Financial Data Analysis

In this section, we will look at the calculation and interpretation of accounting ratios, which are crucial for analysing financial statements. You will develop a thorough understanding of how to analyse financial statements and evaluate the performance of companies. Emphasis will be placed on the practical application and interpretation of financial statements and on relating the analysis to real-life scenarios.

By the end of this section, you will be expected to understand and explain financial ratios, discuss how these financial ratios are applied and demonstrate the ability to evaluate the performance of companies using this information.

Let’s reflect on a topic you studied in Year 1 that relates to accounting ratios. You prepared the income statement to ascertain the net profit of the sole proprietor and the statement of financial position to determine the total assets, liabilities and equities. The table below shows the area.

KEY IDEAS

• Financial stability refers to how secure a business is over time. It indicates whether the company can continue operating even in the face of unexpected problems.

• Investment involves putting money into a business or project, expecting to earn a profit in the future.

• Liquidity is about how quickly a business can turn its assets into cash to pay its immediate bills.

• Profitability shows whether a business is making money. It tells us if the company is earning more than it spends.

• Ratio Analysis is a way of looking at a company’s financial information using ratios. These ratios help us understand how well a business is doing, its strengths and areas that might need improvement.

Accounting ratios are a group of formulas that help to assess how well a company is doing financially, based on its financial reports. They are useful tools for shareholders, creditors and other stakeholders to understand how efficient, profitable, strong and financially healthy a company is. These ratios make it easier to summarise and interpret difficult financial information.

The accounting ratios can be grouped into five categories

1. Profitability Ratios

2. Liquidity Ratios

3. Efficiency/ Management/Activity Ratios

4. Long-Term Solvency Ratios

5. Investment Ratios

Explanation of Categories of Ratios

1. Profitability Ratios

These are ratios that help us see how much money a business made during the year.

They show how well a business can earn a profit. Profitability ratios tell us if a business can make enough money to stay in operation and grow. Examples of Profitability Ratios include

a. Gross Profit as a percentage of Sales

b. Net Profit as a percentage of Sales

c. Return on capital employed

d. Asset Turnover Ratio

2. Liquidity Ratios

These are ratios that show how well a business can pay its short-term debts or liabilities when they are due. Liquidity is about how easily an asset can be converted into cash or another form of asset without losing much of its value. Examples of Liquidity Ratios are

a. Current Ratio

b. Acid Test / Quick Ratio

3. Efficiency/ Management/ Activity Ratios

These are referred to as Activity or Management Ratios. They show how effectively management is using the business’s resources to generate profits. Efficiency ratios measure how efficiently the business generates revenue and profits. They also look at how many days it takes to sell inventory, collect money owed by customers (receivables), and pay what is owed to suppliers (payables). Examples of Efficiency ratios are

a. Receivable Days

b. Trade payables Days

c. Inventory/ Stock Turnover days

4. Long-Term Solvency Ratios

They focus on a business’s long-term financial health. They show how much of the company’s money comes from owners’ (equity) funds compared to borrowed funds (debt). They also analyse the components of the company’s capital, especially the balance between debt and owners’ investments. Examples of Solvency ratios are

a. Debts to Equity Ratio

b. Interest Cover

5. Investment Ratios

These are the ratios investors use to decide whether to invest in a company. Investors use these ratios to decide whether to buy shares in a company. They also show the potential profits or returns that shareholders can earn from their investment. Examples include

a. Dividend per Share

b. Earnings per Share (EPS)

c. Price Earnings Ratio (P/E Ratio)

Activity 2.1 Meaning and Categories of Accounting Ratios

1. Recall what you learnt in year 1 on the preparation of the income statement and statement of financial position of a sole proprietorship.

2. Share your reflections with a friend by answering the following questions

a. Write the format of the income statement and the statement of financial position.

b. List one importance of each of the Statement of Profit or Loss and the Statement of Financial Position to businesses.

