Introduction

 It is necessary to analyse and interpret the financial statements of a business in

order to assess its performance and progress.
 Analysis consists of a detailed examination of the information in a set of
financial statements of a business.
 The results of this analysis are then interpreted in order to assess the
performance of the business.
 Interpretation can include comparing the results of other similar businesses and
also comparing within the business (with the results for previous years and with
targets and budgets).
 To enable this comparison to be carried out in a meaningful way the results are
usually expressed as accounting ratios.
 This is a general term which includes calculations in the form of ratios,
percentages and time periods.
 Ratios are usually divided into:
1. Profitability Ratios
2. Liquidity Ratios
3. Asset Utilisation Ratios
4. Investment Ratios

 Working capital is the difference between the current assets and the current
liabilities and is the amount available for the day-to-day running of the business
(it is also known as net current assets).
 Capital owned is the amount owed by a business to the owner of the business
on a certain date.
 Capital employed is the total funds which are being used by a business.
 This may be calculated as the owner’s capital plus any non-current liabilities
(alternatively, it may be calculated as non-current assets plus net current
assets).
 Capital employed can be defined in several ways - the figure at the start of the
year, the figure at the end of the year, or an average of the two.

Profitability Ratios

 These are used to relate the profit figures to other figures within the same set of
financial statements.
 Profitability ratios measure how much profit the business has generated from
the sales revenue or on the capital employed.
 A business needs to earn sufficient profits to cover its costs and also to give
satisfactory return on owner’s equity.
1. Return on Capital Employed (ROCE)

Net Profit
Return on Capital Employed   100
Capital Employed

 This is a very important ratio as it shows the profit earned for every $100
invested in the business in order to earn that profit.
 The higher the return, the more efficiently the capital is being employed within
the business.

2. Gross Profit Margin

Gross Profit
Gross Pr ofit Margin   100
Turnover (Revenue)

 This is also called gross profit as a percentage of turnover (turnover equals net
sales less sales returns).
 This ratio shows the gross profit earned for every $100 of sales.
 Different types of industries and trades tend to have different gross profit
percentages.
 The same business may have a similar gross profit percentage from year to year.
 The higher the return, the more profitable is the business.
 However, by reducing selling prices slightly (and so reducing the gross profit
percentage), a business may achieve a higher monetary gross profit.
 The gross profit percentage can be improved by measures such as:
a) increasing selling prices
b) obtaining cheaper supplies
c) increasing advertising and sales promotions
d) changing the proportions of different types of goods sold

 However, these measures may have some adverse effects.

 For example, increasing the selling price may result in customers going
elsewhere; obtaining cheaper goods may result in a lower quality of goods, and
so on.
 If the gross profit percentage changes significantly from one year to another the
cause should be investigated.
 A fall in the gross profit percentage may be caused by:
a) increasing the rate of trade discount
b) selling goods at cheaper prices
c) not passing on increased costs to customers
3. Net Profit Margin

Net Profit
Net Profit Margin   100
Turnover (Revenue)
 This ratio shows the net profit earned for every $100 of sales.
 The higher the return, the more profitable is the business.
 This ratio acts as an indicator of how well a business is able to control its
expenses.
 If the net profit percentage of a business increases it indicates that the operating
expenses are being controlled.
 This ratio will be influenced by the different types of expense: some expenses
increase in proportion to the sales e.g. commission paid on sales made, but
other expenses remain the same whatever the sales be e.g. insurance of
buildings.
 Any change in the gross profit percentage will also affect the net profit
percentage.

4. Gross Profit Mark Up

 Mark-upis gross profit expressed as a percentage or fraction of the cost price.

Gross Profit
Gross Profit Mark - up   100
Cost pf Sales

5. Expenses Ratio

 This ratio shows the percentage of expenses incurred for the operation business in order to
generate sales revenue.

