Analysis and Interpretation of Financial Statements

After preparing financial statements, accountants analyse the results to evaluate the performance and financial position of a business. One important method used for this purpose is Ratio Analysis.

Accounting ratios help users of financial statements understand the strengths and weaknesses of a business.

What is Ratio Analysis?

Ratio analysis involves calculating relationships between different financial figures in the financial statements. These ratios help in evaluating profitability, liquidity and efficiency of a business.

Ratios are often used to compare:

Performance of the business over different years
Performance of different businesses in the same industry
Actual performance with planned performance

Profitability Ratios
Gross Profit Margin


Formula:
(Gross Profit / Revenue) × 100

Example:
(20,000 / 50,000) × 100 = 40%

Interpretation
Higher percentage indicates better profitability.

Net Profit Margin


Formula:
(Net Profit / Revenue) × 100

Example:
(14,300 / 50,000) × 100 = 28.6%

Interpretation
Shows the overall profitability after expenses.

Liquidity Ratios
Current Ratio


Formula:
Current Assets / Current Liabilities

Example:
18,000 / 6,000 = 3:1

Interpretation
Shows the ability of the business to pay short-term debts.

Acid Test Ratio (Quick Ratio)


Formula:
(Current Assets − Inventory) / Current Liabilities

Example:
(18,000 − 8,000) / 6,000 = 1.67:1

Interpretation
Measures immediate liquidity of the business.

Practice Question

Using the following information calculate the ratios:

Revenue = 80,000
Gross Profit = 32,000
Net Profit = 16,000
Current Assets = 20,000
Inventory = 6,000
Current Liabilities = 10,000

Calculate:

Gross Profit Margin
Net Profit Margin
Current Ratio
Acid Test Ratio

Quick Check

1. Why is Inventory excluded from the Liquid (Acid Test) Ratio?

A. It is not an asset.
B. It is the least liquid current asset.
C. It is already sold.

Click here to reveal correct answers

Answer: B. Inventory is excluded because it is the most difficult current asset to convert into cash quickly.