Edexcel A-Level Accounting: Analysis of accounting statements (YAC11) – Revision Notes

These notes condense topic 1.5, Analysis of accounting statements, from Unit 1 of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018. They cover outcomes 1.5.1 to 1.5.3, which are Unit 1 (International AS) content and count towards both the International AS and the full International A Level. For full explanations and worked examples, use the study guide.

Then test yourself with the practice questions. Course links: Edexcel A-Level Accounting hub, printable checklist and the free 10-minute diagnostics.

The ten ratios (1.5.1)

The specification states that these formulae will not be supplied in the examinations.

Ratio	Formula	Answer as
Gross profit as a % of revenue	Gross profit / Revenue × 100	%
Percentage mark-up	Gross profit / Cost of sales × 100	%
Profit for the year as a % of revenue	Profit for the year / Revenue × 100	%
ROCE	NPBI / Capital employed × 100	%
Non-current assets to revenue	Revenue / Non-current assets	times
Inventory turnover	Cost of sales / Average inventory	times
Current ratio	Current assets / Current liabilities	x : 1
Liquid (acid test) ratio	(Current assets − Inventory) / Current liabilities	x : 1
Trade payables payment period	Trade payables / Credit purchases × 365	days
Trade receivables collection period	Trade receivables / Credit sales × 365	days

Definitions to recall

• NPBI (net profit before interest) = profit for the year + loan interest.
• Capital employed (sole trader or partnership) = capital + non-current liabilities.
• Partnership capital = capital accounts + current accounts (deduct a debit current account).
• Average inventory = (opening + closing) / 2.
• Liquid assets = current assets − inventory.

The company version of ROCE (issued shares + reserves + non-current liabilities) and the investment ratios are Unit 2 (A2) only.

Which group does each ratio tell you about? (1.5.2)

Group	Ratios	Question it answers
Profitability	GP %, mark-up, profit for the year %, ROCE	Is the business earning enough on its sales and its funds?
Liquidity	current, liquid, inventory turnover, payables period, receivables period	Can it pay its debts as they fall due, and how fast does working capital turn into cash?
Use of assets	non-current assets to revenue	How much revenue do the long-term assets generate?

Method boxes

Appraising a set of ratios

1. Calculate every ratio asked for, with the formula and figures shown.
2. Compare: previous year, similar business, industry figure or the owner’s target.
3. State the direction and size of each change (“fell by 4 percentage points”).
4. Give a likely cause from the scenario (price cut, new machinery, looser credit terms).
5. Give the effect (less cash, higher risk of irrecoverable debts, lower return).
6. Link ratios: a falling profit % with a steady GP % points to expenses.
7. Finish with a supported judgement or recommendation if the command word is Evaluate or Recommend.

Making a projection (1.5.3)

1. Forecast revenue (apply the growth rate).
2. Gross profit = revenue × target margin; cost of sales = revenue − gross profit.
3. Average inventory = cost of sales / target turnover.
4. Closing inventory = 2 × average − opening inventory.
5. Purchases = cost of sales + closing inventory − opening inventory.
6. Trade receivables = credit sales × days / 365; trade payables = credit purchases × days / 365.
7. Comment on whether the assumptions are realistic.

Margin and mark-up conversion

margin  = mark-up / (100 + mark-up) x 100
mark-up = margin  / (100 - margin)  x 100

A mark-up of 100% means a margin of 50%. The margin is always the smaller figure.

Small worked reminders

Partnership ROCE. Capital accounts 60,000 and 45,000; current accounts 3,000 credit and 1,500 debit; bank loan 20,000. Profit for the year is 19,200 after loan interest of 1,200.

Capital employed = 60,000 + 45,000 + 3,000 - 1,500 + 20,000 = 126,500
NPBI             = 19,200 + 1,200                          = 20,400
ROCE             = 20,400 / 126,500 x 100                  = 16.13%

Projected trade payables. Forecast credit purchases are 182,500 and the target payment period is 40 days: 182,500 × 40 / 365 = 20,000.

