Analysis and Interpretation of Accounting Information
What you must understand
Calculate and interpret profitability ratios (gross profit margin, net profit margin, return on capital employed), liquidity ratios (current ratio, quick ratio), efficiency ratios (inventory turnover, trade receivable days, trade payable days) and gearing. Know how to comment on results: compare with prior years, budgets or competitors, and explain causes and consequences. Learn to identify window dressing and the limitations of ratio analysis (historical cost, different policies, non-financial factors).
Traps in questions
- Using the wrong denominator (e.g. profit over sales instead of capital employed).
- Forgetting to express ratios as percentages or times consistently.
- Commenting only on the number without explaining what it means.
- Ignoring that a high current ratio may hide slow-moving inventory.
Worked example
Gross profit $40,000; sales $200,000; net profit $16,000; capital employed $80,000. Gross margin = 40,000/200,000 = 20%. Net margin = 16,000/200,000 = 8%. ROCE = 16,000/80,000 = 20%. Rule of thumb: always state the formula, substitute, then interpret - e.g. "a 20% gross margin means 20 cents of every sales dollar remains after cost of sales."