# 14. ANALYTICAL PROCEDURES

(INCORPORATING ISA 520)

# 14.1 Nature and Purpose of Analytical Procedures

ISA 520 defines analytical procedures as "evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Analytical procedures also encompass the investigation of identified fluctuations and relationships that are inconsistent with other relevant information or deviate significantly from predicted amounts".

Examples of analytical procedures are:

  • .Comparisons of the entity's financial information with:
    • .Prior years.
    • .Other companies in its industry (such as comparing sales to accounts receivables with industry averages).
    • .Budgets or forecasts.
    • .Predictive estimates of the auditor (such as an estimation of depreciation charges).
  • .Analysis of relationships between elements of financial information that are expected to conform to a predictable pattern (such as gross margin percentages).
  • .Comparisons between financial and non-financial information (such as payroll costs to the number of employees).
  • .Comparisons between different branches or locations.

Various methods can be used in performing the above procedures, ranging from simple comparisons to complex analyses using advanced statistical techniques. Analytical procedures can be applied to consolidated financial statements, the financial statements of single entity's or individual divisions or elements of financial information. The engagement team's choice of procedures, methods and level of application is a matter of professional judgement.

Analytical procedures are used for the following purposes:

(a) At the planning stage as a risk assessment procedure to obtain an understanding of the entity and its environment;

(b) As substantive procedures during the execution phases, when their use can be more effective or efficient than tests of details in reducing the risk of material misstatement at the assertion level to an acceptably low level; and

(c) As an overall review of the financial statements at the completion stage to confirm that the financial statements as a whole are consistent with our understanding of the entity.

Benefits of analytical review:

  1. Preliminary risk assessment: Assists in gaining an understanding of the business and helps direct audit work to key audit areas.
  2. Substantive procedures: May be an efficient way of obtaining substantive assurance thereby providing audit evidence to support the audit opinion.
  3. Completion: Assists in the overall review of the financial statements.
  4. Other benefits: Conclusions reached provide a source of recommendations to the client.

Possible sources of information for analytical review purposes include:

  • .Published industry information from newspapers or industry journals.
  • .Prior year financial statements.
  • .Management information (management accounts, budgets, cash flows and forecasts).
  • .Purchase and sales day book summaries and general ledgers.
  • .Tax returns and correspondence.
  • .Non-financial data (for example, number of employees).

# 14.2 Types of Analytical Techniques

Analytical techniques can be classified under three broad headings:

Trend analysis

This is the analysis of changes in a given item over time.

Trend analysis procedures could include:

  • .Period by period comparisons.
  • .Graphs of recent and historic results.
  • .Weighted averages of recent and historical results.
  • .More complicated statistical techniques such as regression analysis.

One danger of trend analysis is that trends may be explained by general explanations without further investigation being undertaken.

Ratio analysis

Ratio analysis procedures compare relationships between items in the accounts over time, or between different entities. Ratio analysis may involve comparison of financial ratios, or items compared with other items (for example, cost of sales as a percentage of sales).

In order for ratio analysis to be helpful, the ratios compared must have been calculated on a consistent basis and the relationship between the factors in the ratio should be stable.

Reasonableness tests

Reasonableness procedures aim to develop an estimate of an item, based on the auditor's understanding of relationships involving relevant financial and operating data. Examples of reasonableness tests include overall verification procedures (such as average hotel occupancy numbers, multiplied by average room charges, should approximate to total revenue) and proof in total tests (such as opening inventory, plus inventory produced, less inventory sold, equals closing inventory, which should equal inventory counted at the accounting year-end). For reasonableness tests to work, all relevant factors have to be considered.

# 14.3 Analytical Procedures as Risk Assessment Procedures

ISA 520 requires that analytical procedures should be applied as risk assessment procedures at the planning stage. The aims of doing so are to:

  • .Assist in understanding the entity's business;
  • .Identify areas of potential risk (such as problems with going concern, liquidity, problems with divisions, locations and other unexpected features); and
  • .Help determine the nature, timing and extent of other auditing procedures.

Analytical procedures at the planning stage can identify potential operating and control problems, and indicate the extent to which analytical review will be used in substantive testing.

