ACCOUNTING RATIOS

SECOND TERM SCHEME OF WORK FOR SS 2 FINANCIAL ACCOUNTING LESSON NOTE

SCHEME OF WORK WITH WEEKLY LESSON NOTES FOR SS 2 SECOND TERM FINANCIAL ACCOUNTING

SUBJECT : FINANCIAL ACCOUNTING

CLASS : SS 2

TOPIC : ACCOUNTING RATIOS

WEEK  : WEEK 4

PREVIOUS LESSON :

DISSOLUTION OF PARTNERSHIP

Learning Objectives:

• Define accounting ratios and their importance in financial analysis
• Identify the users of accounting ratios
• Analyze worked examples of accounting ratios to evaluate financial performance

Materials Needed:

• Whiteboard and markers
• Textbook with worked examples of accounting ratios
• Calculators

CONTENT

INTRODUCTION TO ACCOUNTING RATIOS

Accounting ratios are used to measure the financial performance of a business or organization. There are different types of accounting ratios, each with its own specific purpose.

Here are some examples of accounting ratios and how they can be calculated using naira:

1. Profit Margin Ratio: This ratio measures the profitability of a business. It is calculated by dividing the net profit by the total revenue, and then multiplying the result by 100 to get a percentage. For example, if a business had a net profit of ₦500,000 and total revenue of ₦5,000,000, the profit margin ratio would be:

(₦500,000 ÷ ₦5,000,000) x 100 = 10%

This means that for every naira of revenue earned, the business earned 10 kobo of profit.

2. Current Ratio: This ratio measures a business’s ability to pay its short-term debts. It is calculated by dividing the current assets by the current liabilities. For example, if a business had current assets of ₦1,000,000 and current liabilities of ₦500,000, the current ratio would be:

₦1,000,000 ÷ ₦500,000 = 2:1

This means that the business has two naira worth of current assets for every naira worth of current liabilities.

3. Debt-to-Equity Ratio: This ratio measures the amount of debt a business has relative to its equity. It is calculated by dividing the total liabilities by the total equity. For example, if a business had total liabilities of ₦1,000,000 and total equity of ₦500,000, the debt-to-equity ratio would be:

₦1,000,000 ÷ ₦500,000 = 2:1

This means that the business has two naira worth of debt for every naira worth of equity.

4. Return on Equity (ROE) Ratio: This ratio measures the amount of profit a business generates relative to its equity. It is calculated by dividing the net profit by the total equity, and then multiplying the result by 100 to get a percentage. For example, if a business had a net profit of ₦1,000,000 and total equity of ₦5,000,000, the ROE ratio would be:

(₦1,000,000 ÷ ₦5,000,000) x 100 = 20%

This means that the business generated a 20% return on its equity investment.

5. Inventory Turnover Ratio: This ratio measures how quickly a business sells its inventory. It is calculated by dividing the cost of goods sold by the average inventory, which is the sum of the beginning and ending inventory divided by 2. For example, if a business had a cost of goods sold of ₦2,000,000 and an average inventory of ₦500,000, the inventory turnover ratio would be:

₦2,000,000 ÷ ₦500,000 = 4 times

This means that the business sold its inventory four times during the year.

6. Debt-to-Asset Ratio: This ratio measures the amount of debt a business has relative to its total assets. It is calculated by dividing the total liabilities by the total assets. For example, if a business had total liabilities of ₦1,000,000 and total assets of ₦5,000,000, the debt-to-asset ratio would be:

₦1,000,000 ÷ ₦5,000,000 = 0.2

This means that the business has 20 kobo worth of debt for every naira worth of assets

These are just a few examples of accounting ratios and how they can be calculated using naira. Accounting ratios can help businesses make informed decisions about their financial performance and guide them in making changes to improve their profitability and financial stability

Evaluation

1. Which of the following is an example of a profitability ratio? A. Debt-to-Equity Ratio B. Inventory Turnover Ratio C. Return on Equity Ratio D. Current Ratio
2. The Current Ratio is used to measure a business’s ability to: A. Pay its short-term debts B. Generate profit C. Manage inventory D. Collect its accounts receivables
3. Which of the following ratios measures the amount of debt a business has relative to its total assets? A. Profit Margin Ratio B. Debt-to-Asset Ratio C. Current Ratio D. Inventory Turnover Ratio
4. The formula for calculating the Profit Margin Ratio is: A. Net Profit / Total Revenue B. Current Assets / Current Liabilities C. Total Liabilities / Total Equity D. Cost of Goods Sold / Average Inventory
5. Which of the following ratios measures how quickly a business sells its inventory? A. Profit Margin Ratio B. Current Ratio C. Debt-to-Equity Ratio D. Inventory Turnover Ratio
6. A business had a net profit of ₦500,000 and total revenue of ₦5,000,000. What is its Profit Margin Ratio? A. 5% B. 10% C. 15% D. 20%
7. Which of the following ratios measures the amount of profit a business generates relative to its equity? A. Debt-to-Asset Ratio B. Current Ratio C. Return on Equity Ratio D. Inventory Turnover Ratio
8. The formula for calculating the Debt-to-Equity Ratio is: A. Total Liabilities / Total Equity B. Current Assets / Current Liabilities C. Net Profit / Total Revenue D. Cost of Goods Sold / Average Inventory
9. A business had total liabilities of ₦1,000,000 and total equity of ₦5,000,000. What is its Debt-to-Equity Ratio? A. 0.2 B. 0.5 C. 1.0 D. 2.0
10. Which of the following ratios measures a business’s ability to pay its short-term debts? A. Profit Margin Ratio B. Debt-to-Equity Ratio C. Current Ratio D. Inventory Turnover Ratio

