Ref: No 10/Nov 2007
Simple Facts of Accounting
from infoCPA
11
No:
Finance for Non Accountants
Part 2
Analysing Financial Statements
This is the second leaflet in a two part series of Finance for Non-Accountants and concentrates on analysing a set
of financial statements so they become more meaningful for the reader. Analysing financial statements through
comparative ratio analysis will help business owners identify the company's strengths and weaknesses and
evaluate its true financial position.
Certain financial ratios can be used to evaluate a company’s performance and obtain further information on the
financial health of the company. All the information required to calculate the financial ratios is already contained in
the financial statements. Here are the major quantitative ratios that are useful for measuring the financial position
of your business:
1. Profitability Ratios
Profitability Ratios can be used to measure the trend of the business earnings and the ability of the company to
earn profit over time. Comparison of profit margins to other companies and to previous periods should also
indicate where the business is doing well. Profit margins should also indicate where a business has room to
manoeuvre on pricing.
The important profitability ratios are as follows:
1.
Gross Profit Margin % = Sales – Cost of Sales (Gross Profit) x 100
Sales
Normally gross profit will rise in proportion with sales so the gross profit margin can highlight any efficiency
in the use of resources.
2.
Net Profit Margin % =
Net Profit x 100
Sales
The Net Profit Margin Ratio is widely used as a measure of performance across similar companies in
similar industries. A business working on a low margin may not be reason for concern if the particular
industry has a high turnover e.g. supermarket. It is important to compare this to the industry average or
other businesses in similar industries.
3.
Return on Capital Employed % =
Net Profit x 100
Capital Employed
Return on Capital Employed shows the annual percentage return that an investor receives on their capital.
Capital employed is essentially net assets.
This ratio gives an indication of what return you are making on the money financing the business.
The Institute of Certified Public Accountants in Ireland
The Institute of Cer tified
Public Accountants in Ireland
9 Ely Place, Dublin 2, Ireland
Phone
01 676 7353
Fax
01 661 2367
Email
[email protected]
Web
www.cpaireland.ie
Small Firms Association
84/86 Lower Baggot Street,
Dublin 2
Phone
01 605 1500
Fax
01 661 2861
Email
[email protected]
Web
www.sfa.ie
Liquidity Ratios
These ratios indicate the ease that a company has to turn assets into cash. A business must be able to
perform positively in relation to profitability but must also be able to pay creditors, expenses and loans as
they fall due. The Current and Acid Test Ratios are the best-known measures of this financial strength.
These are calculated as follows:
1.
Current Ratio=
Current Assets
Current Liabilities
The Current Ratio compares the relationship between current assets and current liabilities and is intended
to indicate whether the business has sufficient current assets to meet the current liabilities. The widely
accepted standard holds that current ratio should be at 2:1, that is the current assets should meet current
liabilities by at least twice.
2.
Acid Test Ratio=
Current Assets - Stock
Current Liabilities
The Acid Test Ratio measures current assets that are quickly converted to cash compared to current
liabilities. Stock is excluded as it recognises that it is not easily converted into cash. An acceptable figure is
considered at 1:1, that is current assets, excluding stock should meet current liabilities.
Asset Utilisation Ratios
The Asset Utilisation Ratio measures how effectively the business uses its assets including debtors, stock
and other assets and the speed at which the assets are converted to sales and cash. The two most
important ratios to assess the effectiveness of asset utilisation are:
1.
Average Debtors Days=
Debtors x 365 Days
Annual Credit Sales
Average Debtor Days Ratio measures the number of days that it takes for the debts to be collected by the
business. A short collection period implies prompt payment of debtors and an excessively long collection
period implies inefficient collection procedures.
2.
Stock Turnover=
Average Stock x 365 days
Sales or COS
This ratio measures the number of times stock turns over in a business. A high stock turnover would
indicate that the business is in fast moving goods. The example above shows an increase in days, which
indicates a slow down of stock turnover.
Conclusion
As we have outlined any manager can use their financial statements to get further information on the
company’s financial position and ratio analysis can give you an indication of the performance of your
business. Ratio Analysis enables the business owner/manager to spot trends in a business and to compare
its performance and condition with the average performance of similar businesses in the same industry.
However a ratio on its own has little meaning and these ratios must be compared to previous years, the
industry average and competitors to give them a true meaning.
Analysing your financial statements through ratio analysis may provide important early warning indications
that allow you to solve your business.
The Institute of Certified Public Accountants in Ireland
www.cpaireland.ie
Disclaimer
This information bulletin is intended to be used as a guide to Family Business, the
Future... For further information you should speak to your CPA professional advisor.
Neither the Institute of Certified Public Accountants in Ireland, or the Small Firms
Association can be held liable for any error, or for the consequences of any action, or
lack of action arising from this bulletin.
For further assistance…
Please contact the Institute of Certified Public Accountants in Ireland at
01 6767353, who can put you in touch with your nearest CPA practice.
The Institute is a statutory accountancy body with 5,000 members and
students. CPAs work both in practice and all areas of Irish commercial
life, and work in 28 countries around the world.