Understanding and Applying Accounting Ratios

o Why do businesses analyze financial statements?

o How do we know if a business is profitable or financially healthy?

 Introduce the three main types of ratios:

o Profitability Ratios
o Liquidity Ratios
o Efficiency Ratios

Key Ratios

(a) Profitability Ratios – Measures Business Profitability

1. Gross Profit Margin

 Formula: Gross Profit Margin=(Gross Profit/Revenue) ×100

 Example:
If a business has Gross Profit = $20,000 and Revenue = $50,000, (20,00050,000)×100=
40%
 Interpretation: The business retains 40% of sales after covering the cost of goods sold
(COGS).

2. Net Profit Margin

 Formula: Net Profit Margin= (Net Profit/ Revenue)×100 = 20%

 If Net Profit = $10,000 and Revenue = $50,000, =20%

 Interpretation: After all expenses, the business retains 20% of sales revenue as profit.

(b) Liquidity Ratios – Measures a Business's Ability to Pay Debts

3. Current Ratio (Working Capital Ratio)

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  Formula: Current Ratio= Current Assets / Current Liabilities
 Example:
If Current Assets = $30,000 and Current Liabilities = $15,000, 30,00015,000=2:1

 2:1 Interpretation: The business has $2 of assets for every $1 of liabilities, which is
good liquidity.

4⃣ Quick Ratio (Acid Test Ratio)

 Formula: Quick Ratio = Current Assets − Inventory Current Liabilities

 Example:
If Current Assets = $30,000, Inventory = $10,000, and Current Liabilities = $15,000,
30,000−10,000/ 15,000 = 1.33:1

 Interpretation: The business can pay its short-term debts without selling inventory.

(c) Efficiency Ratios – Measures How Well a Business Utilizes Resources

5. Debtors Collection Period (Accounts Receivable Turnover)

 Formula: Debtors Collection Period = (Trade Receivables Credit Sales)×365

 Example:
If Debtors (Accounts Receivable) = $12,000 and Credit Sales = $48,000,
(12,00048,000)×365=91.25 days
 Interpretation: It takes an average of 91 days to collect money from credit customers.

6. Creditors Payment Period (Accounts Payable Turnover)

 Formula: Creditors Payment Period= (Trade Payables/Credit Purchases)×365

 Example:
If Creditors (Accounts Payable) = $8,000 and Credit Purchases = $32,000,
(8,00032,000)×365=91.25 days

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  Interpretation: The business takes 91 days to pay suppliers.

3. Practical Application (15 minutes)

Class Activity

 Provide students with a simplified Income Statement and Balance Sheet.

 Ask them to calculate at least three ratios and interpret their meaning.
 Discuss results and how different businesses might use them.

Example Question:

A business provides the following financial information:

 Sales Revenue: $100,000

 Gross Profit: $40,000
 Net Profit: $20,000
 Current Assets: $25,000
 Current Liabilities: $10,000
 Trade Receivables: $8,000
 Credit Sales: $32,000

Tasks:

1. Calculate the Gross Profit Margin.

2. Calculate the Net Profit Margin.
3. Calculate the Current Ratio.
4. Calculate the Debtors Collection Period.
5. Interpret the results.

4. Summary & Review (5 minutes)

 Recap key ratio formulas and their purpose.

 Discuss how ratios help businesses make decisions.
 Ask students to give real-life examples where ratios might be useful (e.g., applying for a
loan, improving cash flow).

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1. Gross Profit Margin (%)

Gross Profit Margin=(Gross Profit/Sales Revenue)×100- 40000/100000 X 100 = 40%

Interpretation:

 The business earns $0.40 in gross profit for every $1 of sales revenue.
 A higher gross profit margin indicates good cost control over goods sold.

2. Net Profit Margin (%)

Net Profit Margin=(Net ProfitSales Revenue)×100 =(20,000/100,000)×100 =20%

Interpretation:

 The business retains $0.20 of every $1 in sales after all expenses.

 A higher net profit margin means efficient expense management.

3. Current Ratio

Current Ratio=Current Assets Current Liabilities {Current Ratio} =25,000 / 10,000 = 2.5:1

Interpretation:

 The business has $2.50 in current assets for every $1 of current liabilities.
 A ratio above 1:1 indicates the business can cover its short-term debts.

4. Debtors Collection Period (Days)

Debtors Collection Period = (Trade Receivables Credit Sales) = 8,000 / 32,000)×365

=91.25 days

Interpretation:

 Customers take an average of 91 days to pay their debts.

