CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

STUDY MATERIAL C2

510

THE INTERPRETATION OF FINANCIAL STATEMENTS

14.6 Liquidity ratios

These are also known as solvency ratios , as they refer to the ability of the business to pay its

payables in the short term.

There are two main liquidity ratios.

14.6.1 The current ratio

This is also known as the working capital ratio, as it is based on working capital or net

current assets. It is a measure of the liquidity of a business that compares its current assets

with those payables due to be paid within 1 year of the statement of ﬁ nancial position date

(otherwise known as current liabilities). It is calculated as:

Current assets

Current liabilities



9 701

1 086

891

,

.:

N

otice how the ratio is expressed, as a comparison of assets with liabilities. The ratio can

also be stated as:

Current assets : current liabilities

The importance of this ratio is the information it gives about the liquidity of a business.

Current liabilities all have to be settled in cash within a reasonably short space of time.

Does the company have sufﬁ cient liquid resources to do this? Clearly, its cash and bank

balances are liquid; receivables should convert into cash quite soon; and inventories will

presumably soon be sold, again eventually generating cash. The calculation tells us that the

company has $8.90 in current assets with which to pay every $1 of its current liabilities.

A high ratio, such as the one in our example, means that current assets are easily suf-

ﬁ cient to cover current liabilities. A ratio of below one – meaning that current liabilities

exceed current assets – could imply danger of insolvency. It used to be thought that a

ratio of 2:1 was ideal, but this depends on the type of business and its reliance on credit

transactions.

Although a high ratio gives comfort to payables, it may mean that the company is hold-

ing more in current assets than it requires in the short term. This is wasteful, as current

assets rarely earn income – inventories need to be sold in order to produce proﬁ ts, receiva-

bles will not pay more than the amount outstanding, and bank balances may earn only

very small amounts of interest. Indeed, a company with a high level of inventories might

indicate difﬁ culty in selling them, while a high level of receivables might indicate poor

credit control.

14.6.2 The quick ratio

This is also known as the acid test ratio and is calculated by:

Current assets excluding inventories

Current liabilities



8,2276

1 086

100 7 61

,

.:

or it can be expressed as:

C

urrent assets excluding inventories : current liabilities

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THE INTERPRETATION OF FINANCIAL STATEMENTS

This is similar to the current ratio, but takes the more prudent view that inventories

may take some time to convert into cash, and therefore the true liquidity position is meas-

ured by the relationship of receivables and cash only to current liabilities. The calculation

tells us that the company has $7.60 in ‘ quick ’ assets with which to pay each $1 in its cur-

rent liabilities. Again, a very high ratio is very comforting, but may be wasteful as men-

tioned above. Generally, a ratio of 1:1 is considered ‘ ideal ’ but many retail companies with

very regular cash sales have very low ratios, due to their lack of receivables.

A low ratio might need further investigation before conclusions can be drawn, for exam-

ple, if the current liabilities ﬁ gure includes payables not due for payment until well into

the next accounting period (e.g. income tax), the ﬁ gure may be distorted.

14.7 Efficiency ratios

These are also referred to as use of assets ratios. They measure the efﬁ ciency of the manage-

ment of assets, both non-current and current.

14.7.1 Asset turnover ratios

These ratios compare the assets with the sales revenue (turnover) that they have earned.

The end result is often expressed in money value to represent the value of sales revenue for

each $1 invested in those assets. The formula is:

Sales revenue

Assets

........... $

The calculation can be per

formed on any combination of assets, from total net assets to

individual groups of assets, such as plant and machinery.

Sales: total capital employed (capital turnover)

This is the sales revenue generated per $1 of average total capital employed.

Sales revenue

Average total capital employed



23 636

18 925

,

$11 249,

(S

ee Section 14.5.4 for the calculation of average total capital employed).

The result tells us that we generated $1.249 in sales for every $1 invested in net assets.

Sales: non-current assets (non-current asset turnover)

This is the sales revenue generated per $1 of non-current assets.

Sales revenue

Non-current assets



23 636

14 135

1 672

,

£.

This tells us that for ever

y $1 invested in non-current assets, sales revenue of $1.672 was

earned. This ﬁ gure is meaningless on its own – it is commonly compared with previous

years ’ results, as comparison between ﬁ rms is less useful.

14.7.2 Inventories days

Inventories may be analysed by calculating the ratio of inventories to cost of sales, and

then multiplying by the number of days in a year to give inventories days.

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THE INTERPRETATION OF FINANCIAL STATEMENTS

The calculation is:

Inventories

Cost of Sales

inventories days365

1 425

8 799

365 59

,

 days

This

ﬁ

gure gives the number of days that on average an item is in inventories before it is

sold; this may alternatively be expressed as the number of days a ﬁ rm could continue trad-

ing if the supply of goods ceased.

