Evaluation of adequacy of accounting ratios as a means of monitoring the state of business (TASK 8).
GROSS PROFIT RATIO (GP RATIO)
It is a profitability ratio that shows the relationship between gross profit and total net sales revenue. It is a popular tool to evaluate the operational performance of the business. The ratio is computed by dividing the gross profit figure by net sales.
The following formula/equation is used to compute gross profit ratio:
When gross profit ratio is expressed in percentage form, it is known as gross profit margin or gross profit percentage. The formula of gross profit margin or percentage is given below:
The basic components of the formula ...view middle of the document...
It is computed by dividing the net profit (after tax) by net sales.
For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax. All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. Examples of non-operating revenues include interest on investments and income from sale of fixed assets. Examples of non-operating expenses include interest on loan and loss on sale of assets.
The relationship between net profit and net sales may also be expressed in percentage form. When it is shown in percentage form, it is known as net profit margin. The formula of net profit margin is written as follows:
As per Task 7:
Percentage of Net Profit is 8.98% which is approx. 9% which out of Rs. 100 sales the business is able to generate a profit of Rs. 9 and all the expenses are Rs. 91.
Significance and Interpretation:
Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio indicates the efficient management of the affairs of business.
There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability or not, the analyst should compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net profit ratio.
The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably the assets have been used during the period.
CURRENT RATIO (ALSO KNOWN AS WORKING CAPITAL RATIO)
It is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short period of time, usually one year.
Current ratio is computed by dividing total current assets by total current liabilities of the business. This relationship can be expressed in the form of following formula or equation:
As per Task 7:
The current ratio is 0.576:1
Significance and interpretation
Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it. Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a company with low current ratio may be able to pay its current obligations as they...