Interpretation and analysis of financial statements: ratio analysis, profitability, liquidity, and efficiency
Domain 7 tests ratio calculation and interpretation. Profitability ratios include gross profit margin = gross profit/revenue; operating profit margin = operating profit/revenue; and ROCE = operating profit/(equity + non-current liabilities). Liquidity ratios include current ratio = current assets/current liabilities and quick ratio = (current assets − inventory)/current liabilities. Efficiency ratios include inventory turnover = cost of sales/average inventory; receivables collection period = receivables/credit sales × 365; and payables period = payables/credit purchases × 365. Gearing = debt/(debt + equity).
Worked example
Revenue N$500,000; cost of sales N$300,000; operating profit N$60,000; current assets N$120,000 including inventory N$50,000; current liabilities N$60,000. Gross profit = 200,000, so gross margin = 40%. Operating margin = 12%. Current ratio = 120/60 = 2.0:1. Quick ratio = (120 − 50)/60 = 1.17:1. Inventory turnover = 300/50 = 6 times using closing inventory; average inventory is preferable. Reasoning: the quick ratio removes inventory because it may be slow to convert to cash.
Interpretation
Compare ratios over time, against budgets and against similar businesses. A high current ratio may reflect idle cash or slow inventory, not strength. High gearing increases risk in a downturn. Ratios are limited by different accounting policies, inflation and year-end window dressing.
Traps
Confusing mark-up (gross profit/cost) with margin (gross profit/revenue); using closing rather than average inventory when averages are available; treating a higher ratio as always better; using profit rather than cash flow to judge liquidity; ignoring the effect of a share issue on ROCE.