The use of ratios and comparisons in auditing, Ken Garrett
In the F8 exam you can be asked to compute and interpret key ratios used in analytical procedures at both the audit planning stage and when collecting audit evidence. Ratios and comparisons can be used to identify where the accounts might be wrong and where additional auditing effort should be spent.
Calculating a ratio is easy, usually little more than dividing one number by another. Indeed, the calculations are so basic they can be programmed into a spreadsheet. The real skill comes in interpreting the results and using that information to carry out a better audit. Saying that a ratio has increased because the top line in the calculation has increased (or the bottom line decreased) is rather pointless: this is simply translating the calculation into words. Use the mnemonic RATIO to remind yourself to keep asking:
- R Why has this change occurred?
- A Is the change real or simply an artefact, an accident of calculation?
- T What can be done to test our conclusions? What other work should we do?
- I What does this change mean? Liquidity crisis? Poor management etc?
- Other information. Is this consistent with other information?
You don’t have to set out these queries formally in your answers, but the five classes of questions should always be at the back of your mind. Note that quoting RATIO and saying what the letters stand for will get you no marks.
There is a huge variety of businesses and this diversity will be reflected in their financial statements. To judge whether a figure or ratio is worth investigating, it is absolutely necessary to compare it to its equivalent in either the same company in the previous period, or other companies in the same industry. Comparisons provide benchmarks.
To look at some of the techniques and interpretations, we will use the financial statements of Ocset Plc, shown below.
Comparison of two consecutive years
Perhaps the first thing to do is simply to compare the two sets of financial statements. Here we have results from 2009 and 2008. So look down the figures, just comparing like with like, and see what queries or hypotheses you might be able to generate. The mnemonic RATIO will be used formally for the first comparison. Here are some first thoughts:
|Non-current assets: intangible||Substantial increase in goodwill. Reason: acquisition?. Is it real or an artefact? How can the amount be checked, verified and tested? Implications: What was bought? How paid for? What type of business? Is this consistent with other information, such as additional non-current assets, increased finance and so on? Who audits it? When was it bought|
|Non-current assets: tangible||Substantial increase. Some might be because of the acquisition, some might be organic. How paid for? How can we test it?|
|Inventory||Relatively small increase. Will be interesting to compare to sales|
|Receivables||Relatively small increase. Will be interesting to compare to sales|
|Cash||Large increase. Why? Where has that come from?|
|Trade payables||About a 15 – 20% increase. Why? Large compared to receivables and cash. Compare to cost of sales later. How can we verify these liabilities? It might be an accident (artefact) of timing, for example, when the payables processing was just after year end.|
|Short term borrowings||Doubled, but could be brought back to 2008 levels by using some of the cash. Why have cash and an overdraft at the same time?|
|Net current assets/liabilities||About the same both years. Alarmingly, both years show net current liabilities. However, the business has survived a year like this.|
|Share capital||No material change|
|Reserves||Increased by retained profit|
|Long term liabilities||Substantial increase. Presumably, this is a major source of funding for non-current assets. Expect an increase in financing costs. Need to verify that the liabilities are indeed long-term.|
|Revenue||Very substantial increase (around 15%). How much is organic and how much because of acquisition? We would expect changes in inventory and payables.|
|Cost of sales||An increase roughly in line with the increase in sales.|
|Commercial and administrative costs||Substantial increase. Perhaps temporary after the takeover and before rationalisation. Might indicate poor cost control.|
|Tax and dividends||Fairly consistent.|
If you were now told that the financial statements are modelled on a supermarket business, then you might be able to make more sense of some of the figures – particularly the net current liabilities. Supermarkets have low receivables and low inventory (it’s perishable) yet can squeeze their suppliers hard. They can therefore survive well on large trade payables confident that inventory will steadily turn into cash. However, now that we know we are dealing with a supermarket, we should be interested in why they have substantial receivables at all.
Ratio analysis is useful because it allows you to see if two figures have moved consistently with one another. You should be concerned if they haven’t.
