Accounting V: Analysis and Interpretation of Financial Statements
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Ratios turn the figures in the financial statements into information about performance and position. They are useful only when compared with earlier years, competitors, or industry averages (Atrill & McLaney, 2019; Weygandt et al., 2019).
Key Ratios
| Category | Ratio | Formula |
|---|---|---|
| Profitability | Gross profit margin | Gross profit ÷ revenue × 100 |
| Net (or operating) profit margin | Profit ÷ revenue × 100 | |
| Return on capital employed (ROCE) | Profit before interest and tax ÷ (equity + non-current liabilities) × 100 | |
| Return on equity (ROE) | Profit after tax ÷ equity × 100 | |
| Liquidity | Current ratio | Current assets ÷ current liabilities |
| Quick (acid test) ratio | (Current assets − inventory) ÷ current liabilities | |
| Efficiency (activity) | Inventory turnover | Cost of sales ÷ average inventory; days = 365 ÷ turnover |
| Receivables collection period | Trade receivables ÷ credit sales × 365 | |
| Payables payment period | Trade payables ÷ credit purchases × 365 | |
| Asset turnover | Revenue ÷ total assets (or capital employed) | |
| Gearing and solvency | Gearing | Long-term debt ÷ (debt + equity), or debt ÷ equity |
| Interest cover | Profit before interest and tax ÷ interest | |
| Investor | Earnings per share (EPS) | Profit attributable to ordinary shareholders ÷ number of ordinary shares |
| Price-earnings (P/E) ratio | Share price ÷ EPS | |
| Dividend yield; dividend cover | Dividend per share ÷ share price; EPS ÷ dividend per share |
Worked Example
A business has revenue 2 000 000, cost of sales 1 200 000, operating expenses 500 000, and interest 50 000, and pays tax at 25 percent. Current assets are 600 000 (including inventory 200 000) and current liabilities are 300 000.
- Gross profit = 800 000; gross margin = 40 percent.
- Operating profit = 300 000; operating margin = 15 percent.
- Profit before tax = 250 000; tax = 62 500; profit after tax = 187 500.
- Current ratio = 600 000 ÷ 300 000 = 2.0; quick ratio = 400 000 ÷ 300 000 = 1.33.
- Interest cover = 300 000 ÷ 50 000 = 6 times.
Interpreting Ratios
A good answer states the ratio, compares it, gives possible reasons (for example, falling gross margin could result from higher input costs or discounting), and suggests action. Remember the limitations: ratios rely on historical data, accounting policies differ, window dressing, inflation, and the need for non-financial information.
Common Mistakes
- Using total sales rather than credit sales for receivables days.
- Computing ratios correctly but not interpreting them.
- Comparing companies in different industries without caution.
CHAPTER 8