FAC1502 · Financial Accounting · Study Unit 17
Analysis & Interpretation
Reading the Numbers — Ratios, Trends & What They Mean
Contents
01
Purpose of Financial Analysis
Financial statements present the raw numbers. Financial analysis gives those numbers meaning by expressing relationships between figures — as ratios, percentages, or days — and comparing them against benchmarks, prior periods, or competitors.
A single figure tells you almost nothing. Revenue of R5 million is impressive for a corner café but underwhelming for a listed retailer. A ratio provides context — it normalises scale and allows meaningful comparison.
Three Bases for Comparison
Trend analysis — comparing the same entity’s ratios over multiple periods. Are things improving or deteriorating?
Cross-sectional analysis — comparing ratios to industry averages or direct competitors. Is this business performing above or below its peers?
Benchmark comparison — comparing to widely accepted thresholds (e.g. current ratio ≥ 2:1 as a general rule of thumb). Use benchmarks cautiously — they are starting points, not absolute standards.
02
The Five Ratio Categories
FAC1502 organises financial ratios into five groups, each answering a distinct question about the business:
In FAC1502 exam questions, you will usually be asked to calculate a ratio and comment on what it means. Always structure your answer as: (1) state the ratio value, (2) interpret it in context, (3) note what it suggests about financial health. A bare number with no interpretation earns half marks at best.
03
Liquidity Ratios
Liquidity ratios measure the ability to pay short-term debts from short-term assets. They draw on the current assets and current liabilities sections of the balance sheet.
Current Assets ÷ Current Liabilities
(Current Assets − Inventory) ÷ Current Liabilities
The difference between the current ratio and the acid-test ratio highlights the weight of inventory in current assets. A business with a current ratio of 3:1 but an acid-test of 0.8:1 is heavily inventory-dependent — its liquidity is only strong if it can sell that stock quickly.
04
Profitability Ratios
Profitability ratios measure how effectively the business converts revenue and assets into profit. They are expressed as percentages or as a return on a base.
(Gross Profit ÷ Revenue) × 100
(Net Profit Before Tax ÷ Revenue) × 100
(Net Profit After Tax ÷ Total Equity) × 100
(Net Profit Before Interest & Tax ÷ Total Assets) × 100
Watch whether the question asks for net profit before or after tax. ROE typically uses after-tax profit; ROA typically uses profit before interest and tax (EBIT) to remove the effect of financing decisions. State your assumption if the question is ambiguous.
05
Solvency & Gearing Ratios
Solvency ratios examine the long-term financial structure. Gearing (also called leverage) measures how much of the business is funded by debt versus equity. High gearing amplifies returns in good times but increases risk — and interest obligations — in downturns.
Total Debt ÷ Total Equity
Total Liabilities ÷ Total Assets
Total Equity ÷ Total Assets
EBIT ÷ Interest Expense
Total Debt can mean different things. In FAC1502, it typically refers to total interest-bearing borrowings (long-term loans + short-term portion of loans + bank overdraft), not total liabilities. Read the question carefully — if it says “total liabilities” use that; if it says “total debt” use only borrowings.
06
Efficiency (Activity) Ratios
Efficiency ratios measure how effectively the business manages its working capital — the cycle of converting inventory into sales, collecting cash from debtors, and paying creditors. They are expressed in days or as turnover multiples.
(Average Inventory ÷ Cost of Sales) × 365
Cost of Sales ÷ Average Inventory
(Trade Debtors ÷ Credit Sales) × 365
(Trade Creditors ÷ Credit Purchases) × 365
The Cash Conversion Cycle
The Cash Conversion Cycle (CCC) links all three working capital ratios into a single measure of how long cash is tied up in the operating cycle:
CCC = Inventory Days + Debtors Days − Creditors Days
A lower CCC means cash cycles through the business faster. A negative CCC (common in large retailers) means the business collects cash before it pays suppliers — essentially funded by its creditors.
Use average inventory = (Opening + Closing) ÷ 2 when both figures are available. If only one figure is given, use it directly. The same averaging rule applies to average debtors and average creditors if the question provides opening and closing balances.
07
Investment Ratios
Investment ratios assess the returns and value delivered to shareholders. They are most relevant to listed companies but appear in FAC1502 in the context of companies with issued share capital.
