CHAPTER 16 – INTRODUCTION TO RATIOS

INTRODUCTION
Accounting ratios are used to enable us to analyse and interpret accounting
statements. Ratios are sometimes used to draw up financial statements from
incomplete records. Without the use of such accounting ratios, the construction of
financial statements from incomplete records would often be impossible.
Incomplete records exist where a business does not keep detailed accounting
records. In these circumstances, accountants have to construct the records that
would have existed had a proper set books been maintained, so that they can then
prepare the financial statements. Because of the logical relationships that exist
between many of the items in financial statements, and because of the unambiguous
rule of double entry ratios defining the relationship between various items can be
used to assist in this investigation. So, for example, if the opening inventory is
known, what was purchased and what inventory is left at the end, the sales can
easily be worked out.
MARK-UP AND MARGIN
Purchase cost, gross profit and selling price of goods or services may be shown as:
Cost Price (CP) + Gross Profit (GP) = Selling Price (SP)
When shown as a fraction or percentage of the cost price, the gross profit is known
as the mark-up.
When shown as a fraction or percentage of the selling price, the gross profit is known
as the margin.
CP + GP = SP
KES 4 + KES 1 = KES 5
Mark-up = GP/CP as a fraction, or if required as a percentage, multiply by 100:
= ¼, or ¼*100=25%
Margin = GP/SP as a fraction, or if required as a percentage, multiply by 100:
= 15, or 1/5*100=20%
CALCULATING MISSING FIGURES
Now we can use these ratios to complete trading accounts where some of the figures
are missing.
Example 1
The following figures are for the year 2018:
KES

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Inventory 1.1.2018 40,000
Inventory 31.12.2018 60,000
Purchases 520,000
A uniform rate of mark-up of 20% is applied.
Required:
Find the gross profit and sales.
Trading account for the year ending 31 Dec 2018
KES KES
Sales ?
Less: Cost of goods sold
Inventory 1.1.2018 40,000
Add: Purchases 520,000
560,000
Less: Inventory 31.12.2018 (60,000)
500,000
Gross Profit ?

Cost of goods sold - COGS (same as CP) + Gross Profit = Sales

So: COGS + % mark–up = Sales
500,000 + 20% COGS = Sales
Sales = 500,000 + 20%*500,000
= 500,000 + 100,000
= 600,000
Trading account for the year ending 31 Dec 2018
KES KES
Sales 600,000
Less: Cost of goods sold
Inventory 1.1.2018 40,000
Add: Purchases 520,000
560,000
Less: Inventory 31.12.2018 (60,000)
500,000
Gross Profit 100,000

Example 2
Another business has the following figures for2019:
KES
Inventory 1.1.2019 50,000

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Inventory 31.12.2019 80,000
Sales 640,000
A uniform rate of margin of 25% is in use.
Required:
Find the gross profit and purchases.

Trading account for the year ending 31 Dec 2019

KES KES
Sales 640,000
Less: Cost of goods sold
Inventory 1.1.2019 50,000
Purchases ?
?
Less: Inventory 31.12.2019 80,000
?
Gross Profit ?
COGS + GP = Sales
Sales – GP = COGS
Sales – 25% (sales) margin = COGS
COGS = 640,000 – 640,000*25%
= 640,000 – 160,000 = 480,000
Now the following figures are known:
KES KES
Sales 640,000
Less: Cost of goods sold 510,000
Inventory 1.1.2019 50,000
Purchases (1) ?
(2) ?
Less: Inventory 31.12.2019 80,000
480,000
Gross Profit 160,000

The 2 missing figures are found by normal arithmetic deduction:

(2) less KES 80,0000 = KES 480,000
Therefore (2) = KES 480,000 + KES 80,000 = KES 560,000
So that KES 50,000 opening inventory + (1) = KES 560,000
Therefore (1) = KES 560,000 – KES 50,000 = KES 510,000

The completed trading account section of the income statement can now be shown:

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 Trading account for the year ending 31 Dec 2019
KES KES
Sales 640,000
Less: Cost of goods sold
Inventory 1.1.2019 50,000
Purchases 510,000
560,000
Less: Inventory 31.12.2019 (80,000)
480,000
Gross Profit 160,000
RELATIONSHIP BETWEEN MARK-UP AND MARGIN
Both of these figures refer to the same gross profit, but express it as a fraction or a
percentage of different figures. This connection through gross profit means that if
one is known (mark-up or margin) t is possible to determine the other, as follows:

Mark-up Margin
1 1 = 1
4 4+1 5
2 2 = 2
11 11+2 13

Margin Mark-up
1 1 = 1
6 6-1 5
3 3 = 3
13 13-3 10

COMMONLY USED ACCOUNTING RATIOS

There are some ratios that are in common use for the purpose of comparing one
period’s results with those of a previous period. Two of those most in use are the
ratio of gross profit to sale, and the rate of inventory turnover (also known as
‘stockturn’).

