The use of ratios and comparisons in auditing

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:

• Reason. Why has this change occurred?

• Artefact. Is the change real or simply an artefact, an accident of calculation?

• Test. What can be done to test our conclusions? What other work should we do?

• Implications. 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 Co, 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 20X9 and 20X8. 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:

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

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.

Profitability ratios

Comments on GP%

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

• A different sales mix.

• Squeezing better prices from suppliers (test by looking at correspondence?).

• Better inventory management and less wastage. Test inventories carefully.

Comments on NP%

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

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:

• Disruption costs arising (e.g. due to an event indicated in the scenario).

• 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?

Comments on ROCE

It is important to realise that this is this first ratio we have calculated that makes use of a balance in the statement of financial position. These 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. For example, if capital is raised at the end of a financial year, the investment will not be reflected in profit (e.g. higher revenue and/or reduced costs) until the following year.

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

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. 

Liquidity ratios

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 20X8 statement of financial position until the present one (and the current ratio has improved), so there should be no particular alarm.

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 20X9 statement of financial position than on the 20X8 one. Why? Has interest income increased too?

ancial position than on the 20X8 one. Why? Has interest income increased too?

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:

• 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 loss allowance for receivables. 

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.

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.

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.

• 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?

Risk ratios

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.

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:

• 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).

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 20X8 to 20X9 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.

Conclusion

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.