Question

An ACCOUNTING RATIO is a number that shows the relationship between two elements on a firm’s financial statements. Like the individual elements on the financial statements, these ratios can be compared with those of competitors, with industry averages, and with the firm’s ratios from previous accounting periods. Since there are many accounts shown on the business’s financial statements, there can be many ratios. The four most popular types of ACCOUNTING RATIOS are LIQUIDITY RATIOS, PROFITABILITY RATIOS, ACTIVITY RATIOS and LEVERAGE RATIOS. Depending upon your perspective, you would work a certain ratio in order to help you make an important decision or to answer an important question, i.e., as the business owner, is your money “in the right place,” should you extend credit to this business, are there areas in the business that deserve your managerial attention, etc. Nothing can eliminate risk in today’s business environment - but working and interpreting ratios can help reduce risk. Based upon the financial statements for Harvest Gold on pages 441 and 444, the six most common ACCOUNTING RATIOS are below. (BS) means that the account totals are found on the Balance Sheet and (IS) means that the account totals are found on the Income Statement. LIQUIDITY RATIOS Liquidity ratios are used by current and future suppliers when a firm requests credit. They give insight into a company’s ability to meet their short-term debt obligations. CURRENT RATIO Current Assets (BS) 600,000 $2.08 to $1.00 Current Liabilities (BS) 288,000 Interpretation: For each dollar of current debt, this firm has $2.08 of current assets with which to pay it The average current ratio for all businesses is 2.0, but it varies greatly from industry to industry. A high current ratio indicates that a firm can pay its current liabilities. A low current ratio can be improved by repaying current liabilities, by reducing dividend payments to stockholders to increase the firm’s cash balance, or by obtaining additional cash from investors. QUICK RATIO or ACID-TEST RATIO Liquid Current Assets (BS) 15,000 + 200,000 + 50,000 265,000 $ .92 to $1.00 Current Liabilities (BS) 288,000 288,000 Interpretation: For each dollar of current debt, this firm has $ .92 of liquid current assets with which to pay it. The Quick Ratio takes a closer look at the company’s Current Assets than the Current Ratio. It considers only the most liquid Current Assets. The term “liquid” deals with the conversion of the asset to cash. An “Inventory Liquidation Sale” is an attempt to sell the merchandise inventory in order to generate cash. Current Assets are listed on the Balance Sheet in the order of liquidity. Since cash is the most liquid asset, it will always be listed first. PROFITABILITY RATIOS Profitability ratios are used by managers, owners and prospective owners to see if the business is profitable and will be a good investment. RETURN ON SALES Net Income (IS) 49,000 .07 to $1.00 Net Sales (IS) 700,000 Interpretation: For each $1.00 of net sales the company made .07 profit A higher return on sales is better than a low one. Today, the average return on sales for all business firms is between 4 and 5 percent. A low return on sales can be increased by reducing expenses, by increasing sales, or both. RETURN ON EQUITY Net Income (IS) 49,000 .23 to $1.00 Owner’s Equity (BS) 213,000 Interpretation: For each $1.00 of owner’s equity, the company made .23 profit. The business owners have many choices as to where to put their money. If they had put their money into a savings account at their local bank it would have returned less than .01 on each dollar. As always, risk has to be considered. There is no risk associated with most bank accounts as they are insured by the FDIC. Even though the owners received .23 return on their investment during this accounting period there is no guarantee that they will receive anything on their investment next year. ACTIVITY RATIOS Activity ratios focus on a specific action in the business, such as the speed with which it sells and restocks its inventory and the speed with which it collects its accounts receivables. INVENTORY TURN-OVER RATIO Cost of Goods Sold (IS) 410,000 410,000 1.9 times/year Average Inventory (IS) (200,000 + 230,000) / 2 215,000 Interpretation: The firm completely sells the value of their inventory 1.9 times per year, or every 192 days. The average inventory turnover for all firms is about nine times a year, but turnover rates vary widely from industry to industry. The quickest way to improve inventory turnover is to order merchandise in smaller quantities at more frequent intervals. LEVERAGE RATIOS Leverage ratios focus on a firm’s total debt. They are used by providers of long-term debt, such as mortgage brokers. They give insight into the firm’s ability to meet all of its obligations. DEBT TO EQUITY RATIO Total Liabilities (BS) 613,000 2.88 to $1.00 Owners Equity (BS) 213,000 Interpretation: For each $1.00 invested by the owners of the firm, the firm has borrowed, and owes, 2.88. This ratio compares the claims against the assets by “outsiders,” in the form of liabilities, and the owners, or the “insiders.” The lower the Debt-to- Equity ratio, the better. A Debt-to-Equity ratio greater than $1.00 like this one would mean that the business is owned more by the creditors than the owners themselves.

From the FINANCIAL STATEMENTS completed above, set up, work and interpret the following ACCOUNTING RATIOS:

                                    A.         Return on Investment Ratio

                                    B.         Return on Sales Ratio

                                    C.         Debt to Equity Ratio

                                    D.         Current Ratio

                                    E.         Acid Test Ratio / Quick Ratio

                                    F.         Inventory Turnover Ratio

Answer 1

Return on investment = Net Profit sfter tax/ Owners's equity

=$49000/$213000

=0.23 or 23%

Interpretation: For each $ 1 invested in business the company is earning $0.23. Interest onsaving banks is only 1% as given in question. A very high percentage as 23% is a very good sign for the business.

Return on sales ratio = Net profit after tax/ Net sales

=$49000/$700000

=0.07 or 7%

Interpretation: For each $ 1 of merchandise sold by the company, company is earning $0.07. Industry rate is 4 to 5%. The company is earning 7 % is a good sign. It implies the company's profitability is good.

Debt To Equity Ratio = Total Liabilities/ Owners' Equity

=$613000/$213000

=2.88:1

Interpretation: For each $ 1 of investment by the owners, the debt taken by the company is $2.88, A ratio higher than 1:1 indicates that the business is owned more by the creditors than the owners.

It implies that the company's long term liquidity position is not very sound.

Current Ratio = Current Assets/ Current Liabilities

=$600000/$288000

=2.08

Interpretation: For each dollar of current debt, this firm has $2.08 of current assets.  A high current ratio indicates that a firm can pay its current liabilities. It implies that the company's short term liquidity position is satisfactory.

Quick Ratio = Quick Assets/ Current Liabilities

=$265000/$288000

=0.92

Interpretation: For each dollar of current debt, this firm has $0.92 of current assets. Quick assets are generally the current assets other than inventories and prepaid expenses. The industry norm is not given. But a quick ratio of 1:1 is desired. The ratio of the company is slightly lower than desired. So. the current liquidity position may be slightly troublesome.

Inventory turnover ratio = Cost of goods sold / Average inventory

=$410000/$215000

=1.90 times

Interpretation : The firm completely sells the value of their inventory 1.9 times per year, or every 192 days. The ratio is very low as compared to other businesses as they generally have inventory of nine times a year. It indicates that the activity of the firm is very low.