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Accounting Ratios (Form 4)

Covers profitability and liquidity ratios including margin, mark-up, and current ratio.

📘 Topic Summary

Accounting ratios are a set of financial metrics used to analyze and evaluate the performance of a business. This study guide covers profitability and liquidity ratios, including margin, mark-up, and current ratio, providing students with a comprehensive understanding of these essential concepts.

📖 Glossary
  • Profitability Ratio: A measure of a company's ability to generate earnings compared to its expenses.
  • Liquidity Ratio: A measure of a company's ability to pay its short-term debts.
  • Gross Margin: The difference between revenue and the cost of goods sold, expressed as a percentage.
  • Markup: The amount by which the selling price exceeds the cost price.
  • Current Ratio: A measure of a company's ability to pay its short-term debts using its current assets.
⭐ Key Points
  • Profitability ratios help investors and creditors assess a company's ability to generate earnings.
  • Liquidity ratios indicate a company's capacity to meet its short-term obligations.
  • Margin and markup are used to calculate the profit earned on each unit sold.
  • Current ratio is an important indicator of a company's financial health.
  • Understanding accounting ratios helps businesses make informed decisions about investments, financing, and operations.
🔍 Subtopics
Profitability Ratios

Gross profit margin is the ratio of gross profit to sales, calculated as (gross profit / total revenue) x 100%. It measures a company's ability to maintain profitability. The higher the margin, the more profitable the company. Return on Sales (ROS) is another profitability ratio, calculated as net income divided by total revenue. It shows the percentage of revenue that contributes to the company's overall profitability.

Liquidity Ratios

The Current Ratio measures a company's ability to pay its short-term debts, calculated as current assets divided by current liabilities. A ratio greater than one indicates the company has sufficient liquid assets to meet its obligations. The Quick Ratio, also known as the Acid-Test Ratio, is similar but excludes inventory and prepaid expenses from current assets.

Margin and Markup

Markup refers to the difference between a product's selling price and its cost. It is calculated by subtracting the cost from the selling price and dividing by the cost. Margin, on the other hand, is the percentage of markup as a proportion of the cost. For example, if a product costs $100 and sells for $120, the markup is $20 ($120 - $100) and the margin is 20% ($20 / $100).

Current Ratio

The Current Ratio is calculated by dividing current assets by current liabilities. It provides insight into a company's ability to pay its short-term debts. For example, if a company has current assets of $50,000 and current liabilities of $20,000, the Current Ratio would be 2.5 ($50,000 / $20,000). This indicates that the company has sufficient liquid assets to meet its obligations.

🧠 Practice Questions

  1. What is a profitability ratio?

  2. What is markup?

  3. What is gross margin?

  4. What is current ratio?

  5. Which ratio measures a company's ability to maintain profitability?

  6. What is the formula for calculating the current ratio?

  7. What is the purpose of a liquidity ratio?

  8. What is the difference between gross margin and markup?

  9. What is the significance of a high current ratio?

  10. What is the relationship between profitability ratios and liquidity ratios?

  1. Calculate the current ratio for a company with current assets of $50,000 and current liabilities of $20,000. (2 marks)

  2. Calculate the gross margin for a company with revenue of $100,000 and cost of goods sold of $60,000. (2 marks)

  3. Calculate the markup for a product that costs $50 and sells for $70. (2 marks)

  4. What is the significance of a low current ratio? (2 marks)

  5. How do profitability ratios help investors and creditors make informed decisions about investments and financing? (2 marks)

  1. Discuss the importance of accounting ratios in business decision-making. (20 marks)

  2. Explain the role of accounting ratios in evaluating a company's financial health. (20 marks)