FINANCIAL REPORTING ANALYSIS

In this example, the sales have increased 59.3% over the five-year period while the cost
of goods sold has increased only 55.9% and the operating expenses have increased only
57.5%. The trends look different if evaluated after four years.

At the end of 2018, the sales had increased almost 20%, but the cost of goods sold had
increased 31%, and the operating expenses had increased almost 41%.

These 2018 trend percentages reflect an unfavourable impact on net profit because costs
increased at a faster rate than sales. The trend percentages for net profit appear to be
higher because the base year amount is much smaller than the other balances.

Work out the workings for the percentage changes shown above.

Common Size Analysis

By comparing two or more years of common size statements, changes in the mixture of
assets, liabilities, and equity become evident.

On the statement of profit of loss, changes in the mix of revenues and in the spending
for different types of expenses can be identified.

Example 3

A common-size analysis for the latest two years of JPT Pte Ltd is shown in the following
example. To calculate the common-size for the 2019 statement of financial position, each
amount was divided by $114,538, the “total asset” amount.

For the 2018 statement of financial position, the common-size percentages were
calculated by dividing by $118,732, “total assets.”

For the 2019 Statement of Profit or Loss, each amount was divided by $129,000 the “sales,
net” amount, and for the 2018 Statement of Profit or Loss, each amount was divided by
$97,000, the “sales, net” amount.

Statement of Profit or Loss 2019 % 2018 %

Sales, net $129,000 100.0 $ 97,000 100.0
Cost of goods sold 70,950 55.0 59,740 61.6
Gross profit 58,050 45.0 37,260 38.4
Operating expenses 42,600 33.0 38,055 39.2
Operating profit 15,450 12.0 (795) (0.8)
Interest expense 1,900 1.5 1,500 1.5
Profit before income taxes 13,550 10.5 (2,295) (2.3)
Income tax expense (benefit) 5,420 4.2 (895) 0.9
Net profit (loss) $ 8,130 6.3 $(1,400) (1.4)

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Calculation of Common-Size Analysis

2019 2018
Amount Percent Amount Percent
Statement of Financial Position
Assets % %
Non-Current Assets
Property, plant & equipment, net $ 74,422 65.0 $ 78,938 66.5
Other assets 1,750 1.5 1,500 1.3
Current Assets
12,309 10.7 12,202 10.3
Inventory
18,567 16.2 19,230 16.2
Accounts receivable, net
540 0.5 532 0.4
Prepaid expense
6,950 6.1 6,330 5.3
Cash
Total current assets 38,366 33.5 38,294 32.2
Total assets $114,538 100.0 $118,732 100.0
Equity and Liabilities
Equity $ 71,593 62.5 $ 65,385 55.1
Long-term debt 15,000 13.1 23,000 19.4
Current Liabilities
Accounts payable 15,560 13.6 16,987 14.3
Salaries payable 9,995 8.7 9,675 8.1
Accrued expenses 2,390 2.1 3,685 3.1
Total current liabilities 27,945 24.4 30,347 25.5
Total liabilities and stockholders' equity $114,538 100.0 $118,732 100.0

Ratio Analysis
Ratio analysis help financial statement users to understand relationships among various
items reported in the financial statements.

Ratio analysis is used to evaluate a number of issues with an entity, such as its profitability,
liquidity, efficiency, solvency and investment ratio.

1. PROFITABILITY RATIO

How efficient is the entity in utilizing the business’s resources in earning profits?
 It measures the profit or operating success of an entity for a given period of
time.

Profitability can be measured by reference to sales or by reference to capital employed.

These ratios show the profitability of the products or serves of the business and the
efficiency of utilizing the business resources in earning profits.

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1.1 Gross Profit Margin / Gross Profit as a Percentage of Sales

Gross Profit Margin = Gross Profit x 100 (%)

Sales

 It indicates an entity’s ability to maintain an adequate selling price above its

cost.
E.g. Gross profit percentage = 20%

- Means that 80% of the sales revenue was used to pay for the cost of goods
sold, leaving 20% as gross profit, or

- For each $1 of sales generated, the entity earns 20 cents gross profit.

Gross profit is sales revenue less the cost of goods sold. All or nearly all the costs
charged in the calculation will be variable costs – that is, costs which vary in accordance
with production or sales.

