Accounting statements must be properly analysed and interpreted to be useful. To do this, we calculate ratios that help us better understand a business’ performance in the following areas:

• profitability

• liquidity

• efficiency

Stakeholders are people within or affected by the business who would be interested in the business’ financial performance. There are internal stakeholders and external stakeholders.

Profitability

Gross Margin %

To calculate gross margin, we divide gross profit by revenue and multiply by 100 to get a percentage.

Example:

A business’ gross profit is $20,000.
Revenue is $100,000
Gross margin = (20 000/100 000)*100 = 20%

This means that, for every $1 of revenue, 20 cents is returned as gross profit.

A fall in the gross margin could have been caused by:

• a decrease in markup (selling price)

• an increase in trade discounts to attract customers

• an increase in supplier costs not passed onto the customer

To improve gross margin, a business could:

• increase markup (selling price)

• reduce the cost of sales by finding a cheaper supplier

• change the product range to include more profitable products

You can turn gross margin into markup using the formula:

Mp = Mg/(1-Mg)

Where Mp is the markup rate and Mg is the margin percentage.

Markup %

Markup is the amount added to the cost price of a good to arrive at the selling price. It is calculated by dividing gross profit with cost of sales and multiplying by 100 to get a percentage.

Example:

A business’ gross profit is $30,000.
The cost of sales is $100,000

Markup = (30 000/100 000)*100 = 30%

This means that, for every $1 of cost, the business adds 30 cents to arrive at the selling price.

You can turn markup into gross margin percentage using the formula:

Mg = Mp/(1+Mp)

Where Mg is the margin percentage and Mp is markup rate.

Profit Margin %

To calculate profit margin, we divide profit for the year with revenue and multiply by 100 to get a percentage.

Example:

A business’ profit for the year is $40,000.
Revenue is $260,000
Profit margin = (40 000/260 000)*100 - 15.38%

This means that, for every $1 of net sales, the business returns 15.38 cents as profit.

A fall in the profit margin could be caused by:

• a fall in the gross margin

• an increase in expenses as less control is had over them

A rise in the profit margin could be caused by:

• an increase in the gross profit margin

• a decrease in expenses or better control over them

Return on Capital Employed (ROCE) %

ROCE measures how efficiently a businesses uses the money invested in it by owners and lenders.

To calculate return on capital employed, we divide profit from operations (profit before finance costs) with capital employed (equity + non-current liabilities) and multiply by 100 to get a percentage.

Example:

A business’ profit from operations is $90,000.
Capital is $400,000.
There is a 5-year bank loan of $30,000

ROCE = 90 000/(400 000 + 30 000) * 100 = 20.93%

This means that, for every $1 of capital employed by both internal and external investors, the business returns 20.93 cents as profit.

Liquidity

Current Ratio

To calculate current ratio, we divide current assets with current liabilities to get a ratio.

Example:

A business’ current assets are $45,000.
Current liabilities are $22,500

Current ratio = 45 000/22 500 = 2

The answer is then put into the ratio as 2:1.

This means that, for every dollar of current liabilities, the business has $2 of current assets to pay the short-term debts in the coming accounting period.

A current ratio should be at least 1:1. Problems of having a high current ratio are:

• high accounts recievable can lead to more bad debts

• too much inventory that may become obsolete

• too much cash, better invested as a term deposit to earn interest

The consequences of having a low current ratio are:

• problems in meeting debts as they fall due

• inability to take advantage of cash discounts

• difficulties in obtaining further supplies

• inability to take advantage of business opportunities as they arise

A business can improve their current ratio by borrowing long term, investing more capital in the form of cash, selling idle non-current assets for cash, and decreasing drawings.

Liquid (Acid) Test

To calculate the liquid ratio, we divide current assets (not including inventory) with current liabilities. Inventory is subtracted from current assets as there is no guarantee they will be turned into cash in 1-3 months. It is the best indicator of liquidity.

Example:

A business’ current assets are $50,000.
Inventory is $10,000.
Current liabilities are $40,000

Liquid ratio = (50 000 - 10 000)/40 000 = 1

The answer is then put into the ratio as 1:1.

This means that, for every dollar of liquid liabilities, the business has $1 in liquid assets with which to pay its immediate debts in the next month or so.

The optimum liquid ratio is 1:1-1.5:1.

We can improve the liquid ratio in the same ways as the current ratio, but also by having a clearance sale to sell obsolete inventory.

Efficiency

Rate of Inventory Turnover

This ratio measures the number of times a business sells its inventory and replaces it in a year. The ratio is measured in times.

To calculate the rate of inventory turnover, we divide cost of sales with average inventory. Average inventory is opening and closing inventory divided by two.

Example:

A business’ cost of sales is $855,000.
Opening inventory is $9,000.
Closing inventory is $13,000

Average inventory = (9 000 + 13 000) / 2 = 11 000

Rate of inventory turnover = 855 000 / 11 000 = 77.73 times

If the rate of inventory turnover is high, the more they replace their products with new products that will be the new and current. If the rate is slow, the business may not be managng its inventory efficiently; inventory could pile up and become old and unattractive. The money tied up could have been used more productively elsewhere.

Inventory turnover needs to be compared to like businesses. A bakery would expect a higher turnover than a jewellery shop. Comparing with the previous year or like industries is also useful.

Trade Receivables’ Collection Period

This ratio measures the collection period for trade receivables. It is measured in days.

To calculate the collection period for trade receivables, we divide trade receivables with credit sales and multiply by 365. If the answer comes out to a decimal, always round up.

Example: Trade receivables is $66,000.
Credit sales for the year are $790,000, what is the collection period for trade receivables?

Collection period for trade receivables = (66 000/790 000) * 365 = 30.49 days = 31 days.

The collection period should be no more than 30 to 35 days. If it is longer, a business could implement the following strategies:

• offer trade discounts for prompt payments

• send regular reminder letters of statements

• charge interest on overdue accounts

• stop selling further products on credit

• more effective credit screening before approving credit

Trade Payables’ Payment Period

This ratio measures the payment period of trade payables. It is measured in days.

To calculate the payment period for trade payables, we divide trade payables with credit purchases and multiply by 365. If the answer comes out to a decimal, always round up.

Example: A business’ trade payables are $68,000.
Credit purchases are $490,000.

Payment period for trade receivables = (68 000/490 000) * 365 = 50.65 days = 51 days.

Much like trade receivables, a payment period of 30 to 35 days is acceptable. 51 days is not acceptable as the business risks:

• missing out on cash discounts

• being denied further purchases of goods on credit

• interest being charged on the overdue account

Non-Current Asset Turnover

This measures the amount of sales the business is obtaining from its investment in non-current assets, or its efficiency of non-current assets to generate revenue. It is measured in times.

To calculate the non-current asset turnover, we divide net revenue with the total net book value of non-current assets.

Example:

A business’ net revenue is $192,000.
The net book value of all its non-current assets is $157,000.

Non-current asset turnover = 192 000/157 000 = 1.22 times.

This means that there are 1.22 times as many dollars of revenue as there are of dollars of non-current asset. For every dollar of revenue, there are 82 cents of non-current assets.

Limitations of Accounting Information

By the time the financial statements are reported, important events may have occurred that are not reflected in the accounts.

The monetary measurement concept means that financial statements can only include data that has monetary value. As a result, some important characteristics of a business can be overlooked such as motivation of workforce, good location, highly effective managing director(s), and so on.

Inflation is also ignored when comparing data and this can distort the results such as when sales may have increased but inflation was high in comparison to the previous year, meaning the real difference in revenue may not be significant.