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Meaning of Ratio Analysis
A tool used to conduct a quantitative
analysis of information in a company's
financial statements.
Ratios are calculated from current year
numbers and are then compared to previous
years, other companies, the industry, oreven the economy to judge the performance
of the company.
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Uses of accounting ratios
Enable comparison of the performance of
the company
- in different years
- with its budgets and forecasts
- with other companies in similar trades
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Uses of accounting ratios
Provide information of the company in respect of
the liquidity, profitability, use of assets and capital
structure Eliminate the effects of the scale and size of
different companies or different years of the same
company so comparison can be provided.
Appraise the performance of the company, make
predictions for future performance and assist in
future planning
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Accounting ratios and
interpretation Liquidity
- current ratio / working capital ratio
- acid test ratio / quick ratio / liquid ratio
- stock turnover rate
- stock turnover period - debtors collection period
- creditors payment period
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Liquidity
Liquidity is a measure of the amount of
funds a company can quickly use to settle
its debts.
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Liquiditycurrent ratio
This ratio indicates the ability of a business tomeet its short-term liabilities from its currentassets.
FormulaCurrent assets/Current liabilities
The norm is 2:1.
If the ratio is too high, the company may be
holding too many idle short-term assets. (Theymay be used in a more profitable way.)
If the ratio is too low, the company may not havesufficient funds to meet its short-term liabilities.
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Liquidityacid test ratio
This ratio indicates the ability of the business to
meet its short-term liabilities from its quick assets.
Formula- Quick Assets/Current Liabilities The norm is 1:1.
If the ratio is too high, the company may be
holding excessive liquid assets. If the ratio is too low, the company may have a
liquidity problem / cash flow problem.
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Liquiditystock turnover rate
It shows the number of times that a business
can sell its average stock in a period.
FormulaCOGS/Average Stock
A high ratio means high sales, fast stock
turnover and a low stock level.
A low ratio means low sales, low stock
turnover and a high stock level. (goods may
become obsolete, high storage cost)
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Liquiditydebtors collection
period This ratio measures the debt collection
period of a business.
FormulaCredit Sales/Average Debtors
A low ratio means debtors pay back their
debts in a short period of time. The
company may have sufficient liquid fund.
A high ratio indicates a poor credit control
and a high risk of bad debts.
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Liquiditycreditors payment
period This shows the length of time taken to pay
the creditors.
FormulaCredit Purchases/Average
Creditors
A long payment period may indicate that
the company has a liquidity problem. Therelationship between the company and the
suppliers may be affected.
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Examples of interested group
Liquidity
- shareholders
- suppliers
- creditors
- competitors
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Limitations of ratio analysis
Differences in management and background of
various businesses may affect the comparison.
Different accounting definitions, methods,techniques and policies used by various businesses
may affect the comparability.
It is difficult to set up a proper standard for good
performance.
Short term fluctuations may not be reflected.
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Thank You
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