Procedures at the planning stage will normally be of a general nature reviewing key business ratios. Appendix II: Key Business Ratios gives examples of ratios that may be used in understanding an entity's business and trends of performance, while Appendix II: Guide to Drawing Conclusions from Analytical Procedures provides some consideration that may be considered in drawing conclusions from the use of analytical procedures as risk assessment procedures. As well as the key business ratios, other key ratios in the industry in which the client operates should be considered, if relevant sources of information are available. The forecast or actual amounts for the current period should be compared with the corresponding prior year's audited amounts.

The conclusions from analytical procedures as risk assessment procedure should be recorded on From 05.06 - Analytical Review set out in Part E of the Manual.

# 14.4 Analytical Procedures as Substantive Procedures

The engagement team may design and perform substantive procedures to be responsive to the related assessment of the risk of material misstatement at the assertion level. The use of substantive procedures at the assertion level may comprise tests of details or substantive analytical procedures, or a combination of both. The decision about which audit procedures to use to achieve a particular audit objective is based on the engagement team's judgment about the expected effectiveness and efficiency of the available audit procedures in reducing the assessed risk of material misstatement to an acceptably low level. The use of analytical procedures as substantive procedures requires the design of procedures and comparing the outcomes with expectations that the engagement team has developed against which to compare the outcomes.

When relying on analytical procedures as a substantive procedure, the engagement team will ordinarily inquire of management as to the availability and reliability of information needed to apply substantive analytical procedures and the results of any such procedures performed by the entity. It may be efficient to use analytical data prepared by the entity, provided the team is satisfied that such data is properly prepared.

When designing and performing analytical procedures as substantive procedures, the engagement team will need to consider a number of factors such as the following:

  • .Suitability of using substantive analytical procedures given the assertions.
  • .The reliability of the data.
  • .Whether the expectation is sufficiently precise

# 14.4.1 Suitability of Using Substantive Analytical Procedures Given the Assertions

Substantive analytical procedures are generally more applicable to large volumes of transactions that tend to be predictable over time. The application of substantive analytical procedures is based on the expectation that relationships among data exist and continue in the absence of known conditions to the contrary. The presence of these relationships provides audit evidence as to the completeness, accuracy and occurrence of transactions captured in the information produced by the entity's information system. However, reliance on the results of substantive analytical procedures will depend on the engagement team's assessment of the risk that the analytical procedures may identify relationships as expected when, in fact, a material misstatement exists.

In determining the suitability of substantive analytical procedures given the assertions, consideration should be given to the following:

(a)The assessment of the risk of material misstatement - The engagement team considers the understanding of the entity and its internal control, the materiality and likelihood of misstatement of the items involved, and the nature of the assertion in determining whether substantive analytical procedures are suitable. For example, if controls over sales order processing are weak, the team may place more reliance on tests of details rather than substantive analytical procedures for assertions related to receivables. As another example, when inventory balances are material, one does not ordinarily rely only on substantive analytical procedures when performing audit procedures on the existence assertion. (b)Any tests of details directed toward the same assertion - Substantive analytical procedures may also be considered appropriate when tests of details are performed on the same assertion. For example, when auditing the collectibility of accounts receivable, one may apply substantive analytical procedures to an ageing of customers' accounts in addition to tests of details on subsequent cash receipts.

# 14.4.2 The Reliability of the Data

The reliability of data is influenced by its source and by its nature and is dependent on the circumstances under which it is obtained. In determining whether data is reliable for purposes of designing substantive analytical procedures, consideration should be given to the following:

(a) Source of the information available -For example, information is ordinarily more reliable when it is obtained from independent sources outside the entity.

(b) Comparability of the information available - For example, broad industry data may need to be supplemented to be comparable to that of an entity that produces and sells specialised products.

(c) Nature and relevance of the information available - For example, whether budgets have been established as results to be expected rather than as goals to be achieved.

(d) Controls over the preparation of the information.For example, controls over the preparation, review and maintenance of budgets.

When testing the reliability to data, the engagement team should consider testing the controls, if any, over the entity's preparation of information which is to be used by the engagement team in applying substantive analytical procedures. When such controls are effective, the team develops greater confidence in the reliability of the information and, therefore, in the results of substantive analytical procedures.

