Interpretation of Accounts (Ratio Analysis)

Objectives, Users, and Limitations of Ratio Analysis

The primary objective of ratio analysis is to transform raw balance sheet and profit and loss figures into relative indicators. These allow users to evaluate performance over time, compare the business against industry benchmarks or competitors, and make informed financial decisions.

Stakeholders and Their Interests

• Ordinary shareholders: Interested in profitability and returns. They monitor ROSF, EPS, DPS, dividend yield, dividend cover, P/E ratio, and share price to decide whether to buy, hold, or sell shares.
• Banks and debenture holders: Concerned with financial security and debt service. They examine gearing, interest cover, liquidity, and available fixed assets to decide whether to grant loan finance.
• Trade creditors (suppliers): Focus on the acid test ratio and creditors' credit period to confirm the firm can pay for supplies on time.
• Management: Track all ratios, especially gross margin, expenses, stock turnover, and collection periods, to control day-to-day operations and plan strategy.
• Employees and trade unions: Review profits and liquidity to evaluate job security and back up wage negotiations.
• Revenue Commissioners: Scrutinise reported profits and turnover to ensure correct tax assessment.

Limitations of Ratio Analysis

While essential, ratios have distinct limitations:

• Historical records: Accounts record past performance, which may not continue into the future.
• Balance sheet snapshot: Year-end figures represent a single date and often mask seasonal trading fluctuations.
• Inflation: Fixed assets are recorded at historical cost, distorting comparisons across years or between older and newer businesses.
• Varying accounting policies: Differences in depreciation methods or stock valuation make comparisons between different firms unreliable.
• Industry differences: What counts as a healthy ratio varies by sector. A supermarket operates safely on a very low acid test ratio due to rapid daily cash intake.
• Window dressing: Management may temporarily manipulate year-end balances, such as rushing debt collections or holding off purchases just before year-end.
• Non-monetary factors: Financial accounts omit employee morale, staff skill, customer goodwill, and competitive threats.
• Symptoms rather than causes: Ratios highlight where problems exist, but they do not explain why they occurred without further investigation.

Working Backwards: Deducing Hidden Figures

Higher Level examination questions frequently require you to work out missing figures by working backwards from the ratios given before you can complete the required calculations.

Mark-up versus Margin

• Mark-up is gross profit expressed as a percentage of cost of sales.
• Margin is gross profit expressed as a percentage of sales.

A mark-up of 25% means gross profit is $\frac{25}{100}$ of cost of sales, meaning sales equals $\frac{125}{100}$ of cost of sales. A margin of 20% means gross profit is $\frac{20}{100}$ of sales, meaning cost of sales is $\frac{80}{100}$ of sales. To convert: $\text{Margin} = \frac{\text{Mark-up}}{100 + \text{Mark-up}} \times 100$.

Example: Cost of sales is €480,000 and mark-up is 25%.

• Gross profit = €480,000 $\times 0.25$ = €120,000
• Sales = €480,000 + €120,000 = €600,000
• Margin = $\frac{€120,000}{€600,000} \times 100 = 20\%$

Finding Stock from Stock Turnover

When cost of sales is €480,000, stock turnover is 8 times, and opening stock is €56,000:

• $\text{Average Stock} = \frac{\text{Cost of Sales}}{\text{Stock Turnover}} = \frac{€480,000}{8} = €60,000$
• $\text{Opening Stock} + \text{Closing Stock} = €60,000 \times 2 = €120,000$
• $\text{Closing Stock} = €120,000 - €56,000 = €64,000$

Finding Credit Sales and Cash Sales

Using the debtors' collection period:

If the collection period is given in days, multiply by 365 instead of 12. Apply the same logic with trade creditors to calculate credit purchases and deduce cash purchases.

Working Back to Market Price

Using the P/E ratio:

Using dividend yield:

Profitability and Efficiency Ratios

Profitability ratios show how well the business uses its resources to make a profit. Returns must be evaluated against the risk-free rate on government bonds or bank deposits (use any rate given in the exam question, typically 2% to 4%) and the interest rate charged on borrowings.

Return on Capital Employed (ROCE)

• Numerator: Use operating profit (net profit + interest). If taxation appears in the accounts, use profit before interest and tax.
• Denominator: Capital employed equals ordinary share capital plus reserves (profit and loss balance) plus preference shares plus long-term debt (debentures or bank loans). Alternatively, calculate it as total assets less current liabilities.
• Benchmark: Must exceed the risk-free rate and exceed the borrowing rate on debt to ensure positive financial returns.

Return on Ordinary Shareholders' Funds (ROSF)

This isolates the return earned strictly on equity funds after meeting all fixed commitments.

Trading Margins

• Gross Profit Margin: $\frac{\text{Gross Profit}}{\text{Sales}} \times 100$
• Net Profit Margin: $\frac{\text{Net Profit}}{\text{Sales}} \times 100$

A dropping gross margin suggests higher supplier purchase prices or increased trade discounts. A drop in net margin while gross margin stays steady points to poor overhead cost control.

Rate of Stock Turnover

Expressed in times per year. Stock turnover can also be stated as a period in months: $\frac{\text{Average Stock}}{\text{Cost of Sales}} \times 12$.

A faster rate improves profitability because each inventory turn realizes a profit mark-up, expanding total annual profit. It reduces storage and insurance costs, minimises waste and damage, and secures bulk-buying discounts.

Liquidity, Solvency, and Working Capital Ratios

Examiners regularly test the difference between liquidity and solvency:

• Liquidity: Measures the ability of the firm to pay its short-term debts as they fall due using liquid assets (cash, bank, and debtors).
• Solvency: Measures whether a business has sufficient total assets to meet all outside liabilities if it were wound up. A business is solvent when total assets exceed total liabilities.

