M01-Ratio Analysis Overview eng -060409 - Education … · PPT#9 – 10 Student Worksheet pp. 1 - 9 15 minutes. Topic M01: Ratio Analysis for Business Topic Overview P.3 BAFS Learning

Topic M01: Ratio Analysis for Business Topic Overview P.1

BAFS Learning and Teaching Example As at April 2009

Learning Objectives: 1. To understand the basic concept of accounting ratios and their formula; 2. To calculate accounting ratios from financial statements; 3. To assess business performance with a range of accounting ratios; and 4. To apply their accounting ratio knowledge in real life situations. Overview of Contents: Lesson 1 Basic Concept, Classification and Calculation of Accounting Ratios Lesson 2 Assessing Business Performance with Accounting Ratios Resources:

Topic Overview and Teaching Plan PowerPoint Presentation Student Worksheet

Suggested Activities:

Group Discussion Problem Solving

Topic Overview Topic BAFS Elective Part – Business Management Module – Financial

Management M01: Financial Analysis – Ratio Analysis for Business

Level S5 / S6 Duration 2 lessons (40 minutes per lesson)



Lesson 1

Theme Basic Concept, Classification and Calculation of Accounting Ratios Duration 40 minutes Expected Learning Outcomes: Upon completion of this lesson, students will be able to: 1. Understand the basic concept of accounting ratios and their formula; 2. Classify accounting ratios into three major categories; and 3. Calculate accounting ratios from financial statements. Teaching Sequence and Time Allocation:

Activities Reference Time

AllocationPart I: Introduction

Elaborate on the concept of accounting ratios; the definition and uses of 12 accounting ratios will be discussed.

The two lessons are connected by team games which generate scores and will be accumulated throughout the 2 lessons to determine the final winner.

PPT#1 – 8 5 minutes

Part II: Content

Activity 1 – Accounting ratio formula Divide students into teams of 4 - 5 students. Ask

them to form ratios by combining the paper stripes cut out from Student Worksheet pp.1-8, and then paste them on a large piece of paper (A1 or A0) under the appropriate category of ratio.

Record the time used by teams in completing the task and paste students’ completed work on the whiteboard.

Verify answers with students. The team producing the most correct answers wins the game. The champion gets 3 scores, first runner-up 2 scores and second runner-up 1 score. If two teams tie,

PPT#9 – 10 Student

Worksheet pp. 1 - 9

15 minutes



the fastest team wins. Activity 2 – Finding ratios from financial statements

Teams are given the financial statements of two companies. They must calculate the required accounting ratios with the data given in the statements.

Upon completion, teams exchange worksheets to check results. Teacher verifies each answer with teams. Each correct answer generates one score.

For more capable students an extended activity is available. They are asked to comment on the financial performance of the two companies in Activity 2.

PPT#11 – 13

Student Worksheet pp. 10 – 14

PPT#14

15 minutes

Part III: Conclusion Announce the accumulated scores for each team and the

winning team. Conclude the lesson by recapping the use, classification

and calculation of accounting ratios.

PPT#15 5 minutes



Lesson 2

Theme Assessing Business Performance with Accounting Ratios Duration 40 minutes Expected Learning Outcomes: Upon completion of this lesson, students will be able to: 1. Compare the performances of different companies based on ratio analysis; and 2. Apply the knowledge on accounting ratios in daily life. Teaching Sequence and Time Allocation:

Activities Reference Time

AllocationPart I: Introduction

Revision on different uses of accounting ratios in comparing performance of different companies.

PPT#16 – 20 5 minutes

Part II: Content

Activity 3 – Which company performed better? Teams are provided with the accounting ratios of

two Companies 1 and 2. Students have to determine which company performed better and give reasons.

Ask each group to share their views with the class before teacher offers the correct answers. Each pair of correct answers earns one score.


Worksheet p. 15

15 minutes

Activity 4 – Which company are they talking about? Each team is provided with 3 sets of statements

(X, Y and Z) and a dialogue between two suppliers. Based on the dialogue, teams are required to match the statements with the 3 companies (A, B and C) mentioned in the dialogue.

After 10 minutes, record the answers of each team and invite students to explain their answers.

Verify team answers and give 3 scores for all correct matches, 2 scores with 2 correct matches,


Worksheet pp. 16 - 21

15 minutes



and so on. Record team scores and calculate the accumulated

score of each team.

Part III: Conclusion

Announce the final score and appraise the winning team Conclude the session by reviewing the key concepts

covered in the unit. PPT#27 5 minutes

1

BAFS Elective PartBusiness Management Module –

Financial Management

Topic M01:Financial Analysis –Ratio Analysis for Business

Technology Education Section Curriculum Development Institute

Education Bureau, HKSARGApril 2009

Introduction

This session aims to introduce to students the concepts of ratio analysis of a business. Students will be able to build a solid understanding on this topic through active participation in various activities.

Duration

Two 40-minute lessons

Contents

Lesson 1 – Basic Concept, Classification and Calculation ofAccounting Ratios

Lesson 2 – Assessing Business Performance with Accounting Ratios

2

BAFS Elective PartLearning and Teaching Example

Topic M01Ratio Analysis for Business 2

Accounting RatiosUsage: to evaluate and compare the financial performance and position of different companies

Categories:

Profitability Liquidity Managementratios ratios Efficiency ratios

Lesson 1

Teacher begins the lesson by recapping the basic concept and formula of accounting ratios. The two activities in this lesson are designed to arouse the interest of students in learning accounting ratios and therefore these activities are relatively easy when compared to those in lesson two.