Reading ratios together

What you see	Likely cause	Effect to mention
GP % down, mark-up down	Lower selling prices or dearer purchases	Less gross profit per dollar of sales
GP % steady, profit for the year % down	Expenses growing faster than revenue	Look for the expense that rose
ROCE down, profit steady	More capital or a new loan not yet earning	Owner may earn more by investing elsewhere
Non-current assets to revenue down	New non-current assets, or revenue falling	Assets not yet earning their keep
Inventory turnover down	Over-buying, slow-moving or obsolete lines	Cash tied up; storage and obsolescence costs
Receivables period up	Looser credit control or longer terms to win sales	Slower cash inflow; irrecoverable debt risk
Payables period up	Delaying payment to conserve cash	Lost cash discounts; suppliers may refuse credit
Current ratio up but liquid ratio flat	Build-up of inventory	Liquidity looks better than it is

Limits of ratio appraisal

• The statement of financial position shows one date; year-end balances may not be typical.
• Businesses may use different inventory valuation or depreciation methods, so inter-firm figures may not compare like with like.
• Inflation distorts comparisons across years.
• Ratios ignore non-financial factors such as staff skills, location or customer loyalty.
• A projection depends entirely on its assumptions.

Must-know distinctions

• Margin vs mark-up. Same gross profit; margin divides by revenue, mark-up by cost of sales.
• Current vs liquid ratio. The liquid ratio removes inventory because it must be sold, and often collected from customers, before it becomes cash.
• Profit for the year vs NPBI. ROCE uses NPBI so that the return matches capital employed, which includes the loan.
• Expense vs appropriation. In a partnership, salaries, interest on capital and profit shares are appropriations. They are not deducted when you measure profitability.
• Credit sales vs revenue. The collection period uses credit sales; cash sales never create a receivable.
• Times vs days. Inventory turnover and non-current assets to revenue are “times”; the two payment periods are “days”.
• High is not always good. A high current ratio can mean idle cash, slow inventory or slow customers. A long payables period helps cash but risks supplier goodwill.

Quick self-test

1. Revenue 250,000, cost of sales 175,000. Calculate the gross margin and the mark-up.
2. A trader’s mark-up is 60%. What is the gross margin?
3. A trader’s gross margin is 20%. What is the mark-up?
4. Opening inventory 18,000, closing inventory 22,000, cost of sales 160,000. Calculate inventory turnover.
5. Current assets 54,000 (inventory 21,000), current liabilities 30,000. Calculate both liquidity ratios.
6. Trade receivables 15,600, credit sales 189,800. Calculate the collection period.
7. Trade payables 11,680, credit purchases 146,000. Calculate the payment period.
8. A sole trader’s profit for the year is 31,000 after loan interest of 2,000. Capital is 150,000 and the loan (non-current) is 25,000. Calculate ROCE.
9. Revenue 360,000, non-current assets 144,000. Calculate non-current assets to revenue.
10. Profit for the year 27,000 on revenue 300,000; the gross margin is unchanged from last year but the profit percentage was 11% last year. What has happened?
11. Next year’s revenue is forecast at 400,000 with a gross margin of 25%. Target inventory turnover is 6 times and opening inventory is 46,000. Find closing inventory.

Answers

1. Gross profit 75,000. Margin = 75,000 / 250,000 × 100 = 30.00%. Mark-up = 75,000 / 175,000 × 100 = 42.86%.
2. 60 / 160 × 100 = 37.50%.
3. 20 / 80 × 100 = 25.00%.
4. Average inventory 20,000; 160,000 / 20,000 = 8 times.
5. Current = 54,000 / 30,000 = 1.80 : 1. Liquid = 33,000 / 30,000 = 1.10 : 1.
6. 15,600 / 189,800 × 365 = 30 days.
7. 11,680 / 146,000 × 365 = 29.2 days.
8. NPBI 33,000; capital employed 175,000; ROCE = 18.86%.
9. 360,000 / 144,000 = 2.5 times.
10. Profit for the year is 9.00% of revenue, down from 11%. With gross margin steady, expenses have risen as a share of revenue.
11. Cost of sales 300,000; average inventory 300,000 / 6 = 50,000; closing inventory = 100,000 − 46,000 = 54,000.

Where marks are usually lost

• Using revenue, not cost of sales, as the base for mark-up and inventory turnover.
• Using closing inventory alone instead of the average.
• Forgetting to add loan interest back to reach NPBI.
• Including current liabilities in capital employed, or leaving out the non-current loan.
• Deducting a partner’s salary or interest on capital before finding ROCE.
• Ignoring a debit balance on a partner’s current account.
• Using total revenue for the collection period when credit sales are given.
• Missing the format: “x : 1” for liquidity, “times” for turnover, “days” for periods.
• Commenting with “better” or “worse” and no cause or effect from the scenario.
• In projections, taking the forecast closing inventory as the opening figure.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018, first teaching September 2015, published by Pearson Education Limited. Unit 1, topic 1.5 Analysis of accounting statements, and Appendix 7: Formulae.