5. interpretation of financial statements Flashcards
What is profitability?
The ability for business operations to produce profits from trading (sales)
What are profitability ratios?
A relative measure and allows for comparison between business of different sizes
What are the comments for gross profit margin?
- Gross profit margin indicates an increase in the ability to turn sales into gross profits (by (difference))
- Sales have increased by (% diff in sales) whilst total cost of goods sold have actually fallen (suggesting increased demand and strong management cost control)
What are the comments for net profit margin?
- Net profit margin indicates a fall in the ability to turn sales into net profits (by (difference))
- Where sales and gross profits have increased , a fall in net profit margin suggests an inability of management to control operating expenses (which have increased by (%diff in operating expenses)
What is liquidity?
The ability to access cash in order to maintain/support trading operations
What are the comments for current ratio?
- Current ratio comparison indicates a fall in liquidity
- This is further evidenced by a fall of (bank diff) in the bank balance
- Business managers should look carefully into this issue as an otherwise profitable business can quickly fall through lack of working capital.
Comments for quick ratio?
- The quick ratio supports the indication of a fall in liquidity
- These ‘simple’ ratios will require further investigation to establish the distribution of working capital ‘element’ values
- all working capital ratios are ‘snapshot’ and may not be representative of the position throughout the whole year
What is efficiency?
- Getting the most out of assets with minimised input (output/input).
- This will include maximising efficiency in turning trading activities into cash received
What are the comments for average debtors repayment period (receivable days)?
- the debtor/receivable days ratio indicates that accounts receivable are taking longer to pay
- this may need investigation of sales ledger/trade receivables ledger procedures and will also be a contributory factor in the movement of the bank balance into overdraft, decreasing liquidity
What are the comments for average creditor repayment period (payable days)?
- the creditor/payable days ratio indicates that accounts payable are being paid earlier
- this will result in an investigation of purchase ledger and finance office procedures and will also be a contributory factor in the movement of the bank balance into overdraft, decreasing liquidity
What are the comments for average stock turnover (days in stock)?
- average days in stock/turnover has increased
- may be due to increase in sales for the year, but total purchases have actually fallen and the increased stock/inventory may be an inefficient use of resources
What are the comments for average stock turnover (times per year)?
- average stock/inventory turnover (times per year) has decreased
- this is in line with the days in stock ratio as slower moving stock/inventory will require replacement less often
What are the comments for cash operating cycle:
- cash operating cycle has increased significantly
- indicates an increase in the working capital requirement to support current operations
- this is another indicator for management investigation and control requirement
What is asset utilisation?
Measure of the cost assets and the sales generated by the investment
How to calculate the ratio of sales/fixed assets?
Sales / fixed assets
How to calculate the ratio of sales/current assets?
Sales / working capital
How to calculate the ratio of sales/total assets?
Sales / (total assets less current liabilities)
What are the comments for sales/fixed asset?
- increased (by how much per £?)
- this is an improvement but could be expected where sales demand is increased and fixed asset values fall (through depreciation)
What are the comments for sales/current assets?
- increased (by how much per £?)
- this may be seen as an improvement, but care must be taken in the light of declining working capital support and the bank overdraft
What are the comments for sales/total assets?
- increased (by how much per £)
- this may be seen as an improvement but care must be taken in the light of falling fixed asset values and declining working capital support
What do the asset utilisation ratios highlight?
the importance of understanding the underlying factors and implications (beyond the basic ability to calculate values) for useful user information
What do investment ratios recognise?
the fundamental business requirement to provide a return to the owner/lenders investment
How to calculate ROCE?
(Net operating profit/Total assets less current liabilities) x 100
How to calculate capital gearing?
(borrowed funds (long-term debt)/total assets less current liabilities) x 100
What are the comments for ROCE?
- increased (by how many percentage points?)
- it may be said that these returns are good in light of current UK economic conditions, but care must be taken (going forwards) in the light of increased demand and a reduction in investment (long-term loans)
What are the comments for capital gearing ratio?
- the ratio measures the proportion of total business assets owned by parties other than business owners
- the ratio has fallen
- this is to be expected after a 25% reduction in the long-term loan value
What are the comments for return on owner’s investment?
- no change (similar profits and similar capital account balances)
- care must be taken when taking these values as guidance for future decision-making because of the reasons discussed
What are incomplete records?
Accounting ratios can be used to derive financial reporting values where complete information is not available
Formulae needed for incomplete records?
- Sales = gross profit / gross profit margin
- sales = (closing receivables / debtor days) x 365
- cost of sales = sales less gross profit
- gross profit = net profit add operating expenses
- opening inventory = (average inventory x 2) - closing inventory
Why would a business be unable to delay supplier payment?
- purchase ledger staff
- supplier relationships
- industry standards
- relative size differences
