The 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 do this project work until it is completed. At this point, I would like to express my sincere thanks to those who have contributed help to 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 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 is also used in locating weakness of the company’s processes 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 future of its financial performance. This history information can help the company to formulate the future plans, for where to invest.

It is necessary to know how healthy the company is performing over the years and as compared to the companies of the related 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 play an important role in financial performance.

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

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

RATIOS AND ITS PURPOSE IN ACCOUNTING DECISIONS

Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs.

Current ratio (also known as working capital ratio) measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities

Current Ratio = Current Asset

Current Liabilities

Acid-test ratio (also known as quick ratio) Quick assets are defined as cash, marketable (or short-term) securities, and accounts receivable and notes receivable, net of the allowances for doubtful accounts. These assets are considered to be very easy to obtain cash from the assets (liquid) and therefore, available for immediate use to pay obligations. The acid-test ratio is calculated by dividing quick assets by current liabilities.

Acid-test Ratio = Quick Assets

Current Liabilities

The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires further analysis of receivables to understand how often the company turns them into cash. It may also indicate the company needs to establish a line of credit with a financial institution to ensure the company has access to cash when it needs to pay its debts.

Receivables turnover ratio calculates the number of times in an operating cycle (normally one year) the company collects its receivable balance. It is calculated by dividing net credit sales by the average net receivables. Net credit sales are net sales less cash sales. If cash sales are unknown, use net sales. Average net receivables are usually the balance of net receivables at the beginning of the year plus the balance of net receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.

Receivable Turnover = Net credit sales

Average net receivables

Average collection period (also known as day’s sales outstanding) is a variation of receivables turnover. It calculates the number of days it will take to collect the average receivables balance. It is often used to evaluate the effectiveness of a company's credit and collection policies. The thumb rule for this is the average collection period should not be significantly greater than a company's credit term period. The average collection period is calculated by dividing 365 by the receivables turnover ratio.

Average collection period = 365

Receivable turnover

Inventory turnover ratio measures the number of times the company sells its inventory during the period. It is calculated by dividing the cost of goods sold by average inventory. Average inventory is calculated by adding beginning inventory and ending inventory and dividing by 2. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.

Inventory turnover ratio = Cost of goods sold

Average inventory

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

Days sales on Hand = 365

Inventory turnover

Profitability ratios measure a company's operating efficiency, including its ability to generate income and therefore, cash flow. Cash flow affects the company's ability to obtain debt and equity financing.

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

Profit Margin = Net income

Net sales

Asset turnover ratio measures how efficiently a company is using its assets. The turnover value varies by industry. It is calculated by dividing net sales by average total assets.

Asset turnover = Net sales

Average total assets

Return on assets ratio (ROA) is considered an overall measure of profitability. It measures 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 calculated 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) measures how much net income was earned relative to each dollar of common stockholders' equity. It is calculated by dividing net income by average common stockholders' equity. In a simple capital structure (only common stock outstanding), average common stockholders' equity is the average of the beginning and ending stockholders' equity.

Return on common Net Income

Stockholder’s equity = Average common stockholder’s Equity

Earnings per share (EPS) represent the net income earned for each share of outstanding common stock. In a simple capital structure, it is calculated by dividing net income by the number of weighted average common shares outstanding.

Earnings per share = Net Income

Weight Average common share outstanding

Price-earnings ratio (P/E) is quoted in the financial press daily. It represents the investors' expectations for the stock. A P/E ratio greater than 15 has historically been considered high.

Price-Earnings ratio = Marketing price per common share

Earnings per share

Payout ratio identifies the percent of net income paid to common stockholders in the form of cash dividends. It is calculated by dividing cash dividends by net income.

Payout Ratio = Cash Dividends

Net Income

A more stable and mature company is likely to pay out a higher portion of its earnings as dividends. Many startup companies and companies in some industries do not pay out dividends. It is important to understand the company and its strategy when analyzing the payout ratio.

Solvency ratios are used to measure long-term risk and are of interest to long-term creditors and stockholders.

Debt to total assets ratio calculates the percent of assets provided by creditors. It is calculated by dividing total debt by total assets. Total debt is the same as total liabilities.

Debt to total asset ratio = Total debt

Total assets