Topic M01: Ratio Analysis for Business Topic Overview P.

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)

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

BAFS Learning and Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business Topic Overview P.2

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:

Time
Activities Reference
Allocation
Part I: Introduction
Elaborate on the concept of accounting ratios; the
definition and uses of 12 accounting ratios will be
discussed.
PPT#1 8 5 minutes
The two lessons are connected by team games which
generate scores and will be accumulated throughout the
2 lessons to determine the final winner.
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)
PPT#9 10
under the appropriate category of ratio.
Student
Record the time used by teams in completing the 15 minutes
Worksheet
task and paste students completed work on the
pp. 1 - 9
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,

BAFS Learning and Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business Topic Overview P.3

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 PPT#11 13
accounting ratios with the data given in the
statements. Student
Upon completion, teams exchange worksheets to Worksheet 15 minutes
check results. Teacher verifies each answer with pp. 10 14
teams. Each correct answer generates one score.
For more capable students an extended activity is PPT#14
available. They are asked to comment on the financial
performance of the two companies in Activity 2.
Part III: Conclusion
Announce the accumulated scores for each team and the
winning team.
PPT#15 5 minutes
Conclude the lesson by recapping the use, classification
and calculation of accounting ratios.

BAFS Learning and Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business Topic Overview P.4

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:

Time
Activities Reference
Allocation
Part I: Introduction
Revision on different uses of accounting ratios in
PPT#16 20 5 minutes
comparing performance of different companies.
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 PPT#21 23
determine which company performed better and Student
15 minutes
give reasons. Worksheet
Ask each group to share their views with the class p. 15
before teacher offers the correct answers. Each
pair of correct answers earns one score.
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
PPT#24 26
required to match the statements with the 3
Student
companies (A, B and C) mentioned in the 15 minutes
Worksheet
dialogue.
pp. 16 - 21
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,

BAFS Learning and Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business Topic Overview P.5

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 PPT#27 5 minutes
covered in the unit.

BAFS Learning and Teaching Example

As at April 2009
 BAFS Elective Part Accounting Ratios
Usage: to evaluate and compare the financial
Business Management Module performance and position of different companies
Financial Management
Categories:
Topic M01:
Profitability Liquidity Management
Financial Analysis ratios ratios Efficiency ratios
Ratio Analysis for Business
Technology Education Section
Curriculum Development Institute
Education Bureau, HKSARG
Topic M01 BAFS Elective Part
April 2009 Ratio Analysis for Business 2 Learning and Teaching Example

Introduction Lesson 1
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
Teacher begins the lesson by recapping the basic concept and formula of
through active participation in various activities.
accounting ratios. The two activities in this lesson are designed to arouse
the interest of students in learning accounting ratios and therefore these
Duration activities are relatively easy when compared to those in lesson two.
Two 40-minute lessons
Teacher explains that accounting ratios are generated from financial
statements which are then used to evaluate and compare the financial
Contents
performance and financial position of different companies.
Lesson 1 Basic Concept, Classification and Calculation of
Accounting Ratios
There are mainly three categories of accounting ratios:
Lesson 2 Assessing Business Performance with Accounting Ratios
1. Profitability ratios
2. Liquidity ratios
3. Management efficiency ratios

1 2
 Profitability Ratios Profitability Ratios
Net Profit
To measure the ability of a company 3.Return on Capital Employed =
in making profits. Capital Employed *

Gross Profit Net Profit

1. Gross Profit Ratio = 4. Return on Total Asset =
Net Sales Total Assets
Net Profit
2.Net Profit Ratio =
Net Sales
*Remarks: Capital = (Opening Capital + Closing Capital) / 2
For limited company, Capital = Equity + Long Term Liabilities

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 3 Learning and Teaching Example Ratio Analysis for Business 4 Learning and Teaching Example

Profitability ratios measure the ability of a company in generating profits. 3. Return on Capital Employed
This information helps stakeholders e.g. investors, suppliers, customers etc. A ratio measuring how much net profit a company has gained in the
select companies which have good profit earning performance. accounting period per unit capital the company has employed.

