Interpretation and Analysis of Accounting Information
Users and ratios
Users such as owners, lenders and suppliers interpret financial statements using ratios and comparisons. Learn these groups:
- Profitability: gross profit margin (gross profit ÷ sales × 100), net profit margin (net profit ÷ sales × 100), return on capital employed.
- Liquidity: current ratio (current assets ÷ current liabilities) and quick ratio (current assets − inventory) ÷ current liabilities.
- Efficiency: rate of inventory turnover (cost of goods sold ÷ average inventory).
Interpreting results
A high gross margin may reflect pricing power or lower cost of goods sold; a low margin may indicate discounting or theft. A current ratio of about 2:1 is often regarded as healthy, but too high may mean idle assets. The quick ratio ignores inventory because it may be hard to sell. Always compare with prior years or other firms, and comment on trends.
Traps to watch
Use the correct figures: gross profit margin uses gross profit, not net profit. The quick ratio excludes inventory. Inventory turnover uses cost of goods sold, not sales. Do not say a ratio is "good" or "bad" without a reason. Also, percentages must be multiplied by 100.
Rule of thumb
For every ratio, state the formula, calculate it, then give one reason for the result and one consequence for the business.
Worked example
Gross profit $30,000; sales $120,000. Gross profit margin = 30,000 ÷ 120,000 × 100 = 25%. If last year was 30%, the fall suggests higher purchase costs or increased discounting.