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Financial ratios are calculated to analyse the performance of a business using figures in the financial statements. When learning the principles of accounting, you should be aware of the figures presented in the Income Statement and Balance Sheet.
You can use the results of financial ratios to make internal and external comparisons of a business. If a question presents figures for several years or other similar businesses, you can compare the performance of one year against another or one business against other similar businesses.
By comparing results of financial ratios, the strengths and weaknesses in specific areas of the business are revealed. Students can then make comments on the performance.
This article looks at 4 financial ratios that can be calculated using the Income Statement and 3 financial ratios using the Balance Sheet. A short explanation is provided for the financial ratios to assist students in answering questions that ask you to comment on the performance.
4 Financial ratios for the Income Statement
The Income Statement ratios reveal the profitability of the business. This financial statement contains all income and expenses figures.
Here are 4 financial ratios using these figures.
Gross profit percentage
The gross profit percentage formula calculates how much gross profit is made for every $1 earned.
Looking at the top part of the Income Statement, we can see how increasing the figure for sales can improve the result of the gross profit percentage ratio.
When commenting on the figure, you should be able to apply this to the real world of business. By increasing selling price, this looks good on paper but the downside is customers may find the price is too high. You can make suggestions to reduce other expenses.
Mark-up
The mark-up formula calculates how much gross profit is made for every $1 spent.
Looking at the top part of the Income Statement, we can see how reducing the figure for cost of sales can improve the result of the mark-up ratio.
When commenting on the figure, you should be able to apply this to the real world of business. By reducing cost of sales, this looks good on paper but the downside is customers may find the quality of goods is too poor. You can make suggestions to reduce other expenses.
Rate of inventory turnover
The rate of inventory turnover formula calculates how many times the business sells its stock and replaces it during the year.
A high rate of inventory turnover can mean that sales are good while a low one can represent poor sales of inventory. However, high sales of a particular inventory can also mean less variety of products are offered to customers.
Look at the Income Statement provided in the question given to you and make suggestions based on those figures. You can suggest that the business advertise to improve sales, cut storage space costs by purchasing less of a particular inventory, or find a cheaper place to rent.
Net profit percentage
The net profit percentage formula calculates how much profit is made for every $1 earned after all expenses.
An increase in net profit percentage means that either the sales figure is good or expenses are low. A decrease can mean either the sales figure is low or expenses are high.
You can suggest ways to improve gross profit or reduce expenses. Just remember that in the real world of business, reducing expenses can mean having poorly paid workers or bad working conditions by not repairing damaged equipment and furniture. This can result in poor performance by staff.
3 Financial ratios for the Balance Sheet
The Balance Sheet ratios reveal the financial position of the business. This financial statement contains all assets, liabilities and capital figures.
Here are 3 financial ratios using these figures.
Current ratio
The current ratio sees how much funds are available to meet the debts of the business. The results are determined based on the type of business.
If the current ratio is good, then the business has the right amount of net current assets over working capital. If it is lower than usual, then the business is struggling to pay everyday operating expenses.
You can make a few suggestions for the business. It can introduce more capital, borrow long term funds, decrease drawings, make more profits, hold up on capital expenditure, or sell off unused fixed assets.
Acid test ratio
The acid test ratio shows the liquidity of the business. This means it shows how much cash is readily available to cover the debts of the business quickly.
According to the type of business, a good acid test ratio indicates that the business can meet its commitments in the short term. A low ratio means that the business would be unable to meet its debts immediately.
You can make a few suggestions. Avoid buying inventory that may not sell quickly, invest more capital, borrow funds, decrease drawings, increase sales, lower expenses, put off capital expenditure or sell off unused fixed assets.
Return on investment
The return on investment ratio measures how much profit the owner makes on capital. This could be calculated on closing capital or an average of opening and closing capital.
An increasing ratio indicates that the business is using the resources effectively. A decreasing ratio shows that the business is not using the resources effectively.
You can make a few suggestions to improve the ratio. The business can improve profits by increasing sales or reducing expenses. Also, it can invest less capital.
Conclusion
These 7 financial ratios will help you greatly to analyse the performance of a business when doing basic accounting. Learn formulas for ratios for the Income Statement and Balance Sheet to be competent in doing your analyses. Use our suggestions to make comments and try some of your own.
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See also:
Accounting Cycle: Complete basic accounting in 8 steps
Capital: Invested assets and the liquidity of a business
Income Statement: 6 key points for reporting profitability
Balance Sheet: 10 key parts of the statement of financial position
Trial Balance: 6 important things to know
Journals: Complete 7 Day Books with 4 types of transactions
Ledger accounts: Simple breakdown of Types, Format, Double Entry, Balance
Assets: Owned fixed and liquid items with a debit balance
Liabilities: Owed long and short term items with a credit balance
Expenses: Spending that’s direct, indirect, operating and non-operating
Cash Book: How to record cash, bank and discounts
Debit and Credit: Simple view of in and out
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