Analysing Financial Statements — full notes
Paper No. 1: Financial Accounting · Analysing Financial Statements (Ratio Analysis)
Analysing Financial Statements (Ratio Analysis)
1. Three families of ratio
| Family | Question it answers | Ratios in this pack |
|---|---|---|
| Profitability | How much of each shilling of sales turns into profit? | Gross profit margin, Net profit margin, ROCE |
| Liquidity | Can the business pay its short-term debts? | Current ratio, Quick (acid test) ratio |
| Efficiency | How well is inventory, receivables, and payables managed? | Inventory days, Receivables days, Payables days |
2. Formulas
| Ratio | Formula |
|---|---|
| Gross profit margin | Gross Profit / Sales x 100 |
| Net profit margin | Net Profit / Sales x 100 |
| Return on Capital Employed (ROCE) | Net Profit / (Capital + Non-current liabilities) x 100 |
| Current ratio | Current Assets / Current Liabilities |
| Quick ratio | (Current Assets - Inventory) / Current Liabilities |
| Inventory days | Inventory / Cost of Sales x 365 |
| Receivables collection days | Trade Receivables / Sales x 365 |
| Payables payment days | Trade Payables / Cost of Sales x 365 |
The quick ratio strips out inventory - the least liquid current asset - for a more cautious view of short-term solvency.
3. Worked example — Zuri Enterprises
Sales KES 1,000,000, Cost of Sales KES 600,000, operating expenses KES 250,000. Inventory KES 60,000, receivables KES 100,000, bank KES 40,000. Trade payables KES 100,000, a long-term loan of KES 100,000, capital KES 500,000.
Profitability: Gross profit = 400,000, margin 40%. Net profit = 150,000, margin 15%. ROCE = 150,000/(500,000+100,000) x 100 = 25%.
Liquidity: Current assets = 200,000. Current ratio = 200,000/100,000 = 2.0. Quick ratio = (200,000-60,000)/100,000 = 1.4.
Efficiency: Inventory days = 60,000/600,000 x 365 = 36.5 days. Receivables days = 100,000/1,000,000 x 365 = 36.5 days. Payables days = 100,000/600,000 x 365 = 60.8 days.
Read together: this business collects from customers in about the same time it takes to sell inventory, but takes noticeably longer to pay suppliers than it waits to be paid - a reasonably comfortable cash flow position on these figures.
4. A ratio on its own says little
Ratios are genuinely useful only in comparison - against the same business's prior years, or against similar businesses in the same industry. The comparability characteristic from Introduction to Accounting, doing real work again.