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Topic Overview
Topic BAFS (Compulsory Part)
Introduction to Accounting – Basic Ratio Analysis
Level S4
Duration 8 lessons (40 minutes per lesson)
Learning Objectives:
1. Understand the concept and general function of accounting ratios.
2. Understand the calculation and interpretation of following financial ratios:
gross profit margin, net profit margin, return on capital employed, working
capital, current ratio and acid test ratio.
3. Use accounting ratios to evaluate a company’s profitability and liquidity.
Overview of Contents:
Lesson 1 Concept of Financial Statement Analysis
Lesson 2 Concept and General Function of Accounting Ratios
Lesson 3 Calculation and Interpretation of Profitability Ratios
(Gross Profit and Net Profit Margin)
Lesson 4 Calculation and Interpretation of Profitability Ratios
(Return on Capital Employed)
Lesson 5 Working Capital and Its Management
Lesson 6 Liquidity Position and Liquidity Problems
Lesson 7 Calculation and Interpretation of Liquidity Ratio
(Current Ratio and Acid-test Ratio)
Lesson 8 Evaluation on the Liquidity and Profitability of a
Business Using Accounting Ratios and Its Limitation
Resources:
Topic Overview and Teaching Plan
PowerPoint Presentation
Student Worksheet
Suggested Activities:
Group discussion
In-class exercise
Assignment
Quiz
Lesson 1
Theme Concept of Financial Statement Analysis
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. describe the basic concept of financial statement analysis.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher starts the lesson by a discussion.
Teacher invites students to share their ideas on
how to evaluate the performance of a business.
PPT #2 – 3 6 minutes
Part II: Content
Teacher explains the concept of financial
analysis and different types of users of financial
report.
PPT #4 – 6 6 minutes
Teacher describes the format and contents of
income statement which is used for financial
analysis.
PPT #7 – 9
6 minutes
Activity 1: Class discussion
Teacher invites students to share their
ideas on how to evaluate a business with
an income statement.
Teacher goes through the answer and
makes conclusion.
PPT #10
PPT #11
3 minutes
4 minutes
Teacher describes the format and contents of
statement of financial position which is used for
financial analysis.
PPT #12 – 14 6 minutes
Activity 2: Class discussion
Teacher asks students to compare income
statement and statement of financial
position.
Teacher goes through the answer and
makes conclusion.
PPT #15
PPT #16
3 minutes
4 minutes
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
Lesson 2
Theme Concept and General Function of Accounting Ratios
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. describe the general concept and function of accounting ratios.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher explains financial statement analysis is
a vital part of internal analysis and introduces
four areas for financial analysis.
PPT #2 – 3 3 minutes
Part II: Content
Activity 1: Class discussion
Teacher invites students to share their
ideas on the performance of the business
based on the four areas for financial
analysis.
Teacher goes through the answer and
makes conclusion.
PPT #4
PPT #5
4 minutes
3 minutes
Teacher explains the purpose of financial
analysis using ratios.
Teacher explains the three types of comparison
for analysis.
PPT #6 – 7
PPT #8 – 11
7 minutes
9 minutes
Activity 2: Group Discussion
Students are divided into groups of three
to four for discussion.
Teacher invites students to share their
ideas and makes conclusion.
PPT #12
PPT #13 – 14
8 minutes
4 minutes
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
Lesson 3
Theme Calculation and Interpretation of Profitability Ratios (Gross Profit
and Net Profit Margin)
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. calculate gross profit margin and net profit margin;
2. analyse and comment on these profitability ratios.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher recaps the four areas for financial
analysis and explains to students the discussion
of the lessons will be focused on profitability
and liquidity of a business.
PPT #2 2 minutes
Part II: Content
Teacher explains the concept of profitability
ratios.
Teacher explains the concept of gross profit
margin and demonstrates its calculation and
provides comments on its result.
PPT #3 – 5
PPT #6 – 8
8 minutes
8 minutes
Activity 1: Calculation of Gross Profit Margin
Teacher asks students to calculate and
comment the gross profit margin for two
years.
Teacher goes through the answer and
makes conclusion.
PPT #9
PPT #10
3 minutes
4 minutes
Teacher explains the concept of net profit
margin and demonstrates its calculation and
comments on its result.
PPT #11 - 13
6 minutes
Activity 2: Calculation of Net Profit Margin
Teacher asks students to calculate and
comment the net profit margin for two
years.
Teacher goes through answers and makes
conclusion.
PPT #14
PPT #15
3 minutes
4 minutes
Lesson 4
Theme Calculation and Interpretation of Profitability Ratios (Return on
Capital Employed)
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. calculate the return on capital employed;
2. analyse and comment on the profitability ratio.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Activity 1: Group discussion
Teacher starts with a discussion to recap
students’ understanding of gross profit
margin and net profit margin.
Teacher goes through the answer and
makes conclusion.
PPT #2
PPT #3
6 minutes
4 minutes
Part II: Content
Teacher explains the concept of return on
capital employed, demonstrates its calculation
and comments on its result.
PPT #4 – 6
12 minutes
Activity 2: Calculation of Profitability Ratio
Teacher asks students to calculate the
gross profit margin, net profit margin and
ROCE for XYZ Ltd.
Teacher goes through the answer and
makes conclusion.
PPT #7
PPT #8
8 minutes
5 minutes
Teacher explains the purposes of using
profitability ratios.
PPT #9
3 minutes
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
Lesson 5
Theme Working Capital and Its Management
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. understand the concept of working capital;
2. calculate the working capital of a company.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher explains the concept of working
capital.
