Reporting & Decision Making
Analysis and Communication of Accounting Information
This topic tests your ability to calculate, interpret, and evaluate a wide range of accounting ratios — and to communicate your findings clearly to non-accountants. Ratio calculation is just the starting point; marks are awarded mainly for interpretation and informed recommendations.
A ratio on its own means nothing. Always: (1) state whether the ratio has improved or deteriorated, (2) explain what that means for the business (e.g. “trade receivables days have increased from 32 to 47 days, suggesting the business is collecting debt more slowly, which could strain cash flow”), (3) compare to industry benchmark or prior year if data is given, and (4) suggest a possible cause or action. One mark for the figure, two or three marks for the analysis.
Ratio Quick Reference
| Category | Ratio | Formula | What it measures |
|---|---|---|---|
| Profitability | Gross profit margin | Gross profit ÷ Revenue × 100 | % of revenue remaining after cost of sales |
| Profit for year margin | Profit for year ÷ Revenue × 100 | Overall profitability after all expenses | |
| Return on equity (ROCE) | Profit for year ÷ Total equity × 100 | Return generated on shareholders’ funds | |
| Liquidity | Current ratio | Current assets ÷ Current liabilities | Ability to meet short-term obligations |
| Quick (acid test) ratio | (Current assets − Inventory) ÷ Current liabilities | Liquidity excluding least liquid current asset | |
| Trade payables days | Trade payables ÷ Cost of sales × 365 | Average days taken to pay suppliers | |
| Efficiency | Inventory turnover (days) | Inventory ÷ Cost of sales × 365 | Average days inventory is held before sale |
| Trade receivables days | Trade receivables ÷ Revenue × 365 | Average days to collect cash from customers | |
| Asset turnover | Revenue ÷ Total assets (or net assets) | Revenue generated per $ of assets | |
| Investment | Earnings per share (EPS) | Profit after tax ÷ Number of ordinary shares | Profit attributable to each share |
| Dividend per share | Total dividends ÷ Number of ordinary shares | Cash return per share to shareholders | |
| Dividend yield | Dividend per share ÷ Market price per share × 100 | Cash return relative to share price | |
| Gearing | Gearing ratio | Non-current liabilities ÷ (Equity + Non-current liabilities) × 100 | Proportion of finance from long-term debt |
| Interest cover | Profit from operations ÷ Finance costs | Times interest is covered by operating profit |
Key Concepts to Revise
Limitations of Ratio Analysis
Ratios use historical data — may not reflect current position. Different accounting policies (e.g. depreciation method, inventory valuation) make inter-firm comparison unreliable.
Window dressing, seasonal factors, one-off items, and inflation all distort ratios. Ratios don’t reveal why a change occurred — only that it has.
Interpreting Gearing
High gearing (>50%): higher financial risk, interest obligations must be met regardless of profit; concern for lenders and equity investors
Low gearing: more conservative, lower risk. Interest cover <2× is generally considered risky; >3× is comfortable.
Stakeholder Perspectives
Investors: EPS, dividend yield, P/E ratio, ROCE — focus on return and growth potential
Lenders: gearing, interest cover, current ratio — focus on security and repayment ability
Management: all ratios, especially efficiency and profitability trends
Communication of Accounting Info
Written reports must be: clear, concise, relevant to the audience (avoid jargon for non-accountants), and supported by evidence from the accounts
Structure: calculate ratio → compare to prior year or benchmark → interpret the change → suggest cause → recommend action
Working Capital Management
Ideal: receivables days < payables days (collect cash before you pay it out). High inventory days = slow-moving stock risk.
Cash operating cycle = Inventory days + Receivables days − Payables days. A longer cycle means more cash is tied up in working capital.
Investment Ratios — Ltd Companies
P/E ratio = Market price per share ÷ EPS — high P/E implies market expects strong growth
Dividend cover = EPS ÷ Dividend per share — how many times profit covers the dividend; <1× means dividend paid from reserves