Some important ratios:

Liquidity measures:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
i) Current Ratio/Short term solvency ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
Measure the short term solvency of a business. It indicates the firm’s ability to pay off it’s obligations
when they comes due. Too high or too low of this value is not desirable. Too low indicate the firm’s
inability to pay off creditors due and too high indicates inefficiency in asset management. Current assets
are regarded as non-performing asset which generate no return or low return compare to fixed assets.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
ii) Quick Ratio=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

Profitability Measures
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
i) Gross Margin = Also known as gross profit margin.
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
This ratio gives an indication of product sourcing efficiency of an
organization.

𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡

ii) Net Operating Profit Margin =
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
Combining this ratio with gross margin, a company can get an indication
about its cost management performance.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
iii) Net Margin =
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
iv) Return on Assets (ROA) =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
v) Return on Equity (ROE) =
𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
vi) Sales return and allowances as a percentage of sales
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝑎𝑛𝑑 𝑎𝑙𝑙𝑜𝑤𝑎𝑛𝑐𝑒
= 𝑔𝑟𝑜𝑠𝑠 𝑠𝑎𝑙𝑒𝑠

High values are desirable for these ratios.

Asset Management:
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
i) Total Assets Turnover ratio =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
ii) Fixed Asset Turnover ratio=
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
iii) Accounts Receivable collection period = 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
360

Also known as Days sales outstanding.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 (𝐶𝐺𝑆)
iv) Inventory Turnover ratio =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑀𝑒𝑟𝑐ℎ𝑎𝑛𝑑𝑖𝑠𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
360
Days in inventory =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜

High values are desirable for these ratios.

Debt Management:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
i) Debt ratio =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

ii) Equity ratio =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equity ratio = 1 – Debt Ratio

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
iii) Debt equity ratio/ Capital structure ratio =
𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

High debt ratio indicates high risk exposure of the firm.

***For service organization, sales will be replaced by revenue.

The Trial Balance for Audio Concepts at December 31, 2012, is as follows:
AUDIO CONCEPTS
Trial Balance
December 31, 2012

Accounts Debit Credit

Cash 20,000
Accounts Receivable 11,000
Supplies 4,000
Prepaid Insurance 6,000
Audio Equipment 205,000
Accumulated Depreciation—Audio Equipment 29,000
Accounts Payable 19,000
Note Payable 70,000
Salaries Payable 3,000
J. Franco, Capital 112,000
J. Franco, Drawing 14,000
Audio Revenue 123,000
Advertising Expense 18,000
Depreciation Expense 12,000
Insurance Expense 3,000
Rent Expense 17,000
Salaries Expense 40,000
Supplies Expense 6,000
Totals 356,000 356,000

Instructions
(a) Prepare the income statement and statement of owner’s equity.
(b) Prepare a classified balance sheet for Audio Concepts at December 31, 2012 assuming the note
payable is a long-term liability.
(c) Compute the ratios relating to liquidity, profitability, asset management and debt management.
Solution
a.
AUDIO CONCEPTS
Income Sheet
For the period ended December 31, 2012
———————————————————————————————————————————
Revenue
Audio Revenue 123,000

Expenses
Advertising Expense 18,000
Depreciation Expense 12,000
Insurance Expense 3,000
Rent Expense 17,000
Salaries Expense 40,000
Supplies Expense 6,000
Total expenses 96,000
Net income $ 27,000

AUDIO CONCEPTS
Statement of Owner’s Equity
For the period ended December 31, 2012
———————————————————————————————————————————

J. Franco, Capital, January 1 $112,000

Add: Net Income 27,000
139,000
Less: Drawings 14,000
J. Franco, Capital, December 31 $125,000
(b)
AUDIO CONCEPTS
Balance Sheet
December 31, 2002
———————————————————————————————————————————
Assets
Current assets
Cash ................................................................................................. $ 20,000
Accounts receivable ........................................................................ 11,000
Supplies ........................................................................................... 4,000
Prepaid insurance ............................................................................ 6,000
Total current assets ................................................................. 41,000
Property, plant, and equipment
Audio equipment ............................................................................ $205,000
Less: Accumulated depreciation—audio equipment ...................... 29,000 176,000
Total assets ............................................................................. $217,000

Liabilities and Owner's Equity

Current liabilities
Accounts payable ............................................................................ $ 19,000
Salaries payable ............................................................................... 3,000
Total current liabilities ............................................................ 22,000
Long-term liabilities
Note payable ................................................................................... 70,000
Total liabilities ......................................................................... 92,000
Owner's equity
J. Franco, Capital ............................................................................. 125,000
Total liabilities and owner's equity ......................................... $217,000
Liquidity measures:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio/Short term solvency ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
41,000
= = 1.86.
22,000
Favorable.

Profitability Measures
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 27,000
Profit Margin = = = 21.95%.
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 123,000

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒𝑡 27,000

Return on Assets (ROA) = = = 12.44%
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 217,000

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 27,000

Return on Equity (ROE) = = = 21.6%
𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 125,000

Asset Management:
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 123,000
Total Assets Turnover ratio = = = 0,567 times
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 217,000

Higher value indicates higher revenue generating capacity of assets.

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 123,000

Fixed Asset Turnover ratio= = = 0.699 times.
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 176,000

Higher value indicates higher revenue generating capacity of per taka

invested in fixed assets.
Debt Management:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 92,000
iv) Debt ratio = = = 42.40%
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 217,0000

𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 125,000

v) Equity ratio = = = 57.60%
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 217,0000

Equity ratio = 1 – Debt Ratio = 1- 42.40% = 57.60%

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
vi) Debt equity ratio/ Capital structure ratio =
𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
92,000
= = .731 times
125,000

High debt ratio indicates high risk exposure of the firm.