PPT #2 2 minutes
Part II: Content
Activity 1: Class discussion
Teacher invites students to share their
ideas on the implication of a negative
working capital.
Teacher goes through the answer and
makes conclusion.
PPT #3
PPT #4
3 minutes
3 minutes
Activity 2: Calculation of Working Capital
Students are required to calculate and
comment the working capital of a
company.
Teacher goes through the answer and
makes conclusion.
PPT #5
PPT #6
4 minutes
3 minutes
Teacher explains the causes of a change in
working capital.
PPT #7 – 10 9 minutes
Teacher explains the concept of working capital
management.
Teacher explains the relationship of working
capital management and business solvency.
PPT #11 – 12
PPT #13 – 14
3 minutes
4 minutes
Activity 3: Group discussion
Students are divided into groups of three
to four to discuss the implication of a
conservative working capital policy to a
company.
PPT #15
4 minutes
Teacher goes through the answer and
makes conclusion.
PPT #16 3 minutes
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
Lesson 6
Theme Liquidity Position and Liquidity Problems
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. understand the concept of working capital management and liquidity;
2. evaluate the liquidity of a company.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher explains the concept of Liquidity. PPT #2 4 minutes
Part II: Content
Teacher explains how to measure the liquidity
of a company.
Teacher explains what is liquid asset.
PPT #3
PPT #4
3 minutes
3 minutes
Activity 1: Class discussion
Teacher invites students to give some
examples of liquid assets.
Teacher goes through the answer and
makes conclusion.
PPT #5
PPT #6
3 minutes
3 minutes
Teacher explains the risks of a company when
there is liquidity problem.
PPT #7 3 minutes
Activity 2: Group discussion
Students are divided into groups of three
to four to discuss the signs of liquidity
problem.
Teacher goes through the answer and
makes conclusion.
PPT #8
PPT #9
9 minutes
7 minutes
Teacher explains how a company cope with its
liquidity problem.
PPT #10 3 minutes
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
Lesson 7
Theme Calculation and Interpretation of Liquidity Ratio (Current Ratio
and Acid-test Ratio)
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. calculate the liquidity ratio (current ratio);
2. analyse and comment on the current ratio.
3. calculate the liquidity ratio (acid test ratio);
4. analyse and comment on the acid test ratio.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher introduces liquidity ratios. PPT #2 3 minutes
Part II: Content
Teacher explains how to measure the liquidity
of a company.
Teacher explains the concept of current ratio
and demonstrate its calculation and provides
comments on its result.
PPT #3
PPT #4 – 7
2 minutes
7 minutes
Activity 1: Calculation of Current Ratio
Students are required to calculate and
comment the current ratio of a company.
Teacher goes through the answer and
makes conclusion.
PPT #8
PPT #9
2 minutes
3 minutes
Teacher explains the limitation of using current
ratio.
PPT #10 5 minutes
Teacher explains the concept of acid test ratio
and demonstrate its calculation and provides
comments on its result.
PPT #11 – 14
7 minutes
Activity 2: Calculation of Acid Test Ratio
Students are required to calculate and
comment the acid test ratio of a company.
Teacher goes through the answer and
makes conclusion.
PPT #15
PPT #16
2 minutes
3 minutes
Teacher explains the advantages and PPT #17 4 minutes
disadvantages of using acid test ratio.
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
Lesson 8
Theme Evaluation on the Liquidity and Profitability of a Business Using
Accounting Ratios and Its Limitation
Duration 40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1. evaluate the liquidity and profitability of a business using accounting ratio and
make business decision;
2. describe the limitation of using accounting ratios.
Teaching Sequence and Time Allocation:
Activities Reference Time
Allocation
Part I: Introduction
Teacher recaps the question which was asked in
the first lesson and invites students to share
their learning experience.
Teacher concludes that the use of accounting
ratios can help a company to understand its
financial performance and financial position.
PPT #2
PPT #3
2 minutes
2 minutes
Part II: Content
Teacher demonstrates how to work out
different accounting ratios for a company and
make comments accordingly.
PPT #4 – 6
9 minutes
Activity 1: Case Study
Students are required to calculate the
accounting ratios and make decision.
Teacher goes through the answer and
makes conclusion.
PPT #7
PPT #8 – 10
8 minutes
9 minutes
Teacher explains other factors that affecting
business decision.
Teacher explains the limitations of accounting
ratio analysis.
PPT #11
PPT #12
3 minutes
5 minutes
Part III: Conclusion
Teacher concludes the lesson by reviewing the
key points covered.
2 minutes
1
Teacher starts the lesson with the question above and explains to students that they will learn how to evaluate a business’s performance using accounting ratios in the lessons followed.
2
Teacher explains the three basic aspects to evaluate a business. Teacher explains the concept of financial analysis.
4
Teacher explains to students that it is required by Companies Ordinance that a company must prepare income statement and statement of financial position every year.
5
Teacher explains different types of users of financial reports.
6
Teacher explains the purpose of preparing income statement.
7
Teacher describes the format and content of an income statement.
Teacher explains the following calculations:
Sales ‐ Cost of Sales = Gross Profit
The other (operating) expenses are then charged against gross profit to derive operating profit.
i.e. Gross Profit – Operating Expenses = Operating Profit or Net Profit Before Interest and Tax
9
Teacher invites students to share their ideas.
10
Teacher makes conclusions and provides answer.
11
Teacher explains the nature of statement of financial position.
12
Teacher describes the content of a statement of financial position. Teacher describes the content of statement of financial position including non‐current assets, current assets, current liabilities, non‐current liabilities and equity.
