Level 2Analysis & Interpretation

Achievement Standard 90225 (2.6)

ACC 10/2/9

The Standard requires:

Achievement Achievement with Merit

Achievement with Excellence

Analyse financial information.

Analyse a range of financial information.

Analyse a wide range of financial information.

Interpret information and make recommendation(s).

Interpret a range of information and make recommendation(s).

Interpret a wide range of information and make justified recommendation(s).

A wide range would typically involve nearly all of explanatory notes 3 and 6.

A recommendation details a strategy that will improve an identified weakness.

A justified recommendation explains how the recommendation will improve the identified weakness.

Analyse financial informationmeans calculate analysis measures selected from:

measures of profitabilitymark-up percentagegross profit percentageexpenses percentagesnet profit percentagereturn on equity percentagerate of return on total assets percentage

measures of liquidityworking capitalcurrent ratio/working capital ratioliquid ratio/quick asset ratio

measures of financial stabilityequity ratio

measures of management effectivenessinventory turnoverage of accounts receivable.

Interpret information includes:

• explain the analysis ratios • explain possible reasons for trends • explain possible consequences of a continued trend• provide links between analysis measures and other

information• provide links between related analysis measures• validly comment on an entity’s financial performance, and/or

financial position, and/or cash flows, using comparative figures (including industry averages) and results of analysis

• compare the financial and/or non-financial information relating to the business, or to two sole proprietor

businesses.

Teaching PointsAssessment Criteria Word

Possible meaning/requirement of the word(s)

Analyse Calculate analysis measures

Interpret Explain the analysis ratios, possible reasons for trends, possible consequences of a continued trendProvide links between analysis measures and other information; between related analysis measuresComment on the validity of an entity’s financial performance, and/or financial position, and/or cash flows, using comparative figures (including industry averages) and results of analysisCompare the financial and/or non-financial information relating to the business, or to two sole proprietor businesses.

Recommendation A strategy that will improve an identified weakness

Justifiedrecommendation

An explanation of how the recommendation(s) will improve the identified weakness – gives a clear transaction that would improve the percentage/ratio and linked this transaction clearly to the accounts affected

Three Components of Business Health

Profitability

Stability Liquidity

Profitability–Am I making enough Net Profit considering the efforts I am putting in and the money that I have tied up in business capital?

Liquidity–Can I pay my bills as they fall due?

Stability–Can I weather the storm if there is an expected or unexpected downturn in profitability and/or liquidity?

Gross Profit PercentageFormula:

Gross Profit x 100

Net Sales

What does it tell us? e.g. 30% means for every $1 of Sales there is 30c of gross

profit. This tells us how much of our sales are returned as gross profit

(the higher, the better) as expenses need to be covered.

How to Improve it? Improve mark-up percentage; get a cheaper supplier

Mark up %Formula:

Gross Profit x 100

COGS

What does it tell us? This tells us the amount that is added to the cost price to get the selling

price. - example on next page

How to Improve it? Increase mark-up percentage. Change in sales mix (A sales mix is a change in quantity sold of both high &

low mark up goods).

If Mark Up% increases, Gross Profit % increases or vice versa

Example of Mark Up %

Watches (mark up % of 50%) Earrings (15%)Watches that cost $100 will sell for $150Earrings that cost $5 will sell for $5.75

Sales Yr 1: 20 Watches 3 EarringsSales Yr 2L3 Watches 17 Earrings

Year 2 will have a smaller profit because the business has sold less expensive items (watches) and more cheaper items (earrings).

A business mark-up percentage depends on competitor’s mark up

Expense percentagesFormula:

Expense Group x 100

Net Sales

What does it tell us? Example: Distribution cost percentage of 10%. This means for every $1

of sales, 10c goes towards paying distribution costs. This tells us the proportion of sales revenue that is spent on paying

expenses. It indicates how well expenses are being controlled.

How to Improve it? Maintain better control over expenses.- Name the expense or expense

group that needs better control. Use a specific example.

Net Profit %Formula:

Net Profit x 100

Net Sales

What does it tell us?e.g. 12% this means for every $1 of revenue, 12c is profit.

This tells us how much of sales is returned as net profit.

How to Improve it? Decrease expense % by maintaining better control over

expenses. Increase GP% by increasing mark up%

Return on Equity (ROE or ROI)Formula:

Net Profit x 100

Average OE

What does it tell us? This measures the return on the owner’s investment in the

business. The return must be sufficient to compensate the owner for the

risk taken by investing in the business. This return needs to be compared to alternative investment

opportunities. e.g. interest rates, industry average return, return in other companies.

How to Improve it? Increase net profit

Return on Total Assets (ROTA)Formula:

Net Profit + Interest x 100

Average Total Assets

What does it tell us? This measures how productive the assets we used are in earning profit

for the business. The business wants this to be as high possible. e.g. Old assets = Repairs/Maintenance increased

= NP decreased

= Return on Assets decreased

How to Improve it? Improve Net Profit by maintaining better control over expenses

especially repairs & maintenance.

Sell idle (unused) or obsolete (old) non-current assets.

