Financial Accounting · Lesson 14

Ratios: liquidity, profitability and efficiency

JAMBWAECNECO

What the syllabus asks

JAMB: Topic 16 interpretation of accounts using simple ratios (current ratio, acid test, stock turnover, gross and net profit margins, return on capital employed)

WAEC: Interpretation of financial statements using simple ratios; stock valuation incl. weighted average (see fa6)

NECO: Interpretation of financial statements using simple ratios; stock valuation incl. weighted average (see fa6)

What you will learn

Explain the purpose and users of ratio analysis.
Calculate profitability ratios: gross and net margin, mark-up, ROCE.
Calculate liquidity ratios: current and acid test, working capital.
Calculate efficiency ratios: inventory turnover, collection and payment periods.
Calculate gearing and interest cover.
Interpret ratios, compare years and state limitations.

Key points

Ratios relate figures so performance can be compared over time and between firms.
Gross margin = GP ÷ sales; mark-up = GP ÷ cost of sales.
Net margin = NP ÷ sales.
ROCE = profit before interest ÷ capital employed.
Current ratio = CA ÷ CL; acid test = (CA − inventory) ÷ CL.
Inventory turnover = cost of sales ÷ average inventory.
Collection period = receivables ÷ credit sales × 365; payment period = payables ÷ credit purchases × 365.
Gearing = long-term debt ÷ capital employed; interest cover = PBIT ÷ interest.
Interpret: state change, reason and action.
Limitations: historical, policy differences, inflation, window dressing, non-financial factors.

Start here: Why we interpret financial statements

Final accounts tell us that a business made ₦1 200 000 profit. Is that good? For a roadside kiosk it would be excellent; for a supermarket with ₦8 000 000 of capital it might be poor. To judge performance we must relate figures to each other: profit to sales, profit to capital invested, current assets to current liabilities. These relationships are accounting ratios.

Users and what they look for

Owners and shareholders: profitability and return on their investment; whether to invest more.
Managers: efficiency, cost control, inventory and credit management.
Banks and lenders: liquidity (can the business pay interest and repay?) and gearing.
Suppliers: liquidity and payment period: will they be paid on time?
Employees and unions: profitability and stability for wage negotiations and job security.
Government and tax authorities: profits for tax, performance of sectors.
Prospective buyers or investors: overall value and trends.

Bases of comparison

Trend (time-series): this year vs previous years.
Inter-firm: this business vs a similar competitor.
Industry average: published norms for the sector.
Budget or target: actual vs planned.

A ratio on its own is like a temperature reading without knowing what is normal: it needs a benchmark.

Ratios in everyday Nigerian business

A bank officer reviewing a loan request from a pharmacy in Benin City will ask for two or three years of accounts and calculate a handful of ratios in minutes: can the business pay its current debts, how quickly does it sell its drugs, how much profit does it earn on sales and on capital, and how much does it already owe? A trader seeking supplier credit from a large manufacturer faces the same questions. Learning ratios therefore helps you not only in the exam but in any future business or career.

In short, ratios turn raw figures into meaningful information.

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Practice questions

1. Current assets ₦900 000; current liabilities ₦500 000. Current ratio:

1.8 : 1
0.56 : 1
1.2 : 1
2 : 1

Show answer

A: 1.8 : 1
₦900 000 ÷ ₦500 000 = 1.8.

2. Using the same figures with inventory ₦300 000, the acid test ratio is:

1.8 : 1
0.6 : 1
1 : 1
1.2 : 1

Show answer

D: 1.2 : 1
(₦900 000 − ₦300 000) ÷ ₦500 000 = 1.2.

3. Sales ₦4 000 000; cost of sales ₦3 000 000. Gross profit margin:

75%
20%
25%
33.3%

Show answer

C: 25%
(₦4 000 000 − ₦3 000 000) ÷ ₦4 000 000 = 25%.

4. With the same figures, the mark-up is:

50%
33.3%
25%
75%

Show answer

B: 33.3%
₦1 000 000 ÷ ₦3 000 000 = 33.3%.

5. Operating profit ₦600 000; capital employed ₦3 000 000. ROCE:

Show answer

A: 20%
₦600 000 ÷ ₦3 000 000 × 100 = 20%.

Key words

Ratio analysis: Calculating and interpreting relationships between items in financial statements.
Gross profit margin: Gross profit as a percentage of sales.
Net profit margin: Net profit as a percentage of sales.
Capital employed: Equity plus long-term liabilities (or total assets − current liabilities).
ROCE: Profit before interest and tax as a percentage of capital employed.
Liquidity: Ability to meet short-term obligations as they fall due.
Current ratio: Current assets divided by current liabilities.
Acid test (quick) ratio: Current assets minus inventory, divided by current liabilities.
Working capital: Current assets minus current liabilities.
Inventory turnover: Number of times average inventory is sold in a period.
Average inventory: (Opening inventory + closing inventory) ÷ 2.
Collection period: Average days taken by customers to pay.

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