Business Compliance Checks Accounting Ratios

Contents Page Introduction 3 Chapter 1 Accounting Ratios 5 Appendix 89

Pre-assessment

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© Crown Copyright Version 2.1

October 2016

This material is OFFICIAL.

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Business Compliance Checks – Accounting Ratios Introduction

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About this Manual

This introduction gives you some general information about the self-study manual (SSM) on Business Compliance Checks: Accounting Ratios.

Prior learning

This manual assumes that you have completed, or have knowledge equivalent to, the learning in Introduction to Bookkeeping or Essential Principles of Bookkeeping.

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You can find more details on the particular criteria you'll be assessed on in the catalogue entry for the product.

Content of this manual

In this manual, you look at how to calculate key accounting ratios and to analyse their significance.

Chapter 1 – Accounting Ratios

Common accounting ratios, their significance and use in compliance checks.

Appendix A The ratios are summarised here to aid your study and revision.

Introduction Business Compliance Checks – Accounting Ratios

OFFICIAL 4 5-Oct-16

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We estimate it should take you this long to finish the manual.

Reading main text 3hrs

Completing activities and the learning check 2hrs

Total 5hrs

Other tax professional learning products (TPLPs)

Within this manual you will see references to some other TPLPs which you may find useful. We've listed them below.

Bookkeeping – Essential Principles

Bookkeeping – An Introduction to Bookkeeping

Business Compliance Checks – Records Examination

Communication – Conducting Compliance Meetings

Business Compliance Checks – Records Examination

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Business Compliance Checks – Accounting Ratios Chapter 1 – Accounting Ratios

5-Oct-16 5 OFFICIAL

Contents

Page

Introduction 7 Learning outcomes and study objectives 7

Study advice 8

1.1 Accounting Ratios 9

1.1.1 Gross profit margin rate 10

1.1.2 Net profitability 23

1.1.3 Debtors ratio 25

1.1.4 Creditors ratio 36

1.1.5 Creditors to closing stock 43

1.1.6 Stock to cost of goods sold 49

1.1.7 Expense to turnover ratio 56

1.1.8 Employees to sales 60

1.1.9 Current ratio 62

1.1.10 Borrowing ratio 67

1.1.11 Fixed asset utilisation 68

1.1.12 Return on capital employed 70

Review 77

Learning check 79

Learning check – answers 83

Before moving on 87

Chapter 1 – Accounting Ratios Business Compliance Checks – Accounting Ratios

OFFICIAL 6 5-Oct-16


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Introduction

Testing the customer's records is a fundamental part of any compliance check.

Accounting ratios can help you judge whether the records are complete and correct. They're used as a diagnostic tool in HMRC, the accountancy profession and the wider business community. They can be used for businesses of all sizes although some are more appropriate for certain sizes or types of business.

In this chapter, you learn about accounting ratios. This includes

how to calculate them

their significance

and

their use in a compliance check.

In this manual we have expressed percentage ratios, where appropriate, to two decimal places and ratios which give the answer in days to the nearest whole number. The most important thing, however you express the results, is to be consistent.

Learning outcomes and study objectives

The following table sets out what you will be able to achieve after you have successfully studied this chapter.

Learning outcomes Study objectives

You will To achieve this you need to be able to

be able to calculate common accounting ratios

understand the significance of common accounting ratios.

calculate common accounting ratios

describe their significance and interaction with each other.


OFFICIAL 8 5-Oct-16

Study advice

We estimate it should take you this long to finish the chapter.

Reading main text 3hrs

Completing activities and the learning check 2hrs

Total 5hrs

You will need a calculator.


5-Oct-16 9 OFFICIAL

1.1 Accounting Ratios

The balance sheet is a snapshot of a business on one particular day, the last day of the period of account. By contrast, the trading and profit and loss account incorporates all the transactions of the whole period of account. Keep this in mind as you work through this chapter.

You can find out more about balance sheets and trading and profit and loss accounts in the Bookkeeping module.

It is not appropriate to consider every ratio in every case. The more complex the case, the more ratios you are likely to consider. However, think about the specific case, the nature of its trade and the risks in deciding which ratios are appropriate to it.

You may find that RIS has calculated some of the ratios in the Standard Information Package (SIP).

Look first at the result produced by each ratio in isolation, then together with the results produced by other ratios. It's also helpful to look more widely at the typical ratios for the specific trade. You can find information to help you with that on the Business Information Unit (BIU) site.

Cross-referencing relevant ratios helps you spot if any

individual ratio is out of line with that for similar businesses or with the pattern of earlier years

and

any ratio which seems to conflict with another ratio or which, taken together, raises questions about the credibility of the accounts.