Teacher explains that accounting ratios are generated from financial statements which are then used to evaluate and compare the financial performance and financial position of different companies.

There are mainly three categories of accounting ratios:1. Profitability ratios2. Liquidity ratios3. Management efficiency ratios

3



Profitability Ratios

To measure the ability of a company in making profits.

Sales NetProfit NetRatio Profit 2.Net

Sales NetProfit GrossRatio Profit Gross 1.

=

=

Profitability ratios measure the ability of a company in generating profits. This information helps stakeholders e.g. investors, suppliers, customers etc. select companies which have good profit earning performance.

The major profitability ratios are:1. Gross Profit Ratio

A ratio measuring how much gross profit a company has gained in the accounting period per unit net sales made.

2. Net Profit Ratio

A ratio measuring how much net profit a company has gained in the accounting period per unit net sales made.

4



Profitability Ratios

*Remarks: Capital = (Opening Capital + Closing Capital) / 2For limited company, Capital = Equity + Long Term Liabilities

AssetsTotalProfit Net AssetTotal on Return 4.

*Employed CapitalProfit NetEmployed Capital on 3.Return

=

=

3. Return on Capital Employed

A ratio measuring how much net profit a company has gained in the accounting period per unit capital the company has employed.

4. Return on Total Assets

A ratio measuring how effectively a company uses its total assets to generate earnings.

Remarks:

The four ratios measure profit making ability of a company in different perspectives. Gross (Net) Profit Margin measures a company’s ability of making gross (net) profit based on a dollar of net sales the business has made. On the other hand, Return on Capital Employed and Return on Total Assets measure a company’s ability of making net profit based on capital used and total assets used respectively.

For all of the profitability ratios, the higher the better.

5



Liquidity Ratios

To measure the abilities of a company in

repaying debts.

sLiabilitie CurrentStock - AssetsCurrentRatio Quick 2.

sLiabilitie Current AssetsCurrentRatio Current 1.

=

=

Liquidity Ratios are used to measure a company’s ability to repay debts in the short run.

The major Liquidity Ratios are:1. Current Ratio

A ratio measuring the current assets a company has to cover its current liabilities.

2. Quick Ratio

A ratio measuring how much highly liquid asset (current asset less stock) a company has to cover its current liabilities. The reason why stock is subtracted from the current assets is because people argue that it may not be easy to sell stock in a short time and it should not be considered a readily available source to cover short term liabilities. This is regarded as a more stringent version of liquidity ratios.

Remarks:

Imagine if a company has $100 of debt to be settled soon (current liability), the company has to use $100 of its current assets e.g. cash at bank, cash collected from debtors and cash from selling off inventories to cover its debts. If the company does not have enough current assets to cover its current liabilities, it may be forced to sell off its fixed assets, or introduce more equity or long term debts and these may have serious impacts on the future performance of the company. If these tactics do not work, the company may be forced to wind up! Since a dollar of current liability requires a dollar of current assets to cover it, the numerator in a liquidity ratio should be at least as large as the denominator. As a rule of thumb, the current ratio should be at least 2:1 and quick ratio should be at least 1:1 for safety.

6



Management Efficiency Ratios

To measure the efficiency of a company in

controlling stocks, debtors and creditors.

#Remarks: Average Stock = (Opening Stock + Closing Stock) / 2

Sold Goods of CostX365Stock AveragePeriod Turnover Stock 2.

Stock AverageSold Goods of CostRatio Turnover Stock1.

#

(days)

#(times)

=

=

Management Efficiency Ratios are used to measure the management’s efficiency in controlling stocks, debtors and creditors.

The major Management Efficiency Ratios are: 1. Stock Turnover Ratio, unit = time(s)

A ratio measuring how many times the stock is turned over (or sold) in an accounting period. It indicates how well inventory is managed. A high turnover is generally viewed as positive. The quicker stock is turned over, the greater the sales and the greater the profits, given a fixed profit ratio.

2. Stock Turnover Period, unit = day(s)

A ratio measuring the time, in terms of days, required to sell the stock. The shorter the turnover period, the quicker the stock is sold, which means, greater sales and profits achieved with constant profit ratios. Hence, a shorter stock turnover period is generally more preferable.

7




Sales365 x DebtorsPeriod Collection Debtors 4.

DebtorsSalesRatio Turnover Debtors 3.

(days)

(times)

=

=

3. Debtors Turnover Ratio, unit = time(s)

A ratio measuring the number of times debtors turn over during the accounting period. Higher turnover indicates a shorter time between sales and cash collection. It reflects the effectiveness of a company’s payment terms.A low ratio may indicate the company is offering lenient payment terms or having difficulty in collecting debts, which will adversely affect the cash flow. Generally, the greater this ratio the better. When debts are recovered quicker, there will be more cash in hand. However, these ratios vary significantly depending on the nature of the business and the products being sold. So, it is useful to compare this ratio with industry averages.

