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Ratios & What They Measure

Interpretation of Financial Statements


Nicola Pennygar

PROFITABILITY

Measure

Calculation

Details

Gross Profit %

Gross Profit/Revenue x 100

This % should be similar from year to year. A significant


change, particularly a drop should trigger investigation into
buying & selling prices.
An increase is an improvement, a decrease is a deterioration

Expense/Revenue %

Specified Expense/Revenue x 100

A large expense or overhead item can be expressed as % of


revenue, eg if Marketing is calculated at 10% last year and now
works out at 20%, it could show that increased spend on
marketing didnt generate any increased revenue. An increase
is a deterioration, a decrease is an improvement.

Operating Profit %

AAT Level 4 (Tech)


Interpretation of Financial Statements

As with Gross Profit % this is usually similar from year to year.


An increase each year indicates that that overheads etc are
being kept under control and that the business is generating
more profit from its revenue. Any decrease should be
investigated as maybe a particular expense might have
increased. The movement in % from Gross Profit % should be
similar, if not, a scenario like the one described for
Expense/Revenue % might have occurred. An increase is an
improvement, a decease is a deterioration

Ratios & What They Measure

Ratios & What They Measure


Interpretation of Financial Statements
Nicola Pennygar

Return on Capital
Employed (ROCE)

Profit from Operations/Total Equity


+ Non-Current Liabilities x 100

This measures the relationship between profits & equity + non


current liabilities and compares it to the return that you might
have got from a bank, had you invested your money in a bank
not a business. So a person setting up a business, investing a
sum of money in that business and the profit is the return
achieved on his investment. It should be higher than the return
from a bank for example because of the extra risks involved. An
increase shows that the business is generating more profit from
the available capital than before. An increase is an
improvement, a decrease is a deterioration

Return on Shareholders
Funds

Profit after Tax/Total Equity x 100

This ratio provides important information to shareholders as it


shows the return that the company is making from their funds.
They may decide to move if they get a better return elsewhere.
An increase is an improvement, a decrease is a deterioration

AAT Level 4 (Tech)


Interpretation of Financial Statements

Ratios & What They Measure

Ratios & What They Measure


Interpretation of Financial Statements
Nicola Pennygar

LIQUIDITY

Measure

Calculation

Details

Current Ratio
(sometimes called working
capital ratio)

Current Assets/Current Liabilities


= ??? : 1

This uses figures from the SFP to measure the relationship


between current assets & current liabilities. It is thought that an
acceptable ratio is about1.5:1 or 2:1 eg 2 of current assets to
every 1 of current liabilities though some cash businesses can
operate on less as it doesnt have as many Trade Receivables.
If the ratio is too high, investigation is needed, it maybe you
have too much stock, too many trade receivables etc

Acid Test Ratio

Current Assets-Inventories/Current
Liabilities = ??? : 1

This ratio again uses figures from SFP without inventories for a
comparison between trade receivables and cash to current
liabilities. No less than 1 : 1. that is 1 of liquid assets to every
1 of current liabilities. (Liquid assets can be turned into cash
quickly) If a lower result than 1:1 this may mean that the
business would have trouble meeting its trade payables.

AAT Level 4 (Tech)


Interpretation of Financial Statements

Ratios & What They Measure

Ratios & What They Measure


Interpretation of Financial Statements
Nicola Pennygar

USE OF RESOURCES

Measure

Calculation

Details

Inventory Holding Period

Inventories/Cost of Sales x 365


days

This calculation shows, on average, the number of days that


inventories are held. The lower the amount of days the better
but varies from different types of business. (No good for service
businesses)

Inventory Turnover (times


per year)

Cost of Sales/Inventories

This calculation gives you the number of times that Inventories


were turned over in a year. The higher the better (No good for
service businesses)

Trade Receivables
Collection Period

Trade Receivables/Revenue x 365


days

This indicator will show, on average, how many days it takes a


customer to pay for goods/services. Most businesses have
payment terms of 30 days. A figure close to payment terms
shows good credit control

Trade Payables Payment


Period

Trade Payables/Cost of Sales x


365

This shows how long on average your company is taking make


payments to suppliers. Being as long as possible is not
necessarily a good thing as it may cause problems with future
suppliers etc. Being too short generally isnt good for cash flow

AAT Level 4 (Tech)


Interpretation of Financial Statements

Ratios & What They Measure

Ratios & What They Measure


Interpretation of Financial Statements
Nicola Pennygar

Working Capital Cycle

Inventory Days + Receivable days


Payable Days

Asset Turnover(total asset)


Ratio

Revenue/ Non current Assets =


how many times

Asset Turnover(net Assets)


Ratio

Revenue/Total Assets-Current
Liabilities = how many times

AAT Level 4 (Tech)


Interpretation of Financial Statements

Measures the time between goods received into stock and the
collection of payment from customers in respect of the sale. If
the time has reduced it is a better position. If the time has
increased it is a worse position
Both this ratio and the one below measure efficient use of
assets in generating revenue. An increase from one year to the
next indicates greater efficiency. A falling result might be caused
by a drop in revenue or an increase in assets. You may have
increased stock or more trade receivables because of poor
credit control, so an increase is an improvement, a
decrease is a deterioration
See above

Ratios & What They Measure

Ratios & What They Measure


Interpretation of Financial Statements
Nicola Pennygar

FINANCIAL POSITION
Measure

Calculation

Details

Interest Cover

Profit from Operations/Finance


Costs = how many times

This gives an indication of the safety margin of profit over the


finance costs. Eg If the Profit from Ops was 10,000 and the
finance Costs were 5,000, this would give interest cover of 2
times. (quite low) Ten times is better showing that the profit from
Ops can cover the finance costs, so an increase is an
improvement, a decrease is a deterioration

Gearing

Non-Current Liabilities/Total Equity


+ Non-Current Liabilities x 100

This ratio gives a picture of longer term financial stability. It


measures how much the company is financed by debentures &
loans. The higher the gearing % the less secure the company
will be. Debt is very expensive in finance costs. It is thought
that most investors or lenders would not want to see a gearing
% of more than 50%. A high gearing % may also mean that the
business will find it difficult to attract further financing. So an
increase is a deterioration, a decrease is an improvement

AAT Level 4 (Tech)


Interpretation of Financial Statements

Ratios & What They Measure

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