Categories of Accounting Ratios

Categories of Accounting Ratios

Accounting ratios are normally classified according to the aspects of business they are designed to highlight. These aspects fall under the following categories:

a)      Financial soundness and stability, short term and long term. During the short term the interest is liquidity and during the long term it is solvency.

These ratios measure the ability of the firm to meet its maturing obligations as they fall due, both immediately and in the long run.

 

Current Ratio

This gives an indication of the ability of a firm to meet its current liabilities. It assumes that current assets will be converted into cash to meet current liabilities. It is calculated as:

	Current Ratio	=	Current Assets
			Current Liabilities

Acid Test Ratio

Current ratio assumed that current assets could be converted into cash immediately. However, not all current assets can be readily converted into cash. The acid test ratio recognizes this limitation and excludes stocks, for example, in its computation. It is calculated as:

	Acid Test Ratio	=	Current Assets - Stocks
			Current Liabilities

Other current assets like prepayments are also not readily available for meeting maturing obligations. Therefore, in computing this ratio such items have to be considered if material.

Debt Service Coverage Ratio

This is also known as interest coverage ratio. It measures the ability of a firm to service from operations interest payments that are due to loan financiers. Inability to pay interest on loans may force financiers to put a firm under receivership and finally liquidation.

This ratio is computed as follows:

	Debt Service Coverage Ratio	=	Profits before Interest and Taxes
			Annual Interest Payments

Debt Repayment Coverage

Borrowed money should eventually be used to generate profits. Repayment of borrowing then will be made out of profits after interest charges and income tax. Debt repayment coverage ratio gives an indication of the length of time it will take to repay borrowings out of profits of the business.

It is calculated as:

	Debt Repayment Coverage	=	Long-term + Current Liabilities – Current Assets
			Profit after Interest and Tax

b)     Profitability and return on equity or assets

Profitability and Returns

Ratios associated with this aspect measure the ability of a firm to generate profits, that is, revenues in excess of expenses. That ability can be measured according to volume of sales or resources employed in generation of the profits. These ratios therefore measure the rate of profitability per a shilling value of sales or an asset value. For profitability ratios, profit is taken to be Net Profit before interest and taxes (PBIT).This is because performance resulting from operating decisions needs to be separated from that which is influenced by financing decisions. By using PBIT, distortions arising out of differences in capital structures and application of taxation rules in computation of income tax for different companies are avoided.

Ratios falling under this category are:

Gross Margin Ratio

Commonly known as the gross profit ratio and computed as follows:

	Gross Margin	=	Gross Profit	×	100
			Sales

Unless there is a change in the relationship between Sales and Cost of Sales the Gross Margin Ratio should show little change from one year to the next.

Net Profit Ratio

It shows net profit before interest and taxes as a percentage of sales. It gives some indication on structure and changes in operating expenses. It is calculated as:

	Net Profit Ratio	=	Profit before Interest and Taxes	×	100
			Sales

Return on Capital Employed (ROCE)

This ratio measures profit per value of net assets. The net assets figure is arrived at by assuming the value of fixed assets and current assets and deducting current liabilities. Alternatively, Capital Employed is Total Assets minus Current liabilities.

ROCE is given by:

	ROCE	=	Profit before Interest and Taxes	×	100
			Capital Employed

Return on Total Assets

This ratio measures the ability of a firm in utilizing its total assets in generating profits.

It is given by:

	Return on Total Assets	=	Profit before Interest and Taxes	×	100
			Total Assets

Where there is a significant change in total assets during a year, it is advisable to use an average total assets figure in the above formula.

 

c)      Activity or efficiency measures

Activity or Efficiency Ratios

Various aspects of the efficiency with which assets are utilized can be gauged from turnover ratios.

The most important ones are:

a)      Inventory turnover

b)     Collection period for Accounts Receivable

c)      Collection period for Accounts Payable.

d)     Total assets turnover.

