0452 · 6.2Interpretation of accounting ratios

Comparing profits across years

0:00Nisha Outdoor Supplies sells more goods this year, yet less money remains after its running costs. Customers also take longer to pay, so meeting payments becomes harder. This video covers comparisons between years, interpretation of ratios, and improvements to profitability, liquidity and working capital. We will also examine changes in inventory valuation, prices and quantities, and the reasons for the difference between cash and profit. Analysis examines the figures in detail, while interpretation explains their significance.

0:30An accounting ratio expresses the relationship between two accounting figures, so it can reveal changes that totals alone conceal. Start by identifying what changed, then explain what that change suggests. Finally, propose an action that addresses the particular cause, while recognising its possible disadvantage. Revenue is the income a business earns from its main activity, such as selling goods or providing services. Nisha earns hers by selling tents, boots and other outdoor goods.

0:58Expenses are the costs used up in running the business and earning revenue during a period. Comparing these amounts shows whether increased sales have actually improved performance. A larger business can produce more sales income but retain a smaller proportion after its costs. Inventory means goods held for resale, while cost of sales is the cost of inventory sold during a period. For Nisha, this is mainly the purchase price of the goods her customers buy.

1:23Gross profit is revenue minus cost of sales. This amount must help cover the other expenses of running the business. A change in purchasing prices can therefore affect the amount available before rent or advertising is considered. Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date. Nisha prepares them at the end of each financial year.

1:44The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period. Her statements for two years supply the comparison that follows. Prepare the comparison with matching items in rows and the two years in separate columns. Earlier revenue was eighty thousand dollars, and cost of sales was forty-eight thousand dollars. Eighty thousand minus forty-eight thousand gives gross profit of thirty-two thousand dollars.

2:10In the later year, revenue reached one hundred thousand dollars and cost of sales rose to sixty-five thousand dollars. Their difference gives gross profit of thirty-five thousand dollars. Other income is income from activities other than the main one, such as rent received or discount received. Earlier other income was two thousand dollars, and expenses excluding cost of sales were eighteen thousand dollars. Profit for the year is the amount by which revenue exceeds expenses over one financial year.

2:36Thirty-two thousand plus two thousand minus eighteen thousand gives profit for the year of sixteen thousand dollars. Later other income reached three thousand dollars, while those expenses rose to twenty-eight thousand dollars. Thirty-five thousand plus three thousand minus twenty-eight thousand gives ten thousand dollars. Revenue increased by twenty thousand dollars, but gross profit increased by only three thousand dollars. Cost of sales therefore absorbed much of the additional revenue. Other income increased by one thousand dollars, but running expenses rose by ten thousand dollars.

3:09These changes reduced profit for the year by six thousand dollars. Higher rent or advertising expenditure could explain the expense increase, but the totals do not prove which expense changed. Profitability is the ability to earn profit in relation to revenue or resources invested.

Profitability ratios and ROCE

3:26The gross profit margin and the profit margin are indicators of a business’s profitability. Gross profit margin measures gross profit as a percentage of revenue. It shows how much remains from each hundred dollars of sales before other income and running expenses enter the calculation. Divide thirty-two thousand by eighty thousand, then multiply by one hundred. The earlier gross profit margin is forty per cent. For the later year, thirty-five thousand divided by one hundred thousand, multiplied by one hundred, gives thirty-five per cent.

3:54Gross profit increased in dollars, but less remained from each hundred dollars of revenue. Higher purchasing prices or lower selling prices could explain this fall. Profit margin measures profit for the year as a percentage of revenue. Sixteen thousand divided by eighty thousand, multiplied by one hundred, gives twenty per cent. The later calculation uses ten thousand divided by one hundred thousand, multiplied by one hundred. This gives ten per cent.

4:21The business now retains ten dollars from each hundred dollars of revenue after all the year’s income and expenses are included. The gross profit margin fell by five percentage points, while profit margin fell by ten percentage points. The greater fall in profit margin reflects the additional pressure from running expenses, despite increased other income. Mark-up is gross profit as a percentage of cost of sales, while margin is gross profit as a percentage of revenue.

4:47Keep the denominator matched to the measure named in the question. Owner’s equity, also called capital, is the owner’s investment in the business, or the amount the business owes the owner. Capital employed is the total of issued shares, reserves and non-current liabilities. A sole trader has no shares, so owner’s capital takes the place of shares and reserves. With no long-term loans either, Nisha’s capital employed is simply her capital.

5:11It was sixty-four thousand dollars in the earlier year and fell to sixty-two thousand five hundred dollars in the later year. Return on capital employed, or R O C E, measures profit for the year before interest as a percentage of capital employed. With no loan interest to add back, Nisha uses profit for the year. Sixteen thousand divided by sixty-four thousand, multiplied by one hundred, gives twenty-five per cent.

5:35The later R O C E is ten thousand divided by sixty-two thousand five hundred, multiplied by one hundred. That gives sixteen per cent. Each hundred dollars invested therefore produced a smaller annual return. R O C E shows the return on the money invested in the business. Compare it with the interest a bank would pay on the same money. If a bank paid five per cent interest, Nisha's sixteen per cent would still reward the greater risk of running a business.