Expenses
Expenses Ratio   100
Turnover

Liquidity Ratios

 In business, the term “liquidity” relates to money and liquidity ratios measure
the ease and speed with which assets can be turned into cash.
 Liquidity ratios measure the extent to which the company has sufficient current
assets to meet its current liabilities.
 It shows the ability of the business to pay for its debts on time.
 Therefore liquidity ratios indicate the financial stability of a business.
1. Current Ratio

Current Assets
Current Ratio  or Current Assets : Current Liabilities
Current Liabilities

 This is also referred to as the working capital ratio.

 It compares the assets which are in the form of cash, or which can be turned
into cash relatively easily within the next 12 months, with the liabilities which
are due for repayment within the that period of time.
 This measures the ability of a business to meet its current liabilities when they
fall due.
 Ratios between 1.5 : 1 and 2 : 1 are generally regarded as satisfactory, but it is
important to consider the size and type of business:
a) Some businesses necessarily need a large amount of non-current assets
whereas other businesses have a higher proportion of current assets;
b) some businesses always purchase goods on credit whereas others always
pay cash;
c) some businesses obtain long-term loans whereas others make use of
short-term loans or a bank overdraft.
 If the current ratio is over 2 : 1 it may indicate poor management of the current
assets.
 The working capital of a business must be adequate to finance the day-to-day
trading activities.
 A business which is short of working capital may encounter the following
problems:
i. cannot meet liabilities when they are due
ii. experiences difficulties in obtaining further supplies on credit
iii. cannot take advantage of cash discounts
iv. cannot take advantage of business opportunities when they arise

 Ways to improve the working capital position include:

i. introduction of further capital by the owner(s)
ii. obtaining non-current loans
iii. selling surplus non-current assets
iv. reducing drawings by the owner(s) (or reduction in dividends).
 The actual cash position can also be improved by measures such as delaying the
payment of creditors, increasing the proportion of cash sales, and reducing the
period of credit allowed to debtors.
 These measures may also have some adverse effects such as the refusal of
further supplies on credit, customers moving to other suppliers where longer
credit is allowed etc.
2. Quick/ Acid Test Ratio

Current Assets - Inventory

Current Ratio 
Current Liabilities

 This is also known as the acid test ratio. It compares the assets which are in the
form of money, or which will convert into money quickly, with the liabilities
which are due for repayment in the near future.
 This is a similar calculation to the current ratio, but the quick ratio excludes
inventory as this is not regarded as a liquid asset.
 Inventory is two stages away from being money
i. the goods have to be sold
ii. then the money has to be collected from the debtors.
 A ratio of 1 : 1 is usually regarded as satisfactory, but, as with the current ratio,
the size and type of business should also be considered.
 A ratio of 1 : 1 indicates that the immediate liabilities can be met out of the
liquid assets without having to sell inventory.
 Where inventory has to be sold immediately it can sometimes only be done at a
reduced price.
 If the quick ratio is over 1 : 1 it may indicate poor management of liquid assets
such as having too high a balance on a bank account

Asset utilisation ratios

 Asset utilisation ratios show how effective the business is in use of its assets.
 These ratios measure how efficiently management uses and control the
resources from day to day activities of the business e.g. stock, debtors and
creditors.

1. Rate of Inventory Turnover

Cost of Sales
Rate of Inventory Turnover 
Average Inventory

Opening Inventory  Closing Inventory

Where Average Inventory 
2

 The rate of inventory turnover is sometimes referred to as inventory turn.

 This ratio calculates the number of times a business sells and replaces its
inventory in a given period of time.
 The rate of inventory turnover will obviously vary according to the type of
business.
 Businesses selling luxury goods such as expensive jewellery and private jet
planes will have a low rate of inventory turnover whereas businesses selling low
value “everyday” items such as fresh bread and newspapers will have a high rate
of inventory turnover.
 The same business may have a similar rate of inventory turnover from year to
year.
 If the rate increases it may indicate improved efficiency: if the rate decreases if
may indicate that the business has too much inventory or that the sales are
slowing down.
 The quicker the rate of inventory turnover, the less time funds are tied up in
inventory which is regarded as the least liquid of the current assets.
 A lower rate of inventory turnover can be caused by factors such as:
i. lower sales (resulting in higher inventory levels)
ii. inventory over-purchased
iii. too high selling prices
iv. falling demand
v. business activity slowing down
vi. business inefficiency

2. Trade Receivable Days

Trade Receivables
Trade Receivable Days   365 days
Credit Sales

 This is also referred to as the trade receivables/sales ratio.

