Interpretation and Analysis of Financial Statements
Interpretation and analysis uses ratios and comparisons to assess profitability, liquidity, efficiency and gearing. The exam tests calculation, interpretation and comment on trends, not just arithmetic.
Key ratios
- Gross profit margin = gross profit / sales × 100.
- Net profit margin = net profit / sales × 100.
- ROCE = operating profit / capital employed × 100.
- Current ratio = current assets : current liabilities.
- Quick ratio = (current assets - inventory) : current liabilities.
- Inventory days = inventory / cost of sales × 365; receivables days = receivables / credit sales × 365; payables days = payables / credit purchases × 365.
- Gearing = debt / (debt + equity) × 100.
Worked example
Sales €200,000; gross profit €40,000; net profit €12,000. Gross margin = 20%; net margin = 6%. Current assets €60,000 including inventory €25,000; current liabilities €30,000. Current ratio = 2:1; quick ratio = (60,000 - 25,000)/30,000 = 1.17:1. The business is liquid, but inventory is a large part of current assets.
Traps
Using mark-up instead of margin; mixing closing and average balances without saying so; comparing ratios without a benchmark; and treating a high current ratio as automatically good. Comment on causes and consequences, such as overtrading or slow receivables.