Gross profit and inventory valuation

6:01Gross profit for the year can be affected by the valuation of inventory, sales quantity and changes in selling and purchasing prices. To separate these effects, change one factor at a time. Suppose Nisha sells one hundred identical items at forty dollars each. Each item costs twenty-five dollars to purchase, and all are sold during the period. One hundred multiplied by forty gives revenue of four thousand dollars. Multiplying one hundred by twenty-five gives cost of sales of two thousand five hundred dollars.

6:30Subtracting gives gross profit of fifteen hundred dollars. Raising only the selling price to forty-three dollars produces revenue of four thousand three hundred dollars. Cost of sales remains two thousand five hundred dollars, so gross profit becomes eighteen hundred dollars. Return to the original situation and raise only the purchase price to twenty-eight dollars. Revenue remains four thousand dollars, but cost of sales becomes two thousand eight hundred dollars. Gross profit falls to twelve hundred dollars.

6:57Keeping the original prices but selling one hundred and forty items produces revenue of five thousand six hundred dollars. Cost of sales becomes three thousand five hundred dollars, so gross profit reaches two thousand one hundred dollars. More sales increased total gross profit because each additional item contributed a positive amount. The gross profit margin stays unchanged when selling and purchasing prices remain constant for these identical items. A price increase can improve the margin, but customers might buy fewer goods.

7:27The actual result therefore depends on both the amount earned per item and the quantity sold. Opening inventory is the value of goods held for resale at the start of a financial period. The goods remaining at its end are called closing inventory. Cost of sales equals opening inventory plus the cost of goods purchased minus closing inventory. We subtract closing inventory because those goods have not yet been sold.

7:51A higher closing valuation therefore reduces the calculated cost of sales and increases gross profit. A figure recorded too high is overstated, and one recorded too low is understated. Suppose later closing inventory is overstated by five hundred dollars. Cost of sales becomes five hundred dollars too low. Reported gross profit rises from thirty-five thousand dollars to thirty-five thousand five hundred dollars. This changes the reported result without creating any additional sales.

8:19An opening inventory overstatement has the opposite effect because that amount is added when calculating cost of sales. The same closing error becomes an opening error in the following year unless corrected. Cost is the purchase price plus costs of bringing goods to their present location and condition. For goods held, net realisable value is the expected selling price minus costs to complete and sell the goods. Inventory should be valued at the lower of cost and net realisable value.

Liquidity and working capital ratios

8:47Liquidity is the ability to meet short-term debts when they fall due. Slower customer payments make this a concern for Nisha. Assets are resources owned or controlled by a business that bring future benefit. Her bank balance and unsold goods are both assets. Current assets are assets expected to be turned into cash or used up within twelve months, while current liabilities are amounts due for payment within twelve months.

9:11Working capital is current assets minus current liabilities. The current ratio, also called the working capital ratio, compares current assets with current liabilities. Earlier, twenty thousand dollars divided by ten thousand dollars gives two to one. Later current assets of thirty thousand dollars cover current liabilities of twenty thousand dollars one point five times. The ratio is therefore one point five to one. This means one dollar and fifty cents of current assets for each dollar due within twelve months.

9:40The reduction suggests a smaller short-term cushion. However, inventory cannot pay a supplier until it is sold and cash is received. The acid test ratio, also called the liquid ratio, compares current assets excluding inventory with current liabilities. Earlier, twenty thousand minus nine thousand leaves eleven thousand dollars, and dividing by ten thousand gives one point one to one. For the later year, thirty thousand minus seventeen thousand leaves thirteen thousand dollars.

10:08Thirteen thousand divided by twenty thousand gives zero point six five to one. Only sixty-five cents of assets excluding inventory now support each dollar of current liabilities. This suggests greater reliance on selling inventory before debts can be paid. Slow inventory sales would make that position more concerning. Very low liquidity ratios suggest difficulty paying debts, but unusually high ratios can indicate idle resources. Excess cash might earn little return, while excessive inventory ties up money.

10:39The rate of inventory turnover measures how many times average inventory is sold and replaced during a period. Calculate it as cost of sales divided by average inventory. Average inventory usually equals opening inventory plus closing inventory, divided by two. Earlier, seven thousand plus nine thousand is sixteen thousand, so average inventory is eight thousand dollars. Forty-eight thousand divided by eight thousand gives a rate of six times. In the later year, nine thousand plus seventeen thousand makes twenty-six thousand, and half of that is thirteen thousand dollars.

11:13Sixty-five thousand divided by thirteen thousand gives five times. The slower turnover means goods stay unsold for longer, so money remains tied up in inventory. A very high turnover can also create shortages if goods are not replaced quickly enough. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services. Trade receivables turnover in days measures the average time credit customers take to pay.

11:38Divide trade receivables by credit sales, then multiply by three hundred and sixty-five days. Six thousand divided by seventy-three thousand, multiplied by three hundred and sixty-five, gives thirty days. The later calculation uses ten thousand eight hundred divided by eighty-seven thousand six hundred, multiplied by three hundred and sixty-five. That gives forty-five days, so customers now take fifteen days longer to pay. This slower collection delays cash and could reflect weak follow-up or more generous payment terms.

