Analysing Accounting Reports
The main reason for producing accounting reports is to provide information needed for decisions. Final reports can provide a great deal of information on the performance and financial position of a business. A full analysis of a business, however, involves more than reading through columns of numbers. To assess the performance of a business, key figures need to be selected from the reports, and then compared with a goal or standard in order to interpret the financial results.
In analysing the results of a business, the standard comparison can be budgeted figures set by the owner/manager of the business, the previous year’s results, industry averages, performance of similar businesses, and standard economic indicators such as the inflation rate, interest rate, or growth of the economy as a whole.
Some comparisons can be made using figures directly from the financial statements. Other comparisons look at ratios between key figures in the reports.
The aim of ratio analysis is to reduce the large number of items in the balance sheet and profit report down to a set of more informative and easily understood numbers. Ratio analysis looks at the changes in the relationship between items. They help to assess whether changes in items are due to normal growth of a business or whether they require further investigation.
Businesses, when planning for the future, usually take into account the reporting of past results of the business. It is therefore very important that the reporting of information is correct and done is a clear and understood fashion. This allows management to interpret results and make the appropriate decisions for the future.
Analysis and interpretation is not just one single process. They involve two distinct operations.
- Analysis is the process of breaking down something complex into simpler, smaller portions in order to identify it or study its structure.
- Interpretation is the process of explaining the meaning of the completed analysis.
When based on dollar values, the profit and loss statement provides limited information. When the same report is analysed (or broken down) into percentages, additional information becomes available. Management is now able to interpret the report in terms of the percentage of the sales dollar consumed by each of the expense classifications. Analysis can be used to break down accounting reports into smaller segments ready for interpretation.
A second type of analysis is horizontal comparisons.
Horizontal analysis looks at the performance of a business in specific areas over several accounting periods. It is used to detect changes that have occurred over time. Quite often a pattern can be detected, enabling management to implement changes for the future. (Take the example above but also take the same reports in previous years.)
Vertical analysis can provide detailed information about the current accounting period, but when this is compared with previous periods, it may be seen in a different light. Vertical analysis is limited as it only considers the one accounting period. If previous years’ figures (horizontal analysis) are also made available, a different opinion of the performance may be formed.
Analytical Ratios
Once final reports have been prepared, accountants will often extract different pieces of information and compare them with one another in an attempt to find out more about the business. When you do this, an analytical ratio is created.
A ratio is the comparison of two items that have a particular relationship to one another. For example, current assets may be compared with current liabilities in order to measure the liquidity of the business.
Because ratios bring all figures back to a common base, analytical ratios allow the performance of business to be compared in different periods.
The vertical analysis shown previously is based on a collection of analytical ratios:
- Gross profit ratio: which is gross profit divided by sales.
- Selling expense ratio: which is selling expenses divided by sales.
- Net profit ratio: which is net profit divided by sales.
Ratio Yardsticks
When ratios are calculated, they are usually compared to a yardstick of measurement in order to evaluate the success or failure of business performance. Typical yardsticks include:
- Previous accounting periods: comparisons to previous years allows for trends in the ratio to be detected.
- Industry averages, or comparisons with other similar business: an accountant may be able to state if a business’s performance is above or below that of similar businesses. (Such information, however, is not always publicly available).
- Budget estimates or predicted results: although ratios may indicate improved performance, they may not be at a level predicted by management.
- Alternative investments: ratios that look at profitability should be compared against the rates of return available on other forms of investment.
When a ratio has been calculated, it should be compared with one or more yardsticks to give the ratio some meaning. Depending on the ratios, different yardsticks would be used. As long as analytical ratios are calculated in a consistent manner, they can provide management with important information about the performance of the business in a number of different areas.
Types of Analytical Ratios
There are literally hundreds of different ratios that can be calculated to measure different aspects of the performance of a business. The most important of these are:
- Profitability ratios - these ratios looks at how profitable a business has been during the period. Profitability may be measured by eg. comparing profit with an investment or by looking at what happed to the sales dollar during a period.
- Operating efficiency ratios - these look at how efficiently management has used the assets available to them. The investment in stock, debtors, current assets or non-current assets can all be examined in terms of how efficiently they have been utilised.
- Liquidity Ratios – these ratios look at the ability of a business to meet it’s debts as they fall due. They are usually based on short term events (within next 12 months).
- Financial stability ratios - these ratios look at the dependence of a business on borrowed funds compared with the owner’s funds. They measure the level of financial risk. Financial stability looks at a business in the long term and takes in all types of liabilities.
Keep in mind, however, that one ratio may have a direct impact on another ratio in a different area. For example, liquidity ratios take into account current liabilities. As these are borrowed funds, they are also relevant to financial stability ratios.
Profitability Ratios
Profitability is the comparison of a profit figure with a base figure, such as the investment made. Profit is the dollar value determined when expenses incurred are deducted from revenue earned over a given period. So, when determining the business profitability, it is necessary to go beyond just determining the net profit. Profitability ratios, as well as ascertaining the profitability of a business, also looks at the underlying reasons for changes in the profitability of a business.
Gross Profit Ratio
The percentage of the sales dollar earned as gross profit is one of the most important factors that influence the profit of a trading business. The relationship between the cost price and the selling price of the goods sold by the business is critical to profitability. If cost prices have increased over time and selling prices have remained constant, the gross profit ratio will fall.
When evaluating a gross profit ratio, it is important to compare it against yardsticks such as the previous period’s gross profit ratios and the budget gross profit rate.
Gross profit can fall due to:
- Cost prices increasing whilst selling prices remain constant;
- Cost prices remaining constant, while selling prices decrease;
- Both cost prices and selling prices increasing, but cost prices increased at a greater rate.
Net Profit Ratio
The relationship between a business’s total revenues and total expenses is the net profit ratio achieved by the business. Once the gross profit rate has been calculated, the level of the business’s operating expenses will determine the percentage of the sales dollar which remains as the net profit for the period.
The net profit ratio should be compared with the rate achieved in past periods, the budgeted rate and the rate achieved by similar businesses. Although each business is unique in terms of its own revenues and expenses, if similar businesses earn a much higher net profit rate, then this can act as a warning sign that something may be wrong.
Operating Profit Ratio
A percentage rate can be calculated for each functional classification or, if desired, for each individual expense item. These types of ratios can inform management about the percentage of the sales dollar consumed by each expense group.
Expense ratios should be compared with previous periods’ results and the expense budgets.
Unexpected expense items and major changes in expense ratios should always be investigated as they have a direct impact on the net profit rated earned by the business.
Rate of Return on Owners Investment Ratio
The rate of return can also be calculated on the actual investment made by the proprietor of the business. As with the above ratio, an average of the proprietor’s capital is the preferred figure to be used. When evaluating an owner’s personal rate of return the usual yardsticks include comparisons with:
- Alternative investments in the money market.
- The budgeted, or expected, rate of return.
- Previous periods’ rates of return.
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