Analysis and communication of accounting information

Accounting AS · Financial accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Different users read financial statements for different reasons. Owners and investors look at profit and return. Lenders and suppliers want to know if they will be paid. Managers need detailed and frequent figures. Employees look at job security and pay, customers at continued supply, and the government at tax.

Ratios turn the figures into measures that can be compared with last year or with a similar business. They fall into three groups: profitability (how well profit is earned), liquidity (ability to pay short-term debts) and efficiency (how well assets are used).

A ratio means little on its own. Always compare it, and remember that different accounting policies and year-end dates can distort comparisons.

Rules to remember

Gross profit margin = gross profit ÷ revenue × 100. Mark-up = gross profit ÷ cost of sales × 100.
Profit margin = profit for the year ÷ revenue × 100. Operating expenses to revenue ratio = operating expenses ÷ revenue × 100.
Return on capital employed = profit from operations ÷ capital employed × 100, where capital employed = equity + non-current liabilities.
Current ratio = current assets : current liabilities. Acid test ratio = (current assets − inventory) : current liabilities.
Trade receivables turnover (days) = trade receivables ÷ credit sales × 365. Trade payables turnover (days) = trade payables ÷ credit purchases × 365.
Inventory turnover (days) = average inventory ÷ cost of sales × 365. Rate of inventory turnover (times) = cost of sales ÷ average inventory.
Non-current asset turnover = net revenue ÷ net book value of non-current assets.

Common mistake

Mixing up margin and mark-up. Both use gross profit on top, but margin divides by revenue and mark-up divides by cost of sales, so the mark-up percentage is always the larger one.

Worked example

A business had credit sales of $292,000 for the year and trade receivables of $36,000 at the year end. It allows customers 30 days' credit. What is the trade receivables turnover in days, and what does it show?

Trade receivables turnover = trade receivables ÷ credit sales × 365.
= $36,000 ÷ $292,000 × 365 = 45 days.
Compare with the credit period: 45 − 30 = 15 days longer than allowed.

Answer: 45 days. Customers take about 15 days longer than the agreed 30 days, so credit control needs to improve.

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