C hapter 1: Introduction to accounting

ratios
Contents of chapter
This chapter introduces common accounting ratios and their calculations.

Notes for teachers

This chapter is mainly concerned with the calculation of ratios and using ratios to find missing figures.
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The interpretation of ratios is left to Chapter 11, Volume 2.

2

Accounting ratios are widely used throughout the business world.

3

Many business targets are set in terms of ratios, e.g.

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(i) to increase the gross profit ratio to 25 per cent.
(ii) to reduce stock levels so that a stockturn of 5 times a year can be achieved.
(iii) to increase the net profit ratio by 10 per cent.

When budgeting, business owners often use accounting ratios to find needed figures.

Section 1.3, which mentions the relationship between mark-up and margin, is a useful section for
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students. Many questions assume that students know this relationship. If they don’t, very often they
cannot deduce some of the missing figures.

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 Answers to MCQs and exercises
1.1 C 1.2 C 1.3 A 1.4 D 1.5 D

1.6
(i) (a) 25% (b) 20% (ii) 25% (iii) 20%

1.7X
1 1
(i) (a) 50% (b) 33 % (ii) 100% (iii) 33 %
3 3

1.8 (Horizontal)

K Ying
Trading Account for the year ended 31 July 20X5
$ $
Opening stock 1.8.20X4 4,936 Sales 30,000
Add Purchases (iii) 25,374
30,310
Less Closing stock 6,310
Cost of goods sold (ii) 24,000
Gross profit (i) 6,000
30,000 30,000

Mark-up is 25%, therefore margin is 20%, consequently gross profit is 20% × $30,000 = $6,000.
Figures (i), (ii) and (iii) can then be found, in that order, by arithmetical deduction.

1.9X
(i) Average stock = $4,000
2, 000 + Closing Stock
i.e. = $4,000. Therefore, closing stock is $6,000.
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(ii) T Poon
Trading Account for the year ended 31 August 20X9
$ $
Opening stock 2,000 Sales 21,000
Add Purchases 18,000
20,000
Less Closing stock 6,000
Cost of goods sold 14,000
Gross profit 7,000
21,000 21,000

Cost of goods sold is then calculated as $14,000. Given mark-up is 50%, Sales = $14,000 + ($14,000 × 50%) = $21,000.

(iii) As gross profit = $7,000, and net profit is 10% of sales (=$2,100), the maximum amount of expenses he can afford
= $7,000 – $2,100 = $4,900.

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1.10
Cost of goods sold
(i) Rate of stock turnover =
Average stock
Cost of goods sold
i.e. 7 =
$4, 200
∴ Cost of goods sold = $29,400

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(ii) Given: Margin is 33 %, i.e. mark-up is 50%
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Gross profit = Cost of goods sold × mark-up
∴ Gross profit = $29,400 × 50%
= $14,700.

(iii) Sales = $29,400 + $14,700 = $44,100.

(iv) Total expenses = 70% of gross profit = $14,700 × 70% = $10,290.

(v) Net profit = Gross profit less expenses, i.e. $14,700 – $10,290 = $4,410.

1.11X
Category A Category B
(i) Sales × (1 – Margin) $3,000 (1 – 20%) $7,000 (1 – 25%)
= Cost of goods sold = $2,400 = $5,250

(ii) Sales – Cost of goods sold $3,000 – $2,400 $7,000 – $5,250

= Gross profit = $600 = $1,750

(iii) Total expenses = 10% of sales $300 $700

(iv) Gross profit – Expenses $600 – $300 $1,750 – $700

= Net profit = $300 = $1,050

Cost of goods sold $2,400 $5,250

(v) = Stock turnover = = 12 times p.a. = = 20 times p.a.
Average stock ? ?
So, by arithmetical deduction, = $200 = $262.50

1.12
(i) Trading and Profit and Loss Account for the year ended 31 March 20X7
$ $
Opening stock 30,000 Sales 200,000
Add Purchases 180,000
210,000
Less Closing stock ($210,000 – $160,000) 50,000
Cost of goods sold ($40,000 ÷ 25%) 160,000
Gross profit c/d 40,000
200,000 200,000
Wages and salaries ($200,000 × 10%) 20,000 Gross profit b/d 40,000
General expenses ($200,000 × 5%) 10,000
Net profit 10,000
40,000 40,000

Cost of goods sold $160,000

(ii) = = 4 times per annum
Average stock ($30,000 + $50,000) ÷ 2

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 1.13X
(i) Trading and Profit and Loss Account for the year ended 30 June 20X8
$ $
Opening stock 50,000 Sales 480,000
Add Purchases 380,000
430,000
Less Closing stock 70,000
Cost of goods sold 360,000
Gross profit c/d ($480,000 × 25%) 120,000
480,000 480,000
Commission paid ($480,000 × 7.5%) 36,000 Gross profit b/d 120,000
General expenses 22,700
Net profit 61,300
120,000 120,000

