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CHAPTER+22.+Analysis+and+Interpretation.+Ans

The document provides a comprehensive analysis of financial statements, focusing on profitability and liquidity ratios to assess business performance. It details how these ratios can be calculated, their implications, and factors affecting them, as well as the importance of comparing results with similar businesses. Additionally, it discusses the users of accounting statements and the limitations of financial statements in capturing non-financial aspects and historical costs.

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49 views11 pages

CHAPTER+22.+Analysis+and+Interpretation.+Ans

The document provides a comprehensive analysis of financial statements, focusing on profitability and liquidity ratios to assess business performance. It details how these ratios can be calculated, their implications, and factors affecting them, as well as the importance of comparing results with similar businesses. Additionally, it discusses the users of accounting statements and the limitations of financial statements in capturing non-financial aspects and historical costs.

Uploaded by

n0M
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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1

22. ANALYSIS AND INTERPRETATION


22.1 Introduction
Analysis consists of a detailed examination of the information in a set of financial statements of
a business. The results of this analysis are interpreted to assess the performance of the
business.

Interpretation includes comparing the results of the business with other similar businesses or
comparing its results with its previous years. To enable the comparison to be carried out
meaningfully businesses use accounting ratios.

Ratios are categorized into two types.


1. Profitability ratios
2. Liquidity ratios

22.2 Profitability ratios

This measures the success in selling goods. The ratio shows the gross profit earned per $100 of
sales.

The gross margin can be improved by:


 Increasing selling price
 Obtaining cheaper supplies
 Reducing the rate of trade discount
 Passing on increased costs to customers

Gross profit margin may fall due to:

 Selling goods at lower prices


 Allowing higher rates of trade discount for bulk buying
 Not passing on increased costs to customers
 Buying more expensive goods

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
2

This measures the overall success of the business. The ratio shows the net profit earned per $100 of
sales. The ratio indicates how well the business controls its expenses.

The profit margin can be improved by:


 Increasing the gross margin
 Controlling the expenses
 Increasing other incomes
A fall in profit margin may be due to:
 Decrease in gross margin
 Increase in expenses
 Decrease in other incomes
 Change in type of expenses

The ratio shows the profit earned per $100 employed in the business. The ratio measures the
profitability of the investment in the business. The ratio shows how efficiently the capital is being
employed.

The return on capital employed is important it: -


 Measures overall profitability of the business in relation to resources used.
 Indicates adequacy of return on owner’s investment
 Enables comparisons to be made, e.g. against other investments, earlier years,
similar firms.
 Assists decision-making, e.g. in production, cost of borrowing or other acceptable
points

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
3

22.3 Liquidity Ratios

Liquidity ratios measure the ease and speed with which assets can be turned into cash.

This is also referred to as working capital ratio. This ratio compares the availability of current
assets to settle the short-tern debts of the business. This ratio shows whether the business has
sufficient liquid assets to meet its current liabilities. The ideal current ratio regarded is 1.5:1 to 2:1.

Problems to a company of having insufficient working capital.


 May have problems paying debts as they fall due.
 May not be able to take advantage of cash discounts.
 Cannot take advantage of business opportunities as they arise.
 Difficulties in obtaining further supplies.

The ways in which a business could increase its working capital.


 Injection of more capital.
 Sale of surplus fixed assets.
 Delaying purchase of non-current assets.
 Reduce drawings.
 Obtain more long-term loans

The liquid ratio compares the liquid assets (current assets less liabilities) with the current
liabilities. The ideal liquid ratio regarded is 0.7:1 to 1:1. If the liquid ratio is over 1:1 it may
indicate poor management of liquid assets such as having too high bank current account
balance.
Why do we use the liquid ratio?

Inventory is not regarded as a liquid asset – a buyer has to be found and then the money collected.
Some stock may prove to be unsalable. The quick ratio shows whether the business would have any
surplus liquid funds if all the current liabilities were paid immediately from the liquid assets.

