Interpretation of Accounting Ratios
Calculating a ratio is only the first step. In an exam answer, the important skill is to interpret whether performance or financial position has improved or worsened, compare the ratio with useful information, explain the meaning, and suggest a possible cause or action.
Topic 1: Why Ratio Interpretation Matters
Ratios become useful when they are compared, explained and linked to possible business causes.
1. Why Interpret Accounting Ratios?
Accounting ratios must be interpreted to decide whether the performance or financial position of a business has improved or worsened. Absolute figures on their own can sometimes be misleading.
Example: Working capital can hide a liquidity problem
2. What Should Ratios Be Compared With?
A ratio becomes much more useful when compared with:
- The same business in a previous year.
- Another similar business in the same industry.
- Budgeted or forecast ratios.
Weak answer
Gross margin = 40%.
Better interpretation
Gross margin increased from 35% to 40%, so the business is earning $5 more gross profit for every $100 of sales.
Topic 2: Profitability Ratios
Profitability ratios help judge how successfully the business earns profit from sales and capital.
3. Profitability Ratios
The chapter identifies three important profitability ratios:
Gross margin
Focuses on gross profit earned from sales.
Profit margin
Focuses on profit for the year earned from sales.
ROCE
Focuses on the return earned from capital employed.
4. Interpreting Gross Margin
A higher gross margin means the business is making more gross profit from every $100 of sales.
2018 gross margin = 50%
2019 gross margin = 60%
The business now earns $60 gross profit per $100 sales instead of $50 per $100 sales. Therefore, gross margin has improved.
5. Why Might Gross Margin Fall?
- Supplier prices have increased.
- Selling prices have been reduced.
- More trade discounts or promotions are being offered.
- Packaging or carriage costs have increased.
- Higher costs have not been passed on to customers.
- Increased competition has forced selling prices down.
6. Improving Gross Margin
Reduce cost of sales
- Find cheaper suppliers.
- Negotiate bulk discounts.
- Reduce carriage inwards.
Increase selling price
If costs remain unchanged, a higher selling price can increase gross margin.
Improve inventory management
Avoid excessive inventory which may deteriorate, become outdated, go out of fashion, or be damaged or stolen.
7. Interpreting Profit Margin
Profit margin considers not only cost of sales but also the business’s expenses.
2018 profit margin = 30%
2019 profit margin = 33.33%
For every $100 of sales, 2018 profit was $30 and 2019 profit was $33.33. Therefore, profitability has improved.
8. Improving Profit Margin
Because profit margin is affected by expenses, a business may improve it by:
- Reducing waste.
- Reducing electricity and power usage.
- Training workers to become more efficient.
- Moving to cheaper or smaller premises.
- Reducing unnecessary staffing costs.
- Outsourcing some work.
- Using lower-cost marketing methods.
9. Gross Margin vs Profit Margin
The difference between gross margin and profit margin provides information about expense control.
Gross margin = 50%
Profit margin = 30%
Difference = 50% − 30% = 20%
This suggests that expenses amount to approximately 20% of sales, assuming there is no other income.
10. Interpreting ROCE
ROCE measures how effectively the business uses its capital.
2018 ROCE = 25.24%
2019 ROCE = approximately 20.22%
Although profit may have increased, ROCE has fallen because much more capital is being employed. The business is getting a lower return from every $100 invested.
Topic 3: Liquidity Ratios and Cash Position
Liquidity ratios judge whether the business can pay short-term debts when they fall due.
11. Interpreting the Current Ratio
The current ratio measures the ability of the business to meet its current liabilities.
2018 = 2.4 : 1
2019 = 2 : 1
Although the ratio has fallen slightly, the textbook considers approximately 1.5 : 1 to 2 : 1 desirable for many businesses. Therefore, a movement closer to this range may actually represent an improvement.
12. Interpreting the Liquid Ratio
A fall in the liquid ratio means the business has fewer liquid assets available to meet current liabilities.
2018 = 1.4 : 1
2019 = 0.63 : 1
This is a significant deterioration in liquidity and may indicate a liquidity crisis. The textbook uses approximately 1 : 1 as a desirable liquid ratio.
13. Improving Working Capital and Cash Position
Improve working capital
- Owner introduces more capital.
- Reduce drawings.
- Obtain a long-term loan.
- Sell surplus non-current assets.
Improve cash
- Increase cash sales.
- Reduce credit sales.
- Shorten the credit period allowed to customers.
- Delay payment to trade payables.
Topic 4: Efficiency Ratios
Efficiency ratios show how quickly inventory moves, customers pay and suppliers are paid.