Cost of goods sold $360 ,000

(ii) Stockturn = = = 6 times per annum
Average stock ($50 ,000 + $70 ,000 ) ÷ 2

1.14
(i) Trading and Profit and Loss Account for the year ended 31 December 20X6
$ $ $ $
Opening stock 6,000 Sales 36,690
Purchases 28,690 Less Returns inwards 440 36,250
Less Returns outwards 660 28,030
Add Carriage inwards 570
34,600
Less Closing stock 5,600
Cost of goods sold 29,000
Gross profit c/d 7,250
36,250 36,250
Wages 2,720 Gross profit b/d 7,250
Accrued 240 2,960
Rent 500
Carriage outwards 110
Sundry expenses 55
Net profit 3,625
7,250 7,250

$7 ,250
(ii) (a) × 100 = 20%
$36 ,250
$3,625
(b) × 100 = 10%
$36,250
$(2, 960 + 500 + 110 + 55)
(c) × 100 = 10%
$36, 250

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1.15
(a)
Mr Wong
Trading and Profit and Loss Account for the year ended 31 March 20X0
$ $
Sales 250,000
Less Cost of goods sold:
Opening stock 60,000
Add Purchases 105,000
165,000
Less Closing stock 40,000 125,000
Gross profit 125,000
Less Operating expenses 75,000
Net profit 50,000

Balance Sheet as at 31 March 20X0

$ $
Fixed Assets 50,000
Current Assets
Stock 40,000
Debtors 70,000
Cash in hand 10,000
120,000
Less Current Liabilities
Creditors 40,000
Net current assets 80,000
130,000
Financed by:
Capital 100,000
Add Profit for the year 50,000
150,000
Less Drawings 20,000
130,000
(b) Calculation of the ratios
Net profit 50,000
(i) Net profit ratio = = × 100% = 20%
Sales 250,000
(ii) Acid test ratio
(Current assets − Stock)
=
Current liabilities
(120,000 − 40 ,000)
=
40 ,000
= 2:1

(c) Limitations of ratio analysis

Difference in nature of businesses:

First, it is impossible to compare two businesses which are completely unlike one another. To compare a
supermarket’s ratios with those of a chemical factory would be rather pointless.

Difference in accounting policies:

Also, different businesses may adopt different accounting policies in preparation of their accounts. This increases
the difficulty in comparing the businesses.

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 Qualitative features of a business:
There are a whole number of factors that the past accounts do not disclose. The desire to keep to the money
measurement concept, and the desire to be objective, exclude a great deal of desirable information such as the
quality of staff, the future plans of the business and its position compared with its competitors, etc.

Lack of a standard form:

Ratios are not always defined in a standard form. They are not directly comparable if different formulae are used
in calculating ratios.

1.16X
(a) (i) Trading and Profit and Loss Account for the year ended 31 December 20X8
$ $ $
Sales 51,900
Less Returns inwards 1,200
50,700
Less Cost of goods sold:
Opening stock 3,900
Purchases 28,800
Less Returns outwards 600 28,200
32,100
Less Closing stock 4,100 28,000
Gross profit 22,700
Discount received 900
23,600
Provision for depreciation:
Fixture and fittings [($11,500 – $2,300) × 10%] 920
Provision for bad debts [($4,200 × 10%) – $350] 70
Wages 9,720
Sundry expenses ($560 + $60) 620
Discount allowed 1,100
Rent, rates and insurance ($2,950 – $170) 2,780 15,210
Net profit 8,390

(ii) Balance Sheet as at 31 December 20X8

Fixed Assets $ $ $
Fixtures and fittings 11,500
Less Provision for depreciation ($2,300 + $920) 3,220 8,280
Current Assets
Stock 4,100
Debtors 4,200
Less Provision for bad debts 420 3,780
Prepayment 170
Bank 2,160
10,210
Less Current Liabilities
Creditors 3,100
Accrual 60 3,160
Net current assets 7,050
15,330
Financed by:
Capital as at 1.1.20X8 14,940
Add Net profit 8,390
23,330
Less Drawings 8,000
15,330

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 $22,700
(b) (i) Gross profit ratio = × 100% = 44.77%
$50 ,700
$8 ,390
(ii) Net profit ratio = × 100% = 16.55%
$50 ,700
$28 ,000
(iii) Stockturn = = 7 times a year
($3,900 + $4 ,100) ÷ 2

(iv) Current assets = $10,210

Current liabilities = $3,160
Current ratio = 3.23 : 1
(v) Acid test ratio = 1.93 : 1

(c) The firm seems to have sufficient liquidity. Its current ratio is much greater than 2 : 1, and even the quick ratio is
above 1 : 1. The amounts of debtors and creditors are close to each other.