4. Debtors Collection Period, unit = day(s)

A ratio measuring the time, in terms of days, required to collect the debts. Generally, the shorter this ratio the better – i.e. Debts being recovered in shorter time means more cash at hand.

8




Purchases365CredtiorsPeriod Repayment Credtiors 6.

CreditorsPurchasesRatio Turnover Credtiors5.

(days)

(times)

×=

=

5. Creditors Turnover Ratio, unit = time(s)

A ratio measuring how many times a payable is turned over in theaccounting period. A high turnover implies a relatively short time between purchase and payment settlement, and this may indicate the company is not taking full advantage of the credit periods. However, a low creditor turnover could result from a shortage of cash in the business.

6. Creditors Repayment Period, unit = day(s)

A ratio measuring the average time, in terms of days, required to repay the debts.A long repayment period may indicate the difficulties that a company is facing in paying debts and the loss of creditor discounts for not paying back on time.

Remarks:

Someone may measure the stock turnover period, debtors collection period and creditors repayment period in terms of month or year; if so, the 365 in the formula should be changed to 12 or 1 respectively.

9



Activity 1:Accounting ratio formulaUse the paper stripes provided to complete the following table:

Categories Ratio Formula

Profitability Ratios: measure the ability to make ________

_______ ________ _______ ________

__________________: measure the ability to repay debts

_______ ________

Management Efficiency Ratios: measure the ability to control ______ and debtors etc.

_______ _______________ _______________ ________

Activity 1:

The objective of the game is to ‘warm up’ the students with a relatively easy activity and arouse their interest in calculating accounting ratios. Students are asked to complete the activity without looking into any reference materials.

Steps:

1. Divide students into teams of 4-5 students that will remain the same throughout the two lessons.

2. Provide each team with a set of Student Worksheets p.1-p.9. Teacher should copy p.1-p.8 on one side only and p.9 should be produced in a large piece of paper in A1 or A0 size.

3. Students should cut off the paper stripes from p.1-p.8 and use them to form different accounting ratios, then paste them on Student Worksheet p.9 (in A1 or A0 size) with the three categories of accounting ratios stated.

10



Activity 1:Accounting ratio formula(Answers)

Categories Ratio Formula

Profitability Ratios: measure the ability to make _profit__

Gross Profit Net Profit _ Net Sales Net Sales

Net Profit Net Profit _ Capital Employed Total Assets

Liquidity Ratios: measure the ability to repay debts

Current Assets Current Assets - Stock Current Liabilities Current Liabilities

Management Efficiency Ratios: measure the ability to control stock and debtors etc.

Cost of Goods Sold Average Stock x 365Average Stock Cost of Goods Sold

Credit Sales Debtors x 365 Debtors Credit Sales

Credit Purchases Creditors x 365Creditors Credit Purchases

Steps (cont’d):

4. Paste students’ completed work on the whiteboard and verify answers with students.

5. The team producing the most correct answers wins the game, the champion gets 3 scores, first runner-up 2 scores and second runner-up 1 score.

6. If two teams tie, the fastest team wins.7. Record the scores for each team. The team scores are accumulative

throughout the two lessons.

To make the game more challenging, students could be asked to compete in answering the questions.

11



Based on the financial statements provided, fill in the following table:

Activity 2: Finding ratiosfrom financial statements

Funny Company Limited Tricky Company Limited

Gross Profit Ratio

Net profit Ratio

Return on Capital Employed

Return on Total Assets

Current Ratio

Quick Ratio

Stock Turnover Ratio

Stock Turnover Period

Debtors Turnover Ratio

Debtors Collection Period

Creditors Turnover Ratio

Creditors Repayment Period

Activity 2:

The objective of the game is to develop students’ skills in extracting correct figures from statements to form ratios. Since different companies will use different account names and format of presentation, it is important for students to know which accounts to extract for ratio calculations.

Steps:

1. Ask teammates to sit together.2. Teams are given the financial statements of two companies. They must

determine the required accounting ratios from the statements.3. Upon completion, teams exchange worksheets to check results. 4. Each correct answer will generate one score.5. Verify each answer with teams and record their scores. Team scores

are accumulative throughout the two lessons.

12



Activity 2: Finding ratiosfrom financial statements (Answers) Ratio Formula Funny Company

LimitedTricky Company

Limited

Gross Profit Ratio

Gross Profit

Net Sales

319500/700000 = 0.46

7500/11000 = 0.68

Net profit Ratio Net Profit

Net Sales

184500/700000 = 0.26

5600/11000 = 0.51


Net Profit _

Capital Employed

184500/1105000 = 0.17

5600/307000 = 0.02


Net Profit

Total Assets

184500/1290000 = 0.14

5600/309000 = 0.02

Current Ratio Current Assets

Current Liabilities

190000/185000 = 1.03

9000/2000 = 4.5

Quick Ratio Current Assets – Stock

Current Liabilities

180000/185000 = 0.97

8000/2000 = 4

The answers for Activity 2 are shown in the above table. Formula and calculations are displayed for easy reference.

