analysis of accounting statements Flashcards
ratio
Profitability
profitability ratio is to assess a business’s ability to generate earning as compared to its expenses
and other relevant costs incurred during a specific period of time
profitability ratios (6) MMSSRR
- margin / gp margin to sales
- markup / gp markup to sales
- sales margin / net profit margin to sales
- selling and distribution /net profit to expense
- return on capital employed
- rate of inventory turnover
markup % formula
gross profit / cost of sales *100
margin % formula
gross profit / revenue *100
sales margin % formula
poty / revenue *100
selling and distribution % formula
poty / expense *100
return on capital employed formula
poty / capital employed *100
rate of inventory turnover % formula
cos / average inventory *100
capital employed formulas (2)
- usually use, Total Assets - Current Liabilities
- long-term investment, Fixed Assets + Working Capital
Ways to increase/improve profitability of a business (4)
By increasing sales.
By reducing cost of goods sold.
By reducing expense.
Advertising campaign boost up sales
Liquidity
Liquidity is the ability to meet short term (1) debts as they fall due (1)
Current assets less current liabilities (1) AO1
Ways to improve liquidity (4)
By investing more into other business which shows the proper utilization of liquid cash.
by selling existing fixed assets which are under-utilized.
by injecting more capital from personal funds.
improving rate of stock turnover. Rate of stock turnover can = by increasing sales and reducing the purchase of stock at the same time within a given time
high liquidity when?
(working capital ratio 5:1
Disadvantage of high liquidity (2)
High closing stock which indicates unpopular goods for the business in market, also increase the warehouse
expenses.
High debtors which increase the chance of risk of bad debt.
Benefits of ratio analysis (5)
- They provide a basis for comparing performance year on year.
- It enables comparison to be made with competitors.
- Ratios is needed to forecast future performance.
- They will focus on management attention on key areas such as profitability and liquidity.
- It is useful for external users of financial information
limitations of ratio analysis (4)
- do not consider non-financial factors such as social and ethical issues.
- High skills are required for the analysis and evaluation of ratios correctly.
- Ratios use historic data which may not reflect the future performance.
- Different businesses may use different accounting policies when calculating ratios
margin %
gross profit margin to sales, gross profit every $100
markup %
gross profit markup to sales, gross profit to the cost of the sales
sales margin %
net profit for every $100 in sales
selling and distributing %
net profit margin to sales, net profit for every $100 in sales
return on capital employed
net profit made for every $100 employed
rate of inventory turnover + ideal ratio
how efficiently a business manages its inventory, sales compared to inventory
2:1
liquidity ratios (4)
- current ratio / working capital
- liquid acid test / quick ratio
- debtors and creditors collection period
current ratio formula
current assets / current liabilities
standard current ratio
2:1
current ratio use
general measure of a company’s ability to pay short-term obligations (due within a year)
acid test ratio formula
current assets - closing inv / current liabilities
acid test ratio standard
1:1
acid test use
measure of liquidity that excludes slow-to-sell inventory from current assets, only current assets that are cash or can be quickly changed to cash, shows sufficient highly liquid assets to cover its short-term liabilities
debtors and creditors collection period formula
debtors / creditors (÷) credit sales/ purchase * 365 days / 12 months
debtors and creditors collection period use
Measures how long it takes a company to collect cash from customers (debtors) and how long it pays its suppliers (creditors).
standard tr dr payment receiving period
28 days
what does Lower Debtors Collection Period show
Indicates faster cash flow from sales.
what is trade receivable
amount owed to a business
what is Trade Receivable Collection Period
measures the average time it takes a company to collect payment from customers after a sale is made
disadvantage of trade receivable collection period increasing (2(
- When trade receivables increase, it means there’s a larger amount of due customer invoices. This translates to a longer period for the company to collect all that money.
-will require credit control.
credit control policies (2)
- Monitoring outstanding invoices, sending payment reminders, and following up on overdue accounts.
- Establishing clear guidelines for extending credit
what does Shorter Creditors Payment Period show
May strain relationships with suppliers, but can improve cash flow in the short term.
ideal debtors and creditors collection period
the debtors collection period should be shorter than the creditor payment period to ensure a positive cash flow cycle.
How to improve rate of stock turnover
Rate of stock turnover can be improved by increasing sales and reducing the purchase of stock at the same time
within a given time.
how to interpret profitability ratios
Higher ratios generally indicate better profitability
how to interpret liquidity ratios
A current ratio above 1 and an acid-test ratio above 1 are generally good signs of liquidity
bank balance and liquidity
- if bank balance positive (dr) good.
- consider the amount of bank balance tho, as small values may make payment difficult
use of ratios to make future financial predictions
how to write ratio analysis answers (3)
- First compare profitability
- compare liquidity using figures
- Given overall discussion based on your profitability and liquidity which one is better (strong
reasons are recommended for your justification).
