Accounting ratios, inter-firm comparison and interested parties

Last time

Before we start: last time, in Incomplete records, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Reading the numbers

Financial statements are full of numbers, but numbers alone do not say whether a business did well. Ratios turn them into comparisons. This lesson covers the main ratios, how to compare businesses, who uses the results, and the limits of it all.

Profitability ratios

Three profitability ratios. Each is a percentage, to two decimal places when asked.

Gross margin, worked

Gross profit 20,000 dollars and revenue 49,000 give a gross margin of 20,000 divided by 49,000, times 100: 40.82 per cent. A higher gross margin means higher selling prices, or cheaper purchases. If gross margin holds but profit margin falls, the expenses have risen.

Liquidity and efficiency ratios

The liquidity and efficiency ratios, with their units.

Inventory turnover, worked

Average inventory is opening plus closing, divided by 2: 4,000 plus 5,000, over 2, is 4,500. Inventory turnover is cost of sales 29,000 divided by 4,500: 6.44 times a year. A higher rate means goods sell faster, so less cash is tied up and less risk of goods going out of date.

Receivables days, worked

Trade receivables of 5,500 dollars and credit sales of 40,000 give 5,500 divided by 40,000, times 365: 50.19 days. If the business allows 30 days' credit, customers are paying too slowly. It could chase debts, offer cash discounts, or stop credit to slow payers.

Interested parties

Owners and investors: profitability and return. Managers: to control costs and plan. Lenders and suppliers: liquidity, to judge whether they will be paid. Employees: job security; the government: tax and statistics; competitors: comparison.

Inter-firm comparison

Comparing with another business shows whether performance is good for the industry. But businesses may use different accounting policies, such as depreciation methods or inventory valuation. They may differ in size, location or type, and their year ends may differ. And the other firm's accounts may be hard to obtain.

Limitations of accounting statements

They use historic cost, so asset values may be out of date, and inflation is ignored. They include estimates, such as depreciation and the allowance for irrecoverable debts. They show only financial facts: not staff skills, customer loyalty, or the location's advantages.

Mistakes that lose marks

Mistake one: forgetting units: per cent, times, days, or the ratio to 1. Mistake two: using total sales instead of credit sales for receivables days. Mistake three: calculating ratios but not interpreting them. The fix: formula, working, units, then what it means.

The full-marks tip

The full-marks tip: show each ratio's formula and working, round as asked, and give the unit. Then compare with last year or another business, and explain the reason for the change.

On one card

So, on one card: ratio analysis. Keep it for revision.