3. In pairs, define accounting ratios.

4. Share your answer with another pair for feedback

5. In groups, explain the following categories of accounting ratios with three examples each

a. Profitability Ratios

b. Liquidity Ratios

c. Efficiency/ Management Activity Ratios

d. Long Term Solvency Ratios

e. Investment Ratios

6. Present your findings to another group for discussion and feedback.

1. For Trend Analysis

Ratios are tools that help to understand how well a company is doing over time. They take information from the company’s financial statements and turn it into simple numbers for comparison. This helps managers assess if their decisions are working and if the company is improving.

2. For inter–firm comparison Ratios are used to compare one company’s performance with other companies in the same industry. This helps to analyse how well a company is doing compared to its competitors and understand the industry’s overall health in the economy.

3. For investment decisions Investors use ratios to decide whether to buy or sell shares in a company. By looking at ratios, investors can determine whether the company’s sales, profits and growth are improving or declining, helping them make informed choices.

4. Helps to determine the financial health of a business Ratios give important information about a company’s ability to pay its debts (liquidity), profits (profitability), and how much debt (liabilities) it has compared to its assets.

This helps determine whether the business is financially healthy.

Limitations of Ratio Analysis

1. Historical Information

Ratios are calculated using information from previous periods. They show what happened in the past, so they might not predict what will happen in the future.

2. Differences in accounting policies Companies may use different accounting policies and methods to prepare their financial statements. This can make it hard to compare ratios accurately because the methods affect the figures.

3. Manipulation of financial statements Sometimes, companies may alter or manipulate their financial reports to make them look better than they really are. This means ratios might not always show the true picture, so analysts need to be careful and check the information thoroughly.

4. Inflationary effects When prices go up over time (inflation), the financial figures might not reflect the true value of money. This makes it difficult to compare figures from different periods unless adjustments are made for inflation.

Activity 2.2 Importance and Limitations of Accounting Ratios

1. Recall what you learnt in the previous lesson on the meaning and categories of accounting ratios. Share your reflections with another group.

2. In groups, read the scenario below and answer questions (a) and (b) that follow.

JosKBaff Company, a Ghanaian textile company, is seeking a loan to expand its operations. The banks request financial statements, and the accountant calculates key ratios, including the current ratio (1.8:1), the debt-to-equity ratio (0.5:1), and the return on equity (18%). The industry averages are: current ratio

– 1.5:1, debt to equity ratio - 0.8:1, and return on equity 15%.

a. Briefly explain three reasons why the accounting ratios of JosKBaff are important to the bank.

b. Discuss three limitations of accounting ratios.

3. Share your answers with another group for feedback and discussion.

These are ratios that help us see how much money a business made during the year. They show how well a business can earn a profit. Profitability ratios indicate whether a business can generate sufficient income to remain in operation and grow.

Examples of Profitability Ratios

1. Gross Profit Ratio: (Gross Profit as a percentage of sales) This ratio shows how much gross profit is generated per sale. It is calculated by dividing gross profit (sales revenue minus cost of goods sold) by sales revenue, then multiplying by 100 to get a percentage. A higher percentage means the company is keeping more of its sales revenue. It is calculated as Gross Profit Ratio = Gross Profit × 100% Sales Revenue

2. Net Profit as a percentage of sales This ratio shows how much profit a company earns from its total sales after all expenses (such as administrative expenses, selling and distribution expenses) have been deducted. It is calculated by dividing net profit (total revenue minus total expenses) by sales revenue, then multiplying by 100. A business with high expenses will have a low net profit margin. A higher net profit margin indicates better profitability. It is calculated as:

Net Profit Ratio = Net Profit × 100% Sales Revenue

3. Return on Capital Employed (ROCE)

This ratio measures a company’s efficiency and profitability relative to the capital it has invested in the business. Capital employed is the capital used to finance the business, that is, funds provided by shareholders (share capital plus reserves) and funds advanced by financial institutions (non-current liabilities).

ROCE = Profit before Interest and tax × 100% Capital employed Where capital employed = Shareholders’ fund + long-term liabilities or Total assets- current liabilities Importance of ROCE ₁. ROCE helps assess how efficiently a company is using its capital to generate profits. A higher ROCE indicates better performance and effective capital utilisation.