Inventory Turnover

This measures the rate at which a business translates stocks into sales. If the rate is too slow or decreasing this may indicate overstocking or presence of obsolete merchandise. If this rate is too high it may indicate under stocking and other problems. Depending on the nature of the business and industry, a certain range of rates is acceptable.

This ratio is calculated by:

	Inventory Turnover	=	Cost of Goods Sold
			Average Stock

Where the figure of cost of goods sold is not available it can be substituted by a sales figure. This should not make a significant interpretative problem as long as the formula is consistently adhered to. It is also possible to use Closing Stock instead of Average Stock. This is especially the case when stock levels remain more or less unchanged.

Accounts Receivable' Average Collection Period

Good credit control is an important aspect of sound financial management. The average length of time Accounts Receivable take to pay the firm is an important indicator of management efficiency.

The period is calculated as follows:

	Accounts Receivable Average Collection Period	=	Accounts Receivable
			Credit Sales ÷ 365

Alternatively this ratio can be computed as follows:

	Accounts Receivable Average Collection Period	=	Accounts Receivable	×	365
			Credit Sales

Accounts Payable' Average Payment Period

To put the Accounts Receivable' average collection period in perspective, credit period granted to customers should not be out of line with the credit period granted by suppliers. Good financial management should ensure a proper balance. Accounts Payable' average payment period is calculated as follows:

	Accounts Payable Average Payment Period	=	Accounts Payable
			Credit Purchases ÷ 365

Alternatively this ratio can be computed as follows:

	Accounts Payable Average Payment Period	=	Accounts Payable	×	365
			Credit Purchases

Total Assets Turnover

This indicates the ability of assets to generate revenues. How much does a shilling of asset generate in terms of sales value?

Total assets turnover is given by:

	Total Assets Turnover	=	Sales
			Total Assets

 

d)     Capital structure or gearing measures.

Capital Structure and Gearing Ratios

The proportion of debt capital to total capital is an important variable to both equity holders and financiers. It reflects riskiness of the business. Excessive debt has an inherent bankruptcy risk.

Gearing ratio defines the proportion of debt capital to ordinary share/equity capital. There are two approaches to calculate gearing ratio. One is the proportion of debt capital to total capital and the other is given by the proportion of debt capital to ordinary share capital.

Note that debt capital plus ordinary share capital gives total capital.

	Debt-Equity Ratio	=	Debt Capital
			Equity Capital

Debt Capital can also be expressed as a proportion of Total Capital and in this case the formula for computing the ratio changes slightly to the following:

	Debt-Equity Ratio	=	Debt Capital
			Debt Capital + Equity Capital

 

       e) Market - based ratios

Market-based Ratios

These are additional ratios that can be computed when data from stock exchange are incorporated. The most common are:

       i.          Dividend Yield

     ii.          Dividend Cover

    iii.          Earnings per Share and

    iv.          Price/Earnings Ratio.

Dividend Yield

This is given by:

	Dividend Yield	=	Dividend per Share
			Share Market Price

It measures the return on the share invested using current market price of the share. If that return is significantly lower than in alternative investment opportunities, shareholders may sell those shares.

Dividend Cover

This ratio indicates the ability of a firm to sustain dividend payments out of its annual distributable profits. It is calculated as follows:

	Dividend Cover	=	Net Profit after Interest and Taxes
			Annual Dividends Payable

Earnings per Share (EPS)

This is the most commonly known and used ratio for valuing shares. It shows the amount of profits made during the year and available to each share whether distributed as dividend or retained for reinvestment in the business. It is calculated as follows:

	Earnings per Share	=	Net Profit after Interest and Taxes
			Number of Ordinary Shares Issued

Price-Earnings Ratio (P/E Ratio)

This ratio is also widely used in financial press. It is usually used in establishing the market value of a company.

It is calculated as:

	Price-Earnings Ratio	=	Share Market Price
			Earnings per Share