The calculation may also use average inventories:

1 325

8 799

365 55

,

 days

This tells us that in the past y

ear, this was the average inventories days. By using the inven-

tories at the end of the year, this tells us what the inventories days will be in the future,

assuming cost of sales remains the same.

The number of inventories days is relevant to the context of the business; in a manu-

facturing company, it will approximate to the production cycle and in a cream cake shop

to 1 day!

If inventories days are relatively high, this may indicate that inventories are too high and

there is additional ﬁ nance tied up in inventories which could perhaps be used more effec-

tively elsewhere. If cash is paid out when the inventories are purchased, but the cash does

not come back in until the inventories are sold to a customer, then this temporary negative

cash ﬂ ow will have to be ﬁ nanced by the company. Moreover, if the inventories are sold on

credit terms and the customer does not pay for, say 1 month, then the delay in getting the

cash back in is even longer.

If the inventories are too low, this may show an overzealous application of the ‘ just-in-

time ’ concept and consequential risks of running out of inventories. It may also indicate a

company meeting a cash ﬂ ow crisis by running down inventories levels.

Inventories days needs to be compared to other companies and compared to previous

years in the same company. Increasing inventories days may be investigated further by sep-

arately analysing raw materials (RM), work in progress (WIP) and ﬁ nished goods (FG) to

cost of goods sold. An increase in RM days may indicate mismanagement in the buying

department; an increase in WIP may indicate production delays. If FG days increase, this

may be a sign of decline in demand for the product and an increase in obsolete items.

The inventories ratio may also be expressed as the number of times an item turns over

in a year – that is, how many times it is bought and sold during the year.

Inventories turnover is calculated as:

Cost of sales

Average inventories

times

8 799

1 325

66

,

.

Y

ou should note here that the word ‘ turnover ’ is being used to mean ‘ turn over ’ and is not

referring to turnover, as in sales.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE INTERPRETATION OF FINANCIAL STATEMENTS

14.7.3 Receivables days

This is a measure of the average time taken by customers to settle their debts. It is calculated by:

Receivables

Sales

days 365

542

23 636

365 8

,

Where details ar

e available, credit sales only should be considered.

‘ The sales ﬁ gure will exclude sales tax but receivables will include sales tax, and so

strictly speaking the ﬁ gure is not comparing like-with-like. This sales tax on sales or receiv-

ables is not usually known and so this is inevitable. However, if the sales tax is known, then

the ﬁ gures should be adjusted so that both either include, or exclude, sales tax.

The result of this calculation should be compared with the number of days ’ credit nor-

mally allowed by the business to its customers. If it appears that customers are taking

longer to pay than they should do, it may be necessary to take remedial action.

As with inventories days, a slowing down in the speed of collecting debts will have a

detrimental effect on cash ﬂ ow. On the other hand, it may be that the business has deliber-

ately offered extended credit in order to increase demand.

14.7.4 Payable days

This is a measure of the average time taken to pay suppliers. Although it is not strictly a

measure of asset efﬁ ciency on its own, it is part of the overall management of net current

assets. It is calculated by:

Payable

Purchases

days 365

1 086

8 999

365 44

,

The pur

chases ﬁ gure should exclude any cash purchases, if this information is available;

where there is no purchases ﬁ gure available the best alternative is to use cost of sales as

the denominator. Similarly, payables should include only trade payables, not payables for

expenses or non-current assets.

The purchases ﬁ gure will exclude sales tax but payables will include sales tax, and so

strictly speaking the ﬁ gure is not comparing like-with-like. The sales tax on purchases or

payables is not usually known and so this is inevitable. However, if the sales tax is known,

then the ﬁ gures should be adjusted so that both either include, or exclude, sale tax.

The result of this ratio can also be compared with the receivables days. A ﬁ rm does not

normally want to offer its customers more time to pay than it gets from its own suppliers,

otherwise this could affect cash ﬂ ow. Generally, the longer the payables payment period,

the better, as the ﬁ rm holds on to its cash for longer, but care must be taken not to upset

suppliers by delaying payment, which could result in the loss of discounts and reliability.

It is important to recognise when using these ratios that it is the trend of ratios that is

important, not the individual values. Payment periods are longer in some types of organi-

sation than in others.

