Interpretation of Accounting Ratios (Copy)
Comparing Results Over Time
- Prepare comparative statements using ratios for different years to identify trends.
- Helps assess if profitability, efficiency, and liquidity are improving or worsening.
- Format for comparison:
| Ratio | Year 1 | Year 2 | % Change |
|---|---|---|---|
| Gross Margin (%) | 40% | 35% | ↓ 5% |
| Net Profit Margin (%) | 18% | 10% | ↓ 8% |
| ROCE (%) | 25% | 16% | ↓ 9% |
| Current Ratio | 2.0:1 | 1.4:1 | ↓ Liquidity |
- Example Insight: Falling profit margins and ROCE indicate increased costs or declining sales; liquidity fall shows working capital strain.
Recommendations to Improve Profitability
- Increase selling prices if market allows.
- Reduce cost of sales by finding cheaper suppliers or better inventory management.
- Reduce operating expenses such as rent, utilities, and salaries.
- Increase productivity or output without increasing costs.
Recommendations to Improve Working Capital
- Improve receivables collection: Offer early payment discounts, reduce credit period.
- Control inventory: Use just-in-time (JIT) or faster turnover strategies.
- Delay payments to suppliers: If terms allow, extend trade credit.
- Reduce unnecessary expenses: Lower fixed and variable costs.
Gross Margin vs. Profit Margin
- Gross Margin: Measures profitability before operating expenses.
- Profit Margin: Measures profitability after all expenses.
| Observation | Interpretation |
|---|---|
| Large difference between gross and profit margins | High operating costs (e.g. rent, admin) |
| Small difference | Efficient cost control, low overheads |
- Efficiency Insight: The greater the gap, the less efficient the business is at controlling expenses after COGS.
Effects of Key Factors on Profitability
| Factor | Relationship / Impact on GP & NP |
|---|---|
| Inventory Valuation | Overstated → GP & NP artificially high; Understated → Lower profit |
| Inventory Turnover | Low turnover → High storage cost, risk of obsolete stock |
| Revenue (Sales) | Increased sales → Potentially higher GP and NP |
| Expenses | Higher expenses → Lower Net Profit and ROCE |
| Equity (Capital) | More capital → May reduce ROCE if profit does not grow |
Example Interpretation:
- Scenario:
Gross Margin = 40%
Profit Margin = 15%
→ 25% of revenue is consumed by expenses (rent, wages, depreciation) - Inventory Turnover = 2 times/year
→ Low turnover indicates inefficient stock management - Current Ratio dropped from 2.0 to 1.2
→ Less liquid, higher risk of cash flow shortages