ANALYSIS AND INTERPRETATION OF ACCOUNTS
Analysis is concerned with the evaluation of the worth, progress and prospects
of a business, and as one aspect of these, the detection of weaknesses.
satisfactory analysis and interpretation is best carried out by assessing the
results over at least three years.
Trends in the business are significant.
Whether such figures as sales and net profit are rising or not may be
more significant than the actual sales figures and profit figures under
of the revenue accounts of an enterprise will give the best indication as to
future prospects. If a
business is operating profitably, weaknesses in the financial structure (as
revealed in the Balance Sheet) may be overcome.
However, a satisfactory financial structure can deteriorate quickly if
losses are being incurred.
comprehensive analysis and interpretation of accounts would include the
the Gross Profit|
THE GROSS PROFIT
amount of Gross Profit is the most important single factor in any business, as
it must be large enough to cover the expenses and produce a profit.
in Gross Profit could be caused by:
being taken which are too low|
mark-ups being taken|
mark-downs caused by inefficient buying|
to charge credit sales or get credits for returns|
allocation of accounts e.g. capital expenditure allocated to purchases|
to take advantage of discounts|
of cash from cash sales|
to keep an accurate record of the owner drawing goods for personal use|
|A change in the sales mix e.g. a greater proportion of goods with a lower mark-up being sold than in previous years|
a pattern of trading has been established, the gross profit (as a percentage of
sales) tends to remain steady. Any
variation in the percentage should be investigated to ascertain the reason.
expenses of a business are predominantly fixed in nature i.e. they will not vary
in accordance with variations in sales.
Business will expand without incurring additional fixed expenses until a
stage is reached when the increased volume of business forces increased expenses
e.g. renting of additional or larger premises, increased wages due to increases
variation in the dollar vale of expenses should be investigated to ascertain the
CONSIDER NET PROFIT
Net Profit is dependent on the foregoing factors and is an overall indicator of
trading and managerial efficiency.
Profit (as a percentage of sales) should remain stable or show an upward trend.
Any variation in the percentage should be investigated to ascertain the
The calculation of various relationships and ratios between items and group totals from the accounting reports is a useful aid to the interpretation function. The most commonly used relationships and ratios are considered under two headings:
∑ Earning Capacity Ė ability to maintain or improve profits
∑ Financial Stability- ability to meet commitments both in the short-term and the long-term
ASSISTING THE ASSESMENT OF EARNING CAPACITY
Gross Profit Ratio
Profit divided by Net Sales.
Is a measure of the margin of profit available to cover operating expenses. It must be sufficient to cover all operating expenses if a Net Profit is to be earned.
Net Profit Ratio
Profit divided by Net Sales.
This measures percentage return on sales after all costs. The trend in this particular ratio is more important than the actual value of the ratio in a particular year.
as a Percentage of Sales
divided by Net Sales.
Measures percentage of cost in proportion to Net Sales. Changes in expenses percentages will often indicate why the Net Profit is higher or lower than previous years.
Profit to Proprietors Funds
Profit divided by the Proprietors Funds (averaged from start to end of year)
Indicates the return on total funds invested by the owner. This percentage may be compared with the return available in alternative forms of investment (and the question asked can I do better by putting my money elsewhere?) as well as comparison with previous years.
Profit to Total Funds
Net Profit divided by (sum of Proprietors Funds plus External Liabilities)
Measures the return on owners capital plus borrowed funds to get a return on all funding to the business.
of Stock Turnover
of Goods Sold divided by Average Stock Held
Indicates how quickly stock is sold/ used up in the manufacturing process. As well as giving an indication of the volume of activity, this figure can assist in detecting overstocking. A business does not want to carry stock for excessive periods, as this is adverse to cashflow and may result in obsolescent stock which canít be sold or used or has to be discounted to be sold.
ASSISTING THE ASSESSMENT OF FINANCIAL STABILITY
Capital (or Current) Ratio
Assets divided by Current Liabilities
Is a measure of the ability of the business to meet its short term commitments with assets intended to be converted into cash in the short term period. It is desirable that current assets should be in excess of current liabilities therefore providing a margin for safety.
Asset (or Liquid) Ratio
Assets (Assets which can be converted into cash immediately) divided by Quick
Liabilities (Liabilities which may become payable immediately).
Is a test of the ability of the business to meet its immediate commitments without disturbing its normal business activities.
Age of Debtors
at end of the period divided by Average daily credit Sales.
measure shows the effectiveness of credit control.
Gives the number of days credit sales represented by outstanding debts
owed to the business. Prompt
collection of funds is an important factor in maintaining financial stability.
A deterioration could
indicate that the business owner should put more emphasis on chasing up
Proprietors Funds divided by Outside Liabilities.
With liabilities, interest payments often have to be maintained. Over reliance on external funding may be a weakness in times of economic crisis.
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