# 14.4.3 Whether the Expectation is Sufficiently Precise

In assessing whether the expectation can be developed sufficiently precise to identify a material misstatement at the desired level of assurance, consideration should be given to the following:

  1. (a)The accuracy with which the expected results of substantive analytical procedures can be predicted. For example, the engagement team should ordinarily expect greater consistency in comparing gross profit margins from one period to another than in comparing discretionary expenses, such as research or advertising.
  2. (b)The degree to which information can be disaggregated. For example, substantive analytical procedures may be more effective when applied to financial information on individual sections of an operation or to financial statements of components of a diversified entity, than when applied to the financial statements of the entity as a whole.
  3. (c)The availability of the information, both financial and non-financial. For example, the engagement team should consider whether financial information, such as budgets or forecasts, and non-financial information, such as the number of units produced or sold, is available to design substantive analytical procedures. If the information is available, the team should also considers the reliability of this information.

# 14.4.4 Amount of Difference of Recorded Amounts from Expected Values that is Acceptable

In designing and performing substantive analytical procedures, the engagement team considers the amount of difference from expectation that can be accepted without further investigation. This consideration is influenced primarily by materiality and the consistency with the desired level of assurance. Determination of this amount involves considering the possibility that a combination of misstatements in the specific account balance, class of transactions, or disclosure could aggregate to an unacceptable amount. Any increase in the desired level of assurance as the risk of material misstatement increases is compensated by reducing the amount of difference from the expectation that can be accepted without further investigation.

When the engagement team performs substantive procedures at an interim date and plans to perform substantive analytical procedures with respect to the intervening period, the team considers how the matters discussed in paragraphs 14.4.1 to 14.4.4 affect the ability to obtain sufficient appropriate audit evidence for the remaining period. This includes considering whether the period end balances of the particular classes of transactions or account balances are reasonably predictable with respect to amount, relative significance, and composition.

# 14.5 Approach to using Analytical Review as Substantive Procedures

If it is decided to use analytical procedures as substantive procedures, a methodical approach is essential. The process can be summarised as a series of stages:

  1. Define the item or relationship to be used

Consider first of all:

  • .The relevance and reliability of the relationship being considered for testing.
  • .The complexity of the relationship.
  • .The level of detail available and required.
  • .Any shortcomings, such as the possibility of over-simplification or circular proofs of relationships.
  1. Define the objectives of the review process

For example, it may be desired to use analytical review techniques to decide on the completeness or accuracy of sales.

  1. Consider any factors that could lead to deviations from expected results

For sales, these could include year-end cut-off procedures or changes in the price or product mix.

  1. Determine the examination methods

This could include the type of procedure to be used, whether complex techniques are to be used, and also whether the use of computerised comparisons is likely.

  1. Define a significant deviation from expected results

Factors to consider would include:

  • .The materiality level chosen.
  • .The level of confidence chosen.
  • .The direction of the test (testing for over or understatement).
  • .The expected sizes of deviation.
  1. Specify the reliance desired (i.e. the assurance required from analytical review procedures)

Factors to consider would include:

  • .The nature of the assertions being audited.
  • .The extent to which assurance will be gained from analytical procedures and other tests.
  • .The risks of error in the population.
  • .The precision of the procedure to be adopted.

# 14.5.1 Utilising the Techniques

  1. Ensure Control - members of the engagement team performing the techniques should be well briefed, and any analytical data generated by the entity should be reviewed.

  2. Ensure the procedures are fully documented.

# 14.5.2 Examine any Deviations from Expected Results

Identify deviations

Deviations may be of a number of different types:

  • .Normal deviations (business trends, seasonal changes, trading cycles).
  • .Isolated deviations (those caused by changes in accounting policies or unusual items).
  • .Abnormal deviations (those caused by accounting policies applied incorrectly, inadequate accounting or irregularities).

Significant movements in the major figures in the financial statements will need to be explained for each audit area.

Investigate significant deviations

If comparisons between the amounts predicted and the amounts recorded reveal unexpected deviations (such as unexpected variations between prior year and current year recorded figures, based on our knowledge of activities which have occurred during the year), these should be discussed with the management of the entity.

Management explanations should not be accepted in isolation. It may be that they are supported by audit evidence already available.