14
Teacher asks students to compare income statement and statement of financial position by their purpose, timeframe and major items.
15
Teacher makes conclusions and provides answer.
16
1
Teacher explains financial statement analysis is a vital part of internal analysis which: • Overall performance could be measured in financial terms.• Indicates the extent to which it is achieving its objectives.• It can help identifying areas of weakness and formulate appropriate strategies.Financial statement analysis is also helpful in providing information for external users for investment and financing decisions such as hold/buy/sell shares, assess credit worthiness etc.
2
3
Teacher explains there are four areas for financial statements analysis:• Profitability: Is the business profitable?• Liquidity and efficiency: Is the trading position satisfactory?• Solvency: Is the business able to meet its long‐term fixed expenses?• Market prospects: Is the business funded properly and using these funds wisely?
Teacher invites students to share their ideas on the performance of the business based on the four areas for financial statement analysis tht learnt in the previous slides.
4
Students are free to share their ideas regarding the four aspects. Some suggested solutions may include:Profitability: The profit after tax in 20X5 is $29,000 higher than 20X4.Liquidity: The company is able to meet its short‐term obligation because the total of current assets is higher than the total of current liabilities for both 20X4 and 20X5.Solvency: The company is able to generate future revenues to meet its long‐term debts because profits earned for 20X5 has already covered 67% (332/497) of the long‐term loan.Market prospects: No idea as there is no market information provided from the financial statements above.Teacher explains to students that conclusions drawn about the performance of a business is limited if we just refer to the numbers presented on the financial statements. To overcome such limitation, teacher can then introduce the concepts of accounting ratios in financial analysis.
5 6
Teacher explains that ratio analysis is a quantitative analysis which is one of the elements in financial statements analysis. Qualitative analysis such as customers’ preference etc. is not covered in this course.
7
Teacher elaborates the importance of comparison in financial statements analysis by using the information provided in activity 1. For example, there is no meaning by merely knowing sales for the year 20X5 is $1,850,000, the information is insufficient for us to make any comments on the sales performance of the company. However, by comparing the sales figures of 20X4 and 20X5, and knowing that there is an increase of $290,000, we can understand that the sales performance of the company is better than previous year.
Teacher explains the need of comparative analysis.
8
Teacher explains the use of intracompany comparison.
9
Teacher explains the use of intercompany comparison.
10
Teacher explains the use of industry averages comparison.
11
Students are divided into groups of three for discussion. Teacher invites students to share their ideas and makes conclusions (the next two slides).
12
13
Teacher explains the types of internal users and how financial ratios assist their decision-making.
14
Teacher explains the types of external users and how financial ratios assist their decision-making.
1
Teacher introduces the four types of ratio for financial analysis and explains to students the discussion of the lessons will be focused on profitability and liquidity of a business.
2
Teacher explains the concept of profitability ratio.
3
Teacher recaps the contents of the income statement and explains the four level of profit for analysis.
4
Teacher introduces the 3 key profitability ratios that show the operating performance of a business in relation to its sales. Generally, the higher the better.
5
Teacher explains the gross profit margin indicates margin between selling price and cost of good sold.
6
Teacher distributes the financial statements of ABC Company to students and illustrates how to work out the gross profit margin of the company for the year 20X4 and 20X5.
7
Teacher recaps the financial statements which had been discussed on last lesson and illustrates how to work out the gross profit margin of the company for the year 20X4 and 20X5.
The Gross Profit Margin for ABC Ltd:
20X5: $915/$1,850 x 100% = 49.46%
20X4: $807/$1,560 x 100% = 51.73%
The GP margin in 20X5 is worse than 20X4 by reducing 2.27%.
For the calculations of GP margin for ABC Ltd, teacher can explain to students the decline in GP % may due to lower in selling price because of keen competition or high purchase costs for the year 20X5.
8
Teacher asks students to complete the calculation and provide comments on the result.
9
Teacher makes conclusions and provides answer.
Remarks: The above is a general comment only and teacher can explain that there are many reasons leading to an increase in GP margin such as an increase in selling price or a better use of marketing strategy to promote sales etc.
10
Teacher explains the net profit margin indicates net income generated by each one hundred dollar of sales. The higher the margin, the higher the return on sales.
11
Teacher illustrates how to work out the net profit margin of the ABC Company for the year 20X4 and 20X5.
12
Teacher recaps the financial statements which had been discussed on last lesson and illustrates how to work out the net profit margin of the company for the year 20X4 and 20X5.
The Net Profit Margin for ABC Ltd:
20X5: $398/$1,850 x 100% = 21.51%
20X4: $359/$1,560 x 100% = 23.01%
The NP margin in 20X5 is worse than 20X4 by reducing 1.5%.
For the calculations of NP margin for ABC Ltd, teacher can explain to students the decline in NP % may due to lower GP or high operating cost for the year 20X5.
13
Teacher asks students to complete the calculation and provide comments on the result.
14
Teacher makes conclusions and provides answer.
Remarks: the above is a general comment only and teacher can explain that there are many reasons leading to a decrease in NP margin such as an unexpected increase in rent or salaries or the strategic increase in marketing expense to build up the company image.
15 16
1
Teacher starts with a discussion to recap students’ understanding of gross profit margin and net profit margin.Students are invited to present their ideas.
2
Teacher makes conclusions and provides answer.Teacher then introduce the concept of ROCE which is another ratio to assess the profitability of a company.
3
Teacher explains the concept and formula of ROCE and its indication.In general, the higher the ratio, the better the ability a company using its capital.
4
Teacher recaps the financial statements which had been discussed on last lesson and illustrates how to work out the ROCE of the company for the years 20X4 and 20X5.