 It measures the average time the debtors take to pay their accounts.
 The answer to this calculation - the length of time debtors actually take to pay
their accounts - should be compared with the term of credit allowed to debtors.
 The quicker the debtors pay their accounts, the better it is: the money can then
be used for other purposes within the business.
 The longer a business has to wait for a debt to be paid the greater the risk of it
becoming a bad debt.
 The same business may have a similar collection period from year to year.
 If the period decreases it may indicate that the credit control policy is being
applied more effectively.
 If the period increases it may indicate that the credit control policy is inefficient,
or that longer credit terms are being allowed in order to maintain the quantity
of credit sales.
 The collection period for trade receivables can be improved by measures such:
i. improving credit control policy (sending regular statements of account,
"chasing" overdue accounts and so on)
ii. offering cash discount for early settlement
iii. charging interest on overdue accounts
 iv. refusing further supplies until any outstanding debt is paid
v. invoice discounting and debt factoring
NB: For a fee, a debt factor will maintain the sales ledger, collect the debts and
advance money against those debts. For a fee, a discounter will advance money
against certain debts, but does not maintain the sales ledger.

3. Trade Payable Days

Trade Payables
Trade Payable Days   365 days
Credit Purchases

 This is also known as the trade payables/purchases ratio.

 It measures the average time taken to pay the creditors’ accounts.
The answer to this calculation should be compared with the term of credit
allowed by creditors.
 The same business may have a similar payment period from year to year.
 If the period decreases, the business is paying the creditors more quickly
 If the period increases it may indicate that the business is short of immediate
funds and is finding it difficult to meet debts when they fall due.
 This ratio can also be influenced by the collection period for trade receivables
 If the debtors do not settle their accounts promptly the business may not be
able to pay the creditors promptly.
 Taking longer to pay the creditors means that the business can use the funds for
other purposes, but there can be adverse effects such as:
i. the supplier refusing credit in the future
ii. the supplier refusing further supplies
iii. the loss of any cash discount for early settlement
iv. damage to the relationship with the supplier

Inter-firm Comparison

 Comparing the ratios calculated for the current financial year with those of
previous years can measure the progress and performance of a business and
indicate the trends in profitability, liquidity and so on.
 Another useful comparison is to compare the ratios with those of a similar
business.
Problems of inter-firm comparison

 A business can often obtain valuable information by comparing their accounting

ratios with those of another business, but the business must be aware of the
limitations of such a comparison.
 Every business is different and has different requirements and accounting
policies.
 A comparison is only meaningful if it is between two or more businesses of the
same type, of the same size and in the same trade.
 The problems of comparison include the following
a. The businesses may apply different accounting policies, for example they may
use different methods of depreciation.
b. The businesses may apply different operating policies such as renting premises
or purchasing premises, obtaining long-term finance from capital only or using
capital and long-term loans. Such policies will affect both the profit for the year
and the balance sheet.
c. Non-monetary items such as the skill of the work-force, the goodwill of the
business and so on do not appear in the accounting records, but are very
important in the success of the business.
d. It is not always possible to obtain all the information about another business
which is needed to make a true comparison. For example, the inventory shown
in the financial statements may not represent the average amount held during
the year; the financial statements do not show the age of the non-current assets
and when they need replacing.
e. The information relating to other businesses may be for one financial year only,
so it is not possible to calculate business trends. That particular year may also
not be a "typical" year.
f. The financial years may end on different dates which can make comparison
difficult. For example, the year end for one business may be at a time when
inventories are particularly low; the year end for another business may be when
inventories are particularly high.
g. The accounts are based on historic cost and do not show the effects of inflation.