Further procedures may, however, be necessary. These may include:

  • .Extending the analytical procedure: The original procedure may need to be adjusted, following additional factors identified in testing. The reliability of such factors will need to be corroborated in the same way as the factors used originally. In some cases a detailed analysis of individual accounts may be necessary, to determine whether the explanations received are acceptable.
  • .Examining documentation: This may be necessary where the difference is caused by a small number of unusual or infrequently occurring transactions.
  • .Making enquiries of others, if possible: Explanations from management in one sector may be confirmed by management in a different one.
  • .Conducting additional substantive tests, if the explanations received appear inadequate.

# 14.5.3 Evaluating the Results and Forming Conclusions

The degree of reliance to be placed on analytical tests needs to be considered. Reliance may range from total reliance (such as proving an account balance in total) to no reliance.

Factors to consider when assessing how much reliance can be placed on the results could include:

  • .Any analytical procedures that show similar results.
  • .The extent variations have been corroborated by explanations or other audit procedures directed towards the same objectives.
  • .The materiality of the items involved (for example, when inventory balances are material, the auditor does not rely only on analytical procedures in forming his conclusions).

In order to be able to place high reliance on analytical review (and therefore assess analytical risk as low), the engagement team must be satisfied that the results represent relevant and reliable evidence, corroborated by explanations and other evidence. If high reliance is being placed on analytical review, it may be possible to confine substantive tests of detail to high value and key items only. However, if the item is particularly material, the engagement team should consider undertaking some testing of representative items (i.e. audit sampling).

The engagement team should also consider whether the conclusions drawn impact on other audit areas (for example, assessment of the management or whether the going concern basis is appropriate).

# 14.6 Recording of Analytical Review

Analytical procedures must be documented in order to provide valid support for the audit opinion.

Any working papers which detail analytical procedures used as substantive tests should include:

  • .The objectives of the tests.
  • .The sources of the information used.
  • .Details of the procedures performed (such as trends, ratios, or reasonableness tests).
  • .The basis of calculations and the documentation of the expectations against which to compare the outcomes.
  • .All assumptions used.
  • .Other factors affecting the procedures used.
  • .Any predictions made and tolerable ranges or results accepted.
  • .The extent and nature of variations, highlighting significant fluctuations.
  • .Explanations obtained for variations, including their origin.
  • .Tests carried out to verify explanations received.
  • .Any re-calculations and other procedures considered necessary.
  • .The extent of any effect on the audit plan, in other areas.
  • .The conclusions reached, including an estimate of the amount of misstatements.

The design of the test is included as part of the audit programme for each audit area where the analytical procedures are to be used as substantive procedures.

# 14.7 Analytical Risk

Analytical risk is the risk that analytical procedures, used as substantive procedures, may fail to detect a material error. In order ensure that analytical risk is low, key relationships need to be predicted with confidence, using available data. If the procedures used by the engagement team are of limited reliability, the team should assume a high analytical risk and rely on alternative audit procedures in obtaining sufficient and reliable audit evidence. High risk means that substantive tests will become more important elements in the audit process, and therefore more assurance will be required from them resulting in higher sample sizes.

The assessment of analytical risk serves two purposes, that is, they:

  • .Help assess whether analytical procedures will be worthwhile as substantive tests. High analytical risk indicates that analytical procedures will not be useful as substantive tests, as they will only provide a low level of assurance.
  • .If analytical procedures are performed, the assessment helps to determine the level of reliance that can be placed on the results of those procedures, and how much the auditor has to rely on detailed tests of balances and transactions.

The analytical risk for each area should be recorded in Form 05.10 - Risk Assessment and Approach to Assessed Risk in Part E of the Manual. Where analytical procedures are not to be used as substantive procedures, the risk recorded will be high.

In conclusion, while analytical procedures may be used as substantive procedures, consideration should be given to the cost-benefit analysis of using them compared to other substantive or compliance procedures that may be more cost effective. Even when analytical procedures are used, the procedures adopted, the reliability of the data used in the procedures, the expectations developed and the conclusions should be recorded as part of the audit work. In the case of small and medium entities which may not have a complex management information system, the use of analytical procedures as substantive procedure may in most cases not provide sufficient and reliable audit evidence.

