Common Mistakes

Common Mistakes: Analysis and Interpretation of Financial Statements for Decision Making

This chapter tests whether you can calculate ratios accurately and interpret them to make decisions. Below are the mistakes candidates most often make and how to avoid them, so you keep both the calculation and interpretation marks.

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Formula and calculation-base mistakes

Liquidity ratio mistakes

Efficiency ratio mistakes

Unit, rounding and presentation mistakes

Interpretation, comparison and conclusion mistakes

Only stating the number without interpreting it. Each ratio must be linked to the performance it measures, e.g. 'Net Profit Margin fell from 12% to 8%, showing weaker control of operating expenses', not merely quoting the value.
Assuming a higher ratio is always better. A very high Current Ratio (e.g. 5 : 1) can indicate idle current assets or overstocking, not necessarily strength. Interpret within the business context.
Comparing unlike businesses or concluding from a single ratio. Compare only businesses in the same industry and over comparable periods, and base a selection decision on a combination of profitability, liquidity and efficiency ratios.
Suggesting improvements unrelated to the findings. Recommendations must follow the weakness found, e.g. if the Debtors Collection Period is long, propose tighter credit terms or cash discounts; if margin is low, review purchase costs and expenses.

Quick reference: ratio formulas and units

Ratio	Formula	Unit
Profitability Ratios
Markup	(Gross Profit / Cost of Sales) x 100	%
Gross Profit Margin	(Gross Profit / Sales) x 100	%
Net Profit Margin	(Net Profit / Sales) x 100	%
Return on Capital	(Net Profit / Capital) x 100	%
Liquidity Ratios
Current Ratio	Current Assets : Current Liabilities	x : 1
Acid Test Ratio	(Current Assets - Closing Stock) : Current Liabilities	x : 1
Efficiency Ratios
Stock Turnover	Cost of Sales / Average Stock	times
Debtors Collection Period	(Debtors / Credit Sales) x 365	days
Creditors Payment Period	(Creditors / Credit Purchases) x 365	days

Average Stock = (Opening Stock + Closing Stock) / 2. Use credit sales/purchases when given.

How do I remember the difference between Markup and Gross Profit Margin?

Both use Gross Profit as the numerator. The difference is the denominator: Markup is on Cost of Sales, Margin is on Sales. Remember 'Markup sits on cost' (cost is the base) and 'Margin follows sales' (sales is the base). That is why the Markup percentage is usually higher than the Margin for the same business.

Must I always use average stock, or can I use closing stock only?

Use Average Stock = (Opening Stock + Closing Stock) / 2 whenever both figures are given, because it better represents stock over the period. Only if the question gives closing stock alone (no opening stock) do you use closing stock. Always show your average calculation so the examiner sees the method.

What is the correct unit for each ratio?

Profitability ratios (Markup, Gross Profit Margin, Net Profit Margin, Return on Capital) are in percent (%). Liquidity ratios (Current Ratio, Acid Test Ratio) are in the form x : 1. Stock Turnover is in times. The Debtors Collection Period and Creditors Payment Period are in days. Without the correct unit the interpretation is incomplete.

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