Ratio Analysis - Theory
Questions (Example from 2024)
b) Interpret and comment upon the results of your calculations for part (a). Identify what further information you would require to perform this analysis in further depth. (10 marks)
c) Briefly discuss the limitations of financial accounting ratio analysis. (10 marks)
Question b) - Interpret and comment
What the question is asking?
The question wants you to expand further on the results you had in question a), using your knowledge of what the rations mean to comment on the performance of the business
Example - 2024
The company improved its profitability significantly in 2024, with higher gross profit margin (52.94% vs. 42.50%) and net profit margin (16.47% vs. 3.85%).
Liquidity improved, as the current ratio increased from 1.57 to 4.07, and the quick ratio rose from 1.11 to 2.78, indicating stronger short-term financial health.
Leverage increased, as the debt-to-equity ratio rose from 0.40 to 0.78, suggesting the company has taken on more debt.
The interest coverage ratio improved from 2.83 to 13.00, indicating much better ability to cover finance costs.
The efficiency ratios show that the asset turnover ratio increased, meaning the company is generating more revenue per unit of assets.
Question b) - Further information
1. Profitability Analysis
Breakdown of Revenue: A detailed revenue segmentation by product, region, or customer type would help analyze revenue trends and profitability per segment.
Breakdown of Cost of Sales: Information on raw materials, labor costs, and overheads would allow better assessment of cost efficiency.
Operating Expenses Details: More information on distribution, administration, and other expenses would provide insight into cost management.
Non-Operating Income and Expenses: Details of other income or one-time expenses (e.g., asset sales, legal fees) would help separate core operating performance from one-off items.
2. Liquidity & Working Capital Management
Accounts Receivable Aging Report: To analyze how long customers take to pay and assess the risk of bad debts.
Inventory Turnover Breakdown: Inventory composition (raw materials, finished goods) and turnover ratio per product category would improve understanding of stock efficiency.
Trade Payables Aging Report: To assess how quickly the company is paying suppliers and whether it is maintaining favorable payment terms.
3. Solvency & Leverage Analysis
Loan Terms & Interest Rates: Details of interest rates, repayment schedules, and financial covenants on outstanding debt would clarify leverage risks.
Lease and Off-Balance Sheet Liabilities: Understanding of lease obligations or off-balance sheet financing would provide a more accurate picture of financial obligations.
4. Efficiency Ratios & Asset Utilization
Fixed Asset Register: Breakdown of property, plant, and equipment (PPE) by type and age to analyze asset efficiency and potential capital expenditure needs.
Capital Expenditure (CapEx) and Depreciation: Understanding of how much is spent on asset maintenance or expansion would clarify long-term asset sustainability.
5. Shareholder & Market Performance Analysis
Earnings Per Share (EPS): If available, EPS would provide insight into profitability per share for investors.
Dividend Policy & Payout Ratio: Details on past dividend payments and future dividend policy would help assess shareholder returns.
Market Price of Shares: If the company is publicly traded, stock price trends and Price-to-Earnings (P/E) ratio would allow comparison to industry benchmarks.
6. Industry & Competitor Comparisons
Industry Benchmark Data: Comparable financial ratios from competitors or industry standards would provide context on whether the company is over- or underperforming.
Macroeconomic Factors: Inflation, interest rates, and market conditions could impact financial performance and should be considered in deeper analysis.
Question c) - Limitations
Historical Data – Ratios are based on past financial statements and may not reflect current or future business conditions, limiting their predictive value.
Lack of Industry Context – Ratios are most useful when compared to industry benchmarks. Without this context, they may provide misleading conclusions.
Different Accounting Policies – Companies use different accounting methods (e.g., depreciation, inventory valuation), making comparisons across firms difficult.
Does Not Consider Non-Financial Factors – Financial ratios ignore qualitative factors such as management quality, brand reputation, customer satisfaction, and market trends, which significantly impact performance.
One-Time Events Can Distort Results – Exceptional items (e.g., asset sales, restructuring costs) can inflate or deflate profitability, making ratios less reliable for long-term analysis.
Inflation and Currency Effects – Financial statements may not always account for inflation or exchange rate fluctuations, which can distort ratio comparisons over time.
Short-Term Focus – Some ratios emphasize short-term performance (e.g., liquidity ratios) and may not capture long-term sustainability or strategic investments.
Manipulation of Financial Statements – Companies can engage in earnings management or creative accounting to make their ratios appear healthier than they are.
Ignores Market Conditions – Ratios do not account for macroeconomic factors such as interest rates, economic downturns, or industry disruptions.
No Definitive Standard – There is no universal "good" or "bad" ratio value; interpretation depends on industry norms, historical performance, and business strategy.