13



Activity 2: Finding ratiosfrom financial statements (Answers) Ratio Formula Funny Company Limited Tricky Company

Limited


Cost of Goods SoldAverage Stock

380500/[(30500+10000)/2]= 18.79

3500/[(1500+1000)/2]= 2.8


Average Stock x 365Cost of Goods Sold

[(30500+10000)/2]x365/380500= 19.43 days

[(1500+1000)/2]x365/3500= 130.36 days


Credit SalesDebtors

700000/150000= 4.67

11000/5000= 2.2


Debtors x 365Credit Sales

150000x365/700000= 78.21 days

5000x365/11000= 165.91 days


Credit PurchasesCreditors

360000/180000= 2

3000/2000 = 1.5


Creditors x 365Credit Purchases

180000x365/360000= 182.50 days

2000x365/3000= 243.33 days

The answers for Activity 2 are shown in the above table. Formula and calculations are displayed for easy reference.

14



Extended Learning Activity

Can you give brief comments on the financial performance of Funny and Tricky?

This is an extended learning activity for more capable students.After checking the answers of Activity 2 with students, teacher may ask students to give brief comments on the financial performance of the two companies – Funny and Tricky.

Teacher should remind students that the accounting ratios in Activity 2 can help them compare the financial performance of the two companies.Extra scores should be given to the groups who can give reasonable comments with justification.

To guide students thinking, teacher may ask students the following questions:

Q1. Which company has higher ability to gain profit from its salesrevenue?

Ans. Tricky Company Limited.

Q2. Which company has higher ability to repay debts?Ans. Tricky Company Limited.

Q3. Which company has higher efficiency in controlling stock?Ans. Funny Company Limited.

further elaboration will be covered in the next lesson.

15



Summary

Profitability Liquidity ManagementRatios Ratios Efficiency Ratios

Usage : to evaluate and compare the financial performance and position of different companies

Ability to gain profit Ability to repay debts Efficiency in controlling

Stock, debtor, creditor

Gross Profit RatioNet Profit Ratio


Return on Total Asset

Current RatioQuick Ratio

Stock Turnover RatioStock Turnover PeriodDebtors Turnover Ratio

Debtors Collection PeriodCreditors Turnover Ratio


Recap what have been covered in this lesson. Focus on the usage of various categories of accounting ratios.

Announce each team’s accumulated score and tell them their scores will be carried forward to the next lesson.

End of Lesson 1

16



Ratio Analysis for Business

Accounting ratios could be used to compare the financial performance and position of different companies.

Lesson 2

Besides measuring profitability, liquidity and management efficiency of individual companies, accounting ratios are useful for making comparison of companies in the same industry with different sizes. For instance, a large company may earn more gross profits than a small company but it would be unfair to say the large company’s gross profit earning power is greater.

We should also consider how much resources the companies used togenerate their gross profits. Therefore, it is more appropriate to compare the gross profit per unit cost used by different companies. For example, Return on Capital Employed should be used for comparison.

Slides 17-19 summarise how the 3 categories of accounting ratios are used to compare the financial performance of different companies. Teacher may review the key concepts with students before moving on to the activities of this lesson.

17




Profitability Ratio(i.e. Gross Profit Ratio, Net Profit Ratio,Return on Capital Employed & Return On Total Asset)

Higher profitability ratio means higher return for every dollar of sales revenues made (or total asset used).

Hence, the higher thebetter!

Profitability ratios are measured by dividing gross or net profits by sales/capital/total assets.

For example, the return on total assets are measured by dividing net profit by total assets. For two companies with the same total assets, the one having higher return on total assets earned more net profits than the other.

A company with a higher return on total assets than industry average performs better than competitors because for every dollar of total asset used, the company has made more net profit than its peers.

Similarly, other profitability ratios could provide similar facts. As a result, we regard a higher profitability ratio as a better profit making ability.

18




Liquidity Ratios(i.e. Current Ratio & Quick Ratio)

For the safety or stability of a business, current ratio should be ≥ 2:1 and quick ratio should be ≥ 1:1

BUT, a very high liquidity ratio may indicate idle cash or lack of investment opportunities.

Higher liquidity ratios mean more current assets available to repay short term debts.

As a rule of thumb, the current ratio should be at least 2:1 and the quick ratio should be at least 1:1 for the safety or stability of a business.

But, if the ratios are too high compared to the industry average, this may indicate current assets are idle due to poor sales or the management is not effectively utilising the current assets e.g. they could not find investment opportunities for the company.

19





Generally, the higher the better?

No, it depends!

Higher is better for: Lower is better for:Stock Turnover Ratio Stock Turnover Period

Debtors Turnover Ratio Debtors Collection Period

Creditors Repayment Period Creditors Turnover Ratio

Generally, for Stock Turnover, Debtors Turnover and Creditors Repayment ratios, the higher ratios mean the companies (of the same industry) performed better.

For two companies with the same cost of goods sold, the one having higher Stock Turnover Ratio kept less stock, which implies lower holding costs. In other words, a company having a higher than average Stock Turnover Ratio should have performed better financially than competitors because a unit of stock were sold more frequently during the accounting period.

Conversely, closely related ratio – Stock Turnover Period (equal to the product of its reciprocal and 365 days) measures how long stock has been warehoused. A lower ratio means better performance because stock was kept for a shorter time period. We could consider the Stock Turnover Ratio and Stock Turnover Period are two sides of the same coin.

The other pairs of ratios - Debtors Turnover Ratio / Debtors Collection Period pair and Creditors Repayment Period / Creditors Turnover Ratio pair could also be analysed with similar arguments.

