THE CALCULATION AND INTERPRETATION OF ACCOUNTING RATIO CHAPTER 14

14.1 Profitability Ratio

a) Gross profit as a percentage of revenue (margin)

b) Gross profit as a percentage of cost of goods sold (mark up)

c) Net profit as a percentage of revenue (net profit margin)

d) Return on capital employed (ROCE)

14.2 Liquidity Ratio

a) Current ratio (working capital ratio)

b) Liquid ratio (Acid Test ratio)

14.3 Efficiency Ratio

a) Accounts receivables collection period

b) Accounts payables payment period

c) Rate of Inventory turnover

Pearson LCCI LEVEL 2 BOOK-KEEPING & ACCOUNTING (ASE20093)

THE CALCULATION AND INTERPRETATION OF ACCOUNTING RATIO CHAPTER 14
Example 1
Barnum plc
Statement of Profit or Loss for the year ending 31 December
2008 2009
£’000 £’000
Sales 15,000 16,200
Profit before interest charges 1,500 1,458
Interest charges 200 260
Profit after interest charges 1,300 1,198
Proposed ordinary dividend 800 820
Retained profits 500 378
Statement of Financial Position as at 31 December
2008 2009
£’000 £’000
Non-current assets at net book value 8,200 9,718
Current assets
Inventory 1,300 1,200
Accounts receivable 1,250 1,620
Bank 830 110
3,380 2,930
Current liabilities
Accounts payable 940 1,010
Proposed dividend 800 820
1,740 1,830
Net current assets 1,640 1,100
9,840 10,818
Non-current liabilities
10% Loans 2,000 2,600
7,840 8,218
Share capital and reserves
8,000,000 ordinary £0.50 shares 4,000 4,000
Share premium account 970 970
Profit and loss account 2,870 3,248
7,840 8,218
Note: The additional £600,000 was borrowed on 1 January 2009

Required
Calculate the following measures:
a) Return on total capital employed
b) Return on shareholders’ (owner’s) capital employed
c) Profit to sales
d) Sales to capital employed
e) Current ratio
f) Liquidity ratio

Pearson LCCI LEVEL 2 BOOK-KEEPING & ACCOUNTING (ASE20093)

THE CALCULATION AND INTERPRETATION OF ACCOUNTING RATIO CHAPTER 14
Example 2
Jason Clee is a retailer of electrical products. His statement of profit or loss for the year ended 31 December 2008, in
vertical format, was:
£ £
Sales 124,800
Less: Cost of Sales
Opening inventory 4,600
Purchases 63,600
68,200
Closing inventory 5,800 62,400
Gross profit 62,400
Expenses 49,920
Net profit 12,480
Calculate:
a) Gross profit percentages expressed as: b) Net profit to sales percentage
i) Mark-up c) Inventory turnover rate
ii) Margin d) Average stock holding period
For year ended 31 December 2009, his plan is to:
1) Increase sales volume by 20%. He considers that this can be achieved by reducing selling price by 3% from 1
January 2009.
2) Increase the average rate of stock turnover to 13 times
3) Achieve 15% net profit/sales percentage compared to the 10% achieved in the year ended 31 December 2008.
Required
Prepare a planned statement of profit or loss for the year ended 31 December 2009.

TARGET PRACTICE
1) Philip acquired a business as a going concern on 1 January 2014. He has noted certain information obtained
from his statement of profit or loss for the year end 31 December 2014 and his statement of financial position
at that date. This information includes:
a) Gross profit rate on turnover – 40% (cost of sold equals 60% of sales)
b) Inventory turnover rate based upon the average of opening and closing stocks – six times
c) Expenses (including depreciation £5,000) - £28,600
The business had only £7,200 inventory when Philip acquired it and, in order to give a better selection to
potential customers, Philip had increased this amount to £12,200 by the year end. Most of his sales were from
cash, but his receivables at 31 December 2014 represented one month’s credit sales. The debtors amounted to
£1,820. All purchases are for cash. To be prudent in his first year, he has purchased no fixed assets (the £5,000
depreciation in his expenses is 20% of the value of fixed assets acquired with the business) and has drawn only
£8,000 as personal living expenses. He has a bank balance of £1,050.
Required
a) In as much detail as possible, prepare:
i) Philip’s statement of profit or loss for the year ended 31 December 2014
ii) Philip’s statement of financial position at 31 December 2014.
b) How much gross profit could Philip earn in 2015 if he is able to increase the stock turnover rate to 7, but
allow stocks to increase by only £1,000?

