Interpretation and Analysis of Financial Statements (Ratio Analysis)
What the exam tests
This domain tests computation and interpretation of profitability, liquidity, efficiency, gearing and investor ratios, and the ability to explain causes and limitations.
Core rules
- Gross profit margin = gross profit/revenue x 100; operating margin = operating profit/revenue; net margin = profit after tax/revenue.
- Current ratio = current assets/current liabilities; quick ratio = (current assets - inventory)/current liabilities.
- Receivable days = receivables/credit sales x 365; inventory days = inventory/cost of sales x 365; payable days = payables/credit purchases x 365.
- Gearing = debt/(debt + equity) or debt/equity, depending on policy; interest cover = operating profit/finance cost.
- Compare with prior years, budgets or industry, and explain the driver, not just the number.
Worked example
Revenue N2,000,000; gross profit N600,000; operating profit N300,000; profit after tax N180,000; current assets N500,000; inventory N200,000; current liabilities N250,000; receivables N150,000. Gross margin = 30%; operating margin = 15%; net margin = 9%; current ratio = 2:1; quick ratio = (500,000 - 200,000)/250,000 = 1.2:1; receivable days = 150,000/2,000,000 x 365 = 27.4 days. The liquidity looks adequate, but a quick ratio of 1.2 still depends on receivables quality.
Traps
Use average balances when opening and closing figures are both available and the question expects it. Do not mix total sales with credit sales in receivable days. A higher current ratio is not always better: idle inventory and slow receivables can inflate it. Gearing formulas differ; state the one used.