14.7.5 Total working capital ratio

This measures the total length of time for which working capital is tied up in inventories,

receivables and payables, before becoming available for use. It is the total of the number

STUDY MATERIAL C2

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THE INTERPRETATION OF FINANCIAL STATEMENTS

of inventories days, receivables days, less payables days. From the preceding three sections,

you can see that this is:

Number of days – inventories 59

Number of days – receivables 8

Less number of days – payables (44)

Total working capital days 23

This tells us that it takes, on average, 23 days in which to sell the inventories, receive pay-

ment from receivables and pay the payables. The total of 23 days may not seem too lengthy

for a manufacturing business, but it does indicate the level of working capital needed in

order to ﬁ nance the ordinary activities of the business, which may result in the need for an

overdraft or other sources of ﬁ nance.

14.8 Capital structure ratios

Different ﬁ rms have different methods of ﬁ nancing their activities. Some rely mainly on

the issue of share capital and the retention of proﬁ ts; others rely heavily on loan ﬁ nance;

most have a combination of the two.

14.8.1 The gearing ratio (or leverage ratio)

Gearing is a measure of the relationship between the amount of ﬁ nance provided by exter-

nal parties (e.g. debentures) to the total capital employed. It is calculated by:

Debt

Total capital employed

 100

4 500

22 750

100 20

,

%

Y

ou should recall from the discussion above regarding the return on total capital employed

(ROCE), that total capital employed is equity plus debt. This ratio has been calculated based

on the capital employed at the date of the statement of ﬁ nancial position. An alter native

would be to use the average capital employed and average loan capital during the year.

The more highly geared a business, the more proﬁ ts that have to be earned to pay the

interest cost of the borrowing. Consequently, the higher the gearing, the more risky is the

owner’s investment. Remember that dividends do not have to be paid out if the directors

decide not to declare them, so there is reduced risk with low-geared companies, especially

in times when proﬁ ts are falling. On the other hand, a highly geared company might be

more attractive to shareholders when proﬁ ts are rising, because there are fewer of them to

share out those proﬁ ts.

An alternative method of calculating gearing is known as the debt: equity ratio. In this

case, the loan capital is expressed as a percentage of equity capital.

In this example, it would be:

Debt

Equity



4 500

18 250

100 25

,

%

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE INTERPRETATION OF FINANCIAL STATEMENTS

14.8.2 Interest cover

Connected to the gearing ratio is a measure of the number of times that the proﬁ t is able

to ‘ cover ’ the ﬁ xed interest due on long-term loans. It provides lenders with an idea of the

level of security for the payment. The formula is:

Operating profit

Interest payable

times

9100

450

20

,

This sho

ws lenders that their interest is covered 20 times by the current proﬁ ts. This would

normally be a fairly comfortable level, but of course, it is future proﬁ ts that will determine

the actual level of cover.

14.9 Ratio analysis for sole traders

All of the above ratios can be calculated for sole traders, as well as for limited companies.

Exercise 14.1

Give the formulae for the following ratios:

(a) Return on capital employed (ROCE),

(b) Gross proﬁ t margin,

(c) Operating proﬁ t margin,

(d) Return on equity (ROE),

(e) Non-current assets turnover,

(f) Inventories days,

(g) Receivables days,

(h) Payables days,

(i) Current ratio,

(j) Quick ratio,

(k) Gearing ratio.

Solution

Refer to the formulae above for the solutions.

14.10 Summary

This very important chapter is one worth spending time over. In a computer-bases assess-

ment, not only will you be expected to calculate ratios, but you may need to be able to do

any or all of the following:

●

explain what the ratio attempts to show;

●

discuss the results of your calculations;

●

suggest possible reasons for good/poor results or differences from previous years, other

companies or expectations.

Although ratios are a useful additional guide to decision-making, they are also very difﬁ -

cult to interpret fully without additional information.

STUDY MATERIAL C2

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THE INTERPRETATION OF FINANCIAL STATEMENTS

Before calculating any ratios the nature of the business should be considered. The fol-

lowing list of questions is a useful starting point:

●

What is the nature of its business?

●

Does it need a lot of assets to operate?

●

How has it obtained its funding (shareholders ’ capital, loan capital or internally gener-

ated proﬁ ts)?

●

Does it have a high or low operating proﬁ t margin on its business?

●

Does it have high or low turnover in relation to the amount of capital that is tied up

in the organisation? (High-margin companies will normally have slower rates of sales/

t urnover because they usually charge higher prices and/or operate in premium segments

of a market.)

●

Does the company appear to be ﬁ nancially unstable (i.e. does it have excessive debts in

relation to its assets)?

●

Do the level of inventories or any other asset, or number of employees appear to be too

high or too low to support the organisation’s level of activity/sales?

●

Is there any information to tell whether the business is more or less efﬁ cient/proﬁ table

than other competitors in the same industry?