Gross profit as percentage of sales (GP% on turnover/Gross margin)

The basic formula is
Gross profit as percentage of sales = Gross profit X 100
Sales 1

This represents the amount of gross profit for ever KES 100 of sales revenue. This
ratio is used as a test of the profitability of the sales. Just because sales revenue has
increased does not, of itself, mean that gross profit will increase.

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 Trading account for the years ending 31 Dec 2016 and 2017
2,016 2,017
KES KES KES KES
Sales 700,000 800,000
Less: Cost of goods sold
Opening inventory 50,000 90,000
Add Purchases 600,000 720,000
650,000 810,000
less closing inventory (90000) (110000)
560,000 700,000
Gross profit 140,000 100,000

In the year 2016 the gross profit as a percentage of sales (GP%) was
140,000 X 100 = 20%
700,000 1
In 2017 it became 100,000 X 100 = 12.5%
800,000 1

Sales had increase but, as the GP% had fallen by a relatively greater amount, the GP
has fallen. There can be many reasons for such a fall in the GP%, including:

1. Perhaps the goods being sold have cost more, but the selling price of the
goods has not risen to the same extent;
2. There may have been a greater wastage or theft of goods;
3. There could be a difference in how much has been sold of each sort of goods,
called the sales mix, between the 2 years, with different kinds of goods
carrying different GP per KES 100 of sales;
4. Perhaps in order to increase sales, reductions have been made in the selling
price of goods.

Inventory turnover
If a business always kept just KES 10,000 of inventory at cost which, when sold,
would always sell for KES 12,500, and this amount was sold 8 times an year, the
business would make GP as follows:

8 X KES 2,500 = KES 20,000.

The quicker the inventory was sold (also referred to as turning over inventory), the
more the profit, if GP % stays the same.

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To check on how quickly the business is turning over the inventory it can use the
formula:

Number of times inventory is turned over within a period = Cost of goods sold
Average inventory

It would be best if the average inventory held could be calculated by valuing the
inventory quite a few times each year, then dividing the totals of the figures obtained
by the number of valuations. However, in most cases the average inventory is simply
calculated by averaging the opening and closing inventories.

Using the trading account above, the inventory turnover is calculated as follows:

2016 = 560,000 = 8 times per year

(50,000+90,000)/2

2017 = 700,000 = 7 times per year

(90,000+110,000)/2

Instead of saying that the inventory turnover is so many times per year, we could say
on average how long we keep inventory before we sell it. We do this by the formula:

To express it in months: 12 / Inventory turnover = x months

To express it in days: 365 / Inventory turnover = x days

From the workings above:

2016 2017

In months 12/8 = 1.5 months 12/7 = 1.7 months

In days 365/8 = 45.6 days 365/7 = 52.1 days

When the rate of inventory turnover is falling it can be due to such causes as:

1. Slowing down of sales activity;

2. Keeping a higher amount of inventory than is really necessary.

The ratio itself does not prove anything; it merely prompts enquiries as to why it
should be changing.

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REVIEW QUESTIONS
1. D. Kofia is a trader who sells all of her goods at 30% above cost. Her books
give the following information at 31 Dec 2019:
KES
Inventory 1 Jan 2019 21,000
Inventory 31 Dec 2019 29,000
Sales for t year 208,000
Required:
Prepare the trading account for D. Kofia for 2019
2. J Garama’s business has a rate of inventory turnover of 7 times per year.
Average inventory is ES 35,[Link]-up is 40%. Expenses are 60% of gross
profit.
Required:
a) Cost of goods sold;
b) Gross profit;
c) Turnover;
d) Tot expenses;
e) Net profit.

3. The following trading account is extracted from the income statement ending
31 Dec 2018 and is given to you by the owner of the business, Mr. Malik:
KES KES
Sales 260,000
Less: Cost of goods sold
Opening inventory 41,000
Add Purchases 218,000
259,000
less closing inventory (49000)
210,000
Gross profit 50,000

Mr. Malik says that he normally adds 30% to the cost of goods to fix the sales
price. However, this year there were some arithmetical errors in these
calculations.

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Required:
a) Calculate what his sales would have been if he had not made any errors;
b) Given his expenses remain constant at 9% of his sales, calculate his net
profit for the year 2018;
c) Work out the rate of inventory turnover for 2018;
d) He thinks that next year he can increase his mark-up to 40%, selling goods
which will cost him KES 240,000. If he does not make any more errors in
calculating selling prices, you are to calculate the expected gross and net
profits for 2019.