Carry out basic ratio analysis
Contents
Key to resources 2
Introduction 3
Calculating ratios 3
Feedback to activities 8
This learning guide is based on the following resource:Textbook
Duncan A (2006) Introductory Accounting, National core Accounting Publications, Bondi
Note
A new edition of this textbook was being published at the same time as this resource.
Where possible, we have provided a second Key to resources to this new edition.
Key to resources
Resource / Textbook (2006 edition)1 / Chapter 20 ‘Basic management reports and analysis’, Overview
2 / Chapter 20, Profitability ratios, pp 595–596
3 / Chapter 20, self-testing exercise 1
4 / Chapter 20, Liquidity ratios, pp 597–599
5 / Chapter 20, self testing exercises 2 and 3 (omit the liquid ratio calculation)
6 / Chapter 20, Leverage ratios, p 601
7 / Chapter 20:
· self testing exercise 2—Calculate the debt to equity ratio
· self testing exercise 3—Calculate the debt to equity ratio.
8 / Chapter 20, section 20.2 Application of ratios to financial statements, pp602–603
9 / Chapter 20, examples for Bowman Trading (pp 603–607) and Hattrick Productions (pp 608–611)
10 / Chapter 20, chapter review questions—Calculate the required ratios (omit the liquidity ratio) in Question 5 (Beta Trading)
Resource / Textbook (2007 edition)
1 / Chapter 18 ‘Basic management reports and analysis’, Overview
2 / Chapter 18, Profitability ratios
3 / Chapter 18, self-testing exercise 1
4 / Chapter 18, Liquidity ratios
5 / Chapter 18, self testing exercises 2 and 3 (omit the liquid ratio calculation)
6 / Chapter 18, Leverage ratios
7 / Chapter 18:
· self testing exercise 2—Calculate the debt to equity ratio
· self testing exercise 3—Calculate the debt to equity ratio.
8 / Chapter 18, section 18.2 Application of ratios to financial statements
9 / Chapter 18, examples for Bowman Trading and Hattrick Productions
10 / Chapter 18, chapter review questions—Calculate the required ratios (omit the liquidity ratio) in Question 5 (Beta Trading)
Introduction
There are four ratios required for study. They are:
· gross profit ratio
· net profit ratio
· working capital ratio also known as the current ratio
· debt to equity ratio.
In addition to calculating the ratio there is a requirement to briefly analyse financial statements using the above ratios. This analysis may use calculations based on actual figures compared to calculations based on one of the following:
· a budget
· previous year’s figures
· industry averages.
Calculating ratios
/ Now go to Resource 1Note the discussion in section 20.1.
Some ratios are actually rates. However the word ‘ratio’ is in common usage as an overall description. Check carefully the summary of ratios showing how each ratio is calculated.
The gross profit, net profit and debt to equity ratios are usually expressed as a %. The current ratio is expressed to 1. The liquid ratio is currently not required for study.
Note that with the debt to equity ratio, the textbook advises the calculation below:
eqn01
This is acceptable. However, an alternate calculation sometimes used is:
eqn02
Use total debt unless advised to the contrary.
/ Now go to Resource 2Check the information under the heading profitability ratios. Under this heading the gross profit and net profit ratios are calculated. Note the discussion about the variances that can occur in ratios depending upon the type of business. Note the difference between the gross profit ratio and the net profit ratio is represented by the operating expenses of the business.
/ Now go to Resource 3/ Now go to Resource 4
Note that the current ratio falls under this heading.
The generally accepted minimum current ratio is 2:1. That is for every dollar of current liabilities there is $2 of current assets.
Check the example for the current ratio as well as the second example for Yardley Engineering. Remember the calculation for the liquid ratio is not required for study.
/ Now go to Resource 5/ Now go to Resource 6
Read the discussion under the heading leverage ratios. Note that the debt to equity ratio falls under this heading.
/ Now go to Resource 7
(Note: The answer is at the end of this document.)
/ Now go to Resource 8
Note in the discussion under the heading Application of ratios to financial statements that possible reasons for a declining gross profit ratio are given.
