The City School

Gulshan Boys Campus

Senior Section
Ratio Analysis and Interpretation
Introduction:
A ratio analysis is a quantitative analysis of information contained in a company’s financial
statements. It is used to evaluate various aspects of a company’s operating and financial
performance.

It is necessary to analyse and interpret the financial statements for business in order to assess its
performance and progress.

Analysis consists of a detailed examination of the information in a set of financial statements of a

business.

Interpretation can include comparing the results of other similar businesses and also comparing
with the business (with the results for previous years and with targets and budgets.)

Reasons of Ratio Analysis:

The reason of analyzing the ratios is to:
 Compare current year financial position with the previous year in the same business
(Trend and Time Series)
 Compare the financial position of one business with another business.

Users of Ratio Analysis:

Bankers and Lenders Government Employees Investors

Customers Suppliers Management

Working Capital:
It is the difference between the current assets and the current liabilities and is the amount
available for the day –to-day running of the business. It is also known as net current assets and is
calculated as:

Working Capital = Current Assets – Current Liabilities

Analysis of Working Capital:

 Positive working capital generally indicates that a company is able to pay off its short-
term liabilities almost immediately.
 Negative working capital generally indicates a company is unable to pay off its short term
liabilities immediately.

This is why analysts are sensitive to decreases in working capital; they suggest a company is
becoming overleveraged, is struggling to maintain or grow sales, is paying bills too quickly, or is
collecting receivables too slowly.
Capital Employed:
It is the total funds which are being used by the business. This may be calculated as:

Capital Employed = Total Assets – Current Liabilities

Capital Employed = Owner’s Capital + Long Term Liabilities

Categories of Ratio Analysis:

Following are the categories of ratio analysis:

1. Profitability Ratios:
These ratios show how well a company can generate profits from its operations. Examples of
profitability ratios are as follows:
 Gross Profit Ratio (Margin)
 Net Profit Ratio / Profit for the year Ratio
 Operating Expenses / Expenses over sale ratio
 Return on assets ratio
 Return on capital employed ratio
 Return on equity (for Companies) / (Sole Trader)

2.Liquidity Ratios:
Liquidity ratios measure a company's ability to pay off its short-term debts as they come due
using the company's current or quick assets.
 Current / Working Capital Ratio
 Quick Current Ratio / Acid Test Ratio)

3. Efficiency / Activity Ratios:

It evaluates how well a company uses its assets and liabilities to generate sales and maximize
profits. Examples are:
 Inventory Turnover Ratios (in days) / times
 Trade Receivable collection period / Trade Receivable over sales
 Trade Payable payment period / Trade Payable over purchase
 Non-Current Assets Turnover

Calculations and Interpretations

1- Gross Profit as a percentage of sales (Gross Profit / Sales):
This is also known as gross profit as a percentage of turnover. It shows that gross profit
earned for every $100 of sales. It is calculated as:
Gross Profit as a percentage of sales = Gross Profit x 100
Net Sales
Margin and Markup:
As we know that:
Cost Price + Gross Profit = Selling Price
Cost Price = Selling Price - Gross Profit
 Markup:
Markup is the gross profit measured as a percentage of the cost price
Markup% = Gross Profit / Cost Price X 100
Cost Price x Markup% = Gross Profit
Margin:
Margin is the gross profit measure as a percentage of selling price
Margin% = Gross Profit / Selling Price X 100
Selling Price x Margin% = Gross Profit

Conversion of
Markup into Margin Margin into Markup
Margin = Markup x 100 Markup = Margin x 100
100 + markup 100 - margin

Interpretation of Gross Profit:

 Higher gross profit indicates that the business has made reasonable profit on sales and has
kept its cost in control.
 Lower gross profit indicates that the business has not made reasonable profit on sales and
has not kept its cost in control.

Improvement in Gross Profit:

Gross profit ratio may be improved by:
 Increasing selling price.
 Obtaining cheaper supplies.

Limitations:
Following are the limitations of taking the above mentioned measure:
 Increasing the selling price may result in customer going elsewhere.
 Obtaining cheaper goods may result in a lower quality of goods.

 Causes of fall in gross margin:

 Increasing the rate of trade discount.
 Selling goods at cheaper price.

2. Net Profit as a percentage of sales (Net Profit / Sales):

This ratio shows the net profit earned for every $100 of sales. The this acts as an
indicator of how well a business is able to control it expenses. It can be calculated as:

Net Profit as a percentage of sales = Net Profit x 100

Net Sales

Interpretation of Net Profit:

 If the net profit percentage of business increases it indicates that the operating expenses
are being controlled.
 If the net profit percentage of business decreases it indicates that the management has
failed to control its operating expenses.
Improvement in Net Profit:
Net profit ratio may be improved by:
 Increasing the gross margin.
 Controlling expenses.
 Increasing other income.

Causes of fall in net profit margin:

 A decrease in the gross profit.
 An increase in expenses.
 A decrease in other income.

