
59,375
Financed by:
Capital 50,000
Add Profit for the year 25,000
75,000
Less Drawings (balancing figure) 15,625
59,375

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(b) Limitations of ratio analysis

Difference in nature of businesses

First, it is impossible to sensibly compare two companies which are engaged in completely different businesses.
For example, to compare a retailer’s figures with those of a manufacturer would be rather pointless.

Difference in accounting policies

Also, different businesses may adopt different accounting policies in preparation of their accounts. This increases
the difficulty in comparing the businesses.

Qualitative features of a business

Past accounts do not disclose much useful information. For the desires to conform to the money measurement
concept, and to be objective, a great deal of desirable information such as the quality of staff, future plans of the
business and its position as compared with that of its competitors, etc. is excluded.

Lack of a standard form

Ratios are not always defined in a standard form. They are not directly comparable if different formulae are used
for calculation of ratios.

11.13
(a) Beauty Ltd 20X1 20X0
$9,000 $45,000
(i) Return on capital employed ( ) 6% ( ) 36%
$150,000 $125,000
$18 ,000 $60 ,000
(ii) Gross profit ratio ( ) 20% ( ) 40%
$90 ,000 $150,000
$9,000 $45,000
(iii) Net profit ratio ( ) 10% ( ) 30%
$90 ,000 $150,000
$37 ,500 $45,000
(iv) Current ratio ( ) 2.0 ( ) 2.4
$18 ,750 $18 ,750
$22,500 $30 ,000
(v) Quick assets ratio ( ) 1.2 ( ) 1.6
$18 ,750 $18 ,750
$15,000 $15,000
(vi) Stock turnover (months) ( × 12 months) 2.5 months ( × 12 months) 2 months
$72,000 $90 ,000

$22,500 $25,000
(vii) Trade debtors collection ( × 12 months) 3 months ( × 12 months) 2 months
$90 ,000 $150,000
period (months)

(b) The liquidity and profitability of the company for 20X1 were not as good as those for 20X0.

Firstly, the return on capital employed, gross profit ratio and net profit ratio of 20X1 were all lower than those for
20X0. It appears that selling prices were reduced or/and the costs of goods sold were increased substantially in
20X1.

Secondly, the stock turnover and trade debtors collection period were all worse than those for 20X0, indicating
that it took the company longer to sell its stock and to collect money from trade debtors.

Lastly, the current ratio and quick assets ratio decreased, indicating that the company’s ability to meet its current
liabilities has weakened, although these ratios are still acceptable.

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 11.14X
(a) HK Limited 20X8 20X7
$1800
, $9,000
(i) Return on equity ( ) 8% ( ) 45%
$22,500 $20 ,000
$3,600 $12,000
(ii) Gross profit ratio ( ) 20% ( ) 40%
$18 ,000 $30 ,000
$1800
, $9,000
(iii) Net profit ratio ( ) 10% ( ) 30%
$18 ,000 $30 ,000
$7 ,500 $9,000
(iv) Current ratio ( ) 2.0 ( ) 2.4
$3,750 $3,750
$4 ,500 $6 ,000
(v) Quick assets ratio ( ) 1.2 ( ) 1.6
$3,750 $3,750

$3,000 $3,000
(vi) Stock turnover (months) ( × 12 months) 2.5 months ( × 12 months) 2 months
$14 ,400 $18 ,000
$4 ,500 $5,000
(vii) Trade debtors collection ( × 12 months) 3 months ( × 12 months) 2 months
$18 ,000 $30 ,000
period (months)

$3,000 $3,750
(viii) Trade creditors payment ( × 12 months) 2.5 months ( × 12 months) 2.5 months
$14 ,400 $18 ,000
period (months)

(b) The financial position and results of the company for 20X8 were not as good as those for 20X7.

Firstly, the return on capital employed, gross profit ratio and net profit ratio of 20X8 were all lower than those for
20X7. It appears that selling prices were reduced substantially in 20X8.

Secondly, the stock turnover and trade debtors collection period were all worse than those for 20X7, indicating
that it took the company longer time to sell its stock and to collect money from trade debtors.

Lastly, the current ratio and quick assets ratio decreased, indicating that the company’s ability to meet its current
liabilities has weakened, although these ratios are still acceptable.

114