Interpreting Accounts Notes

EXAM Technique:

1. Identify the ratio

2. What is the formula

3. What is the ratio trying to measure

4. Compare 2 different years

5. Is the result going up or down

6. Is this good or bad? What does it mean?

7. Comment / Observation – be sensible – look at the accounts as a WHOLE!

Gross Profit Percentage (margin)

• Tells us how well the business is operating.

• It indicates the % of sales which compromises profit

• Higher the GPP = Higher the profitability of the company’s products.

• Good to have a high percentage

ANALYSIS:

• Does the figure fluctuate?

• Look at ALL the figures (has sales increased / cost of sales / stock (including work in progress) / new machinery? – has this caused a big / little increase in the GPP – if not – why not – use the above table to suggest reasons why.

• If GPP is too low – options include putting up prices and / or cutting cost of sales.

• REMEMBER – profitability is not the same as solvency!

Net Profit Percentage

• Tells us how efficiently the company (or business) is operating – it indicates the profitability of a company after taking into account those expenses EXCEPT loan / debenture interest payments / and tax.

• More useful than GPP

• Good to keep as HIGH as possible.

• Calculating PBIT = add interest back into the figure for profit before tax. (OR add interest and tax to the profit after tax).

• Have expenses increased whilst sales have not? [Look at any fixed assets bought / machinery – is rent or depreciation on reducing basis the reason for increase in expense?].

Return on capital employed (ROCE)

• Indicates the return a company is making on the capital invested.

• Capital employed = shareholder funds and LT liabilities)

• Good to have as high as possible

• Tells us how much profit there is before interest and taxation – showing value for money

• Shows how much your business makes on the capital invested in it.

Asset Turnover

• Tells us about the volume of sales being generated by the amount of capital employed. Shows sales in relation to capital employed.

• E.g. Is Asset turnover is 2 = every 1 invested is converted into 2 of turnover.

• If figure is increasing – analyze why? Is it achieved by the acquisition of other businesses or through trading activity?

• Good to keep high

• Food retailers have a higher asset turnover than many sectors

Current Ratio

• Does the business have enough money to pay its way?

• MUST be more than 1 (this means all current liabilities can be met by realising all current assets)

• Goal – around 1.5 is good [depends on nature of the industry / levels of stock / profit margin]

• If too low – the business has a liquidity problem (but consider stock or cash flow)

• If too high – funds are tied up in working capital.

Acid Test Ration

• Provides a more accurate picture about liquidity of business – by removing stock (because stock can be difficult to shift – it is the lease liquid of current assets [i.e. it takes longer to convert stock into cash].

• Acceptable ratio = 0.8 [but always consider what kind of business it is]

• EXAM: Is the ratio improving or deteriorating over the years?

• Is the business a retailer – maybe acid text ratio is less relevant.

• Compare to the current ratio – has the figure dropped significantly – if yes this means the company does not have many current assets (other than stock) to pay off the current liabilities.

Trade debtor days

• Provides the number of days CREDIT given to customers [i.e. how long the business must wait to get paid by debtors]

• AIM – keep as low as possible (e.g. 40 days est.) – BECAUSE it is important for cash flow reasons.

• Gives an idea of how effective the company is in dealing with trade debtors.

• The fewer the days the greater the liquidity of the business.

• How to reduce – write off bad debt.

• Always consider the NATURE of the business – supermarket (will be low) or antiques store (much higher)?

Trade Creditor days

• Provides number of days it takes business to pay money to its...