Interpretation and Analysis of Financial Statements
Why analyse?
Users such as owners, lenders and investors use ratios to judge profitability, liquidity, efficiency and gearing. Compare across years and against similar businesses.
The main ratios
- Gross profit margin = gross profit ÷ sales × 100.
- Net profit margin = net profit ÷ sales × 100.
- Return on capital employed = operating profit ÷ capital employed × 100.
- Current ratio = current assets ÷ current liabilities.
- Liquid (acid test) ratio = (current assets − inventory) ÷ current liabilities.
- Inventory turnover = cost of sales ÷ average inventory.
- Receivables collection period = receivables ÷ credit sales × 365.
- Gearing = long-term debt ÷ (debt + equity) × 100.
Interpreting
A falling gross margin may mean higher purchase costs, more discounting or theft. A high current ratio with low liquid ratio suggests too much inventory. High gearing means more risk in a downturn.
Traps
- Using profit before interest and tax in the wrong place.
- Mixing percentages and ratios: express margins as percentages and liquidity as x:1.
- Forgetting that ratios use average figures where opening and closing balances are available.
- Comparing a business with a different industry without comment.
Rule of thumb
Never state a ratio alone. Say what it is, whether it rose or fell, and give one plausible reason and one consequence. For example: the gross margin fell from 40% to 34%, perhaps because supplier prices rose; the business may need to raise selling prices or find cheaper suppliers.