Of course, the companies under comparison should also be in the same industry for the comparison to be relevant.

20





Caution!

High stock turnover (low turnover period) mayindicate insufficient raw material supply

High repayment period (low stock turnover) mayindicate inability to pay debts.

Remind students that accounting ratios should not be looked individually. Instead, they should be used holistically to help analysts determine the financial performance of a business. Moreover, we should also take into account the ratios’ industry norm for comparison.

For example, if the Creditors Repayment Period is higher than average (i.e. Creditor Turnover Ratio lower than average), it may indicate the company pays its bills later than its peers, but this may also indicate an inability to pay bills. Thus, the liquidity ratios should also be reviewed before any conclusions are made.

21



Activity 3:Which company performed better?

RatiosRatio Values Which

is better1 or 2?

ReasonsCompany 1 Company 2

Gross Profit Ratio 0.31 0.25

Net profit Ratio 0.12 0.15

Return on Capital Employed 0.21 0.24

Return on Total Assets 0.11 0.19

Current Ratio 2.54 : 1 1.47 : 1

Quick Ratio 1.12 : 1 1.30 : 1

Stock Turnover Ratio 4.5 times 3.8 times

Stock Turnover Period 81.11 days 96.05 days

Debtors Turnover Ratio 4.66 3.98

Debtors Collection Period 78.33 days 91.71 days

Creditors Turnover Ratio 3.78 2.56

Creditors Repayment Period 96.56 days 142.58 days

Activity 3:

The objective of the activity is to compare the performance of two companies in the same industry based on their accounting ratios.

Instructions:

1. Each group is provided with the accounting ratios of two companies.2. Students should find out which company performed better and give

reasons.3. For each ratio, a representative from groups will share their views with

the class before teacher provides the answers. For each pair of correct answers, students will gain one score.

4. Record the scores of each group. Team scores will be accumulated till the end of the lesson.

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Activity 3:Which company performed better?(Answers)

RatiosRatio Values Which

is better1 or 2?


Gross Profit Margin 0.31 0.25 1 Higher gross profit gained per unit sales

Net profit Margin 0.12 0.15 2 Higher net profit gained per unit sales

Return on Capital Employed 0.21 0.24 2 Higher net profit gained per unit capital used

Return on Total Assets 0.11 0.19 2 Higher net profit gained per unit asset used

Current Ratio 2.54 : 1 1.47 : 1 1 More capacity to repay short-term debts

Quick Ratio 1.12 : 1 1.30 : 1 2 More capacity to repay immediate debts

After reviewing the answers with students, teacher explains that we could not tell which company performed better simply by looking at one ratio. Various ratios indicate the strengths and weaknesses of two companies in different aspects. Companies should focus on improving their weaknesses in order to become more competitive.

23



RatiosRatio Values Which is

better1 or 2?


*Stock Turnover Ratio 4.5 times 3.8 times 1 More stocks are sold in the period/lower stock level

Stock Turnover Period 81.11 days 96.05 days 1 Stocks required lesser time to be sold/lower stock level

Debtors Turnover Ratio 4.66 3.98 1 Higher ability in collecting debts & more cash in hand

Debtors Collection Period 78.33 days 91.71 days 1 Debts are collected in a shorter period & more cash in hand

Creditors Turnover Ratio 3.78 2.56 2 Enjoyed longer credit term & more cash in hand


96.56 days 142.58 days 2 Debts are repaid in a longer period & more cash in hand

Activity 3:Which company performed better?(Answers)

*Additional information about ‘Stock Turnover Ratio’:

Stock Turnover Ratio is affected by the perishability of goods. Because perishable goods must be sold very quickly before they deteriorate. Therefore, more goods are ‘turned over’ during the accounting period. (i.e. Higher Stock Turnover Ratio) Hence, the comparison of companies in different industries, especially durable and perishable goods industries, is meaningless.

On the other hand, if the Stock Turnover Ratio is too high, this may indicate insufficient supply. However, whether the level is too high can only be judged by experience i.e. comparing it with the industry average and with the historical record of the company’s ratio.

24



Activity 4: Which company are they talking about?

Statement X belongs to Company ?Statement Y belongs to Company ?Statement Z belongs to Company ?

X Y Z

Gross Profit Ratio

Net Profit Ratio



Current Ratio

Quick Ratio







Activity 4:

The objective of the activity is clarify what the accounting ratios mean and how to interpret them in common daily language.

Instructions:

1. Each team is provided with a dialogue between two suppliers of three companies A, B and C. (Student Fact Sheet 4A).

2. Based on the dialogue, teams are required to match the statement (X, Y and Z) with the appropriate company (A, B and C).

3. Teacher guides students as follows: i. Underline (the key) words in the dialogue which are hints for solving

the problem.ii. Students do not need to calculate ALL accounting ratios in order to

match the statements with the appropriate company.iii. Once the accounting ratios to be used are determined, teams

calculate the same ratios for statements X, Y, and Z to compare.Finally, teams check against the dialogue with their calculated ratios to determine the answer.