3. Return on Capital Employed Ratio:

This ratio shows the profit earned for every $100 used in the business in order to earn that
profit. It can be calculated as:

ROCE = Profit for the year before interest x 100

Capital Employed

Interpretation of ROCE:
 The higher the return, the more efficiently the capital is being employed within the
business.
 Lower return indicates that the business has not efficiently employed its capital.

4. Current Ratio:
This is also known as working capital ratio. It compares the assets which are in the form
of cash, or which can turn into cash relatively easily within the next 12 months, with the
liabilities which are due to repament within that period of time. It measures the ability of
business to meet its current liabilities when they fall due. The calculation is:

Current Ratio = Current Assets : Current Liabilities

Interpretation of Current Ratio:
 Ratio between 1.5 : 1 and 2 : 1 ar egenerally regarded as satisfactory, but it is
important to consider the size and type of the business.
 If the ratio is over 2:1, it indicates poor management of the current assets.

Limitation of short of working capital:

 The business cannot meet immediate liabilities when they are due.
 It may experience difficulties in obtaining further supplier on credit.
 It cannot take advantage of cash discout.
 It cannot take advantage of business opportunities when they arise.
Improvement in Current ratio:
 Introducing of further capital by the owner(s).
 Obtaining long-term loans / non-current liabilities.
 Selling surplus non-current assets.
 Delay in purchaing non-current assets.
 Increase profit for the year.
 Reduce the drawings by the owner(s)
 Reduction ofdividends.
5. LIQUID TEST / ACID TEST RATIO:
Liquid test (acid test / quick current ratio) compares the assets whicha re in the form of
money, or which will covert into money quickly, with the liabilities which are due for
repament in the near future. The calculation is:

Acid test ratio = Current Assets – Inventory : Current Liabilities

While calculating the acid test ratio, the inventory is excluded from current assets
because, it is two stage away from being turned into cash. First the goods have to be sold
on credit and then the money has to be collected from the debtors.

Interpretation of Liquid Test Ratio:

 Ratio between 0.7 : 1 and 1:1 are usually regarded as satifactory. It indicates that
the business has the ability to meet its immediate liabilities without having to sell
its inventory.
 It the ratio is over 1 : 1, it indicates the poor management of liquid assets like
having too much balance in the bank account.

6. RATE OF INVENTORY TURNOVER:

This ratio calculates the number of times a business sells and replaces its inventory in a
given period of time. The rate of inventory turnover varies according to the type of
business. Business selling luxury goods such as expensive jewellery and jet planes
willhave a low rate of inventory tunrover. It is calculated as

For Number of Times the Inventory is replaced:

Rate of Inventory Turnover = Cost of Sales
Average inventory

For Number of Days the Inventory is replaced:

Rate of Inventory Turnover = Average Inventory x 365 days
Cost of Sales

For Average Inventory:

Average Inventory = Closing inventory + Opening Inventoyr
2

Interpretation of Inventory Turnover:

 Increase in rate of inventory turnover indicates that the business has efficiently
maintaining the level of inventory. It means that inventory is effectively being
sold and replaced.
 Decrease in rate of inventory turnover indicates that the business is slowing down,
the inventory may be piled up and not being sold. This could lead to the liquidity
crises.
 The quicker the rate of inventory turnover, the less time funds are tied up in
inventory which is regarded as the least liquid of the current assets.
 The rate of inventory turnover ca affect the profit of the business.
 Causes of Lower rate of inventory turnover:
 Lower sales (resulting in higher inventory levels)
 Inventory over-purchased
 Too high selling prices.
 Falling demand
 Business activity slow down.
 Busines inefficiency.

Improvement in Inventory Turnover:

 Improve the sales.
 Reduce the cost
 Eliminate old inventor.
 Reduce purchase quantity.

7. TRADE RECEIVABLES TURNOVER:

This is also referred to as trade receivables / sales ratio. It measures the average time the
credit customers take to pay their accounts. The answer to this calculation, the length of
time credit customers actually take to pay their accounts should be compared with the
term of credit allowed to them. It can be calculated as:

Trade Receivables Turnover (in days) = Trade Receivables x 365

Credit Sales

Trade Receivables Turnover (in weeks) = Trade Receivables x 52

Credit Sales

Trade Receivables Turnover (in months) = Trade Receivables x 12

Credit Sales

Interpretation of Trade Receivables Turnover:

 In comparision, if the period increases, it may indicate that the credit control
policy is inefficient, or that longer credit terms are being allowed in order to
maintain the quaintity of credit sales.
 If the period decreases, it may indicate that the credit control policy is being
applied more effectively.

Improvement in Trade Receivables Turnover:

 Improving credit control policy.
 Offering cash discounts for early settlements.
 Charging interest on overdue accounts.
 Refusng further supplies until any outstanding debts is paid.

