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and to improve the quality of profits。
ACCOUNTING RATIOS
Ratios used in analysing pany accounts are clustered under five headings
and are usually referred to as ‘tests’：
。 tests of profitability；
。 tests of liquidity；
。 tests of solvency；
42 The Thirty…Day MBA
。 tests of growth；
。 market tests。
The profit and loss account and balance sheet in Tables 1。7 and 1。8 above
will be used； where possible； to illustrate these ratios。
Tests of profitability
There are six ratios used to measure profit performance。 The first four profit
ratios are arrived at using only the profit and loss account and the other
two use information from both that account and the balance sheet。
Gross profit
This is calculated by dividing the gross profit by sales and multiplying by
100。 In this example the sum is 30；000 / 60；000 × 100 = 50％。 This is a measure
of the value we are adding to the bought…in materials and services we need
to ‘make’ our product or service； the higher the figure the be。。er。
Operating profit
This is calculated by dividing the operating profit by sales and multiplying
by 100。 In this example the sum is 8；700 / 60；000 × 100 = 14。5％。 This is a
measure of how efficiently we are running the business； before taking
account of financing costs and tax。 These are excluded as interest and tax
rates change periodically and are outside our direct control。 Excluding
them makes it easier to pare one period with another or with another
business。 Once again the rule here is the higher the figure the be。。er。
Net profit before and after tax
Dividing the net profit before and a。。er tax by the sales and multiplying
by 100 calculates these next two ratios。 In this example the sums are
8；100/60；000 × 100 = 13。5％ and 6；723/60；000 × 100 = 11。21％。 This is a measure
of how efficiently we are running the business； a。。er taking account of
financing costs and tax。 The last figure shows how successful we are at
creating additional money to either invest back in the business or distribute
to the owner（s） as either drawings or dividends。 Once again the rule here is
the higher the figure the be。。er。
Return on equity
This ratio is usually expressed as a percentage in the way we might think
of the return on any personal financial investment。 Taking the owners’
viewpoint； their concern is with the profit earned for them relative to the
amount of funds they have invested in the business。 The relevant profit
here is a。。er interest and tax （and any preference dividends） have been
Accounting 43
deducted。 This is expressed as a percentage of the equity that prises
ordinary share capital and reserves。 So in this example the sum is： return
on equity = 6；723 / 18；700 × 100 = 36％。
Return on capital employed
This takes a wider view of pany performance than return on equity
by expressing profit before interest； tax and dividend deductions as a
percentage of the total capital employed； irrespective of whether this capital
is borrowed or provided by the owners。
Capital employed is defined as share capital plus reserves plus long…term
borrowings。 Where； say； a bank overdra。。 is included in current liabilities
every year and in effect bees a source of capital； this may be regarded
as part of capital employed。 If the bank overdra。。 varies considerably from
year to year； a more reliable ratio could be calculated by averaging the startand
end…year figures。 There is no one precise definition used by panies
for capital employed。 In this example the sum is： return on capital employed
= 8；700/18；700 ＋ 10；000 × 100 = 30％。
Tests of liquidity
In order to survive； panies must also watch their liquidity position； by
which is meant keeping enough short…term assets to pay short…term debts。
panies go out of business pulsorily when they fail to pay money
due to employees； bankers or suppliers。
The liquid money tied up in day…to…day activities is known as working
capital； the sum of which is arrived at by subtracting the current liabilities
from the current assets。 In the case of High Note we have ￡21；108 in current
assets and ￡4；908 in current liabilities； so the working capital is ￡16；200。
Current ratio
As a figure the working capital doesn’t tell us much。 It is rather as if you
knew your car had used 20 gallons of petrol but had no idea how far you
had travelled。 It would be more helpful to know how much larger the
current assets are than the current liabilities。 That would give us some idea
if the funds would be available to pay bills for stock； the tax liability and
any other short…term liabilities that may arise。 The current ratio； which is
arrived at by dividing the current assets by the current liabilities； is the
measure used。 For High Note this is 21；108/4；908 = 4。30。 The convention is
to express this as 4。30 ： 1 and the aim here is to have a ratio of between 1。5 ： 1
and 2 ： 1。 Any lower and bills can’t be met easily； much higher and money is
being tied up unnecessarily。
44 The Thirty…Day MBA
Quick ratio （acid test）
This is a belt and braces ratio used to ensure that a business has sufficient
ready cash or near cash to meet all its current liabilities。 Items such as stock
are stripped out as although these are assets； the money involved is not
immediately available to pay bills。 In effect the only liquid assets a business
has are cash； debtors and any short…term investment such as bank deposits
or government securities。 For High Note this ratio is： 12；000/4；908 = 2。44 ： 1。
The ratio should be greater than 1 ： 1 for a business to be sufficiently liquid。
Average collection period
We can see that High Note’s current ratio is high； which is an indication that
some elements of working capital are being used inefficiently。 The business
has ￡12；000 owed by customers on sales of ￡60；000 over a six…month period。
The average period it takes High Note to collect money owed is calculated
by dividing the sales made on credit by the money owed （debtors） and
multiplying it by the time period； in days； in this case the sum is as follows：
12；000/60；000 × 182。5 = 36。5 days。
If the credit terms are cash with order or seven days； then something is
going seriously wrong。 If it is net 30 days then it is probably about right。 In
this example it has been assumed that all the sales were made on credit。
Average payment period
This ratio shows how long a pany is taking on average to pay its suppliers。
The calculation is as for average collection period； but substituting
creditors for debtors and purchase for sales。
Days stock held
High Note is carrying ￡9；108 stock of sheet music； CDs etc and over the
period it sold ￡30；000 of stock at cost （the cost of sales is ￡30；000 to support
￡60；000 of invoiced sales as the mark…up in this case is 100 per cent）。 Using
a similar sum as with average collection period we can calculate that the
stock being held is sufficient to support 55。41 days sales （9；108/10；000 ×
182。5）。 If High Note’s suppliers can make weekly deliveries then this is
almost certainly too high a stock figure to hold。 Cu。。ing stock back from
nearly 8 weeks （55。41 days） to 1 week （7 days） would trim 48。41 days or
￡7；957。38 worth of stock out of working capital。 This in turn would bring
the current ratio down to 2。68 ： 1。
Circulation of working capital
This is a measure used to evaluate the overall efficiency with which
working capital is being used。 That is the sales divided by the working
capital （current assets – current liabilities）。 In this example that sum is：
60；000/16；420 = 3。65 times。 In other words； we are turning over the working
Accounting 45
capital more than three and a half times each year。 There are no hard and
fast rules as to what is an acceptable ratio。 Clearly the more times working
capital is turned over； stock sold for example； the more chance a business
has to make a profit on that activity。
Tests of solvency
These measures see how a pany is managing its long…term liabilities。
There are two principal ratios used here。
Gearing
This measures as a percentage the proportion of all borrowing； including
long…term loa