Chapter 8 BASIC RATIO ANALYSIS Functions of accounting

Chapter 8 BASIC RATIO ANALYSIS

Functions of accounting ratios evaluate the Accounting ratios are usually used to _____ financial performance and position of a business. comparison between They are also useful in making ______ periods or different ______. firms different ____ Accounting ratios can state relationships meaningful _______ between different figures in financial statements.

Functions of accounting ratios Accounting ratios can be used to evaluate many different aspects of a business, in profitability liquidity and ______. particular ____ Liquidity ratios Profitability ratios Measure the ability to pay short-term liabilities when due _________ Measure the ability profits to make _______ 1. Current ratio 2. Quick ratio 1. Gross profit ratio 2. Net profit ratio 3. Return on capital employed

Comparison of financial results of different businesses Exhibit 8. 7 • When comparing the current ratios, it appears that both firms have sufficient / insufficient liquidity. • Edward Co’s quick ratio appears to be sufficient but Frankie Co’s low quick ratio of 0. 83 : 1 indicates that it short-term obligations may have difficulty meeting its __________. Edward Co Frankie Co Current ratio $60, 000 : 1 = 3: 1 $20, 000 $60, 000 : 1 = 2: 1 $30, 000 Quick ratio $40, 000 : 1 = 2: 1 $20, 000 $25, 000 : 1 = 0. 83 : 1 $30, 000

Comparison of financial results of • Edward Co has a higher / lower gross profit ratio but a different businesses higher / lower net profit ratio compared with Frankie Co, due Exhibit expenses to sales. to a much higher proportion of _____ 8. 7 • Overall, Frankie Co is more / less profitable than Edward Co. • However, Edward Co has a higher / lower return on capital employed. This means Edward Co has made better use of capital than Frankie Co. The owner’s investment in its ____ Edward Co is more / less profitable. Edward Co Frankie Co $40, 000 $30, 000 Gross profit × 100% = 40% × 100% = 37. 5% ratio $100, 000 $80, 000 $14, 000 $12, 000 × 100% = 14% × 100% = 15% Net profit ratio $100, 000 $80, 000 $14, 000 $12, 000 Return on × 100% ($80, 000 + $90, 000) ÷ 2 ($90, 000 + $100, 000) ÷ 2 capital employed = 16. 47% = 12. 63%

Importance of maintaining adequate profitability and liquidity trade creditors on time, they 1. If a firm cannot pay its _______ may reduce or even stop supplying goods to the firm. 2. A firm’s profitability is closely linked to its liquidity earnings are ultimately reflected in _____ cash because _____ flows ______. p p If a firm’s profitability remains low, its liquidity will eventually be adversely affected. A firm that is highly profitable does not necessarily mean it has high liquidity. For example, the firm may have a lot of funds tied inventories and _________, non-current assets up in ______ which will adversely affect its liquidity.