Analysis and Interpretation of Accounting Statements Ratios

Uses of ratios To compare the profitability and liquidity of: A company’s performance from year to year. Different companies’ performance in the same type of business. This allows a more meaningful interpretation of the data. It allows identification of trends in the data.

Liquidity ratios Used to assess whether a business has enough working capital and whether or not it is being managed effectively. If they do not have enough working capital the company may not be able to pay all its debts. If they have too much working capital the company may not be making efficient use of its resources.

Who will be interested in these ratios? Bankers and suppliers will be interested in liquidity ratios to help decide whether the business is creditworthy. Managers will also use them to ensure that the business has enough liquid resources to operate efficiently.

Current ratio Current ratio = Current assets : 1 Current liabilities Compares assets and liabilities that will be due in approximately 12 months.

No simple rule about what constitutes a ‘correct’ ratio, but generally 2:1 is acceptable. If a business has a ratio lower than 1:1 it means that the organisation may not be able to pay its debts. On the other hand, if a business has a ratio in excess of 2:1, it might indicate the organisation has too many resources tied up in unproductive assets, which could be invested more profitably elsewhere.

To change the ratio if it is too low an organisation could: Postpone buying fixed assets Sell fixed assets that are not used Increase long-term borrowing Raise capital by selling shares.

Acid test ratio Acid test ratio = Current assets – Stock : 1 Current liabilities This ratio excludes stock, as the business cannot be sure that all the stock will be sold. Stock is the most illiquid current asset – it is the hardest to turn into cash.

A generally accepted ratio is 1:1. If the ratio is less than 1:1, it means that the organisation’s liquid current assets do not cover its current liabilities, and this could indicate potential liquidity problems – the organisation may have trouble paying its short-term debts.

Profitability ratios These ratios assess whether a business has met its objectives. They measure how efficiently a business employs its resources. They measure the relationship between gross and net profit and sales and capital employed.

Who will be interested in these ratios? The owners of the business Banks and suppliers Employees

ROCE = Net profit × 100 Capital employed One of the most important ratios that is used to measure the performance of a business is the ROCE. It compares the efficiency with which the firm generates profits from the amount of capital invested. Return on capital employed (ROCE)

The higher the ratio the better. The ratio can be compared to the previous year’s results and those of other companies to decide whether it is satisfactory. It could also be compared with the interest rates offered by banks’ savings accounts.

The ROCE ratio can be improved by: Increasing the level of profit generated from the same level of capital invested Reducing the level of capital invested but maintaining the same level of profits.

Gross profit margin Gross profit margin = Gross profit × 100 Sales This measures the relationship between the gross profit and the sales, before any expenses are taken into account.

Higher gross profit margins are preferred to lower ones. The level of gross profit margin will vary between different types of organisation. Results must be looked at in the context of the specific industry concerned and compared with different years within the same company.

The gross profit margin could be improved by: Raising the sales price while keeping the cost of sales the same Reducing the cost of sales while keeping the selling price the same.

Net profit margin Net profit margin = Net profit × 100 Sales This measures how well a business controls its expenses. A higher percentage result is preferred.

If the difference between the gross profit margin and the net profit margin is small, this suggests the expenses are low. It should also be compared with changes in the gross profit margin to check whether expenses are increasing or decreasing.

The net profit margin could be improved by: Reducing expenses but keeping the sales revenue the same Increasing sales revenue but keeping expenses the same.

Stockturn Stockturn = Cost of sales Average stock (Average stock = Opening stock + Closing stock ) 2 Expressed as times per year, stockturn shows the number of times stock changes per year. This measures how quickly a business sells its stock.

It is generally desired to sell stock as quickly as possible. Reduction can mean that the business is slowing down. Stocks may be piling up and not being sold, which could lead to a liquidity crisis.

The stock turnover ratio can be improved by: Reducing the level of stock held, without losing any sales Increasing the rate of sales, without increasing the amount of stock held.

Exam tips Questions usually require you to compare two companies’ accounts, or compare accounts from year to year. 1) Calculate your ratios, making sure that you show all your workings. 2) You will need to analyse and evaluate your ratios.

In your analysis state which company or year is the best and why. You will need to include phrases like: ‘The reason for this is...’ ‘This is because …’

  Ratios should be expressed correctly.   Remember to include a detailed analysis and evaluation.

Tasks Complete task sheet and OCR exam question.