Financial Accounting Ratio

Week One (1)
Subject : Financial Accounting.
Class: S. S. 2.
Topic: Financial Accounting Ratio.
Definition/Introduction: A financial ratio is the relationship between two pieces of financial data. Every business firm prepares financial statements that must include at least the Balance sheet and the Profit and Loss account.
The balance sheet shows the financial position at a particular date, while, the profit and loss account shows the results of operation over a particular period.
Uses of Accounting ratio:
Ratio assist users to:
(i) Assess the liquidity position of an organization.
(ii) Assess the efficiency of management.
(iii) Evaluate overall performance of a business.
(iv) Determined how secured one’s investment is in a business.
(v) Compare the performance of other competitors in the same line of business.

Limitations of Accounting ratios:
(i) Accounting ratios only measure quantitative aspect of the firm’s performance and ignores other qualitative aspects.
(ii) The use of different methods/policies in recording transactions limits the effectiveness of comparison between businesses.
(iii) The effect of price level changes/Inflation limit the use of ratios in comparison between different periods.
(iv) The use of ratios as basis for comparison become unfair as firms operate under different conditions.
(v) Some firms window-dress their financial statements thereby using figures that misled users.

Types of Financial ratios:
(1) Liquidity Ratio: These are ratios used to judge the ability of a firm to meet its short term obligations or pay its debt as they fall due. Any business that cannot meet its obligation is insolvent.
The following are some of the ratios under Liquidity ratio:
(i) Current ratio or Working Capital Ratio:
This ratio shows the extent to which claims of short term creditors are covered by assets that will be converted into cash within a year. The higher the ratio, the greater the margin of safety for short term creditors. A normal industry average for this ratio is 2:1. It is calculated as thus:
Current assets /Current liabilities.

(ii) Acid test ratio or Quick ratio or Liquid ratio: This ratio shows the extent to which the cash and those assets most readily convertible to cash can meet the demands of short term creditors. Stock is considered the most illiquid of all current assets because its value are subject to fluctuations.
The bigger the ratio, the greater the margin of safety for short term creditors. A ratio of at least 1:1 is normally considered appropriate. It is calculated as thus:
Current assets less stock ➗ by Current liabilities.

(iii) Stock turnover or Rate of stock turnover: This ratio shows the number of times stock is turned over within the period. The ratio is calculated as:
Cost of goods sold/Average inventory
Average inventory or stock is calculated as opening stock plus closing stock divided by two.

(iv) Stock on current assets: This ratio shows the importance of stock as a percentage of current assets.
It is calculated as
Stock/Current assets multiply by 100%.

(v) Debtors ratio or Average Collection Period: This ratio relates debtors to sales so as to show the average period of credit given to debtors. It shows the average length of time in which the remaining debts will be collected. It can be measured either in days, months, weeks or years.
It is calculated as:
Debtors /Credit sales multiply by 365days.

(vi) Creditors Ratio or Creditors’ payment period: This ratio show the lenght of time in which creditors have not balanced their payment. It can be measured in days, months or weeks or yearly.
The ratio is calculated as thus: Creditors/Credit purchases multiply by 365 days.
Note: To be continued.