4. After 10 minutes, ask students to report and explain their answers.

25



Activity 4: Which company are they talking about? (Answers)

X Y Z

Gross Profit Ratio 352000/700000=0.50 172500/795,000=0.22 20000/80000=0.25

Net Profit Ratio 65000/700000=0.09 30000/795,000=0.04 12000/80000=0.15

Return on Capital Employed 65000/[(109840+141840)/2]=0.52

30000/(500000+300000+128500+19500+225000)=0.03

12000/[(36000+42000)/2]=0.31

Return on Total Assets 65000/(148340+186000)=0.19 30000/1278000=0.02 12000/(2000+46000)=0.25

Current Ratio 186000/132500=1.40

(230000+175500+157500)/(75000+30000)= 5.36

46000/6000=7.67

Quick Ratio (145500+1000+3000)/(132500)=1.13

(175500+157500)/(75000+30000)=3.17

(25000+6000)/6000=5.17

Inventory Turnover Ratio 348000/[(30500+36500)/2]=10.39

622500/[(200000+230000)/2]=2.90

60000/[(25000+15000)/2]=3.00

Inventory Turnover Period [(30500+36500)/2]x365/348000=35.14 days

[(200000+230000)/2]x365/622500=126.06 days

[(25000+15000)/2]x365/60000121.67

Debtors Turnover Ratio 700000/150000=4.67 795000/175500=4.53 67000/25000=2.68

Debtors Collection Period 150000x365/700000=78.21 days 175500x365/795000=80.58 days 25000x365/67000=136.19 days

Creditors Turnover Ratio (360000-10000+4000)/120000=2.95

602500/75000=8.03

50000/5000=10.00

Creditors Repayment Period 120000x365/(360000-10000+4000)=123.73 days

75000x365/602500=45.44 days

5000x365/50000=36.5(1)

(2)

(3)

(4)

(5)

(6), (7)

(8)

(8)

Instruction (cont’d) :

5. Teacher illustrates to students how to solve the problem. The following is an extract of Fact Sheet 4A (Student Worksheet p.15) with key words underlined for mapping with corresponding accounting ratios shown in the above table.

Yuri: Company A did not pay their bills on time. As you know, in our industry, the credit period is usually 30 days. However, (1)Company A did not pay even in

40 days! (A X/Y)

Joseph: Yea! I think we are experiencing the same situation! Our clients also delayed payment creating pressure on our cash flow. Are you worrying about Company A’s ability to pay their bills? (2)They have a double digit Gross Profit Ratio, although only (3) a single digit profit ratio if expenses are subtracted from the gross profit. (A X/Y)

Yuri: Hmm… I think a better way to estimate their ability to pay is to determine the extent their current assets cover current liabilities. I know that (4) Company A’s Current Ratio is far exceeding the safety range of 2:1.(A Y/Z) Even though we (5) exclude the inventory from the calculation, the ratio is still good. (A Y/Z)

Joseph: It’s true. We need not worry about that at least in the short run. But, in the long run, I am concerned about the company’s management efficiency. (6)It can only make $3 net profits for every $100 of capital used. (A Y)The other companies, (7) B and C, both have double digit returns. (B&C X&Z)

Yuri: Well, if the management doesn’t change their direction, Company A will probably be excluded from the market. For example, they should review their inventory control. (8)Company A’s inventory, like that of Company B, was in the warehouse for more than 4 months on average. ( B = Z)

26



Activity 4:Which company are they talking about? (Answers)

Statement X belongs to Company C .

Statement Y belongs to Company A .

Statement Z belongs to Company B .

Instruction (cont’d) :

6. Verify team answers and give 3 scores for all correct matches, 2scores with 2 matches, and so on.

7. Record and sum up all team scores.

27



Conclusion

• Accounting ratios could be used for comparing companies in terms of their profitability, liquidityand management efficiency.

• Higher the ratios do not always mean better situation

• Looking at a single ratio could be misleading. Ratios should be studied as a whole to see the big picture.

Recap the three main themes of the lessons.

Announce the total scores gained by each group and reward the winners.



The End

End of Lesson 2

Topic M01: Ratio Analysis for Business Student Worksheet P.1

BAFS Learning & Teaching Example As at April 2009

BAFS Elective Part – Business Management Module – Financial Management Topic M01: Financial Analysis – Ratio Analysis for Business Activity 1: Accounting ratio formula Cut along the dotted lines and produce paper stripes for the formation of accounting ratios.

Net Sales Total Assets

Capital Employed



Net Profit Net Sales

Current Assets Current Assets – Stock



Average Stock

Credit Sales Credit Purchases

Creditors



Profit Net Profit

Current Liabilities Debtors



Gross Profit Cost of Goods Sold Current Liabilities

Creditors



Cost of Goods Sold Debtors Stock

Liquidity Ratios



Net Profit Average Stock Credit Sales

Credit Purchases



X 365 X 365 X 365 X 365



Activity 1: Accounting ratio formula

Categories Ratios

Profitability Ratios: measure the ability to make ________

_____________ ______________ _____________ ______________

_________________________: measure the ability to repay debts

_______________________ _______________________

Management Efficiency Ratios: measure the ability to control _________ and debtors etc.