The major profitability ratios are: 4. Return on Total Assets

1. Gross Profit Ratio A ratio measuring how effectively a company uses its total assets to
A ratio measuring how much gross profit a company has gained in the generate earnings.
accounting period per unit net sales made.
Remarks:
2. Net Profit Ratio The four ratios measure profit making ability of a company in different
A ratio measuring how much net profit a company has gained in the perspectives. Gross (Net) Profit Margin measures a companys ability of
accounting period per unit net sales made. 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 companys ability of making net profit based on
capital used and total assets used respectively.

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

3 4
 Liquidity Ratios Management Efficiency Ratios

To measure the abilities of a company in To measure the efficiency of a company in

repaying debts. controlling stocks, debtors and creditors.

Cost of Goods Sold
Current Assets 1. Stock Turnover Ratio =
1. Current Ratio = (times) Average Stock #
Current Liabilities
Average Stock # X365
Current Assets - Stock 2. Stock Turnover Period =
2. Quick Ratio = (days) Cost of Goods Sold
Current Liabilities
#Remarks: Average Stock = (Opening Stock + Closing Stock) / 2

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 5 Learning and Teaching Example Ratio Analysis for Business 6 Learning and Teaching Example

Liquidity Ratios are used to measure a companys ability to repay debts in

the short run. Management Efficiency Ratios are used to measure the managements
efficiency in controlling stocks, debtors and creditors.
The major Liquidity Ratios are:
1. Current Ratio The major Management Efficiency Ratios are:
A ratio measuring the current assets a company has to cover its current 1. Stock Turnover Ratio, unit = time(s)
liabilities. 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
2. Quick Ratio turnover is generally viewed as positive. The quicker stock is turned over,
A ratio measuring how much highly liquid asset (current asset less stock) the greater the sales and the greater the profits, given a fixed profit ratio.
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
2. Stock Turnover Period, unit = day(s)
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 ratio measuring the time, in terms of days, required to sell the stock.
a more stringent version of liquidity ratios. The shorter the turnover period, the quicker the stock is sold, which
means, greater sales and profits achieved with constant profit ratios.
Remarks: Hence, a shorter stock turnover period is generally more preferable.
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.

5 6
 Management Efficiency Ratios Management Efficiency Ratios
Sales Purchases
3. Debtors Turnover Ratio = 5. Credtiors Turnover Ratio =
(times) Debtors (times) Creditors
Debtors x 365 Credtiors 365
4. Debtors Collection Period = 6. Credtiors Repayment Period =
(days) Sales (days) Purchases

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 7 Learning and Teaching Example Ratio Analysis for Business 8 Learning and Teaching Example

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 companys
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.
5. Creditors Turnover Ratio, unit = time(s)
A ratio measuring how many times a payable is turned over in the
accounting 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.

7 8
 Activity 1: Activity 1:
Accounting ratio formula Accounting ratio formula
Use the paper stripes provided to complete the following table: (Answers)
Categories Ratio Formula Categories Ratio Formula
Gross Profit Net Profit _
_______ ________ Profitability Ratios: measure the ability Net Sales Net Sales
Profitability Ratios: measure the ability to make _profit__ Net Profit Net Profit _
to make ________ _______ ________ Capital Employed Total Assets
Liquidity Ratios: measure the ability to Current Assets Current Assets - Stock
repay debts Current Liabilities Current Liabilities
__________________: measure the _______ ________
Cost of Goods Sold Average Stock x 365
ability to repay debts
Average Stock Cost of Goods Sold

_______ ________ Management Efficiency Ratios: Credit Sales Debtors x 365

Management Efficiency Ratios: measure the ability to control stock and Debtors Credit Sales
_______ ________ debtors etc.
measure the ability to control ______
and debtors etc. _______ ________ Credit Purchases Creditors x 365
Creditors Credit Purchases

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 9 Learning and Teaching Example Ratio Analysis for Business 10 Learning and Teaching Example

Activity 1: Steps (contd):

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.
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.