# 14.8 Analytical Procedures at Conclusion

ISA 520 requires the auditor to apply analytical procedures at or near the end of the audit, when forming an overall conclusion as to whether the financial statements, as a whole, are consistent with the auditor's understanding of the entity. The conclusions drawn from the results of such audit procedures are intended to corroborate conclusions formed during the audit of individual components or elements of the financial statements and assist in arriving at the overall conclusion as to the reasonableness of the financial statements. However, they may also identify a previously unrecognised risk of material misstatement. In such circumstances, the engagement team may need to re-evaluate the planned audit procedures, based on the revised consideration of assessed risks for all or some of the classes of transactions, account balances, or disclosures and related assertions.

When analytical procedures identify significant fluctuations or relationships that are inconsistent with other relevant information or that deviate from predicted amounts, the engagement team should investigate and obtain adequate explanations and appropriate corroborative audit evidence.

The investigation of unusual fluctuations and relationships ordinarily begins with inquiries of management, followed by:

  • .Corroboration of management's responses, for example, by comparing them with the engagement team's understanding of the entity and other audit evidence obtained during the course of the audit; and
  • .Consideration of the need to apply other audit procedures based on the results of such inquiries, if management is unable to provide an explanation or if the explanation is not considered adequate.

Appendix II: Key Business Ratios gives examples of ratios that may be used at the conclusion stage, while Appendix I: Guide to Drawing Conclusions from Analytical Procedures provides some consideration that may be considered in drawing conclusions from the use of analytical procedures at the conclusion stage.

The conclusions from analytical procedures at the conclusion stage should be recorded on From 05.06 - Analytical Review set out in Part E of the Manual.

Appendix I - Guide to Drawing Conclusions from Analytical Procedures

The Appendix provides a guide to some conclusions that may be drawn by the engagement team when using analytical procedures at the risk assessment and conclusion stages of an audit and issues that could be considered when carrying out analytical review. The list is not exhaustive and there may be other possible reasons for changes in trends and ratios. Significant changes need to be recorded in the Form 05.06 - Analytical Review and Form 05.01 - Audit Strategy and Plan as part of the risk assessment process.

KEY AUDIT AREAS

1.PROPERTY, PLANT AND EQUIPMENT

Possible Conclusions

  • .An increase in property, plant and equipment may be caused by:
    • .Business expansion with possible consequences of increase in business volume.
    • .Changes in the capitalisation policy.
  • .A decrease in property, plant and equipment may be caused by:
    • .The business is being curtailed with possible consequences of lower sales volume, redundancy claims etc.
    • .Going concern issues especially where adequate capital is not available to fund acquisitions required to sustain business levels.
    • .Changes in the capitalisation policy.
  • .Significant changes in the depreciation charge may result from changes in the useful lives of the assets, changes in the estimate of residual values or errors in the computation of depreciation.

Issues to be Considered

  • .Changes in carrying values of property, plant and equipment.
  • .Significant additions and disposals, compared with previous years.
  • .The adequacy of depreciation rates taking into account:
    • .The average useful life compared to the average age of property, plant and equipment taken out of use due to scrapping / obsolescence.
    • .Profit on disposal of property, plant and equipment and estimates of residual values.
  • .The proportion of assets due for replacement within a short period (say two years of the balance sheet date) and their impact on the future gearing and possible going concern implications.
  • .Assets yielding direct income from third parties when compared to the carrying value, income received, direct cost of maintenance including depreciation.

2.INVENTORY

Possible Conclusions

  • .An increase in inventory levels could be caused by:
    • .Changes in purchasing policy.
    • .Obsolete inventory and deteriorating trading conditions.
    • .Absorption of cost which should have been written off to profit and loss.
  • .A decrease in inventory levels could be caused by:
    • .Improved inventory control.
    • .Overtrading, poor ordering or deterioration in supplier trading terms.
    • .Cut-off errors.
  • .High levels of inventory write-offs may indicate:
    • .Poor physical inventory management.
    • .Theft.
    • .Unrecorded sales.
    • .A deteriorating market for the entity's products.