 If this period is too long, the business may face cash flow issues.

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 Final Summary of Answers
Ratio Formula Answer
Gross Profit Margin (Gross Profit ÷ Sales Revenue) × 100 40%
Net Profit Margin (Net Profit ÷ Sales Revenue) × 100 20%
Current Ratio Current Assets ÷ Current Liabilities 2.5:1
Debtors Collection (Trade Receivables ÷ Credit Sales) × 365 91 days

Errors in Accounting & the Trial Balance

Errors Affecting the Trial Balance

These errors cause the trial balance totals to be unequal. They require adjustments to correct the
imbalance.

Types of Errors Affecting the Trial Balance

1. Error of Omission (Partial Omission)

One side of the transaction is recorded, while the other is missing.

Example: Sales of $500 were correctly credited to the Sales account, but no entry was made in the
Debtor’s account.

2. Error of Partial Entry

A different amount is recorded on the debit and credit sides.

Example: A purchase of $2,000 was recorded in the Purchases account as $2,500, but the payment
in the bank was correctly recorded as $2,000.

3. Transposition Error

Numbers are reversed in one account.

Example: A payment of $1,230 is entered as $1,320 in the Cash account.

4. Single Entry Error

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A transaction is recorded only on one side of the accounts.

Example: $5,000 paid for rent was debited to Rent Expense but no credit was made to the Bank
account.

5. Incorrect Balancing

If an account is incorrectly balanced, it may cause the trial balance totals to be different.

Errors Not Affecting the Trial Balance

These errors do not impact the trial balance because both debit and credit entries are affected
equally.

Types of Errors Not Affecting the Trial Balance

1. Error of Omission (Full Omission)

The transaction is completely left out of the books.

Example: A credit sale of $1,000 was not recorded in either the Sales account or the Debtor’s
account.

2. Error of Commission

The transaction is recorded in the wrong personal account but in the correct category.

Example: A credit sale of $600 to John Brown was recorded in the account of James Brown instead.

3. Error of Principle

The transaction is recorded in the wrong type of account.

Example: A $1,500 computer purchase is recorded as an expense (Office Expenses) instead of an

asset (Computers - Fixed Assets).

4. Compensating Errors

Two or more errors cancel out each other.

Example: An overstated purchases figure of $2,000 is balanced by an overstated sales figure of

$2,000.

5. Error of Original Entry

The wrong amount is entered in both the debit and credit sides.

Example: A $300 transaction was mistakenly recorded as $3,000 in both accounts.

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6. Reversal of Entries

The correct amount is entered, but the debit and credit entries are swapped.

Example: A $200 payment to a creditor is debited to the creditor’s account and credited to the Bank
account.

Suspense Account

What is a Suspense Account?

A temporary account used when there is a difference in the trial balance, and the accountant
needs to identify and correct errors.

When is a Suspense Account Used?

 When the debit and credit totals of the trial balance do not match.
 When an unknown transaction occurs, and clarification is needed.
 How to Correct Errors Using a Suspense Account
 If the trial balance is short on the debit side, debit the suspense account.
 If the trial balance is short on the credit side, credit the suspense account.
 Once the errors are found, adjustments are made to remove the suspense account
balance.
 Sales & Purchase Ledger Control Accounts

1. Sales Ledger Control Account (SLCA)

The Sales Ledger Control Account summarizes all transactions related to debtors (accounts
receivable). It acts as a check for individual debtor accounts.

Entries in SLCA

Debits (Increases Debtors/Receivables):

✔ Credit Sales

✔ Dishonored Cheques from Customers

✔ Interest Charged on Debtors

Credits (Decreases Debtors/Receivables):

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✔ Payments from Debtors

✔ Discount Allowed

✔ Sales Returns

✔ Bad Debts Written Off

Example SLCA Format:

Date Details Dr ($) Cr ($) Balance ($)

Jan 1 Opening Balance 10,000 10,000
Jan 5 Credit Sales 3,000 13,000
Jan 10 Payments 4,000 9,000
Received
Jan 15 Discount 500 8,500
Allowed
Jan 20 Sales Returns 300 8,200
Jan 31 Closing Balance 8,200 8,200

2. Purchase Ledger Control Account (PLCA)

The Purchase Ledger Control Account summarizes all transactions related to creditors (accounts
payable). It helps verify the total balance of individual creditor accounts.