The ROCE for ABC Ltd:
20X5: $424/$3,483 x 100% = 12.17%
20X4: $383/$3,394 x 100% = 11.28%The ROCE in 20X5 is better than 20X4 by increasing 0.89% which indicates a more effective use of the company’s capital.
5
Teacher explains that from the perspective of the resources providers of the company, it is very important to have adequate return to their investments. Besides, teacher should explain the inter‐company comparison may be distorted if the result of an EBIT is not used as the numerator .
6
Teacher asks students to calculate the profitability ratios including gross profit margin, net profit margin and ROCE for the two years of XYZ Ltd.
7
Teacher goes through the above and explore other alternative answers in the “comments” column with students. For example, if the gross profit margin decline, it may due to a lower selling price for competition or a higher cost in purchase. Teacher may also highlight the GP will also affect the NP margin as NP is calculated by GP – Op Exp.
8
Teacher asks students to calculate the working capital for XYZ Ltd.
5
Teacher explains the implication of the following:
A positive working capital indicates that the company has sufficient fund to settle short‐term obligations.
A negative working capital indicates that the company does not have sufficient immediate fund to settle short‐term obligations. However, it does not mean the company is insolvent as the company can settle short‐term obligations by using long‐term finance.
Teacher explains the increase in working capital in 20X5 for XYZ Ltd indicates the ability of using available fund to settle short‐term obligations has improved.
6
Teacher explains with examples the situations that will not change the working capital.
9
Teacher invites students to answer and makes conclusion as below:
Sales of goods on credit only increase the trade receivable, the cash would not increase since it has not yet been received.
Company will receive cash for sales of a non‐current asset. The loss on disposal is just an accounting calculation.
Payment of dividend to shareholders and settlement to suppliers incur cash outflow.
Therefore, the answer is B.
10
Teacher explains the concept of working capital management.
11
Teacher explains the importance of working capital management.
12
Teacher explains the relationship of working capital management and business solvency.
13
Teacher describes two different working capital polices.
14
Students are divided into groups of three to four and and discuss the question.
15
Teacher invites students to share their answers and debrief the suggested solution. Teacher also explains that an aggressive policy will lead to an opposite effect.
16
Teacher explains how to measure the liquidity of a company.
3 4
Teacher explains what is liquid asset.
Teacher invites students to share their answers.
5
Teacher makes conclusions and provides answer.Teacher also explains that prepayment is not liquid asset as it cannot be converted in cash but just an entitlement to receive goods or services in future.
6
Teacher explains the risks of a company when there is liquidity problem.
7
Students are divided into groups of three to four and discuss the signals of liquidity problem.
8
Teacher makes conclusions and provides answer.
9
Teacher explains the common ways to cope with liquidity problems in companies.
10
3
Teacher introduces the use of current ratio and acid-test ratio which help to measure the liquidity of a company.
Teacher explains the concept of current ratio.
4
Teacher explains current ratio indicates a company’s short‐term debt‐paying ability. A higher ratio means greater liquidity.
5
Teacher explains the implications of having too high or too low current ratio to a company.
6
Teacher reaps the financial statements which had been discussed on first lesson and illustrate how to work out the current ratios of the company for the years 20X4 and 20X5.
The current ratio for ABC Ltd:
20X5: $634/$351= 1.81 times
20X4: $700/$306 = 2.29 times
The current ratio for 20X5 is lower than 20X4 which indicates the ability to settle short‐term debts is lower. However, it is still satisfactory as it still has sufficient liquidity to cover its liabilities.
7
Teacher asks students to complete the calculation and provide comments on the result.
8
Teacher makes conclusions and provides answer.
Teacher can remark that further investigations can be performed to identify the reasons for the decrease in current ratio such as decline in sales which makes the decline in accounts receivable.
9
Teacher explains the liquidity problem of inventory and introduces the concept of acid test ratio in next slide.
10
Teacher explains the concepts of acid test ratio.
11
Teacher explains quick ratio indicates a company’s immediate short‐term debt‐paying ability.The rule of thumb for the quick ratio is 1:1
12
Teacher explains the indications of too high or too low of the acid test ratio.
13
Teacher reaps the financial statements which had been discussed on first lesson and illustrate how to work out the acid test ratios of the company for the years 20X4 and 20X5.
The acid test ratio for ABC Ltd:
20X5: ($634 ‐ $212)/$351= 1.20 times
20X4: ($700 ‐ $189)/$306 = 1.67 times
The acid test ratio for 20X5 is lower than 20X4 which indicates the ability of a company to meet its liabilities without having to dispose its inventory is lower. However, it is still satisfactory as it still has sufficient quick assets to cover its liabilities.
14
Teacher asks students to complete the calculation and provide comments on the result.
15
Teacher makes conclusions and provides answer.
16
1
Teacher recaps the question which was asked in the first lesson and invites students to share their learning experience after the learning of accounting ratios.
2
Teacher concludes that the use of accounting ratios can help a company to understand its financial performance and financial position and to make economic decision.
3
Teacher asks students to work out different accounting ratios for their uncle and make comments accordingly.
4
Teacher calculates different ratios and comments the results with students.
5
Teacher calculates different ratios and comments the results with students.
6
Students are required to calculate the accounting ratios and suggest a situation for their uncle.
7 8
Teacher goes through the answers and makes comments.
9
Teacher explains the decision may be varied because there are other factors to be considered in making business decision.
10
Teacher explains other factors that affecting business decision and remarks that the use of accounting ratios is just one of the techniques to evaluate a business. Teacher can then bring up the concept of limitation of using accounting ratios.
