Study Notes: Analysis and Communication of Accounting Information (AS Level 9706)
Hello Future Accountant! This chapter, 1.6, is where the magic happens. We stop just counting the numbers and start making them talk. You've spent time preparing financial statements (like the Statement of Profit or Loss and the Statement of Financial Position). Now, you will learn how to read between the lines, analyze performance, and communicate the findings clearly to the people who need them. This is the difference between being a bookkeeper and being a true financial analyst!
Section 1: Users of Accounting Information (Stakeholders)
Financial statements aren't just for the owners. Many different groups have a stake in the business's success and need information for different reasons. These groups are called stakeholders.
Why Different Stakeholders Need Financial Data
Think of accounting information as a news report about the company. Different people read the paper for different reasons:
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Owners/Shareholders/Investors:
Need: Profitability (Did I make money?), Dividend prospects, Future value of the company.
Focus: Gross profit margin, Profit margin, Return on Capital Employed (ROCE). -
Managers:
Need: Detailed information for daily decision-making, efficiency, and control (Is production costing too much?).
Focus: Efficiency ratios, Expense ratios, Cost analysis (detailed, internal reports). -
Employees:
Need: Job security, ability of the business to pay salaries, potential for bonuses or expansion.
Focus: Long-term stability, Overall profitability. -
Lenders (Banks, Creditors):
Need: The business's ability to pay back loans and interest on time.
Focus: Liquidity ratios (Current Ratio, Acid Test Ratio) and stability. -
Suppliers (Trade Payables):
Need: Assurance that the business can pay its short-term debts for goods purchased.
Focus: Liquidity ratios, Trade payables turnover days. -
Government (Tax Authority):
Need: To calculate taxes correctly based on reported profit.
Focus: Statement of Profit or Loss (accurate measurement of profit). -
Customers:
Need: Continuity of supply (Will the company still be around to service the product I bought?).
Focus: Overall stability and going concern. -
Public and Environmental Bodies:
Need: Information regarding environmental impact and community contributions (often found in non-financial reports, but linked to overall financial health).
Key Takeaway: Stakeholders have different focuses. Your job is to select the right information and present it clearly to meet their specific needs.
Section 2: The Core Tool – Financial Ratios
Financial ratios take two key numbers from the financial statements and compare them to produce a meaningful percentage or figure. They standardize performance measurement, allowing for comparison over time and against competitors.
We classify ratios into three main groups: Profitability, Liquidity, and Efficiency.
Remember: YOU MUST use the specific formulas provided in the syllabus appendix (copied below). Incorrect formulas will not be credited.
Section 3: Profitability Ratios
These ratios measure how successfully the business converts its resources into profits.
1. Gross Profit Margin (%)
This shows the percentage of sales revenue that remains after covering the Cost of Sales. It focuses purely on the trading activity (buying and selling goods) before considering operating expenses.
Formula: \( \text{Gross profit margin } (\%) = \frac{\text{Gross profit}}{\text{Revenue}} \times 100 \)
Interpretation: A higher percentage is better, indicating strong pricing power or effective cost control of inventory.
2. Mark-up (%)
Mark-up is the ratio of gross profit to the Cost of Sales. It tells the business how much profit they add onto the cost price of the goods they sell.
Formula: \( \text{Mark-up } (\%) = \frac{\text{Gross profit}}{\text{Cost of sales}} \times 100 \)
Did you know? If Gross Profit Margin is 25%, the Mark-up is 33.33%! They measure the same thing but from different starting points (Revenue vs. Cost of Sales).
3. Profit Margin (%) (Net Profit Margin)
This is the ultimate profitability measure. It shows the percentage of sales revenue that is left as profit after all operating expenses (like rent, salaries, and depreciation) have been paid.
Formula: (Using profit for the year) \( \text{Profit margin } (\%) = \frac{\text{Profit for the year}}{\text{Revenue}} \times 100 \)
Interpretation: A high profit margin means the business manages its operating expenses well.