Net Profit After Tax ÷ Number of Ordinary Shares
Total Dividends Declared ÷ Number of Ordinary Shares
(DPS ÷ EPS) × 100 OR (Total Dividends ÷ Net Profit AT) × 100
(DPS ÷ Market Price Per Share) × 100
Market Price Per Share ÷ EPS
Total Equity ÷ Number of Ordinary Shares
08
Full Worked Example
Calculate and interpret selected ratios for Meridian Retail Ltd using the financial data below. The company has 2 000 000 ordinary shares in issue. Market price per share: R4.50.
| Item | Current Year (R) | Prior Year (R) |
|---|---|---|
| INCOME STATEMENT | ||
| Revenue (all credit sales) | 3 600 000 | 3 200 000 |
| Cost of sales | 2 160 000 | 1 984 000 |
| Gross profit | 1 440 000 | 1 216 000 |
| Operating expenses | 720 000 | 640 000 |
| EBIT | 720 000 | 576 000 |
| Interest expense | 120 000 | 80 000 |
| Net profit before tax | 600 000 | 496 000 |
| Tax (28%) | 168 000 | 138 880 |
| Net profit after tax | 432 000 | 357 120 |
| Dividends declared | 200 000 | 160 000 |
| BALANCE SHEET | ||
| Inventory | 480 000 | 420 000 |
| Trade debtors | 360 000 | 310 000 |
| Cash & equivalents | 90 000 | 60 000 |
| Total current assets | 930 000 | 790 000 |
| Total assets | 2 800 000 | 2 500 000 |
| Total current liabilities | 460 000 | 395 000 |
| Trade creditors (in current liabilities) | 280 000 | 240 000 |
| Long-term loans | 800 000 | 600 000 |
| Total equity | 1 540 000 | 1 505 000 |
Ratio Calculations & Interpretation
| Ratio | Calculation | Result | Interpretation |
|---|---|---|---|
| LIQUIDITY | |||
| Current Ratio | 930 000 ÷ 460 000 | 2.02 : 1 | Just above the 2:1 benchmark. Adequate short-term cover but little buffer — worth monitoring. |
| Acid-Test Ratio | (930k − 480k) ÷ 460k | 0.98 : 1 | Below the 1:1 benchmark. Excluding inventory, current liabilities are barely covered — liquidity depends heavily on selling stock. |
| PROFITABILITY | |||
| Gross Profit Margin | (1 440 000 ÷ 3 600 000) × 100 | 40.0% | Strong and consistent (prior year: 38.0%). Mark-up is improving, suggesting better purchasing or pricing power. |
| Net Profit Margin | (600 000 ÷ 3 600 000) × 100 | 16.7% | Solid operating efficiency. The gap vs. GPM (40% vs 16.7%) reflects operating expenses and growing interest costs. |
| Return on Equity | (432 000 ÷ 1 540 000) × 100 | 28.1% | Excellent return for shareholders — well above typical deposit rates. Rising from ~23.7% prior year. |
| Return on Assets | (720 000 ÷ 2 800 000) × 100 | 25.7% | Assets are generating strong pre-financing returns. ROA > cost of debt signals positive financial leverage. |
| SOLVENCY & GEARING | |||
| Debt Ratio | 1 260 000 ÷ 2 800 000 | 0.45 | 45% of assets financed by creditors. Below 50% — acceptable, but loans grew from R600k to R800k this year. |
| Interest Cover | 720 000 ÷ 120 000 | 6.0× | EBIT covers interest 6 times — comfortable cushion. Prior year was 7.2× — slight deterioration as debt grew faster than EBIT. |
| EFFICIENCY | |||
| Inventory Days | ((480k+420k)÷2) ÷ 2 160k × 365 | 76 days | Stock sits for ~76 days before sale. For a retailer this is moderately high — investigate whether slow-moving lines exist. |
| Debtors Days | 360 000 ÷ 3 600 000 × 365 | 36.5 days | Collections averaging ~37 days. If credit terms are 30 days, collection is slightly slow — monitor debtor quality. |
| Creditors Days | 280 000 ÷ 2 160 000 × 365 | 47.3 days | Taking ~47 days to pay suppliers. Longer than debtors days — suppliers are effectively financing the business. |
| INVESTMENT | |||
| EPS | 432 000 ÷ 2 000 000 | 21.6 cents | Each share earned 21.6c. Up from 17.9c — growing earnings per share is a positive signal. |
| DPS | 200 000 ÷ 2 000 000 | 10.0 cents | 10c dividend declared per share. |
| Payout Ratio | (10.0 ÷ 21.6) × 100 | 46.3% | Just under half of earnings paid out. Retaining 53.7% for reinvestment — a balanced growth/income policy. |
| P/E Ratio | 450c ÷ 21.6c | 20.8× | Market prices the share at ~21× earnings. Reflects growth expectations. Context-dependent — compare to sector peers. |
| NAV Per Share | 1 540 000 ÷ 2 000 000 | 77.0 cents | Market price (450c) is 5.8× the book value — the market assigns significant value to intangibles and future earnings. |
Overall Assessment
Summary Verdict — Meridian Retail Ltd
Strengths: Strong and improving profitability (GPM 40%, ROE 28%). Good interest cover (6×). Growing EPS. Market premium over NAV reflects investor confidence.