Issues to be Considered

  • .Inventory turnover ratio ( Note: where purchases are not evenly spread throughout the year, it may be inappropriate to use annual figures and instead use an adjusted purchases figure).
  • .Inventory volume changes.
  • .Changes in unit inventory prices.
  • .Actual inventory value changes.
  • .Provisions.
  • .Production variances.
  • .The percentage of material, labour and overhead in production costs.
  • .Material usage and scrap or waste material.
  • .Labour standards, total labour costs and hours.
  • .Total production costs incurred and total production costs allocated to inventory.
  • .Production cost variances.
  • .Standard overhead rates and actual costs by type

3.TRADE RECEIVABLES AND TURNOVER

Possible Conclusions

  • .An increase in the level of trade receivables may be caused by:

    • .Increase in turnover or trading activity. Consider overtrading.
    • .Deterioration in the economic climate or in the entity's credit control or debt collection procedures. Considerations should be given to impairment of receivables.
    • .Sales to fictitious customers to increase reported profit.
    • .Unrecorded receipts from customers or delays in banking receipts.
    • .Sales being inflated due to cut-off errors.
    • .Subsequent or delay in the issue of credit notes.
  • .A decrease in the level of trade receivables may indicate:

    • .A decrease in turnover or trading activity.
    • .Improvement in debt collection procedures.
    • .Sales cut-offs or subsequent receipts being reflected in the current year.
  • .A high or rising level of impairment provision may be caused by:

    • .Deteriorating economic conditions.
    • .Poor credit control.
    • .Amounts being written off without proper attempts at recovery or receipts not being banked.
    • .Fictitious sales being reversed through write-offs.

Issues to be Considered

  • .Trade receivables and impairment:

    • .Trade receivables to turnover.
    • .Impairment of trade receivables to trade receivables.
    • .Impairment of trade receivables to turnover.
  • .Sales

    • .Sales volume changes.
    • .Sales price changes.
    • .Theoretical turnover change (prior year actual sales being adjusted by volume and price).
    • .Actual turnover changes (in total or by monthly changes).
    • .Gross profit margin.

4.TRADE PAYABLES AND PURCHASES

Possible Conclusions

  • .A high or increasing level of trade payables may be caused by:

    • .An increase in purchases or trading activity.
    • .A management decision to delay payment (a corresponding increase in cash or a reduction in the bank overdraft would then be expected).
    • .Difficulty in paying debts as they fall due. This may indicate a going concern problem.
    • .A management decision to increase inventory near the year-end.
    • .Payments made shortly before the year-end being recorded in the subsequent period to inflate cash balances or reduce the bank overdraft (again, this may indicate going concern problems).
  • .A low or declining level of trade payables may indicate:

    • .Decrease in purchases or trading activity.
    • .Acceleration in the payment of payables.
    • .Payment orders or cheques being recorded in the cash book but withheld (cheques entered in the cash book around the year-end should be examined for subsequent clearance.
    • .A high incidence of cash purchases which in turn may indicate deterioration in supplier terms and going concern problems.

Issues to be Considered

  • .Trade payables to inventory and purchase volume changes.
  • .Purchase price changes and actual purchases changes (in total or monthly).
  • .Theoretical purchases changes (prior year actual purchases being adjusted by volume and price).

5.LABOUR COSTS

Issues to be Considered

  • .Activity:

    • .The average annual wage per full-time employee.
    • .Changes in bonuses and commissions (these could be compared with sales or profit levels).
  • .Efficiency:

    • .Changes in productive employees.
    • .Changes in the distribution of employees.
    • .Changes in profit per employee.
    • .Changes in turnover per employee.

6.PROFIT AND LOSS ACCOUNT

6.1.Gross Profit

Possible Conclusions

  • .Changes in gross profit margin could be caused by changes in:

    • .Selling price without a corresponding increase in the cost.
    • .Product mix.
    • .Reduction in the cost of sale without a corresponding decrease in the sale price.
    • .Cut-off errors in sales, purchases or inventory.
    • .Under or over-valuation of inventories and work-in-progress.

Issues to be Considered

  • .A disaggregation of the gross profit margin should take place as far as practicable. The following should be considered when comparing gross margins:

    • .Product and service types.
    • .Seasonal variations.
    • .Geographical area.