This ratio calculates the number of times a business sells and replaces its inventory in a given
period of time.
A higher rate of inventory turnover indicates improved efficiency and a lower rate may indicate
that the sales is slowing down. The quicker the rate of inventory turnover, the less time funds
are tied up in inventory.

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
4

A lower rate of inventory can be caused by:


 Lower sales
 Over-purchase of inventory
 Selling price is too high
 Fall in demand
 Business activity slowing down

This ratio measures the average time the credit customers take to pay their accounts
Ways of improving the collection period for debtors / How to encourage Trade Receivable (Debtors)
to pay amounts due on them:

 Send statement of account


 Offer cash discount – not trade discount
 Refuse further business
 Refer to debt collectors
 Charge interest
 Offer future incentives

It measures the average time taken by the business to pay its credit suppliers.
Taking longer to pay the suppliers means that the business can use the funds for other
purposes, but has adverse effects such as:
- Suppliers can refuse supplies on credit
- Supplier can refuse further supplies until dues are settled
- Loss of any cash discount for early settlement
- Damage the relationship with the supplier

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
5

Exercise 1

Ratio Formula Working Answer


Gross margin Gross profit / revenue 60 000 / 250 000 x 100 24.00%
X100

Profit for the Profit for the year / revenue 32 500 / 250 000 x 100 13.00%
year margin X 100

Rate of Cost of sales / Average (9 800+190 300–10 100)


inventory inventory (9 800+10 100) / 2
turnover
190 000 19.10 times
9 950

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
6

Current ratio Current assets / current 33 200 / 19 200 1.73 : 1


liabilities

Acid test ratio Current assets - inventory / (33 200 – 10 100) / 19 1.20 : 1
current liabilities 200

Return on Profit for the year / capital 32 500 / 216 000 X 100 15.05%
capital employed x 100
employed

Exercise 2

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
7

Exercise 3

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
8

0452/12/M/J/19

Exercise 4

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
9

0452/21/M/J/19 Q2

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
10

Exercise 5

0452/22/M/J/18 Q4

Exercise 6

0452/12/M/J/18 Q6

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN
11

22.5 Factors which a company should consider when comparing the


business to other businesses.
 Should compare with a business of approximately the same size.
 Should compare with a business of the same type (sole trader).
 Should compare with business selling same type of goods
 Should compare with a business with approximately the same amount of capital
 The accounts may be for one year only which will not show trends and may not be a
typical year
 The financial year may end at a different point in the trading cycle
 The businesses may operate different accounting policies
 There may be differences which affect profitability and the items on a balance sheet
 The financial statements do not show non-monetary items
 It is not always possible to obtain all the information about a business in order to make
a true comparison

22.6 Users of accounting statements.


Internal users
a. Managers - Assessment of past performance. Basis of future planning. Control the
activities of the business. Identifying areas where corrective action is required
b. Owners – they are interested in both the profitability and liquidity of the business in
order to assess the performance of the business.
External users
a. Bank manager - Assessment of prospects of any requested loan/overdraft repaid
when due. Assessment of prospects of any interest on loan/overdraft being paid
when due. Assessment of the security available to cover any loan/overdraft.
b. Lenders - Assessment of prospects of any requested loan when due. Assessment of
prospects of any interest on loan being paid when due. Assessment of the security
available to cover any loan.
c. Creditor for goods - Assessment of the liquidity position. Identifying how long the
business takes to pay creditors. Identifying future prospects of the business.
Identifying what credit limit is reasonable.

22.7 Limitations of financial statements:

i. Non-financial aspects - Accounts only record information which can be expressed in


monetary terms. This means that there are many important factors which influence the
performance of a business which will not appear in the financial statements (final
accounts) e.g. quality of management, goodwill, skill of workforce etc.

ii. Historical cost Transactions are always recorded at the actual cost. This means that it
can be difficult to compare transactions which have taken place at different times
because of the effect of inflation.

SUBJECT: ACCOUNTING DEPT: IGCSE TEACHER:


MURSHID MOHIDEEN

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