9 10
 Activity 2: Finding ratios Activity 2: Finding ratios
from financial statements from financial statements (Answers)
Ratio Formula Funny Company Tricky Company
Based on the financial statements provided, fill in the following table:
Limited Limited
Funny Company Limited Tricky Company Limited
Gross Profit Gross Profit 319500/700000 7500/11000
Gross Profit Ratio
Ratio Net Sales = 0.46 = 0.68
Net profit Ratio
Net profit Ratio Net Profit 184500/700000 5600/11000
Return on Capital Employed
Return on Total Assets
Net Sales = 0.26 = 0.51
Current Ratio Return on Capital Net Profit _ 184500/1105000 5600/307000
Quick Ratio Employed Capital Employed = 0.17 = 0.02
Stock Turnover Ratio Return on Total Net Profit 184500/1290000 5600/309000
Stock Turnover Period Assets Total Assets = 0.14 = 0.02
Debtors Turnover Ratio Current Ratio Current Assets 190000/185000 9000/2000
Debtors Collection Period Current Liabilities = 1.03 = 4.5
Creditors Turnover Ratio
Quick Ratio Current Assets Stock 180000/185000 8000/2000
Creditors Repayment Period
Current Liabilities = 0.97 =4
Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 11 Learning and Teaching Example Ratio Analysis for Business 12 Learning and Teaching Example

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

11 12
 Activity 2: Finding ratios
from financial statements (Answers) Extended Learning Activity
Ratio Formula Funny Company Limited Tricky Company
Limited
Stock Turnover Cost of Goods Sold 380500/[(30500+10000)/2] 3500/[(1500+1000)/2] Can you give brief comments on the financial
Ratio Average Stock = 18.79 = 2.8

Stock Turnover Average Stock x 365 [(30500+10000)/2]x365/380500 [(1500+1000)/2]x365/3500

performance of Funny and Tricky?
Period = 19.43 days = 130.36 days
Cost of Goods Sold
Debtors Credit Sales 700000/150000 11000/5000
Turnover Ratio = 4.67 = 2.2
Debtors
Debtors Debtors x 365 150000x365/700000 5000x365/11000
Collection Period Credit Sales = 78.21 days = 165.91 days

Creditors Credit Purchases 360000/180000 3000/2000

Turnover Ratio Creditors =2 = 1.5

Creditors Creditors x 365 180000x365/360000 2000x365/3000

Repayment Credit Purchases = 182.50 days = 243.33 days
Period
Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 13 Learning and Teaching Example Ratio Analysis for Business 14 Learning and Teaching Example

This is an extended learning activity for more capable students.

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

13 14
 Summary
Ratio Analysis for Business
Profitability Liquidity Management
Ratios Ratios Efficiency Ratios Accounting ratios could be used to
Usage : to evaluate and compare the financial performance and
position of different companies compare the financial performance
Ability to gain profit Ability to repay debts Efficiency in controlling and position of different companies.
Stock, debtor, creditor
Gross Profit Ratio Current Ratio Stock Turnover Ratio
Net Profit Ratio Quick Ratio Stock Turnover Period
Return on Capital Debtors Turnover Ratio
Employed Debtors Collection Period
Return on Total Asset Creditors Turnover Ratio
Creditors Repayment Period
Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 15 Learning and Teaching Example Ratio Analysis for Business 16 Learning and Teaching Example

Recap what have been covered in this lesson. Focus on the usage of Lesson 2
various categories of accounting ratios.
Besides measuring profitability, liquidity and management efficiency of
Announce each teams accumulated score and tell them their scores will be individual companies, accounting ratios are useful for making comparison
carried forward to the next lesson. 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 companys gross profit earning power is
End of Lesson 1 greater.