11 12
Teacher explains the limitations of accounting ratio analysis.
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 1
Activity 1 - Class Discussion
What can we know by reviewing a company’s income statement?
_______________________________________________
_______________________________________________
_______________________________________________
_______________________________________________
_______________________________________________
_______________________________________________
_______________________________________________
_______________________________________________
_______________________________________________
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 1
Activity 2 - Class Discussion
A company’s financial statements consist of the income statement and statement of
financial position. Compare these two statements.
Income statement Statement of financial position
Purpose
Time frame
Major item
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 2
Activity 1 – Discussion
Your uncle has then provided you with the income statement and statement of financial
position of his business for the last two financial years for your viewing.
20X5 20X4
$'000 $'000
1,850 1,560
(935) (753)
915 807
Distribution (135) (108)
Selling and marketing (182) (161)
General and administrative (174) (155)
424 383
(26) (24)
398 359
(66) (56)
332 303
ABC Ltd
Income Statement
For the year ended 31 December
Profit before tax
Income tax expenses
Profit after tax
Turnover
Cost of sales
Gross profit
Expenses
Operating profit
Interest expenses
20X5 20X4
$'000 $'000
Non-current assets
Equipments 3,200 3,000
Current assets
Inventories 212 189
Trade receivables 304 286
Cash and bank 118 225
634 700
Current liabilities
Trade payables 285 250
Tax payable 66 56
351 306
Total assets less current liabilities 3,483 3,394
Financed by:
Share capital 2,200 2,200
Retained earnings 786 454
2,986 2,654
Non-current liabilities
Long-term loan 497 740
3,483 3,394
ABC Ltd
Statement of Financial Position
As at 31 December
Using the four aspects of financial statement analysis, what can you find out from the
information provided on the financial statements?
Profitability:
Liquidity and Efficiency:
Solvency:
Market Prospects:
BAFS (Compulsory Part) –
Introduction to Accounting
Basic Ratio Analysis
Lesson 2
Activity 2 – Group discussion
Divided into three groups which represent the 1. internal management; 2. lenders; 3.
shareholders (investors) of a company and discuss how the financial ratios can help
you to make business decisions?
Internal Management:
Lenders:
Shareholders (Investors):
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 3
Activity 1 - Calculation of Gross Profit Margin Given the following information, calculate and comment the gross profit margin for
the years of 20X4 and 20X5.
20X4 20X5
Sales $100,000 $120,000
Cost of goods sold $54,000 $62,000
Gross profit ( ) ( )
Gross profit margin ( ) ( )
Comments:
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 3
Activity 2 - Calculation of Net Profit Margin
Given the following information, calculate and comment the net profit margin for
the years of 20X4 and 20X5.
20X4 20X5
Sales $100,000 $120,000
Cost of goods sold $54,000 $62,000
Gross profit $46,000 $58,000
Operating expenses $33,000 $44,000
Net profit ( ) ( )
Net profit margin ( ) ( )
Comments:
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 4
Activity 1 – Class Discussion
What are the differences between gross profit margin and net profit margin?
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
______________________________________________
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 4
Activity 2 – Calculation of Profitability
Refer to the financial statements of XYZ Ltd, calculate and comment its profitability
ratios.
20X5 20X4
$'000 $'000
3,310 2,952
(1,840) (1,632)
1,470 1,320
Distribution (288) (225)
Selling and marketing (349) (293)
General and (227) (187)
606 615
(105) (87)
501 528
(92) (96)
409 432
XYZ Ltd
Income Statement
For the year ended 31 December
Profit before tax
Income tax expenses
Profit after tax
Sales
Cost of sales
Gross profit
Expenses
Operating profit
Interest expenses
20X5 20X4
$'000 $'000
Non-current assets
Equipments 5,500 5,220
Current assets
Inventories 331 292
Trade receivables 504 463
Cash and bank 222 108
1,057 863
Current liabilities
Trade payables 396 367
Tax payable 92 96
488 463
Total assets less current liabilities 6,069 5,620
Financed by:
Share capital 4,000 4,000
Retained earnings 1,022 855
5,022 4,855
Non-current liabilities
Long-term loan 1,047 765
6,069 5,620
XYZ Ltd
Statement of Financial Position
As at 31 December
Calculations Comments
Gross Profit Margin
20X5:
20X4:
Net Profit Margin
20X5:
20X4:
Return on Capital Employed
20X5:
20X4:
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 5
Activity 1 - Class Discussion
Companies should have a positive amount of working capital, i.e. current assets are
greater than current liabilities.
What happens if there were a negative working capital (i.e. current assets < current
liabilities)?
_______________________________________________
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BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 5
Activity 2 – Calculation of Working Capital
Refer to the financial statements of XYZ Ltd, calculate its working capital.
20X5 20X4
$'000 $'000
3,310 2,952
(1,840) (1,632)
1,470 1,320
Distribution (288) (225)
Selling and marketing (349) (293)
General and (227) (187)
606 615
(105) (87)
501 528
(92) (96)
409 432
XYZ Ltd
Income Statement
For the year ended 31 December
Profit before tax
Income tax expenses
Profit after tax
Sales
Cost of sales
Gross profit
Expenses
Operating profit
Interest expenses
20X5 20X4
$'000 $'000
Non-current assets
Equipments 5,500 5,220
Current assets
Inventories 331 292
Trade receivables 504 463
Cash and bank 222 108
1,057 863
Current liabilities
Trade payables 396 367
Tax payable 92 96
488 463
Total assets less current liabilities 6,069 5,620
Financed by:
Share capital 4,000 4,000
Retained earnings 1,022 855
5,022 4,855
Non-current liabilities
Long-term loan 1,047 765
6,069 5,620
XYZ Ltd
Statement of Financial Position
As at 31 December
Working Capital of XYZ Ltd
20X5:
20X4:
BAFS
Ratio Analysis 5
Activity 3 – Group Discussion
How a conservative working capital policy lowers profitability and risk?
