Interpretation of Financial Statements and Ratio Analysis
Interpretation of Financial Statements and Ratio Analysis
This domain tests calculation and interpretation of ratios across profitability, liquidity, efficiency and gearing.
Ratio groups
- Profitability: gross profit margin = gross profit ÷ sales; net profit margin = net profit ÷ sales; return on capital employed = operating profit ÷ capital employed.
- Liquidity: current ratio = current assets ÷ current liabilities; quick ratio = (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.
- Gearing: debt ÷ (debt + equity) or debt ÷ equity, depending on the defined formula.
Worked example
Current assets are ₦300,000 including inventory of ₦120,000; current liabilities are ₦150,000. Current ratio is ₦300,000 ÷ ₦150,000 = 2.0:1. Quick ratio is (₦300,000 − ₦120,000) ÷ ₦150,000 = 1.2:1. If sales are ₦800,000 and gross profit is ₦320,000, gross margin is 40%. Net profit of ₦80,000 gives a net margin of 10%. The liquidity ratios show short-term cover; the margins show profitability.
Traps that cost marks
- Using closing rather than average inventory or receivables without stating the basis.
- Mixing mark-up on cost with margin on sales.
- Comparing ratios across firms with different accounting policies without adjustment.
- Treating a high current ratio as automatically good when inventory is slow-moving.
- Ignoring window dressing and seasonal balances.