Other reasons for a declining gross profit ratio would include the loss (theft) of inventory or cash. Changes in the sales product mix may also affect this ratio.
Any decline in the gross profit ratio will also affect the net profit ratio. If the gross profit ratio is satisfactory and the net profit ratio has decreased then the decline can only be attributed to an increase in operating expenses.
Reasons for a decrease in the current ratio are given under this heading together with some possible remedies to improve poor results in the profitability and liquidity ratios.
An unsatisfactory debt to equity ratio would be rapidly improved by an injection of cash as additional capital. This procedure would also improve an unsatisfactory current ratio.
/ Now go to Resource 9Note that the example for Bowman Trading requires you to calculate all ratios for study as well as to give comments on profitability and liquidity. The example for Hattrick Productions can also be used to check calculations and comments. Note with this example that the variance and percentage of variance between actual and budget has been calculated. This is NOT a requirement for study.
In order to assist analysis the following comparison table for Bowman Trading is shown:
Gross profit / 54.81% / 59.51% / 52% / 55%
Net profit / 9.61% / 12.74% / 14% / 10%
Current / 1.94:1 / 2.35:1 / 2.25:1 / 2.1:1
Debt to equity / 72.93% / 57% / 65% / 60%
/ Now go to Resource 10
Note: The answer is at the end of this material.
/ Activity 1
The following information has been extracted from the OTEN Fan Works for the years ended 30th June 20x6 and 30th June 20x7.
Comparative balance sheets
20x6 / 20x7 / 20x6 / 20x7$ / $ / $ / $
Inventory / 24000 / 39000 / Capital / 161000 / 207800
Land & buildings / 110000 / 130000 / Loan from Finance Co. / 75000 / 65000
Plant & machinery / 37000 / 74800 / Accts payable / 24000 / 39000
Accts. receivable / 51000 / 83000 / Bank / 15000
Cash at bank / 38000
260000 / 326800 / 260000 / 326800
Additional information
$ / $
Sales / 400000 / 520000
Gross profit / 168000 / 166400
Net profit / 44000 / 46800
The loan from the finance company is repayable on 31 March 20x8.
Required
(a) Calculate for 20x6 and 20x7
· gross profit ratio
· net profit ratio
· current ratio
· debt to equity ratio.
(b) Under the headings of profitability and liquidity comment briefly on the position at June 20x7 compared to the position at June 20x6. Your comments should state whether the situation is better or worse and possible reason/s for the change. Include one suggestion for improvement.
Feedback to activities
Feedback to Resource 7(self-testing exercise 2 in textbook)
eqn03
Feedback to Resource 7(self-testing exercise 3 in textbook)
eqn04
Feedback to Resource 10(question 5 in end-of-chapter review questions in textbook)
eqn05
Workings:
Sales / 112000Less: Cost of goods sold / 76000
Gross profit / 36000
Less: Operating expenses / 16000
Net profit / 20000
Feedback to Activity 1
(a)
20x6 / 20x7Gross profit ratio / eqn06 / eqn07
Net profit ratio / eqn08 / eqn09
Current ratio / eqn10 / eqn11
Debt to equity ratio / eqn12 / eqn13
(b) Profitability
Both the gross profit ratio and net profit ratio have deteriorated. The decrease in the gross profit ratio could be due to:
· Increase in the cost price of products with no increase in the selling price
· A decrease in the selling price of products with no decrease in the cost price. Perhaps due to sales at ‘mark-down prices’.
· Inventory or cash misplaced
· The decrease in the net profit ratio is due to the decrease in the gross profit ratio. However the decrease would have been greater had operating expenses not been contained. In 20x6 operating expenses were 31% of sales:
eqn14
In 20x7 operating expenses were 23% of sales:
eqn15
Assuming there has been no change in the cost and selling prices of the product the security of inventory and cash should be investigated.
Liquidity:
The current ratio has deteriorated. The major reason is the change from non-current liability status to current liability status of the loan from the finance company. In addition the cash at bank appears to have been used to finance the purchase of non-current assets. An introduction of cash as additional capital would improve the situation.
Carry out basic ratio analysis XXX
© NSW DET 2006 2006/053/12/2006 LRR 3881