Answers:

1. C
2. A
3. B
4. A
5. D
6. B
7. C
8. A
9. A
10. C

Importance and users of accounting ratios

Accounting ratios are important tools used by businesses, investors, and other stakeholders to evaluate the financial health and performance of a company. Here are some examples of the importance and users of accounting ratios:

1. Business Owners and Managers: Accounting ratios help business owners and managers evaluate their company’s financial performance, identify areas that need improvement, and make informed decisions about how to allocate resources. For example, if a business’s Profit Margin Ratio is low, the owner or manager may need to reevaluate their pricing strategy, cut costs, or increase sales to improve profitability.
2. Investors: Investors use accounting ratios to evaluate the financial health of a company before deciding to invest. They may look at ratios such as Return on Equity (ROE) and Debt-to-Equity Ratio to determine how well a company is generating profits and managing its debt.
3. Lenders: Lenders use accounting ratios to assess the creditworthiness of a borrower before lending money. They may look at ratios such as Current Ratio and Debt-to-Asset Ratio to determine whether a company has enough assets to cover its liabilities and is able to pay back the loan.
4. Creditors: Creditors use accounting ratios to evaluate the financial risk of a borrower before extending credit. They may look at ratios such as Current Ratio and Inventory Turnover Ratio to determine how well a company is managing its current assets and inventory.
5. Government Agencies: Government agencies may use accounting ratios to assess the financial health of companies in industries that are subject to regulation. For example, the Federal Inland Revenue Service (FIRS) may use accounting ratios to evaluate the tax compliance of companies and ensure that they are paying their fair share of taxes.

Accounting ratios are important tools that can help businesses, investors, lenders, creditors, and government agencies evaluate the financial health and performance of a company. It can also be used by finance experts to audit and deduce unknown figures in cases of incomplete records. By using these ratios, stakeholders can make informed decisions and take appropriate actions to improve their financial outcomes.

Worked Examples

Example 1: Profit Margin Ratio A company had a net profit of ₦500,000 and total revenue of ₦5,000,000. What is its Profit Margin Ratio?

Profit Margin Ratio = (Net Profit / Total Revenue) x 100% = (₦500,000 / ₦5,000,000) x 100% = 10%

This means that the company earned a profit of 10 kobo for every naira of revenue generated.

Example 2: Current Ratio A company had current assets of ₦1,000,000 and current liabilities of ₦500,000. What is its Current Ratio?

Current Ratio = Current Assets / Current Liabilities = ₦1,000,000 / ₦500,000 = 2:1

This means that the company has two naira worth of current assets for every naira worth of current liabilities.

Example 3: Debt-to-Equity Ratio A company had total liabilities of ₦1,000,000 and total equity of ₦500,000. What is its Debt-to-Equity Ratio?

Debt-to-Equity Ratio = Total Liabilities / Total Equity = ₦1,000,000 / ₦500,000 = 2:1

This means that the company has two naira worth of debt for every naira worth of equity.

Example 4: Return on Equity (ROE) Ratio A company had a net profit of ₦1,000,000 and total equity of ₦5,000,000. What is its ROE Ratio?

ROE Ratio = (Net Profit / Total Equity) x 100% = (₦1,000,000 / ₦5,000,000) x 100% = 20%

This means that the company generated a 20% return on its equity investment.

Example 5: Inventory Turnover Ratio A company had a cost of goods sold of ₦2,000,000 and an average inventory of ₦500,000. What is its Inventory Turnover Ratio?

