88 ACCOUNTING FOR MANAGERS
Interpreting financial information using ratios
The interpretation of any ratio depends on the industry. In particular, the ratio
needs to be interpreted as a trend over time, or by comparison to industry averages
of competitor ratios. These comparisons help determine whether performance is
improving and where improvement may be necessary. Based on the understanding
of the business context and competitive conditions, and the information provided
by ratio analysis, users of financial statements can make judgements about the
pattern of past performance and prospects for a company and its financial strength.
Broadly speaking, businesses seek:
žincreasing rates of profit on shareholders’ funds, capital employed and sales;
žadequate liquidity (a ratio of current assets to liabilities of not less than 100%)
to ensure that debts can be paid as they fall due, but not an excessive rate to
suggest that funds are inefficiently used;
ža level of debt commensurate with the business risk taken;
žhigh efficiency as a result of maximizing sales from the business’s invest-
ments; and
ža satisfactory return on the investment made by shareholders.
When considering the movement in a ratio over two or more years, it is important
to look at possible causes for the movement. These can be gained by understanding
that either the numerator (top number in the ratio) or denominator (bottom number
in the ratio) or both can influence the change.
Some of the possible explanations behind changes in ratios are described below.
Profitability
Improvements in the returns on shareholders’ funds (ROI) and capital employed
(ROCE) may either be because profits have increased and/or because the capital
used to generate those profits has altered. When businesses are taken over by
others, one way of improving ROI or ROCE is to increase profits by reducing costs
(often as a result of economies of scale), but another is to maintain profits while
reducing assets and repaying debt.
Improvements in operating profitability as a proportion of sales (PBIT or EBIT)
are the result of profitability growing at a faster rate than sales growth, a result
either of a higher gross margin or lower expenses. Note that sales growth may
result in a higher profit but not necessarily in a higher rate of profit as a percentage
of sales.
Improvement in the rate of gross profit may be the result of higher selling
prices, lower cost of sales, or changes in the mix of product/services sold or
different market segments in which they are sold, which may reflect differential
profitability.
Naturally, the opposite explanations hold true for deterioration in profitability.