prepare and comment on simple statements showing comparison of results for different years

Resources | Subject Notes | Accounting

IGCSE Accounting 0452 - 6.2 Interpretation of Accounting Ratios

Objective

Prepare and comment on simple statements showing comparison of results for different years.

Introduction

Accounting ratios are powerful tools for analyzing a company's financial performance and position. By comparing ratios over different periods, we can identify trends, assess improvements or deteriorations, and make informed judgments about the company's health.

Key Ratios and Their Interpretation

Profitability Ratios

These ratios measure how well a company generates profit from its operations.

  • Gross Profit Ratio: $$ \frac{Gross \ Profit}{Revenue} \times 100 $$

    Indicates the percentage of revenue remaining after deducting the cost of goods sold. A higher ratio is generally better.

  • Net Profit Ratio: $$ \frac{Net \ Profit}{Revenue} \times 100 $$

    Shows the percentage of revenue that translates into net profit after all expenses are deducted. A higher ratio is desirable.

  • Return on Capital Employed (ROCE): $$ \frac{Net \ Profit}{Capital \ Employed} \times 100 $$

    Measures how effectively a company uses its capital to generate profit. Capital employed typically includes total assets less current liabilities.

Liquidity Ratios

These ratios assess a company's ability to meet its short-term obligations.

  • Current Ratio: $$ \frac{Current \ Assets}{Current \ Liabilities} $$

    Indicates whether a company has enough liquid assets to cover its short-term liabilities. A ratio greater than 1 is generally considered healthy.

  • Quick Ratio (Acid Test Ratio): $$ \frac{Current \ Assets - Inventory}{Current \ Liabilities} $$

    A more stringent measure of liquidity, excluding inventory which may not be easily converted to cash. A ratio greater than 1 is preferred.

Solvency Ratios

These ratios evaluate a company's ability to meet its long-term obligations.

  • Debt-to-Equity Ratio: $$ \frac{Total \ Debt}{Total \ Equity} $$

    Shows the proportion of debt and equity used to finance a company's assets. A lower ratio generally indicates less financial risk.

Activity Ratios (Efficiency Ratios)

These ratios measure how efficiently a company uses its assets.

  • Inventory Turnover Ratio: $$ \frac{Cost \ of \ Goods \ Sold}{Average \ Inventory} $$

    Indicates how many times a company sells and replaces its inventory during a period. A higher ratio suggests efficient inventory management.

  • Receivables Turnover Ratio: $$ \frac{Revenue}{Average \ Accounts \ Receivable} $$

    Measures how quickly a company collects its debts from customers. A higher ratio is generally better.

Example: Comparing Financial Results Over Two Years

The following table shows a simplified comparison of a company's financial results for the years 2022 and 2023.

Ratio 2022 2023 Change
Net Profit Ratio 5.0% 6.0% +1.0%
Current Ratio 1.8 2.1 +0.3
Debt-to-Equity Ratio 0.8 0.9 +0.1
Inventory Turnover Ratio 8.0 7.5 -0.5

Interpretation of the Example

In the example above, we can observe the following:

  • The Net Profit Ratio has increased from 5.0% to 6.0%, indicating improved profitability.
  • The Current Ratio has increased from 1.8 to 2.1, suggesting improved short-term liquidity.
  • The Debt-to-Equity Ratio has increased slightly from 0.8 to 0.9, indicating a slightly higher level of financial risk.
  • The Inventory Turnover Ratio has decreased from 8.0 to 7.5, suggesting less efficient inventory management in 2023. This could be due to various factors like increased stock levels or slower sales.

Conclusion

By comparing accounting ratios over different periods, we can gain valuable insights into a company's financial performance and identify areas of improvement or concern. It's important to consider ratios in context and compare them to industry averages for a more meaningful analysis.