8. TRADE PAYABLES TURNOVER:

This may also be referred to as the trade payables / sales ratio. It measures the average
time taken to pay the accounts of credit suppliers. The answer to this calculation should
be compared with the term of credit allowed by the suppliers. It can be calculated as:

Trade Payables Turnover (in days) = Trade Payables x 365

Credit Purchases
 Trade Payables Turnover (in weeks) = Trade Payables x 52
Credit Purchases

Trade Payables Turnover (in months)= Trade Payables x 12

Credit Purchases

Interpretation of Trade Payables Turnover:

 In comparision, if the period increases, it may indicate that the business is short of
immediate funds and is finding it difficult to meet debts when they fall due.
 If the period decreases, it indicates that the business is paying the suppliers more
quickly.

INTER-FIRM COMPARISON
Likewise comparing the ratios calculated for the current year with those of previous year, a
business also compares the ratio with those of a similar businesses, to measure its p;rogress and
performance. These ratios help indicate the trends in profitability, liquidity and efficiency of the
business with other businesses.

When comparin the ratios of two businesses, a suggestion has to be offered by the condidates on:
 How the difference has occurred?
 What are the consequences of low or high ratios?

PROBLEMS / LIMITATION OF INTER-FIRM COMPARISON:

 The businesses may apply different accounting policies, for example they may use different
methods of depreciation.
 The businesses may apply different operating policies such as renting premises or purchasing
premises, obtaining long-term finance from capital only or using capital and long term-laons.
Such policies will affect both the profit for the year and the statement of financial position.
 Non-monetary items such as the skill of the workforce, the goodwill of the business and so
on do not appear in the accounting records, but are very important in the succes of the
busines.
 It is not always possible to obtain all the information about another business which is needed
to make a true comparison. For example, the inventory shown in the financial statements may
not represent the average amount held during the year; the financial statements do not show
the age of the non-current assets and when they need replacing.
 The information relateing to other businesses may be for one financial year only, so it is not
possible to calculate business trends. That particular year may also not be a typical year.
 The accounts are based on historic cost and do not show the effects of inflation.

USERS OF ACCOUNTING STATEMENTS:

The owner is not only interested in analysing and interpreting the financial statements of an
organisations. Various other people are also interested in different aspects of the accounts. The
users of accounting statements can be divided into two main groups – internal users and external
users.
1- INTERNAL USERS:

 Owner(s):
The owners of the business such as sole trader or partners wil be interested in all aspects
of the business, both profitability and liquidity, in order to assess the business’s
performance and progress.

 Manager(s):
In many small businesses, the owners manage the business. In some cases, management
may be carried out by an employee. Like the owners, managers are interested in all
aspects of the business. Tehey may use ratios to assess past performance, plan for the
future and take remedial action where necessary.

2- EXTERNAL USERS:

 Bank Manager:
If a business requests a bank loan or an overdraft facility the bank manager will require
the finanial statements of the business. The bank manager will need to know whether
there is adequate security to cover the amount of the loan or overdraft.

 Other Lenders:
Anyone who has made a loan to a business (and any potential lenders) will be interested
in the security available, the repayment of the loan when due and the payment of
interested when due.

 Trade Payables:
Anyone who has supplied a business with goods on credit terms (and any potential credit
suppliers) is interested in the liquidity position and the trade payables turnover. These
factors may be considered when determining the credit limit and the lingth of credit
allowed.

 Potential Buyers of the Business:

Anyone with an interest in purchasing the business or making a turnover bid will be
interested in the profitability of the business and the market value of the assets of the
business.

 Customers:
Customers of the business are interested in ensuring the continuity of supplies.

 Employees and Trade Union:

Employees and trade union want to know that the company is able to continue operating,
and so maintain jobs and continue to pay adequate wages.

 Government Departments:
Government departments may want information for purposes such as compiling business
statistics and checking that the correct amount of tax is being paid.
  Club Members:
The members of the club or society want to know that the club is being well-managed
financially so that it will be able to continue in existence and provide the facilities to
members.

LIMITATIONS OF ACCOUNTING STATEMENTS:

Accounting statements and the ratios calculated from them provide valuable information about a
business. They do, however, have limitations and are not able to provide a complete picture of
the performance and position of a business. The limitations include the following:

 Time Factor:
The accounting statements are a record of what has happened in the past, not a guide to
the future. Additionally, there is a gap between the end of the financial year and the
preparation of the accounting statements. In that time significant events such as changes
in inventory levels and purchasing of non-current assets may have taken place.

 Historical Cost:
The only way to record financial transactions is to use the actual cost price. However,
comparing transactions taking place at different times can be difficult because of the
effect of inflation.

 Accounting Policies:
All businesses should apply the accounting principles of prudence and consistency which
should help in making comparisons. However, there are several acceptable accounting
policies which may be applied, for example there are several different methods of
calculating depreciation. Where businesses have used different accounting policies it is
difficult to make a meaningful comparison of their results. Similarly, where a busines
changes its policy, a comparison with the results of previous years is difficult.

 Different Definitions:
Where a business has borrowed money, for examole in the form of loans or debentures,
the income statement may show the profit from operations and then deduct the finance
costs to give the profit for the year. Another business may not show this distinction.
Businesses may use a different definition of profit when calculating profitbility ratios.