technical
40 student accountant February 2007
ratios
In the exams for CAT Paper 6, Drafting
Financial Statements and Professional
Scheme Paper 1.1, Preparing Financial
Statements candidates are often required to
prepare accounting ratios and to interpret
them. The main ratios that candidates will
need to know are discussed in this article,
and the formulae for them are given in Figure
1 on page 43.
Financial statements provide important
financial information for people who do not
have access to the internal accounts. For
example, current and potential shareholders
can see how much profit a company has
made, the value of its assets, and the level
of its cash reserves. Although these figures
are useful they do not mean a great deal by
themselves. If the user is to make any real
sense of the figures in the financial statements,
they need to be properly analysed using
accounting ratios and then compared with
either the previous year’s ratios, or measured
against averages for the industry.
interpreting financial statements
relevant to CAT Scheme Paper 6
and Professional Scheme Paper 1.1
PROFITABILITY RATIOS
One of the most important measures of
a company’s success is its profitability.
However, individual figures shown in the
income statement/profit and loss account for
gross profit and net profit mean very little by
themselves. When these profit figures are
expressed as a percentage of sales, they are
more useful. This percentage can then be
compared with those of previous years, or with
the percentages of other similar companies.
Changes in the gross profit percentage
ratio can be caused by a number of factors.
For example, a decrease may indicate greater
competition in the market and therefore
lower selling prices and a lower gross profit
or, alternatively, an increase in the cost of
purchases. An increase in the gross profit
percentage may indicate that the company is
in a position to exploit the market and charge
higher prices for its products or that it is able
to source its purchases at a lower cost.
The relationship between the gross and
the net profit percentage gives an indication of
how well a company is managing its business
expenses. If the net profit percentage has
decreased over time while the gross profit
percentage has remained the same, this might
indicate a lack of internal control over expenses.
The return on capital employed (ROCE)
ratio is another important profitability ratio.
It measures how efficiently and effectively
management has deployed the resources
available to it, irrespective of how those
resources have been financed. Various formulae
can be found in textbooks for calculating
ROCE. The most common uses operating profit
(defined as profit before interest and taxation)
and the closing values for capital employed
(although using averages for the year is more
accurate). This ratio is useful when comparing
the performance of two or more companies, or
when reviewing a company’s performance over
a number of years.
LIQUIDITY RATIOS
Liquidity refers to the amount of cash a
company can generate quickly to settle
its debts. A reasonable level of liquidity is
essential to the survival of a company, as poor
cash control is one of the main reasons for
business failure. The current ratio compares
a company’s liquid assets (ie cash and those
assets held which will soon be turned into
cash) with short-term liabilities (payables/
creditors due within one year). The higher the
ratio the more liquid the company. As liquidity
is vital, a higher current ratio is normally
preferred to a lower one. However, a very high
ratio may suggest that funds are being tied up
in cash or other liquid assets, and may not be
earning the highest returns possible.
A stricter test of liquidity is the acid test
ratio (also known as the quick ratio) which
excludes inventory/stock as a current asset. This
approach can be justified because for many
companies inventory/stock cannot be readily
converted into cash. In a period of severe cash
shortage, a company may be forced to sell its
inventory/stock at a discount to ensure sales.
Caution should always be exercised when
trying to draw definite conclusions on the
liquidity of a company, as both the current
ratio and the acid test ratio use figures from
the balance sheet. The balance sheet is only
a ‘snapshot’ of the financial position at the
end of a specific period. It is possible that the
balance sheet figures are not representative
of the liquidity position during the year. This
may be due to exceptional factors, or simply
because the business is seasonal in nature and
the balance sheet figures represent the cash
position at just one particular point in the cycle.
EFFICIENCY RATIOS
Most companies offer their customers credit in
order to increase their sales. However, giving
credit to customers incurs an opportunity cost
as the cash is tied up in financing receivables/
debtors, and there is also the risk of the debts
not being paid. Therefore, companies will
normally seek to collect their debts as soon as
possible. The receivables/debtors collection
period (in days or months) provides an
indication of how successful (or efficient) the
debt collection process has been.