We should also consider how much resources the companies used to

generate 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.

15 16
 Ratio Analysis for Business Ratio Analysis for Business
Profitability Ratio Liquidity Ratios
(i.e. Gross Profit Ratio, Net Profit Ratio,
(i.e. Current Ratio & Quick Ratio)
Return on Capital Employed & Return On Total
Asset)
For the safety or stability of a business,
current ratio should be 2:1 and
Higher profitability ratio means higher return for
quick ratio should be 1:1
every dollar of sales revenues made (or total asset
used). BUT, a very high liquidity ratio may
better! indicate idle cash or lack of
Hence, the higher the investment opportunities.

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 17 Learning and Teaching Example Ratio Analysis for Business 18 Learning and Teaching Example

Profitability ratios are measured by dividing gross or net profits by Higher liquidity ratios mean more current assets available to repay short
sales/capital/total assets. term debts.

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.
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.

Similarly, other profitability ratios could provide similar facts. As a result,

we regard a higher profitability ratio as a better profit making ability.

17 18
 Ratio Analysis for Business Ratio Analysis for Business

Management Efficiency Ratios Management Efficiency Ratios

Generally, the higher the better?

No, it depends!
Higher is better for:
Stock Turnover Ratio
Debtors Turnover Ratio
Creditors Repayment Period
Topic M01
Ratio Analysis for Business 19
Caution!
High stock turnover (low turnover period) may
Lower is better for:
indicate insufficient raw material supply
Stock Turnover Period
Debtors Collection Period High repayment period (low stock turnover) may
indicate inability to pay debts.
Creditors Turnover Ratio
BAFS Elective Part Topic M01 BAFS Elective Part
Learning and Teaching Example Ratio Analysis for Business 20 Learning and Teaching Example

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.
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.

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.

19 20
 Activity 3: Activity 3:
Which company performed better? Which company performed better?
Ratio Values Which
(Answers)
Ratios is better Reasons
Company 1 Company 2
1 or 2?
Gross Profit Ratio 0.31 0.25 Ratio Values Which
Ratios is better Reasons
Net profit Ratio 0.12 0.15 Company 1 Company 2
1 or 2?
Return on Capital Employed 0.21 0.24 Gross Profit Margin 0.31 0.25 1 Higher gross profit gained per unit sales
Return on Total Assets 0.11 0.19 Net profit Margin 0.12 0.15 2 Higher net profit gained per unit sales
Current Ratio 2.54 : 1 1.47 : 1 Return on Capital Employed 0.21 0.24 2 Higher net profit gained per unit capital used
Quick Ratio 1.12 : 1 1.30 : 1 Return on Total Assets 0.11 0.19 2 Higher net profit gained per unit asset used
Stock Turnover Ratio 4.5 times 3.8 times Current Ratio 2.54 : 1 1.47 : 1 1 More capacity to repay short-term debts
Stock Turnover Period 81.11 days 96.05 days Quick Ratio 1.12 : 1 1.30 : 1 2 More capacity to repay immediate debts
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

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 21 Learning and Teaching Example Ratio Analysis for Business 22 Learning and Teaching Example

Activity 3:
The objective of the activity is to compare the performance of two
companies in the same industry based on their accounting ratios.
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.

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.

21 22
 Activity 4: Which company are they talking
Activity 3: about?
Which company performed better? Statement X belongs to Company ?
Statement Y belongs to Company ?
(Answers) Statement Z belongs to Company ?