_____________ ______________

_____________ ______________

_____________ ______________



Activity 2: Finding ratios from financial statements Fact Sheet 2A

Funny Company Limited

Trading and Profit and Loss Account for the year ended 31 December 20XX $ $ Sales 707,000 Less: Returns Inwards 7,000 Net sales 700,000 Less: Cost of Goods Sold Opening Inventory 30,500 Add: Purchases 360,000 390,500 Less: Closing Inventory 10,000 380,500 Gross Profit 319,500 Add: Revenues Discounts received 30,000 349,500 Less: Expenses Provision for depreciation of machineries 20,000 Bad debts 5,000 Discounts allowed 10,000 Debenture interest 10,000 Salaries 120,000 165,000 Net Profit 184,500 Add: Retained profit brought forwards 50,000 234,500 Less: Appropriations Transfer to general reserve 19,500 Preference share dividend 5,000 Ordinary share dividend 10,000 34,500 Retained profit carried forwards 200,000



Activity 2: Finding ratios from financial statements Fact Sheet 2B

Funny Company Limited Balance Sheet as at 31 December 20XX

Cost Provision for

depreciation Net Book

Value

Fixed Assets $ $ $ Machineries 1,800,000 700,000 1,100,000 Current Assets Inventory 10,000 Debtors 150,000 Cash 30,000 190,000 Less: Current Liabilities Trade creditors 180,000 Accrued interest 5,000 185,000 Net current assets 5,000 1,105,000 Financed by: Capital Authorized Issued Ordinary shares 500,000 80,000 Preference shares 200,000 50,000 130,000 700,000 Reserves Share premium 50,000 General reserve 45,000 Retained profit 200,000 Dividend 15,000 310,000 Shareholders’ Equity 440,000 Long Term Liabilities Debenture 665,000 1,105,000



Activity 2: Finding ratios from financial statements Fact Sheet 2C

Tricky Company Limited

Trading and Profit and Loss Account for the year ended 31 December 20XX $ $ $ Sales 12,000 Less: Returns Inwards 1,000 Net sales 11,000 Less: Cost of Goods Sold Opening Stock 1,500 Add: Purchases 3,000 4,500 Less: Closing stock 1,000 3,500 Gross Profit 7,500 Add: Revenues Discounts received 100 7,600 Less: Expenses Provision for depreciation of equipment 200 Bad debts 100 Discounts allowed 200 Salaries 1,500 2,000 Net Profit 5,600 Add: Retained profit brought forwards 50,000 55,600 Less: Appropriations Preference share dividend 1,000 Ordinary share dividend Interim 1,500 Final 1,500 3,000 4,000 Retained profit carried forwards 51,600



Activity 2: Finding ratios from financial statements Fact Sheet 2D

Tricky Company Limited Balance Sheet as at 31 December 20XX

Cost Provision for

depreciation Net Book

Value

Fixed Assets $ $ $ Equipment 800,000 500,000 300,000 Current Assets Stock 1,000 Net debtors 5,000 Cash 3,000 9,000 Less: Current Liabilities Trade creditors 2,000 Net current assets 7,000 307,000 Financed by: Capital Authorised Issued Ordinary shares 150,000 50,000 Preference shares 50,000 10,000 60,000 200,000 Reserves Share premium 10,000 Retained profit 234,500 Dividend 2,500 246,500 Balance as at 31 December 20XX 307,000



Activity 2: Finding ratios from financial statements Calculate the accounting ratios of the two companies with your group members and complete the following table.

Formula Funny Company Limited Tricky Company Limited Gross Profit Ratio

Net profit Ratio



Current Ratio

Quick Ratio







Remarks: After all students finished their worksheets, each team should exchange its worksheet with another team for correction. Verify the answers with the teacher. Each correct answer generate one score.



Activity 3: Which company performed better? Which company performed better, 1 or 2? Complete the following table with your group members and decide which company performed better.

Ratio Values Ratios Company 1 Company 2

Which is better, 1 or 2?

Reasons

Gross Profit Ratio 0.31 0.25

Net profit Ratio 0.12 0.15

Return on Capital Employed 0.21 0.24

Return on Total Assets 0.11 0.19

Current Ratio 2.54 : 1 1.47 : 1

Quick Ratio 1.12 : 1 1.30 : 1

Inventory Turnover Ratio 4.5 times 3.8 times

Inventory Turnover Period 81.11 days 96.05 days

Debtors Turnover Ratio 4.66 times 3.98 times

Debtors Collection Period 78.33 days 91.71 days

Creditors Turnover Ratio 3.78 times 2.56 times

Creditors Repayment Period 96.56 days 142.58 days



Activity 4: Which company are they talking about? Fact Sheet 4A Based on the following dialogue between two suppliers Joseph and Yuri of companies A, B and C, determine which company X, Y and Z statements belong to. Yuri: Hey! How are you Joseph?

Joseph: Oh! Yuri! I could not be better; how about you?

Yuri: Not bad except for some issues with our customer Company A.

Joseph: What’s the issue?

Yuri: Company A did not pay their bills on time. As you know, in our industry, the credit period is usually 30 days. However, Company A did not pay even in 40 days!

Joseph: Yea! I think we are experiencing the same situation! Our clients also

delayed payment creating pressure on our cash flow. Are you worrying about Company A’s ability to pay their bills? They have a double digit Gross Profit Ratio, although only a single digit profit ratio if expenses are subtracted from the gross profit.

