Interpretation of financial statements and accounting ratios
Why ratios
Ratios turn financial statements into comparisons: over time, against other firms and against budgets. The key measures are 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), acid test (current assets − stock : current liabilities), stock turnover (cost of sales ÷ average stock, in times), debtor collection period (debtors ÷ credit sales × 365) and creditor payment period (creditors ÷ credit purchases × 365).
Traps
- Confusing mark-up (on cost) with margin (on sales); a 25% mark-up equals a 20% margin.
- Using closing stock in one place and average stock in another; be consistent and state which.
- Using sales instead of cost of sales in stock turnover.
- Assuming a high current ratio is automatically good; excess stock or slow debtors signals inefficiency.
- Ignoring that ratios rest on historical cost figures and differing accounting policies, so comparisons can mislead.
Worked example
Sales P80,000, cost of sales P60,000, gross profit P20,000, net profit P8,000, capital employed P40,000, stock P6,000. Gross profit margin = 20,000 ÷ 80,000 × 100 = 25%; net profit margin = 10%; return on capital employed = 8,000 ÷ 40,000 × 100 = 20%; stock turnover = 60,000 ÷ 6,000 = 10 times.