X Y Z
Ratio Values Which is
Ratios better Reasons Gross Profit Ratio
Company 1 Company 2
1 or 2? Net Profit Ratio
*Stock Turnover Ratio 4.5 times 3.8 times 1 More stocks are sold in the period/lower stock Return on Capital Employed
level
Return on Total Assets
Stock Turnover Period 81.11 days 96.05 days 1 Stocks required lesser time to be sold/lower
stock level Current Ratio
Debtors Turnover Ratio 4.66 3.98 1 Higher ability in collecting debts & more cash Quick Ratio
in hand Stock Turnover Ratio
Debtors Collection Period 78.33 days 91.71 days 1 Debts are collected in a shorter period &
Stock Turnover Period
more cash in hand
Debtors Turnover Ratio
Creditors Turnover Ratio 3.78 2.56 2 Enjoyed longer credit term & more cash in
hand Debtors Collection Period
Creditors Repayment 96.56 days 142.58 days 2 Debts are repaid in a longer period & more Creditors Turnover Ratio
Period cash in hand
Creditors Repayment Period
BAFS Elective Part Topic M01 BAFS Elective Part
Topic M01 24
23 Learning and Teaching Example Ratio Analysis for Business Learning and Teaching Example
Ratio Analysis for Business

*Additional information about Stock Turnover Ratio: Activity 4:

Stock Turnover Ratio is affected by the perishability of goods. Because The objective of the activity is clarify what the accounting ratios mean and
perishable goods must be sold very quickly before they deteriorate. how to interpret them in common daily language.
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 Instructions:
meaningless. 1. Each team is provided with a dialogue between two suppliers of three
companies A, B and C. (Student Fact Sheet 4A).

On the other hand, if the Stock Turnover Ratio is too high, this may indicate 2. Based on the dialogue, teams are required to match the statement (X, Y
insufficient supply. However, whether the level is too high can only be and Z) with the appropriate company (A, B and C).
judged by experience i.e. comparing it with the industry average and with 3. Teacher guides students as follows:
the historical record of the companys ratio. 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.

23 24
 Activity 4: Which company are they talking Activity 4:
about? (Answers)
X Y Z
Which company are they talking
Gross Profit Ratio (2) 352000/700000=0.50 172500/795,000=0.22 20000/80000=0.25
about? (Answers)
Net Profit Ratio (3) 65000/700000=0.09 30000/795,000=0.04 12000/80000=0.15
Return on Capital Employed 65000/[(109840+141840)/2] 30000/(500000+300000+128500+ 12000/[(36000+42000)/2]
(6), (7) =0.52 19500+225000)=0.03 =0.31
Return on Total Assets 65000/(148340+186000)=0.19 30000/1278000=0.02 12000/(2000+46000)=0.25
Current Ratio
(4)
186000/132500 (230000+175500+157500)/(75000 46000/6000 Statement X belongs to Company C .
=1.40 +30000)= 5.36 =7.67
Quick Ratio (5) (145500+1000+3000)/(132500) (175500+157500)/(75000+30000) (25000+6000)/6000

Inventory Turnover Ratio

=1.13
348000/[(30500+36500)/2]
=3.17
622500/[(200000+230000)/2]
=5.17
60000/[(25000+15000)/2]
Statement Y belongs to Company A .
(8) =10.39 =2.90 =3.00
Inventory Turnover Period [(30500+36500)/2]x365/348000 [(200000+230000)/2]x365/622500 [(25000+15000)/2]x365/60000
(8) =35.14 days =126.06 days 121.67
Statement Z belongs to Company B .
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 602500/75000 50000/5000

=2.95 =8.03 =10.00
Creditors Repayment Period 120000x365/(360000- 75000x365/602500 5000x365/50000
(1) 10000+4000)=123.73 days =45.44 days =36.5
Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 25 Learning and Teaching Example Ratio Analysis for Business 26 Learning and Teaching Example

Instruction (contd) :
5. Teacher illustrates to students how to solve the problem. The following Instruction (contd) :
is an extract of Fact Sheet 4A (Student Worksheet p.15) with key words 6. Verify team answers and give 3 scores for all correct matches, 2
underlined for mapping with corresponding accounting ratios shown in scores with 2 matches, and so on.
the above table.
7. Record and sum up all team scores.
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 As 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 As 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: Its true. We need not worry about that at least in the short run. But, in the
long run, I am concerned about the companys 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 doesnt change their direction, Company A will
probably be excluded from the market. For example, they should review
their inventory control. (8)Company As inventory, like that of Company B,
was in the warehouse for more than 4 months on average. ( B = Z)

25 26
 Conclusion
Accounting ratios could be used for comparing
companies in terms of their profitability, liquidity
and management efficiency.