Yuri: Hmm… I think a better way to estimate their ability to pay is to

determine the extent their current assets cover current liabilities. I know that Company A’s Current Ratio is far exceeding the safety range of 2:1. Even though we exclude the inventory from the calculation, the ratio is still good.

Joseph: It’s true. We need not worry about that at least in the short run. But,

in the long run, I am concerned about the company’s management efficiency. It can only make $3 net profits for every $100 of capital used. The other companies, B and C, both have double digit returns.

Yuri: Well, if the management doesn’t change their direction, Company A will

probably be excluded from the market. For example, they should review their inventory control. Company A’s inventory, like that of Company B, was in the warehouse for more than 4 months on average.

Joseph: Yea, short holding period is so important for their products that go

obsolete quickly…



Activity 4: Which company are they talking about? Fact Sheet 4B

Statement X

Trading and Profit and Loss Account for the year ended 31 December 20XX $ $ $ Sales 707,000 Less: Returns Inwards 7,000 700,000 Less: Cost of Goods Sold Opening Inventory 30,500 Purchases 360,000 Less: Returns Outwards 10,000 350,000 Add: Carriage Inwards 4,000 384,500 Less: Closing Inventory 36,500 348,000 Gross Profit 352,000 Other Income Discounts received 30,000 Rent received 20,300 Reduction in provision in doubtful debts 200 50,500 402,500 Less: Expenses Wages and Salaries 74,000 Insurance 4,000 Rent and rates 140,000 Loan interest 3,000 Carriage outwards 5,000 Discounts allowed 17,000 Advertising expenses 40,000 Bad Debts 2,000 Provision for depreciation – Equipment 36,000 Provision for depreciation – Motor vehicles 16,500 337,500 Net profit for the year 65,000



Activity 4: Which company are they talking about? Fact Sheet 4C

Statement X

Balance Sheet as at 31 December 20XX $ $ $ Fixed Assets Cost Accumulated

Depreciation Net Book Value

Equipment 180,000 70,160 109,840 Motor vehicles 70,000 31,500 38,500 250,000 101,660 148,340 Current Assets Inventory 36,500 Trade debtors 150,000 Less: Provision for doubtful debts 4,500 145,500 Prepayments 1,000 Cash 3,000 186,000 Current Liabilities Trade creditors 120,000 Accrued expenses 2,000 Bank overdraft 10,500 132,500 Net Current Assets 53,500 201,840 Loan-term Liabilities Bank loan 60,000 141,840 Financed by: Capital Balance as at 1 January 20XX 109,840 Add: Net profit for the year 65,000 174,840 Less: Drawings 33,000 Balance as at 31 December 20XX 141,840



Activity 4: Which company are they talking about? Fact Sheet 4D

Statement Y Trading and Profit and Loss Account for the year ended 31 December 20XX $ $ Sales 795,000 Less: Cost of sales Opening Stock 200,000 Purchases (credit purchases $602,500) 652,500 852,500 Less: Closing stock 230,000 622,500 Gross Profit 172,500 Less: Expenses Debenture interest 18,000 Depreciation 37,500 Other expenses 87,000 142,500 Net profit 30,000 Dividend proposed 19,500 Retained profit for the year 10,500 Retained profits brought forward from last year 118,000 Retained profits carried forward to next year 128,500

Statement Y Balance Sheet as at 31 December 20XX

Fixed Assets Property, plant and equipment 715,000 715,000 Current Assets Inventories 230,000 Trade debtors 175,500 Bank 157,500 563,000 Less Current Liabilities Trade creditors 75,000 Accrued expenses 30,000 (105,000) 1,173,000 Capital Share capital 500,000 General reserve 300,000 Accumulated profits 128,500 Debentures 225,000 Proposed dividend 19,500 1,173,000



Activity 4: Which company are they talking about? Fact Sheet 4E

Statement Z

Trading and Profit and Loss Account for the year ended 31 December 20XX $ $ Sales (credit sales $67,000) 80,000 Less : Cost of Goods Sold Opening Inventory 25,000 Purchases 50,000 75,000 Closing Inventory (15,000) (60,000) Gross Profit 20,000 Less: Bank Interest 1,000 Other Expenses 7,000 (8,000) Net Profit 12,000

Statement Z Balance Sheet as at 31 December 20XX

Fixed Assets Plant and Machinery, at cost 10,000 Provision for Depreciation (8,000) 2,000 Current Assets Inventory 15,000 Trade Debtors 25,000 Cash 6,000 46,000 Current Liabilities Trade Creditors 5,000 Bank Overdraft 1,000 (6,000) 42,000 Capital Balance as at 1 January 20XX 36,000 Net Profit 12,000 48,000 Drawings (6,000) 42,000



Activity 4: Which company are they talking about? You may find the following table could help your analysis:

X Y Z

Gross Profit Ratio

Net profit Ratio



Current Ratio

Quick Ratio

Inventory Turnover Ratio

Inventory Turnover Period





Statement X belongs to Company . Statement Y belongs to Company . Statement Z belongs to Company .

M01-Ratio Analysis Overview eng -060409 - Education … · PPT#9 – 10 Student Worksheet pp. 1 - 9 15 minutes. Topic M01: Ratio Analysis for Business Topic Overview P.3 BAFS Learning

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