Current RatioFormula:Current AssetsCurrent Liabilities = x : 1

What does it tell us?e.g. 2.5 : 1 means for every $1 of CL the firm has $2.5 of CA. This tells us our ability to repay short-

term debts (debts that are due in the next accounting period – 1 year).

Ratio should be at least 1:1. Problems of a high current ratio: High accounts receivable – Problem of bad debts, Too much inventory – may become obsolete (expired, out of fashion etc.), Too much cash -better invested in term deposit to earn interest.

How to Improve it? Borrow long term Invest more capital in form of cash. Sell idle non-current assets for cash Decrease drawings.

Liquid RatioFormula:

What does it tell us? e.g. 1.52:1 means for every $1 of liquid liabilities, the

business has $1.52 of liquid assets. This tells us the firm’s ability to repay immediate debts

(debts that are due between 1- 3 months).

Note: The Liquid ratio is the best indicator of liquidity.

How to Improve it? Same as current ratio. Have clearance sale to sell obsolete inventory.

CA-Inventory & Prepayment CL- Secured Bank OD = x :1

Equity Ratio (Gearing Ratio)Formula:Owner’s Equity = x : 1Total Assets

What does it tell us? e.g. 0.6:1 means for every $1 of assets the owner has financed 60c. This tells us how much of the business assets has been financed by the owner. The ratio needs to be greater than 0.5:1 If the ratio is less than 0.5:1, the creditors will force the business to sell the assets to repay

them back. If the ratio is too high, this means the business is not making use of external funds (borrowing)

to expand the business.

How to Improve it? If the ratio is low, the owner must invest more capital. If the ratio is high, borrow more long term funds.

Inventory TurnoverFormula:

Cost of Goods Sold

Average Inventory =_____times per year

What does it tell us?

e.g. 12 times per year means that the business is selling on average its entire stock 12 times per year.

Tells us how long an average inventory is in the store before it is sold and how many times the business sells its entire inventory.

The ideal inventory turnover depends on the type of business activity.e.g. a jeweller may have 1 or 2 stock turns a year, a greengrocer 200 stock turns a year

and a baker will have to have a daily turnover period otherwise the stock is stale and worthless.

Each different business would have its own industry average.Goods with a higher mark-up% usually have a lower turnover.(interrelation). Lower mark-up made up for by greater sales, therefore a high

stock turn

Problems with a low inventory turnover: Money better invested elsewhere. Higher insurance premiums Store and warehousing costs Greater risk of deterioration/obsolescence (out of date) Stock items stolen

How to improve the Inventory Turnover Review purchasing procedure (why are we buying too much?)

Have clearance sale to sell off obsolete stock.

Formula:

What does it tell us? Note: ALWAYS round to the next full day. (general rounding rule does not apply)

e.g. 35.4 = 36 days; 35.8 = 36 days 35.001 = 36 days Means that the business is collecting its accounts receivable on an average every 36

days. Indicates how many days our customers take on average to pay their debts. Should be an average 35-40 days or better.

How to Improve it? Write off long overdue a/c as Bad debts. Perform credit checks. Encourage payment of accounts by offering discounts or charge interest for overdue

accounts. Review credit collection policies. i.e. send regular statements.

Age of Accounts Receivable

Average Accounts Receivable X 365Net credit sales + GST 1

Optimum Age of Accounts Receivable Ratio

35 – 40 days or LESS

Interpretation- What do all the

numbers mean???

Profitability An increase in Mark Up Percentage will increase

Gross Profit Percentage and vice versa.

Mark Up Percentage is linked to both sales and inventory turnover. A decrease in mark up should lead to an increase in sales and an increase in inventory turnover as the sales volume has improved.

An increase in Gross Profit Percentage should lead to an increase in Net Profit Percentage. If not, the firm needs to look at their expenses.

A decrease in Expenses Percentage (better control over expenses) should lead to an increase in Net Profit Percentage.

Profitability Continued… A decrease in Net Profit Percentage is not

necessarily detrimental for the firm if the net profit figure in the Income Statement has increased. A higher net profit figure means that the firm is more profitable even though it may have a lower Net Profit Percentage.

An increase in net profit figure will usually lead to an increase in the return on owner’s equity.

If the capital figure in the Statement of Financial Position (Balance Sheet) has increased, and Net Profit has remained constant the return on owner’s equity would decrease.

Liquidity/Management EffectivenessCurrent

RatioLiquid

RatioCauses Recommendation

High High Too much cash Age of Accounts

Receivable slow

Better invested in interest bearing accounts

Write off bad debts, and check credit collection policies

High Low Decrease in Inventory turnover with the possibility of obsolete stock or overstocking

Clearance sale of obsolete stock or

Check procedures when purchasing stock or

write off any obsolete stock

Low High a large secured bank overdraft

Check assets have been financed by non current liabilities (long term sources)

Low Low Increase in unsecured bank overdraft

Assets financed from short term rather than long term sources

Owner invests cash or reduces amount of drawings

Check assets have been financed by non current liabilities (long term sources)

Stability

If the Equity ratio is low and the liquid ratio is low, the owner should invest more capital

If the Equity ratio is high and the liquid ratio is low, the firm should borrow from long term sources e.g. increase mortgage