Users of Accounting Statements

 It is not only the owner who is interested in analysing and interpreting the
financial statements of a business.
 Various other people are also interested in different aspects of the accounts.
 The users of accounting statements can be divided into two main groups:
internal users and external users.
Internal users

1. Owner(s)
 The owners of a business such as a sole trader or partners will be interested in
all aspects of the business, both profitability and liquidity in order to assess the
business’s performance and progress.
 Any potential partners are interested in the profitability of the business.
The owners of a limited company, the shareholders, and potential shareholders, are
interested in the profitability of the company and also in various investment ratios

2. Manager(s)
 In many small businesses, the owners manage the business. In some cases,
management may be carried out by an employee.
 Like the owners, managers are interested in all aspects of the business.
 They may use ratios to assess past performance, plan for the future and take
remedial action where necessary.

External users

1. Bank manager
 If a business requests a bank loan or an overdraft facility the bank manager will
require the financial statements of the business.
 The bank manager will need to know whether there is adequate security to
cover the amount of the loan or overdraft, whether it can be repaid when due,
and whether interest can be paid when due.

2. Other lenders
 Anyone who has made a loan to a business (and any potential lenders) will be
interested in the security available, the repayment of the loan when due, and
the payment of interest when due.

3. Creditors
 Anyone who has supplied a business with goods on credit terms is interested in
the liquidity position and the payment period for trade payables.
 These factors may be considered when determining the credit limit and the
length of credit allowed.
 In practice, it may not be possible to obtain the accounts of sole traders and
partnership businesses, so other means of checking credit-worthiness are
employed.

4. Potential buyers of the business

 Anyone with an interest in purchasing the business or making a take over bid
will be interested in the profitability of the business and the market value of the
assets of the business.
5. Customers
 Customers of the business are interested in ensuring the continuity of supplies.

6. Employees and trade unions

 Employees and trade unions want to know that the company is able to continue
operating, and so maintain jobs and continue to pay adequate wages (and, in
some cases, contribute to pension schemes).

7. Government departments
 This may be for purposes such as compiling business statistics and checking that
the correct amount of tax is being paid.

Limitations of Accounting Statements

 Accounting statements and the ratios calculated from them provide valuable
information about a business.
 They do, however, have limitations and are not able to provide a complete
picture of the performance and position of a business.
 Their limitations include:

1. Time factor
 The accounting statements are a record of what has happened in the past, not a
guide to the future.
 Additionally, there is a gap between the end of the financial year and the
preparation of the accounting statements.
 In that time significant events such as changes in inventory levels, purchasing of
non-current assets may have taken place.

2. Historic cost
 The only way to record financial transactions is to use the actual cost price.
 However, comparing transactions taking place at different times can be difficult
because of the effect of inflation.

3. Accounting policies
 All businesses should apply the accounting principles of prudence and
consistency which should help in making comparisons.
 However, there are several acceptable accounting policies which may be applied,
for example there are several different methods of calculating depreciation.
 Where businesses have used different accounting policies it is difficult to make a
meaningful comparison of their results.
Similarly, where a business changes its policy, a comparison with the results of
previous years is difficult.

4. Different definitions
 The figure of profit for the year may be adjusted for loan interest, and
sometimes preference share dividends in a limited company.
 A comparison of results is only meaningful if “like is compared with like” and the
same definitions are applied.

5. Money measurement
 Accounts only record information which can be expressed in monetary terms.
 This means that there are many important factors which influence the
performance of a business which will not appear in the accounting statements.
 The factors which are within the control of the business include the quality of
management, the skill and reliability of the workforce, the goodwill of the
business, the age and condition of the non-current assets, and the ability to
adapt in response to changing market conditions.
 Other factors are outside the control of the business. These include government
policies, competition, impact of new technology, and future long-term prospects
for the particular trade or industry.