14. Interpreting Trade Receivables Turnover
Trade receivables turnover shows how long customers take to pay.
2018 = 30 days
2019 = 34 days
Customers are taking 4 days longer to pay. Therefore, the ratio has worsened slightly.
A high number of days may mean
- Customers are paying slowly.
- Credit control is weak.
- Too much money is tied up in trade receivables.
To improve it
- Chase customers more quickly.
- Reduce credit periods.
- Improve credit control.
- Encourage prompt payment.
15. Interpreting Trade Payables Turnover
Trade payables turnover shows how long the business takes to pay suppliers.
2018 = 61 days
2019 = 69 days
The business now takes about 8 days longer to pay its suppliers. This may suggest worsening liquidity or inefficient payment management.
16. Interpreting Inventory Turnover
Inventory turnover measures how quickly inventory is sold and replaced.
2018 = 7.4 times
2019 = 4 times
The business is now selling and replacing its inventory much more slowly. This is generally a deterioration.
- Goods may not be selling.
- Too much inventory may be held.
- Cash may be tied up in inventory.
- Inventory may become obsolete or damaged.
Topic 5: Relationships That Change Ratios
Some accounting figures directly affect profitability and efficiency ratios.
17. Relationship Between Inventory and Profit
Closing inventory affects cost of sales, gross profit, gross margin, profit for the year, profit margin and inventory turnover.
If closing inventory is undervalued
Closing inventory too low → cost of sales too high.
- Gross profit understated.
- Gross margin understated.
- Profit for the year understated.
- Profit margin understated.
If closing inventory is overvalued
The opposite occurs.
- Cost of sales understated.
- Gross profit overstated.
- Gross margin overstated.
- Profit overstated.
- Profit margin overstated.
18. Numerical Inventory Example
The textbook compares three possible closing inventory values to show how an incorrect inventory value can distort the ratios used to judge performance.
| Closing inventory | Gross profit | Gross margin | Profit | Profit margin |
|---|---|---|---|---|
| $4,000 – undervalued | $3,500 | 35% | $1,000 | 10% |
| $4,500 – correct | $4,000 | 40% | $1,500 | 15% |
| $5,000 – overvalued | $4,500 | 45% | $2,000 | 20% |
19. Relationship Between Sales Revenue and Profit
If sales revenue is recorded incorrectly, then gross profit, profit for the year, gross margin and profit margin will also be incorrect.
20. Relationship Between Expenses and Profit
If expenses increase while everything else stays the same, profit for the year decreases and profit margin decreases. Gross margin may remain unchanged because gross margin is calculated before other expenses are deducted.
Suppose gross margin remains 50%.
Profit margin changes from 16% in 2018 to 20% in 2019.
If sales remain constant, the improvement in profit margin indicates that expenses have decreased.
21. Relationship Between Profit and Owner’s Equity
Profit increases owner’s equity, while a loss decreases owner’s equity.
Higher profit leads to higher owner’s equity, all else being equal. ROCE then compares profit before interest with the amount of capital employed.
Topic 6: How to Answer an Interpretation Question
Strong answers compare, explain and give a sensible cause or action.
22. How to Answer an Interpretation Question
A good exam answer should normally do three things:
- State the change. Example: Gross margin fell from 40% to 32%.
- Explain what it means. The business now earns only $32 gross profit for every $100 of sales compared with $40 previously.
- Suggest a possible reason or action. This could have resulted from higher purchase costs or lower selling prices. The business could negotiate lower prices with suppliers.
Quick Interpretation Guide
| Ratio | Usually better when... | Possible problem |
|---|---|---|
| Gross margin | Higher | Cost of sales rising |
| Profit margin | Higher | Expenses rising |
| ROCE | Higher | Capital used inefficiently |
| Current ratio | Around suitable industry level | Liquidity problem or excess current assets |
| Liquid ratio | Around suitable industry level | Insufficient liquid assets |
| Inventory turnover | Higher | Slow-moving inventory |
| Receivables days | Lower | Customers paying slowly |
| Payables days | Within supplier credit period | Business paying suppliers late |
Remember
Gross margin falls → investigate selling price and cost of sales.
Profit margin falls → investigate gross profit and expenses.
ROCE falls → capital may not be generating enough profit.
Current ratio or liquid ratio falls → possible difficulty paying short-term debts.
Receivables days ↑ → customers slower to pay.
Payables days ↑ → business slower to pay suppliers.
Inventory turnover ↓ → inventory selling more slowly.