Why Analyse Financial Statements?
Accounting ratios help owners, investors and banks judge a firm's performance and position so they can make decisions. Ratios fall into three groups: profitability, liquidity and efficiency.
Key idea
Gross profit margin = (Gross profit ÷ Sales) × 100. Net profit margin = (Net profit ÷ Sales) × 100. Current ratio = Current assets : Current liabilities.
Key Ratios
- Gross profit margin — the gross profit earned on every RM100 of sales.
- Net profit margin — net profit on every RM100 of sales; it takes expenses into account.
- Current ratio — the ability to pay short-term debts; around 2:1 is usually healthy.
- Acid-test (quick) ratio = (Current assets − Inventory) : Current liabilities.
- Rate of inventory turnover = Cost of sales ÷ Average inventory.
A Worked Example
Example
Sales RM100,000; cost of sales RM60,000; gross profit RM40,000; net profit RM15,000. Current assets RM30,000 (including inventory RM10,000); current liabilities RM15,000.
Gross profit margin = 40,000/100,000 × 100 = 40%.
Net profit margin = 15,000/100,000 × 100 = 15%.
Current ratio = 30,000:15,000 = 2:1.
Acid-test ratio = (30,000−10,000):15,000 = 1.33:1.
Efficiency Ratios and Interpretation
Efficiency ratios judge how well a business manages its assets and debts. The debtors collection period shows the average number of days customers take to pay, while the creditors payment period shows how long the business takes to pay its suppliers. A high rate of inventory turnover means stock moves quickly and capital is not tied up in unsold goods.
When interpreting, a profit margin that falls compared with last year may signal rising costs or lower selling prices; a current ratio that is too high may mean too much idle cash or stock that is not used efficiently. Managers use these interpretations to make decisions such as controlling expenses, adjusting prices or improving debt collection.
Remember
A ratio only means something when compared — with last year, with another business, or with the industry average. A single figure on its own is not enough to decide.