Current Ratio

Ideal about 2:1. A figure well below this suggests possible difficulty meeting short-term debts; confirm this by checking the acid test ratio. A figure well above 2:1 suggests idle resources tied up in unproductive cash or excess stock.

Acid Test (Quick) Ratio

Ideal is 1:1. Closing stock is subtracted because it is the least liquid current asset and cannot be turned into cash immediately.

Debtors' and Creditors' Periods (Working Capital Ratios)

• Debtors' Period: $\frac{\text{Trade Debtors}}{\text{Credit Sales}} \times 12 \text{ months (or 365 days)}$

Normal terms are 1 to 2 months (30 to 60 days). A lengthening collection period hurts cash flow and raises the risk of bad debts.

• Creditors' Period: $\frac{\text{Trade Creditors}}{\text{Credit Purchases}} \times 12 \text{ months (or 365 days)}$

Taking excessive credit damages credit ratings, risks loss of cash discounts, and may prompt suppliers to halt deliveries.

Capital Structure, Gearing, and Long-Term Funding

Gearing measures how much of the long-term finance comes from fixed-cost debt compared to ordinary shareholders' equity.

Note: Gearing is also accepted as a debt/equity ratio: $\frac{\text{Debt + Preference Shares}}{\text{Ordinary Equity + Reserves}}$. Always state which version you are applying in your workings.

Gearing Levels

• Highly geared (> 50%): Fixed-cost funds exceed equity. While this can magnify returns for ordinary shareholders in successful years, fixed interest must be paid regardless of profit, raising liquidation risk during downturns and making extra borrowing difficult.
• Lowly geared (< 50%): The enterprise is primarily funded by equity, carrying low financial risk.

Reducing Gearing

A company can lower its gearing level by:

1. Issuing further ordinary shares.
2. Repaying loans or redeeming debentures.
3. Retaining more profits in reserves rather than paying dividends.
4. Converting debentures into ordinary shares.

Interest Cover

Expressed in times. Cover of 4 times or higher provides safe debt protection. Below 2 to 3 times means the firm is vulnerable if profits decline.

Funding Policy

Long-term assets should be financed by long-term funds (shares, reserves, debentures). Purchasing fixed assets using a bank overdraft causes a serious funding mismatch and damages liquidity.

Investment Ratios and Stakeholder Evaluative Reports

Investment ratios help existing and prospective equity investors assess potential returns, dividend safety, and share valuations.

• Earnings Per Share (EPS): $\frac{\text{Net Profit} - \text{Preference Dividend}}{\text{Number of Issued Ordinary Shares}}$ (quoted in cents)
• Dividend Per Share (DPS): $\frac{\text{Total Ordinary Dividend Paid}}{\text{Number of Issued Ordinary Shares}}$ (quoted in cents)
• Dividend Cover: $\frac{\text{Net Profit} - \text{Preference Dividend}}{\text{Total Ordinary Dividend Paid}}$ (quoted in times)
• Dividend Yield: $\frac{\text{DPS}}{\text{Market Price per Share}} \times 100$ (quoted in %)
• Price Earnings (P/E) Ratio: $\frac{\text{Market Price per Share}}{\text{EPS}}$ (quoted in years)

Measures the payback period in years. A rising P/E reflects market confidence in growth, but represents a longer recovery period at current earnings.

Report Layout (Higher Level)

When asked to prepare a formal report, adopt standard business presentation:

• To: (e.g., The Board of Directors / Bank Manager / Ordinary Shareholders)
• From: (e.g., Financial Consultant / Accountant)
• Date:
• Subject: (e.g., Performance Review and Loan Assessment for Corrib plc)
• Body: Numbered sections examining each key dimension.
• Conclusion / Recommendation: Clear, direct decision.
• Signed:

Evaluative Writing Checklist

For every ratio comment in the body of your answer, apply this exact sequence:

1. Name the ratio.
2. Quote the figures for both years with exact units (%, :1, times, years, cents).
3. State whether the trend represents an improvement or disimprovement.
4. Compare the figure to an established benchmark or borrowing rate.
5. Explain the practical business implications for the specific stakeholder.

Key terms

Return on Capital Employed (ROCE)

Operating profit before interest and tax expressed as a percentage of total long-term capital employed.

Return on Ordinary Shareholders' Funds (ROSF)

Profit available to ordinary shareholders (net profit less preference dividend) expressed as a percentage of equity funds (ordinary share capital plus reserves).

Acid Test Ratio

A strict test of liquidity that compares liquid assets (current assets less closing stock) with current liabilities; ideal benchmark is 1:1.

Solvency

The state where a company's total assets exceed its total external liabilities, indicating long-term financial survival upon liquidation.

Gearing

The proportion of total capital employed funded by fixed-cost finance (debentures, term loans, and preference share capital).

Interest Cover

Operating profit before interest divided by total annual interest charged, measuring how many times earnings cover annual debt interest costs.

Price Earnings (P/E) Ratio

Market price per share divided by earnings per share, indicating the number of years needed to recoup the market price at current earnings.

Dividend Cover

Net profit after preference dividends divided by total ordinary dividend paid, showing how many times ordinary dividends are covered by current earnings.

Stock Turnover

Cost of sales divided by average stock, reflecting how many times inventory is sold and replaced during an accounting period.

Mark-up

Gross profit expressed as a percentage of cost of sales.

Margin

Gross profit expressed as a percentage of sales revenue.