Higher the ratios do not always mean better The End

situation

Looking at a single ratio could be misleading.

Ratios should be studied as a whole to see the
big picture.

Topic M01 BAFS Elective Part Topic M01 BAFS Elective Part
Ratio Analysis for Business 27 Learning and Teaching Example Ratio Analysis for Business 28 Learning and Teaching Example

Recap the three main themes of the lessons. End of Lesson 2

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

27
Topic M01: Ratio Analysis for Business
Student Worksheet P.1

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
BAFS Learning & Teaching Example
As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.2

Net Profit
Net Sales
Current Assets
Current Assets Stock
BAFS Learning & Teaching Example
As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.3

Average Stock
Credit Sales
Credit Purchases
Creditors BAFS Learning & Teaching Example
As at April 2009
 Topic M01: Ratio Analysis for Business
Student Worksheet P.4

Profit
Net Profit
Current Liabilities
Debtors
BAFS Learning & Teaching Example
As at April 2009
 Topic M01: Ratio Analysis for Business
Student Worksheet P.5

Gross Profit
Cost of Goods Sold
Current Liabilities
Creditors
BAFS Learning & Teaching Example
As at April 2009
 Topic M01: Ratio Analysis for Business
Student Worksheet P.6

Cost of Goods Sold

Debtors
Stock
Liquidity Ratios
BAFS Learning & Teaching Example
As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.7

Net Profit
Average Stock
Credit Sales
Credit Purchases
BAFS Learning & Teaching Example
As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.8

X 365 X 365
X 365 X 365

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.9

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. _____________ ______________

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.10

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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.11

Activity 2: Finding ratios from financial statements

Fact Sheet 2B

Funny Company Limited

Balance Sheet as at 31 December 20XX

Cost Provision for Net Book

depreciation 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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.12

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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.13

Activity 2: Finding ratios from financial statements

Fact Sheet 2D

Tricky Company Limited

Balance Sheet as at 31 December 20XX

Cost Provision for Net Book

depreciation 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

BAFS Learning & Teaching Example

As at April 2009
 Topic M01: Ratio Analysis for Business
Student Worksheet P.14

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

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

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.

BAFS Learning & Teaching Example

As at April 2009
 Topic M01: Ratio Analysis for Business
Student Worksheet P.15
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 Which is Reasons
Ratios Company 1 Company 2 better,
1 or 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

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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.16

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: Whats 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 As 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 As 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: Its true. We need not worry about that at least in the short run. But,
in the long run, I am concerned about the companys 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 doesnt change their direction, Company A will
probably be excluded from the market. For example, they should review
their inventory control. Company As 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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.17

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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.18

Activity 4: Which company are they talking about?

Fact Sheet 4C
Statement X
Balance Sheet as at 31 December 20XX
$ $ $
Fixed Assets Cost Accumulated Net
Depreciation 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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.19

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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.20

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

BAFS Learning & Teaching Example

As at April 2009
Topic M01: Ratio Analysis for Business
Student Worksheet P.21

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

Return on Capital
Employed

Return on Total
Assets

Current Ratio

Quick Ratio

Inventory
Turnover Ratio

Inventory
Turnover Period

Debtors Turnover
Ratio

Debtors Collection
Period

Creditors Turnover
Ratio

Creditors
Repayment Period

Statement X belongs to Company .

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

BAFS Learning & Teaching Example

As at April 2009