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BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 6
Activity 1 - Class Discussion
Can you give some other examples of liquid assets?
7
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BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 6
Activity 2 – Group Discussion
How can we know if a company has a liquidity problem?
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BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 7
Activity 1 - Calculation of Current Ratio
Given the following information, calculate and comment the current ratio for the years of
20X4 and 20X5.
20X4 20X5
Inventory $163,000 $116,000
Accounts receivable
$146,000 $162,000
Cash and bank $23,000 $44,000
Accounts payable $155,000 $171,000
Calculations Comments
Current ratio
20X4:
20X5:
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 7
Activity 2 - Calculation of Acid Test Ratio
Given the following information, calculate the acid test ratio for the years of 20X4 and 20X5
and comment the ratio by comparing with the current ratio calculated in activity 1.
20X4 20X5
Inventory $163,000 $116,000
Accounts receivable $146,000 $162,000
Cash and bank $23,000 $44,000
Accounts payable $155,000 $171,000
Current ratio Acid test ratio Comments
20X4:
20X5:
20X4:
20X5:
BAFS (Compulsory Part) – Introduction to Accounting
Basic Ratio Analysis
Lesson 8
Activity 1 – Case Study
Your uncle’s business is the supplier of DEF Ltd. Your uncle is now considering
whether it is appropriate to sell goods to DEF Ltd on credit or COD (Cash on Delivery).
(Demanding COD might cause DEF Ltd buy less from your uncle’s company.)
Use accounting ratios to help your uncle to make decision
(3,380) (3,410)
1,840 2,120
Distribution (522) (482)
Selling and marketing (414) (398)General and
administrative (331) (303)
573 937
(108) (66)
465 871
(65) (42)
400 829
Profit before tax
Income tax expenses
Profit after tax
Cost of sales
Gross profit
Expenses
Operating profit
Interest expenses
20X5 20X4
$'000 $'000
Non-current assets
Equipments 8,250 7,273
Current assets
Inventories 338 284
Trade receivables 536 406
Cash and bank 34 128
908 818
Current liabilities
Trade payables 782 434
Tax payable 65 42
847 476
Total assets less current liabilities 8,311 7,615
Financed by:
Share capital 5,500 5,500
Retained earnings 1,688 1,288
7,188 6,788
Non-current liabilities
Long-term loan 1,123 827
8,311 7,615
DEF Ltd
Statement of Financial Position
As at 31 December
20X5 Ratio Calculation Result
Gross Profit Margin
Net Profit Margin
ROCE
Current Ratio
Acid Test Ratio
20X4 Ratio Calculation Result
Gross Profit Margin
Net Profit Margin
ROCE
Current Ratio
Acid Test Ratio
Ratio Comments
Gross Profit Margin
Net Profit Margin
ROCE
Current Ratio
Acid Test Ratio
Suggestion
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Basic Ratio Analysis
p.1
Basic Ratio Analysis – Home Assignment
Section A: Multiple Choice Questions (@1, total 10 marks)
1. Why does financial analysis involve the expression of the reported numbers in
relative term?
A. It is easy to calculate.
B. It helps users to make comparison on the same basis.
C. Absolute numbers are difficult to identify.
D. All of the above.
Level of difficulty: **
2. Which of the following cannot be ascertained from an income statement of a
company?
A. Sales generated for the year.
B. Share price of the company.
C. Profit for the year.
D. Operating expenses of the year.
Level of difficulty: *
3. A ratio by itself may have no meaning. Hence, a given ratio is compared to:
A. Ratios from previous years
B. Ratios of other companies
C. Both A and B.
D. None of the above.
Level of difficulty: *
4. The shareholders of the company will analyse the financial statement of the
company and
A. decide whether or not to invest in a company.
B. determine a company’s credit worthiness.
C. evaluate performance of employee and determine relevant compensation.
D. understand the financial performance of the company’s competitors.
Basic Ratio Analysis
p.2
Level of difficulty: *
5. A ___________ ratio is a measure of how profitable a company is in doing its
business.
A. profitability.
B. liquidity.
C. solvency.
D. investment.
Level of difficulty: *
6. Which of the following is the best description for return on capital employed
(ROCE)?
A. It describes a company’s ability to earn a net income from sales.
B. It is the difference between current assets and current liabilities
C. It is defined as the ability to pay your debts when they come due.
D. It is a measure of efficiency of a company in using its capital to generate profit.
Level of difficulty: *
7. Given the following information, calculate the working capital.
Office equipment: $85,000
Furniture & fixture: $24,000
Accounts receivable: $5,200
Inventory: $6,100
Bank overdraft: $1,500
Accounts payable: $4,400
A. $5,400.
B. $8,400.
C. $114,400.
D. $117,400.
Level of difficulty: **
Basic Ratio Analysis
p.3
8. Which of the following description about current ratio is correct?
A. A ratio of 0.8:1 means a company will be liquidated.
B. The higher the ratio the better.
C. Accounts receivables are assumed to be collected on a timely basis.
D. The non-current assets can be sold immediately when there is a liquidity
problem.
Level of difficulty: **
9. Other than the use of accounting ratios, which of the following factors will not
affect the decision of investing in another company?
