Worksheet on the Interpretation of Final Accounts (Student Version)

Worksheet on the Interpretation of Final Accounts (Student Version)

• Interpretation of Final Accounts Worksheet
• Tutor notes

---

• Introduction
• Background Information
• Aim of Task
• Useful Links
• Blank tasks

Introduction

This worksheet is designed to be undertaken within a single hour class, but leaves several openings for further work.

It includes some basic background information so the task can be completed without extra notes, and also utilises links to useful resources so those with time and online access may explore the subject and relevant references in more detail.

It is assumed that students have already achieved a basic understanding of company accounts and are reasonably familiar with the profit and loss account and balance sheet.

---

Background Information

Aims of Final Accounts

When interpreting final accounts we must answer the following questions

• How well has the business performed this year?
• Does it match my competitors?
• What will those interested in the business think of our performance?

When we look at a set of accounts, the above questions cannot be answered simply by looking at the balance sheet and profit and loss accounts. To bring a level of understanding to our business that will be useful to key groups, we must calculate exactly how the business has performed, and ideally relate this to previous years figures.

To do this we need access to the final accounts of the business we are investigating.

There are three key areas to consider:

1. Profitability
2. Liquidity
3. Activity

Each of the above can be calculated quite simply through a series of straightforward long divisions and multiplications. Using the formulae below we rapidly discover the final outcome of each ratio. However, a number alone means very little, the key skill is the ability to evaluate the numbers, and whether they reflect well on the business concerned.

We will examine the profitability ratio in depth within this task. Further research and deduction is required from you to determine the meaning of our other key ratios.

Profitability

• Gross Profit ratio
  • Gross Profit/Sales x 100
• Net Profit Ratio
  • Net Profit/Sales x 100
• Return on capital Employed
  • Net Profit/Capital Employed x 100

Liquidity

• Current ratio (sometimes called working capital ratio)
  • Current assets/current liabilities
• Liquid ratio (sometimes called the acid test ratio)
  • Current assets excluding stock/Current liabilities

Activity

• Stock Turnover ratio
  • Costs of goods sold/average stock
• Debtor Collection Ratio
  • Debtors/Credit sales over the period x 52 weeks
• Creditor payment ratio
  • Creditors/Credit purchase over period x 52 weeks

For an excellent in depth reference on Ratios look at The Business Tools (http://www.businesstools.org/). These are interactive tools that can analyse a whole set of accounting figures but do bear in mind that they are based upon US accounts. The author tells us that a UK version will be released in the future.

---

Aim of Task for student.

Firstly you must complete the profitability ratio tasks included below. By doing this you should become able to calculate other ratios besides being able to look for trends and discrepancies. In addition, we have provided some examples of reasons for changes in ratios over a period, to help you begin to assess the outcomes in this example.

Bear in mind however, that these are theoretical examples, and any true analysis needs to take place with reference to standard industry norms.

Blank Profitability Ratio Tasks

b.Example figures for Profitability Ratios

all figures are in £000's sterling

We can assume that each company operates in a similar industry.

Company	Year	Gross Profit	Sales	Net Profit	Capital Employed
a	00	700	3,100	300	1,250
a	01	785	2,185	350	1,450
a	02	995	3,330	420	1,550
b	00	325	975	120	3,650
b	01	312	1,145	90	2,950
b	02	270	1,070	60	2,650
c	00	842	5,645	530	7,560
c	01	1,005	6,435	730	8,550
c	02	1,375	7,265	850	9,420

---

Profitability

• Gross Profit ratio
  • Gross Profit/Sales x 100

If we find that the margin decreases substantially over the three year period, this could be attributable to a number of factors;

1. The cost of buying inventory has increased faster than selling prices.
2. Selling prices have fallen due to increased competition.
3. The product mix has changed to include goods with lower profit margins.
4. Theft of stock may be taking place.

Company	00...................	01.....................	02........................
a	?	?	?
b	?	?	?
c	?	?	?

Managers may need these figures to predict profitability and cost control. This will aid pricing and buying decisions.

Also auditors and tax authorities will use the gross profit margin to judge the accuracy of accounting systems.

---

• Net Profit Ratio
  • Net Profit/Sales x 100

The Net profit ratio performs the task of measuring the impact of overhead expenses. It should always be read with comparison to our gross profit ratio.

If the gross profit ratio is fairly constant yet the net profit ratio is varied then we can put this down to changes in the expenses. However if the two change in a similar fashion it is probably due to changes in direct costs.

Expense changes could be down to any of our overhead items from rent through to an increase in oil prices. An astute observer of these figures ought to be aware, therefore, of the overall business environment which may affect the industry.

Company	00...................	01.....................	02........................
a	?	?	?
b	?	?	?
c	?	?	?

When a manager looks at these figures, all departments of a business will be under scrutiny, hence the need to set budgets across an organisation.

---

• Return on capital Employed
  • Net Profit/Capital Employed x 100

This figure tells us how much has been returned for each £100 invested in the business. We would compare this with other types of investment if we were looking to buy shares in an organisation. Normally, this would be the ratio that would interest an investment house or fund manager from a large corporation looking to invest funds.

Company	00...................	01.....................	02........................
a	?	?	?
b	?	?	?
c	?	?	?

As a general rule, the higher the figure, expressed in percentage terms, the better the proposition.

When specialists look at the return on capital employed they will look, once again, for progress over the 3 years to identify whether or not the company is becoming more efficient.

---

Upon completing the calculations, your next task is to evaluate your figures based upon

1. Internal Comparison to previous years
2. Competitors figures
3. Relevance to interested parties

Examples of profitability ratios

Secondly, using whatever sources necessary, your next task is to choose 3 companies in an industry area and calculate and evaluate their profitability ratios for homework.

Upon completing the calculations, try to evaluate your figures based upon

1. Internal Comparison to previous years
2. Competitors figures
3. Relevance to interested parties

---

Congratulations!

Using your skill, judgement and previous knowledge, interpret your results based upon their relevance to the business owner, the competitors and the main interested parties such as Customers, Shareholders, Banks, Tax authorities, Suppliers

Now share your results with the rest of the group and discuss why the figures may have changed from year to year and between companies.