Entries in PLCA

Credits (Increases Creditors/Payables):

✔ Credit Purchases

✔ Dishonored Cheques Paid to Suppliers

Debits (Decreases Creditors/Payables):

✔ Payments to Creditors

✔ Discount Received

✔ Purchase Returns

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 Example PLCA Format:

Date Details Dr ($) Cr ($) Balance ($)

Jan 1 Opening Balance 5,000 5,000
Jan 5 Credit Purchases 3,500 8,500
Jan 10 Payments Made 2,500 6,000
Jan 15 Discount 400 5,600
Received
Jan 20 Purchase 600 5,000
Returns
Jan 31 Closing Balance 5,000 5,000
Summary Table: Errors & Control Accounts

This concise but detailed explanation should help CSEC POA students understand these topics for
their exams!

SECTION 1: Errors Affecting & Not Affecting the Trial Balance

Question 1: Identify the Type of Error

For each of the following errors, state whether it affects the trial balance or not and identify the type
of error.

 A sale of $500 to J. Brown was recorded as a sale to J. Green.

 A payment of $800 for rent was recorded as a payment for wages.

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  A purchase of $2,200 was recorded as $2,000 in the Purchases account but correctly
recorded in the Creditor’s account.
 A purchase of office furniture for $5,000 was recorded in the Purchases account instead of
the Furniture account.
 A payment of $3,000 to a creditor was recorded only in the Cash account.

Answers

o Does not affect trial balance – Error of Commission

o Does not affect trial balance – Error of Principle
o Affects trial balance – Error of Partial Entry
o Does not affect trial balance – Error of Principle
o Affects trial balance – Single Entry Error

SECTION 2: Suspense Account

Question 2: Suspense Account Correction

A business’s trial balance does not balance because the total debits exceed the credits by $1,200.
The accountant reviews the books and finds the following errors:

 A credit sale of $600 was recorded only in the Sales account.

 A purchase of $300 was entered as $3,000 in both the Purchases and Creditor’s accounts.
 A wages payment of $900 was recorded as $90.

Required:

(a) Identify which errors require a suspense account.

(b) Correct the errors with journal entries.

Answers

(a) Errors requiring a suspense account:

The credit sale of $600 recorded only in Sales (missing debit entry).

The wages payment of $900 recorded as $90 (incorrect amount).

(b) Journal Entries for Corrections

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Date Account Debit ($) Credit ($)

Correcting missing debit Debtors (A/c) 600

Suspense A/c 600

Correcting wages under-recording Wages A/c 810

Suspense A/c 810

Suspense account will now balance after these corrections.

SECTION 3: Sales & Purchase Ledger Control Accounts

Question 3: Sales Ledger Control Account (SLCA)

A company provides the following transactions for July 2025:

 Opening balance of debtors: $10,000

 Credit sales: $8,000
 Payments from customers: $6,500
 Discount allowed: $500
 Sales returns: $1,000
 Bad debts written off: $300

Required:

Prepare the Sales Ledger Control Account.

Answer

Date Details Dr ($) Cr ($) Balance ($)

July 1 Opening Balance 10,000 10,000

July 5 Credit Sales 8,000 18,000

July 10 Payments Received 6,500 11,500

July 15 Discount Allowed 500 11,000

July 20 Sales Returns 1,000 10,000

July 25 Bad Debts Written Off 300 9,700

July 31 Closing Balance 9,700 9,700

Question 4: Purchase Ledger Control Account (PLCA)

A business recorded the following transactions in August 2025:

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Opening balance of creditors: $5,000

Credit purchases: $7,500

Payments made to suppliers: $6,200

Discount received: $300

Purchase returns: $500

Required:

Prepare the Purchase Ledger Control Account.

Answer

Date Details Dr ($) Cr ($) Balance ($)

Aug 1 Opening Balance 5,000 5,000

Aug 5 Credit Purchases 7,500 12,500

Aug 10 Payments Made 6,200 6,300

Aug 15 Discount Received 300 6,000

Aug 20 Purchase Returns 500 5,500

Aug 31 Closing Balance 5,500 5,500

Final Review

✔ Errors Affecting the Trial Balance – Require adjustments via a Suspense Account.

✔ Errors Not Affecting the Trial Balance – Need reclassification, not trial balance adjustments.

✔ Control Accounts – Help check the accuracy of Debtors (SLCA) and Creditors (PLCA).

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