Chapter 16 Interpretation of accounts – basic ratio analysis

Question 1

16.4 Ratios

Answer 1

Accounting ratios fall under one of the following:
• Profitability – link between profit and sales as well as profit against capital employed in a business
• Efficiency/ asset utilisation – shows efficient use of assets in order to generate income
• Short term liquidity – measures how quickly a company generates cash to settle debts
• Financing/investing ratios – examine how the business finances operations

Question 2

16.4 Ratios - Profitability ratios:

Answer 2

Gross profit margin – gross profit divided by sales times 100% (shows gross profit as a percentage of income)
Operating profit margin – operating profit divided by sales times 100% (shows operating profit before interest and tax as a percentage of income)
Return on capital employed – operating profit divided by capital employed (shareholders’ funds + long term liabilities) times 100% (shows how much operating profit is generated as a percentage of the capital used to generate those profits).

Question 3

16.4 Ratios - Efficiency ratios:

Answer 3

Asset turnover (per year) – sales divided by net assets (for this purpose net assets is fixed assets + net current assets = capital employed). This shows how many times the value of net assets is turned into sales.

Stock turnover (days) – average stock (opening stock + closing stock divided by 2) divided by cost of sales times 365 days. This shows how long on average stock is held before it is sold.
Debtors collection period (days) – trade debtors divided by sales (or credit sales if available) times 365 days. This shows on average how long it takes debtors to pay.
Creditors payment period (days) – trade creditors divided by purchases (or credit purchases if available) times 365 days. This shows on average how long the business takes to pay its trade creditors.

Question 4

Short term liquidity ratios:

Answer 4

Current ratio (working capital ratio) – current assets divided by current liabilities. This shows if a business can meet its short-term liabilities with its current assets.
Quick or acid test ratio – current assets minus stock divided by current liabilities. This shows if a business can meet its short-term liabilities with its current assets excluding stock, as this can take a while to convert into cash.

Question 5

Financing/Investment ratios:

Answer 5

Capital gearing ratio – long term liabilities (creditors due after one year) divided by long term liabilities plus shareholder’s funds times by 100%. This shows how much of the business is financed by long term debt.

Interest cover (times) – operating profit divided by interest payable. This shows how many times interest payments are covered by operating profit.

Earnings per share – profit for the year (after tax) divided by the number of issued ordinary shares. This shows the profit after tax earned by each share.

Question 6

16.6 Limitations of ratio analysis

Answer 6

Ratios should never be looked at in isolation, they should be viewed with the profit and loss account, balance sheet and cash flow statement to put the figures in perspective. The limitations of ratio analysis are:
• Historic data – ratios use historic data, it is difficult to predict future values
• Inflation – the figures in the balance sheet are recorded at cost, in periods of high inflation, figures may be distorted and a comparison to another year may not be accurate.
• Accounting policies – companies in same trade may apply accounting policies in different ways. For example, there are two ways to calculate depreciation
• Economic conditions – it is important to assess the position of the company in light of the prevailing economic climate
• Standard ratios – you need to consider the type of business you are analysing. There may be a standard ratio relative to certain industries that is not applicable to all types of businesses.
• Timing – the profit and loss account provides a summary of trading activities over the last 12 months and the balance sheet provides a snapshot at any one point in time. If there were any unusual increases or decreases in account balances at the end of the accounting period, it can lead to distorted ratio calculations
• Comparing like with like – two companies in the same trade may have different business strategies. One company might rent, which will be an expense reducing profits. One similar business might own their premises which will be included in fixed assets on the balance sheet and impact on efficiency ratios.