2. Investors and stakeholders use ROCE to evaluate the potential return on their investments. It aids in comparing the profitability of different companies or projects.

3. ROCE provides insights into a company’s financial health by showing how well it is managing its capital. It can highlight operational efficiency and profitability.

4. Companies can use ROCE to benchmark their performance against industry standards or competitors, helping identify areas for improvement.

5. ROCE reflects how well a company is managing its debt and equity, offering insights into its capital structure and financial strategy.

6. By analysing ROCE over time, businesses can make informed decisions regarding capital investments, resource allocation and strategic planning.

4. Asset Turnover Ratio

The asset turnover ratio is a financial metric that measures how efficiently a company uses its assets to generate sales revenue. It is calculated by dividing the company’s total sales or revenue by its average total assets over a specific period.

Asset Turnover Ratio= Net Sales /Revenue Net assets or Capital employed A higher asset turnover ratio indicates that the company is using its assets more effectively to produce revenue, while a lower ratio may suggest inefficiencies in asset utilisation.

Activity 2.3 Computation and Interpretation of Profitability Ratios

1. In groups, explain the meaning of profitability ratios with two important aspects.

2. Study the data below extracted from the books of Olumba Brothers Ltd.

GH¢’000 Revenue for the year 6,245 Gross Profit 1,443 Operating profit 546 Non-current assets 2,767 Current assets 5,561 Current Liabilities 3,821 Opening Inventory 50 Closing Inventory 60

3. Calculate and interpret the following ratios based on the data:

a. Gross Profit Ratio

b. Net Profit Ratio

c. Return on Capital Employed

d. Asset Turnover Ratio

4. Explain two reasons why each of the ratios in (2) is important.

5. Present your answers to the teacher for marking.

These are ratios that indicate how well a business can meet its short-term debt or liability obligations when they are due. Liquidity is about how easily an asset can be converted into cash or another form of asset without losing much of its value. These ratios are important because they indicate a business’s financial health, especially during economic uncertainty.

Examples of Liquidity Ratios

1. Current Ratio

The current ratio measures a company’s ability to pay its short-term liabilities with its short-term assets. This ratio is also known as the working capital ratio.

Current Ratio = Current Assets : 1 Current Liabilities A ratio above 1:1 is considered healthy, but it should probably exceed 2:1 to safely indicate that short -term liabilities can be met. Note that this will vary by industry. It is not necessarily true that the “the higher the better” approach applies to this ratio, as it could indicate that a business is too liquid.

2. Quick Ratio / Acid-Test Ratio The quick ratio is a more stringent measure of liquidity than the current ratio. It excludes inventory from current assets since inventory may not be as easily converted to cash.

Acid Test Ratio = Current Assets – Inventory : 1 Current Liabilities A higher acid test ratio means a business is liquid and can meet its obligations. A ratio below 1 can indicate liquidity problems.

Activity 2.4 Computation and Interpretation of Liquidity Ratios

1. Your previous lesson introduced you to profitability ratios. Identify the difference between profitability and liquidity ratios.

2. In groups, study the data below extracted from the books of JosKBaff Ltd.

GH¢’000 Revenue for the year 1,260 Gross Profit 420 Operating profit 315 Non – current assets 1,120 Current assets 300 Current Liabilities 240 Opening Inventory 60 Closing Inventory 140 Calculate and interpret the following ratios

a. Current Ratio

b. Acid Test Ratio

3. Explain two uses of the acid test ratio.

4. Discuss the use of the current ratio.

5. Share your answers with another group for discussion.

6. Present your work to your teacher.

These ratios help assess how well a company uses its assets and manages its operations to generate revenue. These ratios provide insights into the operational efficiency of a business.

They look at the length of time the business uses to sell inventories, collect receivables and pay payables.

Types of Efficiency Ratios

1. Trade Receivables (Debtors) Collection Days /Period This ratio shows the number of days required to collect goods sold on credit. This ratio measures how effectively a company collects its trade receivables or money owed by customers. The shorter the trade receivables’ collection period, the better it is for the business.

