A Role Of Accounting Ratio In Companies

Published Date: 02 Nov 2017

First, before I begin in this I take this prospect to thank Almighty Allah, for providing me the strength and health to make this project work until it is completed. At this point, I would like to express my sincere thanks to those who have contributed to help me while collecting of necessary information to the research, and sharing their ideas and opinions about this assignment. They were very helpful in every area where I faced a difficulty in making this assignment a success.

Then, a special thanks to APU, Malaysia for providing this opportunity in analyzing and developing new ideas to complete the research so that it will benefit me for the future. I am heartily thankful to our lecturer Mr. Gunaseelan A/L Kannan whose guidance and support from initial to the level enabling us to develop and understand the subject more thoroughly to complete the assignment.

ROLE OF ACCOUNTING RATIO IN COMPANIES

Ratio analysis is a very useful tool used by the management of the companies to guide them about the financial strength and the weakness of the company in decision making for the future. With this tool they analyze the financial performance and also the company’s short term and long term wealth position of the company. Ratio analysis for a company is to derive computable measures or direct regarding the predictable capacity of the firm to meet its upcoming financial requirements or expectations.

Advantages of accounting ratio

Ratio analysis is an important method of financial statement analysis. Accounting ratios are handy for considerate the financial position of the company. Concerned users such as creditors, management, investors and bankers use the ratio to consider the financial situation of the company for the purpose of decision making.

Accounting ratios are essential for judging the company’s efficiency in its operations and management. These ratios help to judge how strong the company has been able to consume its assets and earn profit.

Accounting ratios are also used in tracing weakness of the company’s developments even though its overall performance may be rather good. By identifying the weakness management can pay attention to this and take counteractive actions to overcome these weaknesses.

Although accounting information is used to analyze the company’s historical financial performance, they can also be utilized to establish the future of its financial performance. This history information can help the company to formulate the future plans, for where to invest.

It is vital to understand how healthy the company’s attainments above the years and as compared to the companies of the connected environment. Further, it is also significant to know how healthy its different departments are performing among themselves in various years. Ratio analysis assists such evaluation between these related companies.

Disadvantages of Accounting Ratios

Ratios primarily deal in numbers .They don’t reflect issues like quality of product, employee morale and customer service. But these factors comprise an important role in financial performance.

Ratios don’t look at the future. They mainly look at the past. Users are mostly concerned about current and future status.

Ratios are used to compare performance in a quite a number of periods or against similar companies. The challenge is this information’s are not available always from companies.

RATIOS AND ITS PURPOSE IN ACCOUNTING DECISIONS

Gross profit rate is determined by dividing gross profit (net sales less cost of goods sold) by net sales. This rate indicates a company's ability to maintain an adequate selling price above its cost of goods sold. As an industry becomes more competitive, this ratio declines. For example, in the early years of the personal computer industry, gross profit rates were quite high. Today, because of increased competition and a belief that most brands of personal computers are similar in quality, gross profit rates have become thinner. Gross profit rates should be closely monitored over time.

Gross profit rate = gross profit

Net Sales

Liquidity ratios compute the adequacy of present and liquid assets and aid assess the skill of the company to pay its short-term debts. The skill of a company to pay its short-term liabilities is oftentimes denoted to as short-term solvency locale or the liquidity locale of the business. Generally a company alongside adequate present and liquid assets to pay its present liabilities as and after they come to be due is believed to have a forceful liquidity local and a company alongside the insufficient present and liquid assets are believed to have a frail liquidity position. Short-term creditors like suppliers of goods and business banks use liquidity ratios to understand whether the company has adequate present and fluid assets to encounter its present obligations. Commercial institutions waver to proposal short-term advances to companies alongside frail short-term solvency position.

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Current ratio indicates the liquidity of present assets or the skill of the company to encounter its maturing present liabilities. Elevated present ratio finds favor alongside short-term creditors whereas low ratio reasons concern to them. An rise in the present ratio reflects enhancement in the liquidity locale of the company as the cut signals that there has been a deterioration in the liquidity locale of the business. As a convention 2 :1 is considered as satisfactory level i.e. present assets ought to be nearly double than the present liabilities. The believer is to furnish for defeat in the worth of present assets due to probably cut in the marketplace worth and to present for each probable stay in the realization of present assets. Though there is no logical reasoning behind 2 : 1 norm. Current ratio assesses merely the number of present assets rather than the quality of assets. The current ratio is computed by dividing current assets by current liabilities.

Current Ratio = Current Asset

Current Liabilities

Acid-test ratio (also known as quick ratio) this ratio shows that provided creditors and debtors are paid at approximately the same time, a view might be made as to whether the business has sufficient liquid resources to meet its current liabilities. The acid-test ratio is computed by dividing quick assets by current liabilities.

Acid-test Ratio = Current asset - Inventory

Current Liabilities

The ground rule for this ratio is 1:1. Whatever below this level needs more scrutiny of receivables to comprehend how frequently the company turns them into cash. It could additionally indicate the companies needs to institute a line of trust alongside a commercial association to safeguard the company has admitted to cash after it needs to pay its debts.