Pearson LCCI LEVEL 2 BOOK-KEEPING & ACCOUNTING (ASE20093)

THE CALCULATION AND INTERPRETATION OF ACCOUNTING RATIO CHAPTER 14
2) You are to study the following financial statements for two furniture stores and then answer the questions which
follow:
Financial Statements
X Y
£ £ £ £
Statements of Profit or Loss
Sales 555,000 750,000
Less Cost of goods sold
Opening inventory 100,000 80,000
Add Purchases 200,000 320,000
300,000 400,000
Less Closing inventory (60,000) (240,000) (70,000) (330,000)
Gross profit 315,000 420,000
Less Depreciation 5,000 15,000
Wages, salaries and commission 165,000 220,000
Other expenses 45,000 (215,000) 35,000 (270,000)
Net profit 100,000 150,000

Statements of financial position

Non-current assets
Equipment at cost 50,000 100,000
Less Depreciation to date (40,000) 10,000 (30,000) 70,000
Current assets
Inventory 60,000 70,000
Accounts receivable 125,000 100,000
Bank 25,000 210,000 12,500 182,500
Total assets 220,000 252,500
Current liabilities
Accounts payable (104,000) (40,000)
Net assets 116,000 152,000
Finance by:
Capitals
Balance at start of year 76,000 72,000
Add Net profit 100,000 150,000
176,000 222,000
Less Drawings (60,000) (70,000)
Total capital 116,000 152,000
Required:
a) Calculate the following ratios for each business:
i) Gross profit as percentage of sales; vi) Current ratio
ii) Net profit as percentage of sales; vii) Acid test ratio
iii) Expenses as percentage of sales; viii) Accounts receivable/sales ratio
iv) Inventory turnover; ix) Accounts payable/purchases ratio
v) Rate of return of net profit on capital employed (use the
average of the capital account for this purpose);

b) Drawing upon all your knowledge of accounting comment upon the differences and similarities of the
accounting ratios for X and Y. Which business seems to be the most efficient? Give possible reasons.

Pearson LCCI LEVEL 2 BOOK-KEEPING & ACCOUNTING (ASE20093)

THE CALCULATION AND INTERPRETATION OF ACCOUNTING RATIO CHAPTER 14
3) The summarized accounts of Hope (Eternal Springs) Ltd for the years 2015 and 2016 are given below:
Statement of Profit or Loss for the years ending 31 December
2015 2016
£’000 £’000 £’000 £’000
Sales 200 280
Less Cost of goods sold (150) (210)
Gross profit 50 70
Less Administration expenses 38 46
Loan note interest - (38) 4 (50)
Net profit 12 20
Statements of Financial Position as at 31 December
2015 2016
£’000 £’000 £’000 £’000
Non-current assets at cost less depreciation 110 140
Current assets
Inventory 20 30
Accounts receivable 25 28
Bank - 45 5 63
Total assets 155 203
Current liabilities
Accounts payable 15 12
Bank 10 -
25 12
Non-current liabilities
8% loan notes - 50
Total liabilities (25) (62)
Net assets 130 141
Equity
Ordinary share capital 100 100
Retained profits 30 41
Total equity 130 141
Inventory at 1 January 2015 was £50,000

Required:
a) Calculate the following ratios for 2015 and 2016:
i) Gross profit to sales iii) Net profit to sales v) Working capital
ii) Inventory turnover iv) Quick (‘acid test’) vi) Net profit to capital employed

b) State the possible reasons for and significance of any changes in the ratios shown by your calculations.

Pearson LCCI LEVEL 2 BOOK-KEEPING & ACCOUNTING (ASE20093)

THE CALCULATION AND INTERPRETATION OF ACCOUNTING RATIO CHAPTER 14
4) The following figures are for AB Engineering Supplies Ltd at 31 December 2016:
£’000 £’000
Turnover 160
Gross profit 40
Average inventory at cost price 10
Expenses 8
Non-current assets 108
Current assets
Inventory 10
Accounts receivable 8
Bank 2 20
128
Current liabilities (10)
118
Capital 118
a) Calculate:
i) Gross profit as a percentage of the sales iv) Current ratio
ii) Rate of inventory turnover v) Quick asset (acid test) ratio
iii) Net profit as a percentage of sales vi) Net profit as a percentage of total capital
employed (non-current assets plus current assets)

5) The trading inventory of Joan Street, retailer has been reduced during the year ending 31 March 2015 by £6,000
from its commencing figure of £21,000.
A number of financial ratios and related statistics have been compiled relating to the business of Joan Street
for the year ending 31 March 2015. These are shown below alongside comparative figures for a number of
retailers who are members of the trade association to which Joan Street belongs:
Joan Street Trade association
Net profit as % net capital employed 15% 16%
Net profit to sales 9% 8%
Sales to Net Capital Employed 166 ⅔% 200%
Non-current assets/Sales 45% 35%
Working capital ratio 400 : 1 287.5 : 1
Acid Test Ratio
275 : 1 187.5 : 1
Bank + Accounts receivable / Current liabilities
Margin 25% 26%
Accounts receivable collection period 36.5 days 32 17/20 days
Inventory turnover (based on average inventory for
10 times 8 times
the year)
Joan Street has supplied all the capital for her business and has had no drawings from the business during the
year ending 31 March 2015.

Required
a) Prepare the Statement of profit or loss for the year ending 31 March 2015 and statement of financial position
as at that date of Joan Street in as much detail as possible.

Pearson LCCI LEVEL 2 BOOK-KEEPING & ACCOUNTING (ASE20093)