4. Return on Capital Employed (ROCE) (%)
This is one of the most important ratios for investors and owners. It measures the return generated by the total long-term funds invested in the business (the capital employed). It tells you how effectively the total assets funded by long-term capital are generating profit.
Formula: \( \text{ROCE } (\%) = \frac{\text{Profit from operations}}{\text{Capital employed}} \times 100 \)
Where: \( \text{Capital employed} = \text{Issued shares} + \text{Reserves} + \text{Non-current liabilities} \)
Interpretation: The ROCE should always be higher than the interest rate a business pays on its loans, otherwise, the borrowing is unproductive!
5. Expenses to Revenue Ratio (%) (or Operating Expenses to Revenue Ratio)
This ratio helps management control specific spending.
Formula: \( \text{Expenses to revenue ratio } (\%) = \frac{\text{Operating expenses}}{\text{Revenue}} \times 100 \)
Interpretation: A low percentage is desirable, indicating efficient cost control.
Quick Review: Profitability is about making money. Higher ratios are generally better, but must be compared against previous years or industry benchmarks.
Section 4: Liquidity Ratios
Liquidity measures the company's ability to meet its short-term financial obligations (debts due within one year).
1. Current Ratio (Working Capital Ratio)
This compares short-term assets (what we have) against short-term liabilities (what we owe).
Formula: \( \text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}} \)
Interpretation: The answer is presented as a ratio (e.g., 1.5:1). A common benchmark is 2:1.
- If it is too low (e.g., 0.8:1), the business might struggle to pay its debts.
- If it is too high (e.g., 4:1), the business might be holding too much cash or slow-moving inventory unnecessarily, indicating inefficient use of funds.
2. Acid Test Ratio (Quick Ratio)
This is a stricter test of liquidity because it excludes inventory (stock) from current assets. Inventory is excluded because it might be slow to sell or difficult to convert into cash quickly.
Formula: \( \text{Acid test ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}} \)
Interpretation: The answer is presented as a ratio (e.g., 1.2:1). A common benchmark is 1:1. If the ratio is below 1:1, the business relies on selling its inventory just to pay its immediate creditors, which can be risky.
Key Takeaway: Liquidity is about having cash available. Too little cash means trouble; too much cash means missed opportunities for investment.
Section 5: Efficiency Ratios
Efficiency ratios (also known as activity ratios) measure how effectively the company uses its assets to generate income.
1. Non-Current Asset Turnover (Times)
This measures how much revenue is generated for every unit of investment in non-current assets (NCA) like property, plant, and equipment.
Formula: \( \text{Non-current asset turnover (times)} = \frac{\text{Net revenue}}{\text{Total net book value of non-current assets}} \)
Interpretation: A higher figure is better, suggesting assets are being utilized effectively to produce sales. A low figure might mean the business has too many unused or outdated assets.
2. Trade Receivables Turnover (Days)
This tells you the average number of days it takes for customers (who bought on credit) to pay the business.
Formula: \( \text{Trade receivables turnover (days)} = \frac{\text{Trade receivables}}{\text{Credit sales}} \times 365\text{ days} \)
Interpretation: A shorter period is better, meaning cash comes in faster. If this period is much longer than the agreed credit terms (e.g., 30 days), the credit control policy needs review.
3. Trade Payables Turnover (Days)
This tells you the average number of days the business takes to pay its suppliers (who sold to the business on credit).
Formula: \( \text{Trade payables turnover (days)} = \frac{\text{Trade payables}}{\text{Credit purchases}} \times 365\text{ days} \)
Interpretation:
- If the payment period is long, the business is effectively getting free credit, which helps liquidity.
- If the payment period is too long, it can damage relationships with suppliers, leading to loss of trade discount or refusal of future credit.
- If the payment period is very short, the business might not be utilizing its credit facilities fully, losing out on cheap short-term financing.
4. Inventory Turnover (Days and Times)
This measures how quickly inventory is sold and replaced during the period.
