ANALYSIS AND INTERPRETATION OF ACCOUNTS

Financial 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. 

A 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 review. 

Analysis 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. 

A comprehensive analysis and interpretation of accounts would include the following:

STUDY THE GROSS PROFIT

The 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. 

Fluctuations in Gross Profit could be caused by:

Once 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.

EXAMINING EXPENSES

The 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 staff. 

Any variation in the dollar vale of expenses should be investigated to ascertain the reason. 

CONSIDER NET PROFIT

The Net Profit is dependent on the foregoing factors and is an overall indicator of trading and managerial efficiency. 

Net 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 reason. 

USE ACCOUNTING RATIOS

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 – ability to maintain or improve profits

·         Financial Stability- ability to meet commitments both in the short-term and the long-term

RATIOS ASSISTING THE ASSESMENT OF EARNING CAPACITY

The Gross Profit Ratio

Gross 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.

The Net Profit Ratio

Net 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.

Expenses as a Percentage of Sales

Expenses 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.

Net Profit to Proprietors Funds

Net 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.

Net 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.

Rate of Stock Turnover

Cost 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 can’t be sold or used or has to be discounted to be sold.

 RATIOS ASSISTING THE ASSESSMENT OF FINANCIAL STABILITY

 Working Capital (or Current) Ratio

Current 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.

Quick Asset (or Liquid) Ratio

Quick 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.

Average Age of Debtors

Debtors at end of the period divided by Average daily credit Sales. 

This 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 outstanding debts.   

Proprietary Ratio

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.