A. Legal environment.
B. Reputation of the company.
C. Relationship with customers.
D. Research expenses already paid for this investment project.
Level of difficulty: ***
10. If the current ratio of a company is 7:1, the company may be holding
____________ idle short-term assets.
A. too much
B. too little
C. sufficient
D. right level of
Level of difficulty: *
Basic Ratio Analysis
p.4
Section B: Short Questions
Question 1
Briefly describe four internal uses of financial ratios to a company. (4 marks)
Level of difficulty: *
Question 2
What is the reason of using ‘profit before interest and tax’ instead of ‘profit after
interest and tax’ as the numerator in the ROCE formula? (4 marks)
Level of difficulty: *
Question 3
Suggest four methods to a company when there is a liquidity problem to settle the
balance with its supplier in next month. (8 marks)
Level of difficulty: ***
Question 4
Given the following information, calculate the current ratio and acid test ratio of the
company and provide comment on its liquidity. (10 marks)
Non-current assets: $241,000
Accounts receivable: $6,300
Inventory: $15,500
Cash: $5,500
Accounts payable: $9,800
Tax payable: $3,200
Level of difficulty: **
Basic Ratio Analysis
p.5
Question 5
(a) State the characteristics of a company using aggressive working capital policy
byshowing its effects on the level of items listed in the following table. (4 marks)
(b) Briefly describe the overall impacts on profitability and risk to a company using
aggressive working capital policy by outlining its implication to the items listed
in the following table. (10 marks)
Level of
cash
Level of
accounts
receivable
Level of
inventory
Short-term
debts/
long-term
liabilities
Overall
Impact
(a)
Characteristics
----
(b)
Profitability
Risk
Level of difficulty: **
Basic Ratio Analysis
p.6
Solutions:
Section A: MCQs
1. B 2. B 3. C 4. A 5. A
6. D 7. A 8. C 9. D 10. A
Section B: Short Questions.
Question 1
The four internal uses of financial ratios include:
1. Identify deficiencies of the company and take remedial action.
2. Evaluate performance of employees and determine relevant compensation.
3. Compare the financial performance of different divisions within the company.
4. Understand the financial performance and status of the company’s competitors.
(@1, total 4 marks)
Question 2
The reason of using net profit before interest and tax in calculating ROCE is that such
profit is the income generated from the company’s assets regardless of how the
company’s funds come from.
If the company relies heavily on borrowing, the net profit before tax will be adversely
affected because of high interest expense and hence affect the comparison with
companies with different capital structure.
(@2, total 4 marks)
Question 3
A company might consider the following methods to cope with the liquidity
problems:
• Offering an early settlement discount to its customers. This is a reduction in
the amount of the payment required from the customer provided that the
customer pays within a specified time limit.
• Offering trade discount on cash sales to its customers for receiving immediate
cash.
• Buy less inventory = applying Just-in-time inventory system to reduce the
carrying cost of the inventory and increase the cash balance.
• Borrow a short to medium-term loan (e.g. 1 to 3 years) to enhance the liquidity.
[remarks: it is not suggested to use long-term loan as the interest expense will
be too high when it is only a temporary running short of cash.]
Basic Ratio Analysis
p.7
• Disposal of idle non-current assets to improve the liquidity.
• Any other valid suggestions.
(@2, max 8 marks)
Question 4
Calculation Comments
Current
ratio
($6,300 + $15,500 +
$5,500) / ($9,800 +
$3,200) = 2.1:1
(2 marks)
The current ratio is satisfactory as the current
assets are about two times of its current
liabilities which indicates the company has
sufficient short-term funds to settle its
short-term obligations. (2 marks)
Acid test
ratio
($6,300 + $5,500) /
($9,800 + $3,200) =
0.91:1
(2 marks)
The acid test ratio is a bit unsatisfactory as there
is less than $1 dollar of liquid assets to cover $1
dollar of current liabilities. The significant
drop of the ratio indicates there are too many
inventories on hand and the company may not
have sufficient short-term funds without the
sale of inventory to settle its short-term
obligations. (4 marks)
Question 5
Level of
cash
Level of
accounts
receivable
Level of
inventory
Short-term
debts/
long-term
liabilities
Overall
Impact
(a)
Characteristics
Lower Lower Lower Higher/lower -
(b)
Profitability
Increase
investment
opportunity.
Less cost
of
financing
when cash
is
received.
Lower
carrying costs
and
obsolescence.
Lower
interest
expenses.
Higher
return
Risk Higher risk
as less
immediate
cash.
Higher
probably
of bad
debts.
Probability of
stock out and
miss the
chance of
sales.
More
short-term
obligation to
meet.
Higher
risk
(@1, total 14 marks)
Ratio Analysis
p. 1
Basic Ratio Analysis – Quiz
Section A: Multiple Choice Questions (@1, total 10 marks)
1. Which of the following issue can be indicated by reviewing the income statement
of a company?
A. The operating expense spent for the year in percentage of the income for the
year.
B. How much non-current asset is employed to generate profit.
C. Whether the debt level is high or low.
D. Whether the company is able to pay for their short-term obligation.
Level of difficulty: *
2. What can be showed by comparing a computer company’s the financial
information over the past 5 years?
