Revision Notes
Revision Notes: Analysis and Interpretation of Financial Statements for Decision Making
Concise Form 5 Chapter 1 revision notes covering the purpose of analysis, the formulas for the three types of ratios, how to interpret and compare performance, and how to make business decisions.
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Purpose and Types of Financial Statement Analysis
- Financial Statement Analysis is the process of computing and interpreting ratios from the Income Statement and Statement of Financial Position to evaluate a business's performance and position.
- Main purposes: assess profitability, measure liquidity (ability to pay short-term debts), evaluate management efficiency, and help owners and stakeholders make decisions.
- Three main types of ratios: Profitability ratios, Liquidity ratios, and Efficiency (activity) ratios.
- Users of the information: owners, investors, banks/creditors, employees and the government use ratios to assess risk and return before acting.
Profitability Ratios (Formulas and Meaning)
- Gross Profit Percentage on Cost of Sales (Mark-up) = (Gross Profit / Cost of Sales) × 100%; shows the percentage added to cost when setting the selling price.
- Gross Profit Margin = (Gross Profit / Sales) × 100%; a higher ratio means good control of cost of sales or appropriate selling prices.
- Net Profit Margin = (Net Profit / Sales) × 100%; measures overall control of operating expenses after all expenses are considered.
- Return on Capital = (Net Profit / Capital) × 100%; measures the return earned by the owner on capital invested.
- Interpretation tip: the higher the profitability ratio, the better the business is at generating profit.
Liquidity Ratios (Ability to Pay Short-term Debts)
- Current Ratio = Current Assets : Current Liabilities; measures the ability to pay current liabilities using current assets.
- An ideal Current Ratio is commonly around 2:1, enough to pay debts without too many assets left idle.
- Acid-Test Ratio = (Current Assets − Closing Inventory) : Current Liabilities; inventory is removed because it is the slowest to turn into cash.
- An ideal Acid-Test Ratio is commonly around 1:1; too low signals cash-flow problems, too high signals cash assets not used efficiently.
Efficiency Ratios (Managing Inventory and Debts)
- Rate of Inventory Turnover = Cost of Sales / Average Inventory (times); Average Inventory = (Opening + Closing Inventory) / 2. A high rate means inventory sells quickly.
- Debt Collection Period = (Trade Receivables / Credit Sales) × 365 days; a short period means debts are collected quickly and cash flow is good.
- Debt Payment Period = (Trade Payables / Credit Purchases) × 365 days; shows how long the business takes to pay suppliers.
- Ideally the debt collection period is shorter than the debt payment period so that cash comes in before it goes out.
Interpreting and Comparing Performance
- A single ratio is meaningless on its own; it must be compared to give a meaningful interpretation.
- Inter-period (trend) comparison: compare the same business's ratios across the current and previous accounting years to see whether performance improved or declined.
- Inter-firm comparison: compare the ratios of two businesses in the same industry to judge which performs better.
- Link each ratio to the performance it measures, e.g. a low net profit margin despite a high gross profit margin shows operating expenses are not controlled.
- Note the limitations of ratio analysis: it is based on past data, ignores non-financial factors, and can be affected by different accounting policies.
Summarising Findings and Making Decisions
- Working steps: (1) identify the required ratio, (2) calculate using the correct formula, (3) interpret the result, (4) compare, (5) conclude and suggest action.
- Suggestions to raise profitability: control cost of sales, reduce operating expenses, increase sales or review selling prices.
- Suggestions to improve liquidity: collect from receivables more promptly, reduce excess inventory, and manage payments to payables wisely.
- Choosing a business: select the one showing a combination of high profitability, adequate liquidity and good efficiency, not just one ratio.
- State recommendations specifically and based on the ratio figures in the given case, not as general statements.
| Ratio | Formula | Measures |
|---|---|---|
| Profitability Ratios | ||
| Mark-up | (Gross Profit / Cost of Sales) × 100% | Amount added to cost |
| Gross Profit Margin | (Gross Profit / Sales) × 100% | Gross profitability |
| Net Profit Margin | (Net Profit / Sales) × 100% | Expense control |
| Return on Capital | (Net Profit / Capital) × 100% | Owner's return |
| Liquidity Ratios | ||
| Current Ratio | Current Assets : Current Liabilities | Short-term solvency |
| Acid-Test Ratio | (Current Assets − Inventory) : Current Liabilities | Immediate liquidity |
| Efficiency Ratios | ||
| Inventory Turnover | Cost of Sales / Average Inventory | Speed of inventory sales |
| Debt Collection Period | (Receivables / Credit Sales) × 365 | Collection speed |
| Debt Payment Period | (Payables / Credit Purchases) × 365 | Time to pay suppliers |
What is the difference between mark-up and gross profit margin?
Mark-up expresses gross profit as a percentage of Cost of Sales, while gross profit margin expresses gross profit as a percentage of Sales. Same numerator, different denominator.
Why is inventory excluded from the Acid-Test Ratio?
Inventory is the slowest and hardest current asset to turn into cash, so it is removed to measure liquidity more immediately and accurately.
Can a single ratio alone decide which business is better?
No. A sound decision needs a combination of profitability, liquidity and efficiency ratios, plus comparison across periods or between businesses in the same industry.
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