In a wholesaling or retailing business we might therefore expect the gross profit as a

percentage of sales to remain steady, as long as the business is able to pass on the effect
of any price increases.

It follows that any major deviation in the percentage needs urgent investigation, as it may
indicate error or fraud in one or more of the trading account items. This is indeed the main
use of gross profit percentage, and is important for all users with a special interest in errors
or fraud – the company’s management, auditors, and inspectors of taxes.

It also tells us something about the company’s pricing policy. A high gross profit
percentage implies that the operation may be based on charging high prices and thus
achieving a low sales volume. Alternatively, a low gross profit percentage may mean that
prices are being reduced to the minimum to achieve high sales volume.

In a manufacturing business the gross profit percentage is liable to fluctuate more,

because actual costs of production are likely to vary. Nevertheless, it is worth calculating
the ratio, and variations in it should still be investigated, and in this respect it is important
to verify, if possible, how manufacturing overhead has been treated.

Product mix: Naturally, most companies sell more than one product. If each product has
a different gross margin percentage, the overall gross margin percentage will change as
the relative mix of products sold changes.

A high or increase in gross profit margin may be due to:

(i) The company’s market position or location allow it to charge its customers at
higher price.
(ii) The company based on charging high prices and thus achieving a low sales
volume.

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(iii) The company is able to obtain good discounts from its suppliers for bulk
purchases.

A low or decrease in gross profit margin might indicate:

(i) Increased competition in the market and that the selling prices have been
discounted.
(ii) The cost of purchases may have increased significantly due to high costs
associated with carriage inwards.
(iii) The price are being reduced to the minimum to achieve high sales volume.
(iv) Inflation: Normally, price increases by vendors can be offset by price increases to
customers. However, there are instances where customer price-sensitivity does
not allow for all of the price increase to be passed through.

1.2 Net Profit Margin / Net Profit as a Percentage of Sales

Net profit margin = Net profit after tax x 100 (%)

Sales

Alternative Calculation : Net profit before interest and tax x 100 (%)
Sales

 It gives an indication of how well a company is managing its business expenses

 It measures the company’s success in earning profit from its operations.
E.g. Net profit percentage = 15%

 Means that 85% of the sales revenue was used to pay for cost of goods sold
and expenses, leaving 15% as net profit.

Operating profit is net profit before interest and taxation and it represents the net profit
from trading operations before the interest payable expense is taken into account.

Operating Profit Margin is a measure of operational performance and differences in the

way in which a business is financed will not influence this ratio.

This ratio can vary considerably between different types of business. For example:
- Supermarkets tend to operate on low prices and have low operating profit margins
so as to have high level of sales.
- Jewelers tend to have high operating profit margins but lower level of sales.

Factors such as degree of competition, type of customer, economic climate, industry

characteristics e.g. risk level will influence the operating profit margin.

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A decrease in net profit may suggests that the control of costs needs to be improved if the
company is to remain competitive.

If net profit percentage has decreased over time while the gross profit percentage has
remained the same, this might indicate a lack of internal control over expenses.

Note: A significant decrease in Profit Margin which is not accompanied by similar change
in gross profit ratio might indicate that company needs to improve control of its expenses.
If net profit does not rise when turnover rises, this could mean that gross profit margin is
being cut to achieve higher sales, or higher expenditure has been made on advertising
and other selling expenses which has increased sales.

1.3 Assets Turnover

Asset Turnover = Sales x 100 (%)

Capital employed

Capital employed = Shareholders’ equity + long-term liabilities

= Total assets – current liabilities

 This measures how effectively assets are being used to generate sales
 This shows that for every $1 invested in the business $? of sales were being
made.

If the company’s asset turnover is significantly lower than competitors, it indicates an over-
investment in assets.

An increased in asset turnover suggested that the company is being run more efficiently.

1.4 Return on Capital Employed (ROCE)

ROCE = Profit before interest & tax (PBIT) x 100 (%)

Share capital + Reserves + N.C.L.

 It shows how many dollars of profit were earned for each dollar invested by the
owners.

 It measures how efficiently and effectively managements utilized the resources

available to them, irrespective to how those resources have been financed.

Capital employed is equity capital plus preference shares and loan capital. A bank
overdraft may also be regarded as part of capital employed. Capital employed can also

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