To identify the ratios that give cause for concern, a good understanding of the nature of the business and your common sense are vital. Always consider any risks specific to the trade you're looking at.


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It's important to remember, particularly at the start of a compliance check, that ratios identify areas of potential concern. You shouldn't confront the customer or agent with the results of your calculations until you have evidence to support them. If there's no apparent reason for an unusual ratio, ask for an explanation. You can learn more about this in Business Compliance Checks – Records Examination and Communication – Conducting Compliance Meetings.

Any unusual ratio result might represent a greater risk for colleagues working in another head of duty than for 'your' one. Keep an open mind and ask colleagues for their opinion when necessary.

For the rest of the chapter you learn how to calculate the common accounting ratios and about the significance of the results. You start with the gross profit margin rate.

1.1.1 Gross profit margin rate

The gross profit margin rate or gross profit margin percentage is one of the most commonly used ratios, both in HMRC and by customers and their agents. It is the gross profit of a business expressed as a percentage of total sales. Experienced colleagues may refer to this as the gross profit rate or GPR.

Formula

The gross profit is calculated by deducting the cost of goods sold (CoGS) from total sales or turnover.

In a retail trade, CoGS is the total cost of purchases bought for resale and sold during the accounting year. An example follows which shows how to calculate CoGS. You then use the information from the example in an activity.


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On 1 January 2015 The Golden Lion public house has stock on hand valued at £4,500. During the accounting period (AP) to 31 December 2015, the publican buys drinks, mixers and so on for resale. They cost £102,500. Stock on hand on 31 December 2015 is valued at £5,500. The turnover for the AP was £175,000.

The CoGS is as follows.

£

Opening stock 4,500

Add Purchases 102,500

Less Closing stock 5,500

Cost of goods sold 101,500

Stock is defined widely. For example, for a pub stock consists of goods for resale, but for other businesses, such as a manufacturer, stock includes raw materials and consumables used in the production process, as well as work in progress (WiP).

The gross profit is

£

Sales 175,000

Less Cost of goods sold 101,500

Gross profit 73,500

You calculate the gross profit margin rate (GP margin percentage) by

dividing the figure of gross profit by sales/turnover

and

multiplying the result by 100 to express the result as a percentage.

gross profit turnover

x 100 = GP margin percentage

Example

S174 ITTOIA 05 S163 CTA09



Try the following activity.



Activity one What is the GP margin percentage for The Golden Lion public house for the AP ending 31 December 2015?



Response The GP margin percentage for The Golden Lion public house is

gross profit turnover

73,500 175,000

x 100 = GP margin percentage 42%

Significance

Low GP margin percentage

If data is available, compare the GP margin percentage you have calculated with the trade average for the geographical area.

If you're looking at a trade for which you can't make an immediate comparison, consult the following sources.

VAT Control Notes: assurance techniques.

Tactical Information Packages (TIPs).

The internet.

The SIP from RIS may contain information that explains a low GP margin percentage. Local knowledge is also useful.

The Golden Lion has a GP margin percentage of 42% but the average for the city is 44%. There's nothing in the SIP to explain this. However, from local knowledge, you know that the pub is in a quiet area of the city. To attract custom it keeps its prices lower and has special offers such as happy hour.

If there is no apparent reason for why the GP margin percentage for a particular business is lower than the average, that becomes a risk.

Example



Any significant reduction in the GP margin percentage is worth investigating.

Sometimes a trader records all purchases but suppresses some sales. The effect is to reduce the GP margin percentage.

Inflating the cost of purchases also reduces the GP margin percentage. A trader may use false invoices to increase the purchases figure. If you suspect evasion and the case meets certain criteria, you must refer the case to the Evasion Referral Team (ERT).

However, a lower profit margin may be more credible when turnover is high. For example, a business may sell goods at a low profit margin to sell more of them. If that tactic succeeds, the trader may still make a reasonable profit.

Undervaluing closing stock or closing work in progress also reduces the GP margin percentage unless opening stock or opening work in progress should also be undervalued.

Alternatively, a business may sell a line at a loss to attract new customers. This is known as a loss leader.

Now try the next activity.

CH402150



Activity two Look at the gross profit and turnover for two cafés, shown below. One is in a city centre surrounded by shops and offices and the other is in the city's suburbs surrounded by flats and houses. Both cafés are independently owned, similarly sized and offer the same standard of food.

Calculate the GP margin percentage for both cafes and state whether either poses a risk. Explain your answer.

City centre cafe £

Suburban cafe £

Turnover 115,000 65,000

Gross profit 74,000 38,000



Response The GP margin percentages are

city centre café – 64.35%

suburban café – 58.46%.

The location of premises can dictate the type of customer and affect the profit margin. Customers of the city centre café are likely to be workers or shoppers having lunch. To some extent the city centre café has a captive clientele particularly if there isn't much competition close by.