Watch points: Acid-test ratio below 1:1 — liquidity depends on inventory conversion. Inventory days of 76 is moderately high for retail. Loan balances growing faster than equity — gearing creeping up. Debtors days slightly exceeding implied credit terms.
Overall: A financially healthy, growing business but with liquidity and working capital efficiency areas worth management attention in the coming period.
09
Practice Exercises
From the balance sheet of Langa Trading: Current assets R540 000 (including inventory R200 000); Current liabilities R270 000; Total assets R1 800 000; Total liabilities R900 000; Total equity R900 000; EBIT R180 000; Interest expense R45 000.
Calculate: (a) Current Ratio, (b) Acid-Test Ratio, (c) Debt Ratio, (d) Equity Ratio, (e) Interest Cover. Comment briefly on each.
Mhle Distributors reports the following for the year ended 28 Feb 2025: Credit sales R2 400 000; Cost of sales R1 680 000; Opening inventory R310 000; Closing inventory R290 000; Trade debtors (closing) R220 000; Trade creditors (closing) R195 000; Credit purchases R1 700 000.
Calculate: (a) Inventory Days, (b) Inventory Turnover, (c) Debtors Days, (d) Creditors Days, (e) Cash Conversion Cycle. Interpret the CCC.
Stellarion Ltd has 5 000 000 ordinary shares in issue at a market price of R12.60. Net profit after tax: R1 800 000. Dividends declared: R900 000. Total equity: R9 000 000.
Calculate: (a) EPS, (b) DPS, (c) Dividend Payout Ratio, (d) Dividend Yield, (e) P/E Ratio, (f) NAV per share. State whether the market prices the share at a premium or discount to book value.
Reference
Master Ratio Reference — All 18 Ratios
| Ratio | Formula | Unit | Good Signal |
|---|---|---|---|
| LIQUIDITY | |||
| Current Ratio | Current Assets ÷ Current Liabilities | x : 1 | ≥ 2 : 1 |
| Acid-Test Ratio | (CA − Inventory) ÷ CL | x : 1 | ≥ 1 : 1 |
| PROFITABILITY | |||
| Gross Profit Margin | GP ÷ Revenue × 100 | % | Stable or rising |
| Net Profit Margin | NPBT ÷ Revenue × 100 | % | Stable or rising |
| Return on Equity | NPAT ÷ Total Equity × 100 | % | Above cost of equity |
| Return on Assets | EBIT ÷ Total Assets × 100 | % | Above cost of debt |
| SOLVENCY & GEARING | |||
| Debt Ratio | Total Liabilities ÷ Total Assets | decimal | < 0.50 |
| Equity Ratio | Total Equity ÷ Total Assets | decimal | > 0.50 |
| Debt-to-Equity | Total Debt ÷ Total Equity | x : 1 | < 1 : 1 |
| Interest Cover | EBIT ÷ Interest Expense | × times | ≥ 3× |
| EFFICIENCY | |||
| Inventory Days | Avg Inventory ÷ COS × 365 | days | Lower = faster turnover |
| Inventory Turnover | COS ÷ Avg Inventory | × times | Higher = more efficient |
| Debtors Days | Trade Debtors ÷ Credit Sales × 365 | days | ≤ credit terms offered |
| Creditors Days | Trade Creditors ÷ Credit Purchases × 365 | days | ≥ debtors days |
| INVESTMENT | |||
| EPS | NPAT ÷ Shares in issue | cents | Rising year-on-year |
| DPS | Total Dividends ÷ Shares in issue | cents | Sustainable (DPS ≤ EPS) |
| Payout Ratio | DPS ÷ EPS × 100 | % | Consistent with strategy |
| P/E Ratio | Market Price ÷ EPS | × times | Context-dependent |
| NAV Per Share | Total Equity ÷ Shares in issue | cents/R | Market price > NAV = premium |
Study Unit 17 — Key Takeaways
1. Ratios require context — a number alone is meaningless. Always compare to prior periods, benchmarks, or industry norms, and state your interpretation.
2. Five categories: Liquidity (short-term survival), Profitability (earnings quality), Solvency (long-term structure), Efficiency (working capital management), Investment (shareholder returns).
3. Liquidity benchmarks: Current ≥ 2:1; Acid-test ≥ 1:1. The gap between them reveals inventory dependency.
4. Cash Conversion Cycle = Inventory Days + Debtors Days − Creditors Days. A lower CCC means faster cash flow.
5. ROA uses EBIT; ROE uses NPAT. When ROA > cost of debt, financial leverage is creating value for shareholders.
6. Market price vs NAV: A premium signals the market values intangibles and growth beyond book value. A discount can signal undervaluation or distress.