Trade Receivables Collection Days/Period = Trade Receivables × 365 days Credit Sales

2. Trade Payables Payment Days/Period

This explains how long a business takes to pay its suppliers or trade payables after receiving goods or services. It helps to measure how efficiently a company manages its payments. The longer the number of trade payables payment days, the better it is for the business.

Trade payables Payment Period = Trade Payables × 365 days Credit Purchases

3. Inventory Days/ Period

This measures the average number of days a company takes to sell its entire inventory during a specific period. It provides insights into how efficiently a business manages its inventory and how quickly it converts stock (inventory) into sales. The fewer the days, the better it is for the business.

Inventory Days/Period = Average Inventory × 365 days Cost of Sales Average inventory = Opening Inventory + Closing Inventory 2

Activity 2.5 Computation and interpretation of Efficiency or Management Ratios

1. In groups, explain the importance of a shorter trade receivables collection period.

2. Explain the use of trade payables payment days.

3. Discuss the use of inventory turnover days

4. Study the Statement of Profit or Loss for the year ended 31ˢᵗDecember 2024, of JosKBaff Ltd, as given below GH¢ GH¢ Sales Revenue 182,500 Opening inventory 15,000 Purchases 28,500 Closing inventory (18,000) (25,500) Gross Profit 157,000 Expenses (70,000) Net Profit 87,000 Also stated below is the statement of financial position of DB Ltd as at 31ˢᵗDecember, 2024 is GH¢ GH¢ Non – Current Assets 247,810 Current Assets Inventory 18,000 Trade Receivables 25,000 Cash 300 43,300 Total Assets 291,110 Equity and Liabilities Current Liabilities Trade payables 6,000 Bank 2,500 8,500 Capital Opening Balance 195,610 Net Profit 87,000 282,610 291,110 JosKBaff Ltd has also obtained industrial averages for the year ended 31ˢᵗDecember 2024 Trade Payables Payment Days 30 days Inventory Days 95 days Debtors Collections Days Days

a. Calculate the following and explain the performance of the company with respect to the industrial averages.

i. Trade Receivables Collections Days (to the nearest day)

ii. Trade Payables Payment Days (to the nearest day)

iii. Inventory Days (to the nearest day)

b. Present your work to the class for discussion and feedback.

1. Explain Accounting Ratios

2. Explain five reasons why Accounting Ratios are important in financial analysis.

3. Explain three limitations of accounting ratios

4. Discuss three reasons why the Return on Capital Employed (ROCE) ratio is important.

5. Explain three uses of profitability ratios.

6. Explain why the asset turnover is an important accounting ratio.

7. The following financial statements relate to Jossy PLC and Vinso PLC. Both companies are in similar retail business.

Statement of profit or loss for the year ended 31st December, 2023 Jossy PLC Vinso PLC GH¢ GH¢ GH¢ GH¢ Revenue 80,000 120,000 Less: Cost of sales:

Opening inventory 25,000 22,500 Purchases 50,000 91,000 75,000 113,500 Less: Closing inventory 15,000 60,000 17,500 96,000 Gross Profit 20,000 24,000 Less: Expenses 10,000 9,000 Net Profit 10,000 15,000 Statement of financial position as at 31ˢᵗDecember, 2023 GH¢ GH¢ GH¢ GH¢ Non – Current Assets:

Equipment (at cost) 15,000 25,000 Less: Depreciation 8,000 7,000 6,000 19,000 Current Assets:

Inventory 15,000 17,500 Receivables 25,000 20,000

Bank 5,000 45,000 2,500 40,000 Total Assets 52,000 59,000 Equity and Liabilities Stated Capital 32,000 29,000 Retained Earnings 15,000 20,000 47,000 49,000 Current Liabilities:

Payables 5,000 10,000 Total equity and liabilities 52,000 59,000

a. You are required to calculate the following ratios for both companies (present to 2 decimal places)

i. Gross profit margin

ii. Net profit margin

iii. Inventory period

iv. Current ratio

v. Quick ratio

vi. Trade Receivable collection period

vii. Trade Payables payment period

b. Comment on the implications of the following ratios on both companies:

i. Net profit

ii. Current ratio

iii. Receivable collection period