12:06Faster collection generally helps liquidity, although excessively strict terms may discourage customers. Trade payables are amounts owed to credit suppliers that the business has not yet paid. Trade payables turnover in days measures the average time the business takes to pay its credit suppliers. Calculate it as trade payables divided by credit purchases, multiplied by three hundred and sixty-five days. Four thousand divided by thirty-six thousand five hundred, then multiplied by three hundred and sixty-five, gives forty days.

12:35For the later year, nine thousand six hundred divided by fifty-eight thousand four hundred gives sixty days after the same multiplication. Nisha now takes twenty days longer to pay her suppliers. Longer agreed terms can help cash availability, but overdue payment can indicate financial difficulty. Suppliers may refuse further supplies or remove favourable terms. Customers settle after forty-five days and she pays suppliers after sixty, so cash arrives before it leaves.

Improving profitability and liquidity

13:03Suggestions and recommendations for improving profitability should address the causes identified. Nisha could raise selling prices, but some customers might buy fewer goods. Finding cheaper suppliers could reduce cost of sales, although poorer quality may damage future sales. Cutting unnecessary expenses could improve profit margin, but reducing essential maintenance could cause larger costs later. Advertising may increase sales quantity, but it adds an expense, so it helps only if the extra gross profit exceeds that cost.

13:34To improve liquidity and working capital, Nisha could collect overdue customer amounts and reduce excess inventory. Stronger collection releases cash, although pressure on customers can harm relationships. Selling surplus goods releases money, but price reductions may lower gross profit. Paying suppliers later within agreed terms preserves cash, although any cash discount for paying early is lost. Exceeding those terms risks losing supplies and supplier confidence. Capital introduced is extra money or other assets that the owner puts into the business.

14:06This can increase cash and working capital, although the owner may have limited personal funds. Non-current liabilities are amounts due for payment after more than twelve months. A long-term loan can provide immediate cash, but interest increases future expenses. Repayments also create future demands on cash. Non-current assets are assets held for continuing use in the business rather than for resale. Selling unused equipment can release cash without additional borrowing, but equipment needed later would have to be bought again.

14:35Turning inventory or customer amounts into cash improves the availability of money without necessarily increasing total working capital. Collecting a receivable only swaps one current asset for another, so their total stays the same.

Cash versus profit and exam skills

14:48The matching or accruals concept means income and expenses are recorded in the period to which they relate, not when cash is received or paid. This explains many reasons for the difference between cash and profit. A credit sale contributes to the year’s result before the customer pays. Buying on credit means receiving something now and agreeing to pay for it later. Goods sold can therefore enter cost of sales before the supplier receives cash.

15:13Cash spent on inventory does not all become an immediate expense because unsold goods remain an asset. Capital expenditure is spending on buying or improving non-current assets, including costs needed to bring them into use. Buying equipment reduces cash, but its full purchase price does not become that year’s expense. Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use.

15:39Depreciation reduces profit for the year without a current cash payment. Loans received increase cash without creating income, while repayment of loan principal reduces cash without creating an expense. Capital introduced also increases cash without increasing profit for the year. Drawings are money or goods taken from the business by its owner for private use. They are not a business expense, so they never reduce the profit for the year.

16:03Drawings reduce owner’s equity, and money taken by the owner also reduces business cash. A prepaid expense is a cost paid in advance that belongs to a future period. Cash leaves this year, but only this year’s share is charged against profit for the year. An accrued expense is a cost of the current year that is still unpaid at the year end. It reduces this year’s profit before any cash is paid.

16:26Common examination mistakes involve describing movement without explaining its significance. State the direction, give evidence, then connect it to a consequence or possible cause. Treat suggested causes as possibilities unless the question confirms them. Judge liquidity using both the ratios and the availability of cash. Keep cash movements separate from income and expenses when explaining profit. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions.

16:55Prepare means present information in a suitable format, and compare means comment on similarities and differences. Explain means give reasons, why and how, supported by evidence. For a comparison, match the periods and accounting items before discussing changes. A rise in total gross profit can accompany a fall in gross profit margin. Advise means suggest a course of action, while justify means support a case with evidence or argument. Consider whether Nisha should reduce excess inventory to improve liquidity.

17:26Selling surplus goods would release cash and reduce dependence on future sales before suppliers can be paid. However, heavy price reductions could weaken profitability, and insufficient goods could cause lost sales. Nisha should reduce slow-selling surplus inventory, provided enough remains to meet expected customer demand. A justify answer follows the same pattern, with figures from the comparison as its evidence. Nisha's acid test of zero point six five to one and her slower inventory turnover support this recommendation.

17:55Margins show the proportion of revenue retained, while return on capital employed relates the result to finance invested. Liquidity and efficiency ratios reveal whether resources can support payments when they fall due. Cash differs from profit because credit transactions, inventory, depreciation, capital spending, loans, capital introduced and drawings affect them differently.