Interpretation of Accounting Ratios
Question number 01:
Janice was 23 when she graduated and always had a passion for opening her venture, and thus as soon as she graduated, she gathered all her savings and opened her venture of a shoe shop in 2005. As the market got competitive and her business expanded, she decided to start analyzing her business performance in 2011 from the previous year and give an overall insight as to which part she needs to focus on.
Below are the details that are given to calculate the necessary ratios and analyze the performance of the Janice shoe shop in 2010 and 2011.
60% of the total sales are credit sales.
(a) The ratios you are required to calculate are as follows:
1. gross profit margin
2. net profit margin
3. average inventory
4. inventory turnover days
5. receivable collection period
6. payables payment period
7. current ratio
8. quick ratio
9. return on capital employed
(b): Analyze and compare the ratios in both years.
SOLUTION: (b)Between 2010 and 2011, there is a 3% drop in the gross profit margin of Janice, which indicates a slight drop in Janice’s trading performance, which would be either because the selling price has fallen or costly of sales have increased. Despite the fall in gross profit margin, there is an improvement in the net profit margin by more than two percent, which indicates that Janice has phenomenal control over expenses, and the expense to sales ratio fell from 22.5% to 17.4%, which is commendable. This can also be reflected in the fact that ROCE has improved by almost two percent, which slows growth in profitability.
The current ratio was slightly higher than the ideal ratio is 2010, but in 2011 it came within the ideal limit similarly quick ratio has slightly increased and just above the ideal ratio in both the years. Inventory turnover days have dropped by three days, indicating that Janice can sell his inventory more conveniently and rapidly. There is a deterioration of six days in the receivables collection period indicating that Janice is having difficulty in collecting money from receivables and hence in return is paying his payables six days later which is not a very good strategy because by doing this he is not only forgoing discounts but is also compromising on his relationship with the supplier. The overall working capital cycle has slightly improved.
There is a slight deterioration in utilizing resources, and if Janice takes corrective actions, both his profitability and liquidity will further improve. The comparison between 2010 and 2011 shows an overall improvement in Janice’s performance.