Receivables turnover ratio computes the number of periods in an operating cycle (normally one year) the company accumulates its receivable balance. It is computed by dividing net credit sales by the average net receivables. Net credit sales are net sales less cash sales. If cash sales are unfamiliar, usenet sales. Average net receivables are normally the balance of net receivables at the commencing of the year plus the balance of net receivables at the conclude of the year tear by two. If the company is cyclical, an average computed on a reasonable basis for the company's procedures ought to be utilized such as monthly or quarterly.

Receivable Turnover = Net credit sales

Average net receivables

Average collection period (also known as a day’s sales outstanding) is a variation of receivables turnover. It computes the number of days it will take to collect the average receivables balance. It is often utilized to assess the effectiveness of a company's credit and collection policies. The key rule for this is the average collection period ought to not be larger than a company's credit term period. The average collection period is computed by dividing 365 by the receivables turnover ratio.

Average collection period = 365

Receivable turnover

Inventory turnover ratio computes the number of times the company sells its inventory across the period. It is computed by dividing the cost of goods sold by average inventory. Average inventory is computed by adding commencing inventory and concluding inventory and dividing by 2. If the company is cyclical, an average computed on a reasonable basis for the company's procedures ought to be utilized such as monthly or quarterly.

Inventory turnover ratio = Cost of goods sold

Average inventory

Day sale on hand is a variation of the inventory turnover. It computes the number of day's sales being carried in inventory. It is computed by dividing 365 days by the inventory turnover ratio.

Days sales on Hand = 365

Inventory turnover

Profitability ratios compute a company's working efficiency, encompassing its skill to produce income and consequently, cash flow. Cash flow affects the company's skill to attain liability and equity financing.

Operating ratio is an examination of the efficiency of the association in their company operation. It is a way of working efficiency. In normal conditions, the working ratio ought to below plenty so as to depart serving of the sales adequate to give a fair revisit to the investors. Operating ratio plus working profit ratio is 100. The two ratios are certainly interrelated. For example, if the working profit ratio is 20%, it's the way that the working ratio is 80%. A development in the working ratio indicates a plummet in the efficiency. Lower the working ratio, the larger is the locale because larger is the profitability and association efficiency of the concern. The higher the ratio, the less favorable is the situation, because there will be a tinier margin of profit obtainable for the intention of payment of dividend and conception of reserves.

Profit margin ratio, also known as the operating performance ratio, computes the company's ability to turn its sales into net income. To evaluate the profit margin, it has to be contrasted to competitors and industry statistics. It is computed by dividing net income by net sales.

Profit Margin = Net income

Net sales

Asset turnover ratio computes how effectually a company is using its assets. The turnover worth varies by industry. It is computed by dividing net sales by average total assets.

Asset turnover = Net sales

Average total assets

Return on assets ratio (ROA) is considered an overall compute of profitability. It computes how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. It can be computed separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio.

Asset turnover = Net sales

Average total assets

Return on Assets = Profit margin x Asset turnover

Net income = Net Income x Net sale

Average total assets Net Sales Average total assets

Return on common stockholders' equity (ROE) computes how much net income was received comparative for each dollar of public stockholders' equity. It is computed by dividing net income by average public stockholders' equity. In a modest capital structure (only public stock outstanding), average public stockholders' equity is the average of the commencing and concluding stockholders' equity.

Return on common Net Income

Stockholder’s equity = Average common stockholder’s Equity

Earnings per share (EPS) signify the net income received for every share of outstanding public stock. Stockholders normally contemplate in the words of the number of shares they own or design to buy or sell. Expressing net income received on a each allocate basis provides a functional outlook for ascertaining profitability. Profit each allocate is a compute of the net income received on every single allocate of public stock. It is computed by dividing net income by the average number of public shares outstanding across the year. The words "net income each share" or "earnings each share" denote to the amount of net income applicable to every single allocate of public stock. Therefore, after we compute paycheck each allocate, if there are favored dividends uttered for the era, they have to be deducted from net income to appear at income obtainable to the public stockholders

Earnings per share = Net Income

Weight Average common share outstanding

Price-earnings ratio (P/E) The price-earnings ratio is an oft-quoted statistic that measures the ratio of the marketplace worth of every single allocates of public stock to the paycheck each share. The price-earnings (P-E) ratio is a reflection of investors' assessments of a company's upcoming earnings. The larger the P/E ratio, the larger the demand for the shares.

Price-Earnings ratio = Marketing price per common share

Earnings per share

Payout ratio identifies the percent of net income paid to public stockholders in the form of cash dividends. It is computed by dividing cash dividends by net income. Companies that have elevated development rates are described by low payout ratios because they reinvest most of their net income in the company.

Payout Ratio = Cash Dividends

Net Income

An extra stable and mature company is probable to pay out a higher portion of its earnings as dividends. Countless startup companies and in some industries do not pay out dividends. It is vital to comprehend the company and its strategy after analyzing the payout ratio.

Solvency ratios are utilized to compute long-term risk and are of attention to long-term creditors and stockholders.

Debt to total assets ratio is utilized to compute the percent of assets endowed by creditors. It is computed by dividing total debt by total assets. Total debt is the similar as total liabilities.

Debt to total asset ratio = Total debt

Total assets