Appendix II - Key Business Ratios

The Appendix provides illustration on how to calculate some ratios that could be used when carrying out preliminary analytical procedures. There may be other suitable basis for calculating ratios. These may be equally acceptable, provided that the same ratios are used consistently and variations in the formulae documented.

1. FINANCIAL STATUS

These ratios indicate the likelihood of the entity meeting its short or long-term obligations.

  • Acid Test

Current Assets (excluding Inventories)

Current Liabilities

This ratio demonstrates the entity's immediate liquidity position. It should normally exceed 1.0.

  • Current Ratio

Current Assets

Current Liabilities

A ratio of over 2.0 indicates the probability that payments to creditors can be met as they fall due. A low ratio indicates a potential working capital shortage or a going concern problem.

  • .Gearing

(Total Liabilities / Total Liabilities plus Share Capital and Reserves) X 100%

The ratio shows the extent to which the entity is financed by creditors and debt. A high ratio may indicate a high debt burden which in turn could signify liquidity and going concern problems.

  • .Property, Plant and Equipment to Long-Term Liabilities

(Property, Plant & Equipment / Long-Term Liabilities) x 100%

The ratio indicates the extent to which long-term finance is used to finance acquisition of property, plant and equipment. A high score co-existing with significant current liabilities may indicate property, plant and equipment are financed out of current liabilities, which could indicate going concern difficulties.

  • .Property, Plant and Equipment to Equity

(Property, Plant & Equipment / Share Capital plus Reserves) x 100%1

A entity may be under-capitalised if the ratio is significantly high.

  • .Current Liabilities to Equity

(Current Liabilities / Share Capital plus Reserves) x 100%

This shows the contrast between the funds short term creditors have placed with the entity, with the funds invested by the owners. The higher the ratio the less the creditors' security.

  • .Interest Cover

Profit before Interest & Tax

Interest Payable

The ratio shows the extent to which profits are available to service borrowing costs. The higher the ratio, the more likely that the entity will be able to meet its debt service costs. A low ratio could signify reliance on other sources to fund debt servicing costs and likely liquidity problems.

2. ASSET UTILITY

These ratios show how the entity uses and controls its assets. An annualised denominator may be used. However, in situations where the denominator is not evenly spread throughout the year, it may be more appropriate to use annual figures and instead of annualised figures.

  • .Inventory Turnover Days

(Inventories / Cost of Goods Sold)x 365

This ratio is a guide to the speed at which inventories are moving, and varies widely between different industries. A low figure may indicate excessive levels, and hence high storage and financing costs and also obsolete or slow moving inventory. A high figure may be evidence of insufficient supplies and hence lost sales opportunities. A high figure may also signify lack of credit facilities with suppliers or the inability of the suppliers (especially key suppliers) to supply goods. This could give rise to doubts over the entity's going concern status.

  • .Trade Receivable Turnover Days

(Trade Receivables / Turnover) x 365

A high ratio may indicate potential cash flow and working capital problems, or impairment of receivables.

  • .Working Capital Turnover Days

(Working Capital / Turnover) x 365

A high ratio may demonstrate that the entity is over-trading. A low ratio may indicate excessive funds being tied up in working capital.

  • .Trade Payables Turnover Days

(Trade Payables / Purchases) x 365

This shows how the entity is paying its suppliers. A high ratio may indicate that the firm using supplier credit to finance operations.

3. PROFITABILITY AND RETURN

  • .Gross Profit Margin

(Gross Profit / Turnover) x 100%

  • .Net Profit Margin

(Profit before Tax / Turnover) x 100%

  • .Return on Shareholder's Funds

(Profit before Tax / Shareholder's Funds) x 100%

  • .Return on Capital Employed

(Profit before Tax / Total Assets less Current Liabilities) x 100%

  • .Return on Assets

(Profit before Tax / Total Assets) X 100%

The ratios differ between various businesses and sectors and any conclusions should be based on trends and expectations developed for each entity.

4. EMPLOYEE RATIOS

  • .Turnover per Employee

Turnover

Number of Employees

This demonstrates the efficiency of the labour force. A low figure may indicate under-productivity.

  • .Average Wage per Employee

Staff costs

Number of employees

Last Modified: 7/9/2019, 10:45:48 AM