The answers to these questions and to others that are naturally associated with them are

key to understanding how an organisation is currently performing and how it is likely to

perform in the future. Trends in these indicators are of interest to internal managers and

accountants, and also to external users. Examples of external users are:

●

investors and potential investors use this type of information to decide whether to buy,

sell or hold shares in a particular company;

●

lenders and suppliers wish to know about the solvency of an enterprise and its ability to

repay loans or debts incurred in relation to the supply of materials or services;

●

governments charged with the responsibility for framing ﬁ scal policy or industrial policy

in different sectors of the economy will ﬁ nd much of interest in them. Many of the

accounting ﬁ gures are used to compile national statistics on industrial output, gross

national product (GNP), wage levels and inﬂ ation trends.

External sources of comparative information will usually be industry averages compiled by

government agencies or independent industry groups. These are readily available on the

Internet.

517

Question 1 Multiple choice

1.1 Given a selling price of $350 and a gross proﬁ t mark-up of 40 per cent, the cost

price would be:

$...............

1.2 Sales are $110,000. Purchases are $80,000. Opening inventories are $12,000.

Closing inventories are $10,000. Inventories days using average inventories are:

days

1.3 A business commenced with a bank balance of $3,250; it subsequently purchased

goods on credit for $10,000; gross proﬁ t mark-up was 120 per cent; half the goods

were sold for cash, less cash discount of 5 per cent; all takings were banked. The

resulting operating proﬁ t was:

$...............

1.4 The rate of inventories turnover is six times where:

(A) sales are $120,000 and average inventories at selling price is $20,000.

(B) purchases are $240,000 and average inventories at cost is $40,000.

(C) cost of goods sold is $180,000 and average inventories at cost is $30,000.

(D) net purchases are $90,000 and closing inventories at cost is $15,000.

1.5 The formula for calculating inventories days is:

(A) cost of goods sold/inventories  365.

(B) inventories/purchases  365.

(C) cost of goods sold/inventories.

(D) inventories/cost of goods sold  365.

1.6 A business operates on a gross proﬁ t margin of

33

1

3

per cent. Gross proﬁ t on a sale

was $800, and expenses were $680. The operating proﬁ t margin is:

per cent.

Revision Questions

14

THE INTERPRETATION OF FINANCIAL STATEMENTS

REVISION QUESTIONS C2

518

1.7 A business has the following trading account for the year ending 31 May 20X8:

$ $

Sales 45,000

Opening inventories 4,000

Purchases 26,500

30,500

Less : closing inventories (6,000)

(24,500)

Gross proﬁ t 20,500

Its average inventories days for the year is:

days

1.8 A company’s gearing ratio would rise if:

(A) a decrease in long-term loans is less than a decrease in equity.

(B) a decrease in long-term loans is more than a decrease in equity.

(C) interest rates rose.

(D) dividends were paid.

1.9 A company has the following details extracted from its statement of ﬁ nancial position:

$’000

Inventories 1,900

Receivables 1,000

Bank overdraft 100

Payables 1,000

Its liquidity position could be said to be:

(A) very well controlled, because its current assets far outweigh its current

liabilities.

(B) poorly controlled, because its quick assets are less than its current liabilities.

(C) poorly controlled, because its current ratio is signiﬁ cantly higher than the

industry norm of 1.8.

(D) poorly controlled, because it has a bank overdraft.

1.10 The gross proﬁ t mark-up is 40 per cent where:

(A) sales are $120,000 and gross proﬁ t is $48,000.

(B) sales are $120,000 and cost of sales is $72,000.

(C) sales are $100,800 and cost of sales is $72,000.

(D) sales are $100,800 and cost of sales is $60,480.

1.11 Revenue reserves would decrease if a company:

(A) sets aside proﬁ ts to pay future dividends.

(B) transfers amounts into ‘ general reserves ’ .

(C) issues shares at a premium.

(D) pays dividends.

THE INTERPRETATION OF FINANCIAL STATEMENTS

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

1.12 A company has the following current assets and liabilities at 31 October 20X8:

$’000

Current assets

Inventories 970

Receivables 380

Bank 40

1,390

Current liabilities

Payables 420

When measured against accepted ‘ norms ’ , the company can be said to have:

(A) a high current ratio and an ideal acid test ratio.

(B) an ideal current ratio and a low acid test ratio.

(C) a high current ratio and a low acid test ratio.

(D) ideal current and acid test ratios.

1.13 Your company’s income statement for the year ended 30 September 20X8 showed

the following:

$’000

Operating proﬁ t 1,200

Interest (200)

P r o ﬁ t before tax 1,000

Income tax (400)

P r o ﬁ t for the period 600

Its statement of ﬁ nancial position at 30 September 20X7 showed the following:

$’000

Share capital 8,000

Retained earnings 1,200

9,200

10% debenture 2,000

11 , 200

Return on average capital employed (ROCE) for the year ended 30 September

20X8 is:

per cent

CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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