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory = ₦2,000,000 / ₦500,000 = 4 times

This means that the company sold its inventory four times during the year

Evaluation

1. What is the Profit Margin Ratio if a business had a net profit of ₦1,500,000 and total revenue of ₦10,000,000? A. 10% B. 15% C. 20% D. 25%
2. If a business had current assets of ₦2,000,000 and current liabilities of ₦1,000,000, what is its Current Ratio? A. 1:1 B. 1.5:1 C. 2:1 D. 2.5:1
3. What is the Debt-to-Equity Ratio if a business had total liabilities of ₦2,500,000 and total equity of ₦1,000,000? A. 2.5:1 B. 1.5:1 C. 1:1 D. 0.5:1
4. If a business had a net profit of ₦750,000 and total equity of ₦5,000,000, what is its Return on Equity (ROE) Ratio? A. 5% B. 10% C. 15% D. 20%
5. What is the Inventory Turnover Ratio if a business had a cost of goods sold of ₦4,000,000 and an average inventory of ₦1,000,000? A. 1 time B. 2 times C. 3 times D. 4 times
6. If a business had a current ratio of 2:1 and current liabilities of ₦500,000, what is its current assets? A. ₦500,000 B. ₦750,000 C. ₦1,000,000 D. ₦1,500,000
7. What is the Debt-to-Asset Ratio if a business had total liabilities of ₦1,500,000 and total assets of ₦7,500,000? A. 0.2 B. 0.3 C. 0.4 D. 0.5
8. If a business had a net profit of ₦1,000,000 and total revenue of ₦10,000,000, what is its Profit Margin Ratio? A. 5% B. 10% C. 15% D. 20%
9. What is the Return on Equity (ROE) Ratio if a business had a net profit of ₦750,000 and total equity of ₦2,500,000? A. 5% B. 10% C. 15% D. 30%
10. If a business had an Inventory Turnover Ratio of 5 times and cost of goods sold of ₦2,500,000, what is its average inventory? A. ₦250,000 B. ₦500,000 C. ₦1,000,000 D. ₦2,500,000

Answers:

1. C
2. C
3. A
4. B
5. D
6. C
7. B
8. B
9. 30%
10. ₦500,000

Lesson Presentation

Introduction to Accounting Ratios, Users and Importance of Accounting Ratios, and Worked Examples on Accounting Ratios

Previous Lesson 

• DISSOLUTION OF PARTNERSHIP

Introduction (10 minutes):

1. Begin by asking the class if they have heard of accounting ratios before, and if so, what they know about them.
2. Explain that accounting ratios are important tools used to measure financial performance and evaluate the financial health of a company.
3. Discuss how accounting ratios are used by different stakeholders, such as business owners, investors, lenders, and creditors.
4. Introduce the objectives of the lesson.

Body (40 minutes):

1. Define accounting ratios and provide some common examples, such as Profit Margin Ratio, Current Ratio, Debt-to-Equity Ratio, Return on Equity (ROE) Ratio, and Inventory Turnover Ratio.
2. Discuss the importance of accounting ratios in financial analysis, including how they can help businesses identify areas that need improvement and make informed decisions about resource allocation.
3. Identify the users of accounting ratios, such as business owners, investors, lenders, creditors, and government agencies, and explain how each group uses accounting ratios to evaluate financial performance.
4. Present worked examples of accounting ratios and guide students through the calculations and interpretation of the results.
5. Ask students to work in pairs or small groups to solve additional problems and discuss their findings with the class.

Conclusion (10 minutes):

1. Recap the key concepts covered in the lesson, including the definition and importance of accounting ratios, the users of accounting ratios, and worked examples of accounting ratios.
2. Encourage students to continue exploring accounting ratios and their applications in financial analysis.

Assessment:

• Students will be assessed based on their participation in class discussions and group work, as well as their ability to solve accounting ratio problems and interpret the results.
• An end-of-unit test can be administered to assess students’ understanding of accounting ratios and their applications.

Extension:

• Students can be given additional case studies to apply their knowledge of accounting ratios and evaluate the financial health of different companies or industries.
• Students can also research current trends in accounting ratios and their applications in business and finance

Weekly Assessment /Test

1. What are accounting ratios?
2. Why are accounting ratios important in financial analysis?
3. Who are the users of accounting ratios?
4. Give an example of a profitability ratio.
5. What is the formula for calculating the Current Ratio?
6. Give an example of a solvency ratio.
7. What is the formula for calculating the Debt-to-Equity Ratio?
8. Give an example of an efficiency ratio.
9. What is the formula for calculating the Profit Margin Ratio?
10. Give an example of a liquidity ratio.

Answers:

1. Accounting ratios are tools used to measure financial performance and evaluate the financial health of a company.
2. Accounting ratios are important because they can help businesses identify areas that need improvement and make informed decisions about resource allocation.
3. The users of accounting ratios include business owners, investors, lenders, creditors, and government agencies.
4. An example of a profitability ratio is the Profit Margin Ratio.
5. The formula for calculating the Current Ratio is Current Assets / Current Liabilities.
6. An example of a solvency ratio is the Debt-to-Asset Ratio.
7. The formula for calculating the Debt-to-Equity Ratio is Total Liabilities / Total Equity.
8. An example of an efficiency ratio is the Inventory Turnover Ratio.
9. The formula for calculating the Profit Margin Ratio is Net Profit / Total Revenue.
10. An example of a liquidity ratio is the Current Ratio