Ratio Analysis/Interpretation of Accounts

Ratio analysis is a quantitative method to assess the financial performance and financial/liquidity
position of a business by studying its financial statements.

The analysis is performed by calculating and comparing the current year ratios of a business
with:

 Previous year Financial results of the same business

 Financial results of a competitor
 Industry average/standard

Ratios can be classified as:

a) Profitability ratios

These ratios provide information about the financial performance of a business.

b) Liquidity ratios

These ratios provide information about the ability of a business to pay its current
liabilities

4 important points/steps to be kept in mind

 Meaning of accounting ratio

 Calculation of accounting ratio using formula
 Comment on/Interpretation of accounting ratio by comparison
 Reasons for the changes in ratios
 Suggestions to improve the ratios

Profitability ratios

Gross Profit
i) Gross Margin % = X 100 OR (Mark-up % =
Sales Revenue
Gross Profit
X 100)
cost of goods sold

 This ratio provides information about the % gross profit a business is earning
on its sales revenue (or cost of goods sold).
 Higher Gross Margin % is good for the business
 Reasons of (or steps to) increase in Gross Margin %:
 (i) Increasing the sale price
(ii) Decreasing the cost of sales by searching for cheaper supplier

Profit for the year

ii) Profit Margin % = X 100
Sales Revenue

 This ratio expresses profit for the year as a % of sales revenue.

 Higher profit Margin % is good for the business
 A business can increase profit Margin % by:

1. Increasing the Gross profit

2. Increasing other income
3. Controlling its expenses

Profit before interest

iii) Return on capital employed % = X 100
capital employed

 This ratio expresses profit before interest as a % of Capital Employed and

provides information about the % profit/return a business is earning on its
capital employed,
 Higher return on capital employed % is good for the business
 A business can increase return on capital employed % by:

1. Efficient use of capital employed

2. Increasing profits

Profit before interest is also called operating profit.

Note

If there is no information about the “operating profit” in the question, we can use “profit
for the year” instead in above formula.

Capital employed

a. Capital Employed = capital + Non-Current Liabilities (for sole trader and

partnership)

Capital Employed = Shareholder’s equity + Non-Current Liabilities (for company)

Shareholder’s equity = Issued Shares + retained profit + General Reserves

 b. Capital Employed = Total assets – current liabilities

Liquidity Ratios

current assets
i) Current ratio = (This ratio is also known as working capital
current liabilities
ratio)

 This ratio provides information about the current assets of the business to pay
its current liabilities.
 Ideally it should be between 1.5:1 to 2:1.
 If it is below 1.5:1, it can be alarming and business may face difficulties in
paying its current liabilities
 If it is above 2:1, it is still good but too high ratio may mean inefficient use of
current assets.

current assets−inventories
ii) Quick ratio = (This ratio is also known as acid-test
current liabilities
ratio)

 This ratio provides information about the liquid assets (Trade receivables,
Bank and Cash) of the business to pay its current liabilities.
 Ideally it should be between 1:1.
 If it is below 1:1, it can be alarming and business may face difficulties in
paying its current liabilities

Why quick ratio is better measure of liquidity than current ratio?

Answer:

Because it excludes inventory from current assets as inventory is not as liquid as other current
assets.

Reasons of poor liquidity position

 Purchase of non-current assets

 Increased/excessive cash drawings during the year
 Repayment of long term loan.
 Delayed collection from trade receivables
 Early payments to trade payables
Ways to improve liquidity position/bank balance

 Sell surplus non-current assets

 Introduce additional cash/capital into the business
 Take long term loan
 Reduce cash drawings

Cost of Goods Sold

iii) Rate of Inventory Turnover = (answer given in times)
Average inventory

opening Inventory + closing Inventory

Average Inventory =
2

 This ratio provides information about the frequency/speed with which

inventory is sold/turned over.
 This ratio also provides information about the efficiency in inventory
management/control.
 Higher Rate of inventory turnover is good for business as it means more sales
and better inventory management/control

Reasons of fall in rate of inventory turnover

 Increase in sale price

 Availability of better substitutes in market
 Changes in fashion
 Higher levels of closing inventories.

Ways to improve rate of inventory turnover

 Reduce the sale price/Gross profit margin

 Offer promotions/discounts
 Advertisement/marketing

Advantages of holding high inventory levels

 Business can avail trade discounts

 Business can overcome the uncertainty regarding future availability/supply of inventory.
Disadvantages of holding high inventory levels

 Increase in storage cost

 Risk of theft
 Risk of damage
 Risk of obsolescence
 Opportunity cost of money tied up in inventories

trade receivables
iv) Trade Receivable collection period = = X 365
Credit sales

 It refers to the number of days our trade receivables take to pay their debts

Or

it represents the time lag between a credit sale and receiving payment from
the customer

 This ratio is also known as Trade Receivable turnover

 The answer of this ratio is given in days

 Receivable collection period is compared with the credit period already set
by the business to assess how good the business is at collecting the debts

 Short collection period is usually preferred

Note

We can use the total sales in the formula above if credit sales are not separately given

How a business can improve its receivable collection period???

Answer

 Tight credit policy e.g. sending reminders, statement of accounts etc

 offering cash discounts

 charging interest on late payments

 refusing to sell on credit

Advantages of short collection period/tight credit policy

 Less chances of bad debts

 Improved liquidity position

Advantages of long collection period/loose credit policy

 Higher sales because it attracts more customers

 Better competitive position

trade paybles
v) Trade Payable payment period = = X 365
Credit purchases

 It refers to the number of days we take to pay to our trade payables

Or

It represents the time lag between a credit purchase and making

payment to the supplier.

 This ratio is also known as Trade Payable turnover

 The answer of this ratio is given in days

 Payable payment period is compared with the credit period allowed by the
suppliers/creditors to assess how good the business is at paying its the trade
payables

 A lengthy Payable payment period is usually preferred

Note

We can use the total purchase in the formula above if credit purchases are not separately
given

Advantages of lengthy payable payment period

 Improved liquidity position

Advantages of short payable payment period

 Good credit worthiness

 Business can avail cash discounts

 Ensured supply of goods by suppliers in future

 No interest on late payments