A. Trends of financial performance.
B. Company’s competitive position.
C. Development of the industry.
D. Technological change.
Level of difficulty: ***
3. What is the implication of having a higher return on capital employed (ROCE)?
A. The company has a better control on cost of goods sold.
B. The company is able to settle its short-term loan.
C. The company relies too much on capital.
D. The company is more effective in using its capital assets to generate returns.
Level of difficulty: *
Ratio Analysis
p. 2
4. Which of the following may be affected by the profitability of a company?
A. Its ability to obtain debt and equity financing
B. Its liquidity position.
C. Its ability to grow.
D. All of the above.
Level of difficulty: *
5. What is the implication when a company has high gross profit but low net profit?
A. Poor control on working capital.
B. Better control on cost of goods sold and operating expense.
C. Better control on cost of goods sold but poor control on operating expense.
D. Decline in sales demand.
Level of difficulty: **
6. Which of the following would lead to an immediate outflow of cash in a period?
A. Purchase of goods on credit.
B. Payment to suppliers.
C. Unpaid dividend declared.
D. Receipt from customers.
Level of difficulty: **
7. By using aggressive working capital policies, current assets are often financed by
___________.
A. Selling non-current assets.
B. Borrowing short-term debts.
C. Issuing bonds.
D. Issuing shares.
Level of difficulty: *
Ratio Analysis
p. 3
8. Which of the following is not a component of working capital?
A. Plant and machinery.
B. Cash.
C. Trade payables.
D. Inventory.
Level of difficulty: *
9. Which of the following is not a component of quick assets?
A. Trade receivable.
B. Cash.
C. Inventory.
D. None of the above.
Level of difficulty: *
10. Which of the following is not the limitation of financial ratio analysis?
A. Seasonal factor cannot be reflected.
B. Information used are historical.
C. Different accounting practices adopted by companies.
D. Too much accounting information included.
Level of difficulty: *
Ratio Analysis
p. 4
Section B: Short Questions
Question 1
Briefly describe the signs of liquidity problems of a company. (10 marks)
Level of difficulty: *
Question 2
Calculate the following financial ratios for XYZ Ltd for both 20X4 and 20X5, and
comment briefly the result of each ratio.
Gross profit margin.
Net profit margin.
Return on capital employed.
Current ratio.
Acid test ratio.
20X5 20X4
$'000 $'000
23,220 20,123
(16,420) (14,836)
6,800 5,287
Distribution (898) (704)
Selling and marketing (1,322) (1,201)
General and (1,054) (988)
3,526 2,394
(435) (332)
3,091 2,062
(456) (354)
2,635 1,708Profit after tax
Sales
Cost of sales
Gross profit
Expenses
Operating profit
Interest expenses
XYZ Ltd
Income Statement
For the year ended 31 December
Profit before tax
Income tax expenses
Ratio Analysis
p. 5
20X5 20X4
$'000 $'000
Non-current assets
Equipments 45,205 42,084
Current assets
Inventories 1,564 1,186
Trade receivables 2,349 2,561
Cash and bank 851 358
4,764 4,105
Current liabilities
Trade payables 1,894 2,334
Tax payable 456 354
2,350 2,688
Total assets less current liabilities 47,619 43,501
Financed by:
Share capital 30,000 30,000
Retained earnings 8,515 5,880
38,515 35,880
Non-current liabilities
Long-term loan 9,104 7,621
47,619 43,501
XYZ Ltd
Statement of Financial Position
As at 31 December
(20 marks)
Level of difficulty: ***
Ratio Analysis
p. 6
Solutions:
Section A: MCQs
1. A 2. A 3. D 4. D 5. C
6. B 7. B 8. A 9. C 10. D
Section B: Short Questions.
Question 1
The signs of liquidity problems of a company include:
1. Persistent decline in daily or weekly cash inflows.
2. Significant decline in operating profit which indicates the company is unable to
pass the cost on to customers.
3. Unexpected build-up of accounts receivable and inventory which indicates the
company may not be able to collect money from customers or is unable to sell
goods.
4. Unexpected build-up of accounts payable indicates the company is unable to pay
to its suppliers.
5. Shape decline in company’s working capital.
(@2, total 10 marks)
Question 2
Formula 20X5 20X4
Gross
profit
margin
Gross profit /
Sales
$6,800/$23,220 = 29.29% $5,287/$20,123 = 26.27%
Comment: The gross profit margin for 20X5 is better than 20X4 which indicates a
better control on purchase costs (e.g. good bargain with suppliers) and/or
better sales performance of the company.
Net profit
margin
Net profit
before tax /
sales
$3,091/$23,220 = 13.31% $2,062/$20,123 = 10.25%
Comment: The net profit margin for 20X5 is better than 20X4 which indicates a
better control on purchase costs and/or operating expenses and/or better
sales performance of the company..
ROCE PBIT / Average $3,526/$47,619 = 7.4% $2,394/$43,501= 5.5%
Ratio Analysis
p. 7
capital
employed
Comment: The ROCE for 20X5 is better than 20X4 which indicates the company is
more efficient in using its capital asset to generate income.
Current
ratio
Current
assets/Current
liabilities
$4,764/$2,350 = 2.03:1 $4,105/$2,688 = 1.53:1
Comment: There is an increase in current ratio which indicates the ability of the
company to settle its short-term debts is improved. Besides, the current
ratio suggests that the company has sufficient current assets to meet its
short term debts.
Acid test
ratio
(Current
assets –
Inventory)/
Current
liabilities
($4,764 - $1,564)/$2,350 =
1.36:1
($4,105 - $1,186)/$2,688
= 1.09:1
Comment: There is an increase in acid test ratio which indicates the ability of the
company to use settle its short-term debts without having disposed of its
inventory is improved. Besides, the acid test ratio suggests that the
company has sufficient liquid assets to meet its short term debts.
(1 mark for each ratio and 2 marks for each comment, total 20 marks)