Inventory Turnover (Days): The average time inventory is held before being sold.
Formula:
\( \text{Inventory turnover (days)} = \frac{\text{Average inventory}}{\text{Cost of sales}} \times 365\text{ days} \)
Rate of Inventory Turnover (Times): How many times per year the inventory is completely sold out.
Formula:
\( \text{Rate of inventory turnover (times)} = \frac{\text{Cost of sales}}{\text{Average inventory}} \)
Note on Average Inventory: Calculate this as \((\text{Opening Inventory} + \text{Closing Inventory}) / 2\).
Interpretation: A high turnover (low number of days) is usually good, indicating that stock sells fast. However, if the rate is too high, it might indicate insufficient stock leading to lost sales.
Key Takeaway: Efficiency is about speed and utilization. Faster movement (receivables/inventory) is often better, but payables must be managed carefully to maintain supplier relations.
Section 6: Evaluation, Improvement Measures, and Limitations
Calculating ratios is only half the battle. The other half is evaluation (interpretation) and communication (making recommendations).
A. Evaluating the Results (Interpretation)
A ratio figure is meaningless in isolation. You must compare it against:
- Historical Data (Trend Analysis): How does this year compare to last year? (Is profitability improving or declining?)
- Competitors: How does the business compare to others in the same industry?
- Industry Benchmarks/Averages: What is the expected norm for this type of business (e.g., the 2:1 current ratio rule)?
When evaluating, you must always look for interrelationships between ratios.
Example: If the Profit Margin increased, but ROCE decreased, this suggests that while the business is managing its expenses better, the overall Capital Employed (investment) has grown disproportionately large, making the overall return on investment worse.
B. Possible Measures to Improve Performance
When asked to suggest measures, link your ideas directly to the ratios you found weak:
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To Improve Profitability (e.g., ROCE or Profit Margin):
– Increase selling prices (if market allows).
– Reduce operating expenses (e.g., cutting administration costs).
– Dispose of old, unused non-current assets (reducing Capital Employed, thereby boosting ROCE). -
To Improve Liquidity (e.g., Current Ratio, Acid Test):
– Implement stricter credit control (chase debtors faster, reducing Trade Receivables Days).
– Sell off obsolete or slow-moving inventory quickly.
– Seek longer credit terms from suppliers (increasing Trade Payables Days, but be cautious). -
To Improve Efficiency (e.g., Inventory Turnover):
– Implement a Just-In-Time (JIT) inventory system to reduce stock holding.
– Offer discounts for prompt payment to customers (reducing Trade Receivables Days).
C. The Limitations of Accounting Information
Don't worry if this seems tricky at first—even professional analysts know that ratios are not the full picture! Accounting data has several major limitations that restrict its usefulness:
- Reliance on Historical Cost: Financial statements record assets at their original cost (Historic Cost concept). This may mean that the Statement of Financial Position figures (e.g., Non-current assets) are outdated and do not reflect current market values.
- Different Accounting Policies: Businesses can choose different methods (e.g., Straight Line vs. Reducing Balance depreciation, FIFO vs. AVCO inventory valuation). This makes direct comparison between two companies difficult.
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Ignoring Non-Financial Factors: Ratios ignore crucial elements like:
– Staff morale and motivation.
– Quality of management/leadership.
– Market reputation or brand image.
– External economic changes or political instability. - Lack of Context: Ratios do not explain why performance changed. A decrease in current assets might mean liquidity is worsening, or it might mean management successfully invested surplus cash into productive non-current assets.
- Industry Differences: Comparing a supermarket (high inventory turnover) with a luxury yacht builder (slow inventory turnover) is pointless unless they are in the same industry.
Common Mistake to Avoid: When asked for a recommendation, never just say "Profit is too low, so increase it." You must provide specific, actionable advice, such as: "The Expenses to Revenue ratio has increased from 10% to 15%. I recommend reviewing administrative overheads, particularly electricity and maintenance costs, to bring the ratio back below 12%."