There are three main groups of ratios: profitability, liquidity and risk.
|Gross profit percentage||Gross profit x 100Sales revenue||4,218 x 100 = 7.8%54,327||3,230 x 100 = 6.8%47,198|
| Comments on GP%|
This is a significant increase (15%) and an impressive performance in recessionary times. Apart from accounting errors, possible explanations include:
|Net profit percentage||Operating profit x 100Sales revenue||3,206 x 100 = 5.9%54,327||2,450 x 100 = 5.2%47,198|
| Comments on NP%|
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.
|Operating expenses to sales||Operating expensesx100Sales||1,012 x 100 = 1.86%54,327||780 x 100 = 1.65%47,198|
| Comments on operating expenses|
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:
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?
|Return on capital employed||Operating profit x 100Capital employed||3,206 x 100 = 11.8%27,165||2,450 x 100 = 12.020,417|
| Comments on ROCE|
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.
|Asset turnover||Sales revenue x 100Capital employed||54,327 = 2.027,165||47,198= 2.320,417|
| Comments on asset turnover|
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.
|Note: ROCE = Net profit% x Asset turnover||11.8% = 5.9% x 2.0||12.0 = 5.2% x 2.3|
|Current ratio||Current assets Current liabilities||9,209 = 0.7312,582||5,889 = 0.629,362|
| Comments on the current ratio|
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.
|Quick (or acid test) ratio||Current assets (except inventory)Current liabilities|| 9,209 – 2,66912,582|
|5,889 – 2,430 9,362= 0.37|
| Comments on the quick ratio|
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?
|Receivable collection period||Receivables Sales/day||1,798 = 1254,327/365||1,311 = 1047,198/365|
| Comments on the receivables collection period|
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:
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.
|Payables payment period||Payables Cost of sales/day||8,522 = 6250,109/365||7,277 = 6043,968/365|
| Comments on the payables payment period|
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.
|Days of inventory||Inventory Cost of sales/day||2,669 = 19.450,109/365||2,430 = 20.243,968/365|
| Comments on the days of inventory|
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.
A company’s indebtedness is obvious from financial statements, so the risk analysed by external users is normally the risk related to borrowing: the gearing risk,. Borrowing causes risk because interest has to be paid irrespective of profits made. A rise in interest rates or a fall in profit can make the payment of interest very difficult, and lead a business to receivership and liquidation. Risk from borrowing can also arise when capital repayment is required, either on demand (in the case of overdrafts) or at the end of a fixed term. It is very important to understand how any repayment could be financed.
|The gearing ratio||Long term loan finance x 100Equity finance||14,170 x 100 = 109%12,995||8,602 x 100 = 73%11,815|
| Comments on the gearing ratio|
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:
|Interest cover||Operating profit before interest Interest||3,206 = 6.7478||2,450 = 9.8250|
| Comments on interest cover|
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.
Ratio analysis and comparison are invaluable tools to help auditors understand what might have happened in a business. However, the initial calculation of ratios and percentage changes is easy and mechanical. The real skill comes in interpreting the results, and nearly always the results should give rise to more queries than they answer.
|Balance Sheet||30/9/2009$ million||30/9/2008$ million|
|Intangible – goodwill||4,027||2,336|
|Current assets and receivables|
|Cash and cash equivalents||4,742||2,148|
|Net current liabilities||(3,373)||(3,473)|
|Total assets less current liabilities||27,165||20,417|
|Non-current liabilities – borrowings||14,170||8,602|
|Total equity and long term liabilities||27,165||20,417|
|Income Statement||Y/e 30/9/2009$ million||Y/e 30/9/2008$ million|
|Cost of sales||50,109||43,968|
|Commercial and administrative costs||(1,012)||(780)|
|Operating profit before financing||3,206||2,450|
|(Loss)/profit before tax||2,844||2,387|
|(Loss)/profit after tax||2,064||1,717|
|Transferred to reserves||1,178||847|