Interpretation and Analysis of Accounting Information
This section covers Interpretation and Analysis of Accounting Information. The exam tests your ability to calculate ratios from financial statements and, more importantly, to explain what they show about profitability, liquidity, efficiency and financial structure.
Core rules
- Profitability: gross profit margin = gross profit/revenue × 100; mark-up = gross profit/cost of sales × 100; net profit margin = profit before tax/revenue × 100; ROCE = operating profit/(total assets − current liabilities) × 100.
- Liquidity: current ratio = current assets/current liabilities; acid-test = (current assets − inventory)/current liabilities.
- Efficiency: inventory turnover = cost of sales/average inventory; receivable days = receivables/credit sales × 365; payable days = payables/credit purchases × 365.
- Comparisons need a base: prior year, budget or industry. A single ratio is not an interpretation.
- State cause and effect: for example, rising receivable days may reflect poor credit control or sales to slow payers.
Worked example
Revenue €200,000; cost of sales €120,000; expenses €50,000; current assets €60,000 including inventory €25,000; current liabilities €30,000.
Gross profit = €80,000; gross margin = 40%. Net profit = €30,000; net margin = 15%. Current ratio = 60,000/30,000 = 2:1. Acid-test = (60,000 − 25,000)/30,000 = 1.17:1. Inventory turnover = 120,000/25,000 = 4.8 times; inventory days ≈ 365/4.8 = 76 days.
Reasoning: the business is profitable and liquid on the current ratio, but inventory holding is substantial; the acid-test is weaker, so liquidity depends on selling stock.
Traps
- Confusing mark-up on cost with margin on selling price.
- Using closing inventory when the question gives average inventory, or mixing the two.
- Assuming a high current ratio is always good; it may signal idle cash or obsolete stock.
- Ignoring the need to compare like with like across years or businesses.
- Calculating a ratio correctly but giving no interpretation.