Flashcards · 7707 · Topic 6

Analysis and interpretation flashcards

28 cards on Topic 6, subtopics 6.1 to 6.5. Pick a subtopic or study them all.

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6.1 Calculation and understanding of accounting ratios

Gross profit margin, mark-up and profit margin: Gross profit margin = gross profit ÷ revenue × 100. Mark-up = gross profit ÷ cost of sales × 100. Profit margin = profit for the year ÷ revenue × 100.
Return on capital employed (ROCE): Profit for the year before interest ÷ capital employed × 100. Capital employed = issued shares + reserves + non-current liabilities.
Current ratio and acid test (liquid) ratio: Current ratio = current assets : current liabilities. Acid test = (current assets − inventory) : current liabilities. Both are written as x : 1, never as a percentage.
Current assets $51,000 including inventory $21,000; current liabilities $30,000. Current ratio and acid test?: Current ratio 51,000 : 30,000 = 1.70 : 1. Acid test 30,000 : 30,000 = 1.00 : 1.
Rate of inventory turnover and inventory turnover in days: Rate = cost of sales ÷ average inventory (times). Days = average inventory ÷ cost of sales × 365. Average inventory = (opening + closing) ÷ 2.
Inventory $12,000 opening, $18,000 closing; cost of sales $90,000. Rate of inventory turnover and days?: Average inventory 15,000. 90,000 ÷ 15,000 = 6.00 times. 15,000 ÷ 90,000 × 365 = 60.83 days.
Trade receivables turnover and trade payables turnover: Trade receivables ÷ credit sales × 365 (days). Trade payables ÷ credit purchases × 365 (days).
Profit $31,500 after debenture interest of $4,500; shares $120,000, reserves $60,000, debentures $50,000. ROCE?: Capital employed 230,000. (31,500 + 4,500) ÷ 230,000 × 100 = 15.65%.

6.2 Interpretation of accounting ratios

The gross profit margin falls. Possible causes?: Lower selling prices, dearer purchases, or an overvalued opening or undervalued closing inventory.
Profit margin falls while the gross profit margin is steady. Why?: Expenses or interest have risen, or other income has fallen.
Trade receivables days rise above the credit period allowed. Meaning and action?: Customers are paying later, so cash is tied up. Send statements and reminders promptly, offer cash discount for early payment, check credit before selling.
A margin falls from 40.00% to 35.00%. How should the change be described?: A fall of 5.00 percentage points (not 5.00%).
Why can a business have less cash than its profit?: Non-current assets bought, inventory or receivables increased, drawings or dividends paid, a loan repaid. Profit matches income and expenses to the year; cash records money moving.
Why can cash be higher than profit?: Depreciation uses no cash; payables increased; capital introduced or a loan received; inventory or receivables decreased.

6.3 Inter-business comparison

Problems of inter-business comparison: Missing detail (credit figures, opening inventory); different accounting policies; different year ends; businesses not really alike; one unusual year; non-financial aspects left out.
A business makes mostly cash sales. Which ratio does this affect?: Trade receivables turnover: very few days. It reflects the type of business, not better credit control.
A business finances itself with debentures. Effect on ROCE compared with a rival?: Capital employed is larger (it includes non-current liabilities), so ROCE tends to be lower for the same profit before interest.
Two businesses buy and sell the same goods, but value closing inventory at $20,000 and $17,000. Effect on comparison?: The lower valuation raises cost of sales and lowers gross profit by $3,000, so the gross profit margins differ (e.g. 37.50% against 36.00% on revenue of $200,000) from policy alone.
Method for an inter-business comparison answer: Quote the ratio for each business; say which looks stronger; give a factor other than management that could explain the gap; state one problem that limits the conclusion.

6.4 Interested parties

What do owners and managers want from accounting statements?: Owners: is my money earning enough? (profit, ROCE). Managers: where do I act? (margins, expenses, inventory and receivables days).
What do banks and other lenders look at?: Whether the loan and interest will be repaid: current ratio, acid test, profit, existing loans and assets.
What do suppliers and customers want to know?: Suppliers: will we be paid on time? (liquidity, payables days). Customers: will the business still be trading? (profit, liquidity).
Investors compared with lenders: Investors share the risk and look for growth and dividends (profit trend, ROCE). Lenders want interest paid and the loan repaid (liquidity).
Employees, governments and club members as users: Employees: job security and pay (profit trend, liquidity). Governments: tax, grants and statistics (profit). Club members: did subscriptions cover costs? (surplus or deficit).

6.5 Limitations of accounting statements

Historic cost as a limitation: Assets are shown at their original cost, not current value, and money from different years is not comparable. Example: land bought long ago is now worth far more than its cost.
Application of accounting policies as a limitation: Estimates and choices, such as the depreciation method, inventory valuation or the size of the allowance for irrecoverable debts, change profit and asset values.
Non-financial aspects as a limitation: Things not measured in money do not appear: workforce skill, business location, the economic climate. A business with strong statements can still fail because of them.
A $30,000 machine (no residual value): A uses straight-line over 5 years, B 30% reducing balance. First-year difference in profit?: A charges 6,000; B charges 9,000. B’s profit is $3,000 lower from the policy choice alone.