Interpretation of Financial Statements: Ratio Analysis
This domain tests your ability to calculate and, more importantly, comment on ratios covering profitability, liquidity and efficiency. Questions give extract figures and ask for ratios to two decimal places, then a short interpretation. Marks are often lost on the comment rather than the calculation, so link every ratio to what it tells a user.
Profitability ratios
- Gross profit margin = gross profit ÷ sales × 100.
- Net profit margin = net profit ÷ sales × 100.
- Mark-up = gross profit ÷ cost of sales × 100.
- Return on capital employed = operating profit ÷ capital employed × 100.
Liquidity ratios
- Current ratio = current assets ÷ current liabilities, with 2:1 as a rough benchmark.
- Acid test or liquid ratio = (current assets − stock) ÷ current liabilities, with about 1:1 as a benchmark, because stock may be slow to convert into cash.
Efficiency ratios
- Stock turnover = cost of sales ÷ average stock; stock holding period = 365 ÷ turnover.
- Debtors collection period = debtors ÷ credit sales × 365.
- Creditors payment period = creditors ÷ credit purchases × 365.
- Asset turnover = sales ÷ net assets.
Worked example
Sales 1,000,000; cost of sales 700,000; gross profit 300,000; net profit 120,000; current assets 400,000 including stock 150,000 and debtors 180,000; current liabilities 200,000. Gross profit margin = 30%; net profit margin = 12%; current ratio = 400,000 ÷ 200,000 = 2:1; acid test = 250,000 ÷ 200,000 = 1.25:1; stock turnover = 700,000 ÷ 150,000 = 4.67 times or about 78 days; debtors period = 180,000 ÷ 1,000,000 × 365 = 66 days. Comment: liquidity is acceptable, but the gap between the current ratio and the acid test shows reliance on stock, and debtors take over two months to pay.
Limitations and traps
- Using sales instead of cost of sales in stock turnover.
- Including stock in the acid test.
- Reading a ratio in isolation instead of comparing with the prior year, a budget or the industry.
- Forgetting that ratios are distorted by historical cost, inflation and different accounting policies such as depreciation methods.
- Quoting a ratio without saying what it means.