The use of ratios and comparisons in auditing

This is a significant increase (15%) and an impressive performance in recessionary times. Apart from accounting errors, possible explanations include:

• A different sales mix (possibly because of the acquisition implied by the increase in goodwill).
• Squeezing better prices from suppliers (test by looking at correspondence?).
• Better inventory management and less wastage. Test inventories carefully.

Reasonably good cost control has been maintained despite the substantial increase in sales. To test this, it is worth comparing the commercial and administrative costs to sales.

These costs are low compared to revenue. Does that make sense, or we worry about expenses being understated? Supermarkets rely on high volumes and low margins and this could explain the relatively low operating costs:revenue ratio, indicating that huge volumes of sales are efficiently pushed through the business.

However, efficiency of the operation has deteriorated and it is important to try to determine why this has happened. Obvious causes are:

• The operations of the acquired business are not as efficient as the holding company’s.
• Disruption costs arising from the takeover.
• Overstretched management.

These theories need to be tested. There might be other implications too. If management hopes to reduce operating expenses, are they, for example, planning warehouse closures and redundancies? Is some sort of provision needed?

It is important to realise that this is this first ratio we have calculated that makes use of a balance sheet figure. Balance sheet figures are taken at only one point in time, and this can lead to distortions in the ratios. Changes might be little more than artefacts arising from accidents of timing. Compare where capital was raised and an expansion took place in the first month of the period, to where this happened in the last month of the year. The final capital of both companies will include the additional finance, but only the first company is likely to get a significant increase in its operating profit. The second company’s ROCE is likely to show a decline from one year to the next.

This effect may have caused the decrease in ROCE seen in Ocset Plc and it would be useful to know when any expansion or acquisition took place.

This shows how many $ of sales are generated by each $ of assets. It’s sometimes described as ‘how hard the organisation works its assets’. The decline in the ratio shows that although capital (and therefore assets) have increased, sales have not increased proportionately – but that could simply be just an artefact caused by the date of the asset increase.

Normally current assets are used to pay the current liabilities. A current ratio of less than one is often regarded as alarming as there might be going-concern worries, but you have to look at the type of business before drawing conclusions. In a supermarket business, inventory will probably turn into cash in a stable and predictable manner, so there will always a supply of cash available to pay the liabilities. The company survived 12 months from the date of the 2008 balance sheet until the present one (and the current ratio has improved), so there should be no particular alarm.

= 0.52

The quick ratio is useful when inventory is turned over slowly, as the payment of current liabilities will depend on receivables and cash. A quick ratio of less than one is often worrying, but it again depends on the business and comparatives. Here the quick ratio is much more generous on the 2009 balance sheet than on the 2008 one. Why? Has interest income increased too?

In a supermarket, most sales are for cash, and comparing receivables to sales that have no impact on receivables is rather pointless. It would be much better if sales could be split into cash and credit sales and the true collection period for credit sales worked out.

However, there does seem to have been a disproportionate increase in the collection period. Possible reasons are:

• A different sales approach – perhaps offering customers credit facilities.
• A different range of products – perhaps offering customers a credit card. Look at board minutes.
• Poor management so that credit control deteriorates.
• Economic problems causing customers to pay more slowly – and presumably an increased risk of bad debts. There might be implications for the bad debt provision.

We should check other information too. For example, if debtors are taking longer to pay (or a credit card is offered), is the company earning interest on the balances?

A receivables circularisation will be important to test the accuracy of the receivables figure.

There’s nothing remarkable here. The increase could be evidence of pressurising suppliers and could be consistent with the improvement in gross profit percentage.

We should check that there will be no future supply difficulties (correspondence, board minutes) and assess whether the company is losing valuable discounts.

This is a 4% fall and would appear to suggest tight inventory control. However, always go through (at least in your mind) the RATIO list.

• Reason – accidental or deliberate? How was the decrease achieved?
• It could be an artefact. For example, where a weekend falls with respect to the year end.
• Inventory always needs to be carefully verified – existence, quantity valuation etc.
• Implications. If there a fewer days of inventory, are customer service levels being adversely affected? Is stock wastage reduced?
• Other information. For example, has the company invested in new IT systems which allow better inventory control? Has the distribution system changed? Have more trucks been bought to allow the company to operate with lower inventory?

The gearing ratio can also be defined in other ways, particularly comparing long term loan finance to total finance. As gearing increases so does the risk that the interest can’t be paid. But it is difficult to define a ‘safe’ level of gearing. For example, a property company with properties leased to tenants will have fairly predictable rental income. Such a company can probably safely sustain substantial borrowings (though could be in trouble if interest rates increased significantly). A company with volatile streams of income would have to keep its gearing lower as it must ensure that interest can be paid during the lean times.

Supermarkets could be expected to have reasonably predictable income: people have to keep eating, so will keep buying food!

The gearing ratio calculation shows that there is a large increase in the company’s gearing. You should consider:

• Reason: deliberate financial planning or problems?
• Is there any reason to suppose that the effect is temporary or an accident of timing?
• Loan agreements need to be verified for term and security
• If the loan period is relatively short, how will it be repaid?
• We would expect the amount of interest paid to increase (unless the additional loan was taken out very close to year end).

Interest cover shows how many times interest can be paid out of earnings. Neither of these ratios would give cause for concern. The fall from 2008 to 2009 is consistent with the rise in borrowing that was identified earlier. The interest amounts would have to be tested to see that they were reasonable, given interest rates and when the additional borrowings were made.