The café in the suburbs has a lower GP margin percentage but it doesn't have the same advantages. There may be some offices and so on located nearby which provide custom but the café probably has to rely on local residents or casual customers for its trade. The owners have to make a profit but if the prices are too high people will simply go elsewhere.

However, local knowledge is vital to interpreting results. Accounting ratios can highlight issues but do not provide answers! It may be that the city centre café has stiff local competition which means that although there are a large number of people nearby who require lunch every day, they have the choice of going elsewhere if prices are too high. In this case, the city centre café probably would have a higher turnover but lower GP margin percentage than the suburban café. If so, the lower GP margin percentage for the café in the suburbs may be a risk.

Note that the expected GP margin percentage for a café ranges from 61 – 66% but there are many reasons why that may vary.



High GP margin percentage

It isn't only a low GP margin percentage that should interest you. An unusually high GP margin percentage could indicate that the trader is suppressing part of their business. For example, the trader could be omitting purchases and sales from their records which increases the GP margin percentage.

Prove this for yourself by completing the following activity.

Activity three Janine has total sales of £130,000, of which £30,000 are cash sales. Her CoGS is £45,000, of which cash purchases are £20,000.

She excludes cash purchases and sales from her records and accounts, so her omitted gross profit is £10,000.

Using this information, calculate the following.

a) The GP margin percentage from Janine's financial accounts.

b) Her actual GP margin percentage.



Response a) As a result of suppressing cash business, Janine's GP margin percentage in the accounts is 75%, calculated below.

£

Total sales Less Cost of goods sold Gross profit

100,000 25,000 75,000

Gross profit x 100 Sales

75,000 100,000

x 100 = 75%

b) The actual GP margin percentage for Janine's business is 65.38%, calculated below.

£

Total sales Less Cost of goods sold Gross profit

130,000 45,000 85,000

Gross profit x 100 Sales

85,000 130,000 x 100 = 65.38%

As you can see, by suppressing both purchases and sales, Janine has increased the GP margin percentage.



Sensitivity of GP margin percentage

The lower the turnover, the greater the sensitivity of the GP margin percentage.

Howard's turnover is £200,000, and his gross profit is £100,000. He has omitted £2,000 from sales (but not the related purchases) which reduces the GP margin percentage by 0.5%.

Jordan's turnover is £20,000, and his gross profit is £10,000. He too has omitted £2,000 from sales but not purchases, which reduces his GP margin percentage by about 4.5%.

Fluctuating profit margins

Fluctuating profit margins (both GP margin percentage and net profitability, which you look at next) may indicate risk. To suppress sales in the accounts yet retain a sensible GP margin, purchases must also be suppressed at a corresponding level. That takes a lot of control so isn't easy to manipulate and can result in fluctuating profit margins from one period to the next.

Factors affecting GP margin percentage

Factors which affect the GP margin percentage include

pricing policy – for example, fewer items sold at a high price, or more items at a low price

wastage of stock such as theft or perished items

failure to record all takings

failure to record all purchases

undervaluing or overvaluing stock or work in progress.

Example



Certain types of irregularity, or activity, don't affect the GP margin percentage, eg

subsidiary activity

failing to disallow private expenditure

misrecording of sales between different rates of VAT. If your compliance check concerns VAT and the business has goods or services at more than one VAT rate, misrecording of sales between VAT rates may not affect the overall GP margin percentage but it can certainly lead to tax losses.

Service trades

In a service trade only a small part of the turnover relates to the resale of goods. Most income is generated by labour charge. This means that GP margin percentage is less relevant in such a case. To use GP margin percentage in a meaningful way, identify the amount of the turnover relating to the sale of any goods.

Shakeel is an electrician. He uses electrical components in his work and his accounts show CoGS of £17,000.

Shakeel's turnover is £120,000 but you cannot establish from the accounts how much of that turnover derives from the resale of electrical components and how much from his labour. This means that you are unable to calculate his GP margin percentage without that further information.

Example



1.1.2 Net profitability

The net profit is the actual profit of the business after taking into account all income and expenditure. It's the reward to the owner of the business for taking the investment risk of running the business. Consider whether the net profit declared is credible in relation to the degree of risk taken by the proprietor.

Mary runs a small business into which she had, initially, invested several thousand pounds. She has made either a very low net profit or a loss over the last 10 years. Is the business viable?

You can check the net profitability of a business by comparing the turnover of the business with its net profits and see how it has changed over the years.

Formula

The formula for calculating net profitability is as follows.

Sole traders and partnerships net profit x 100 turnover

Companies

For a company, directors' remuneration and pension contributions are deducted before the net profit figure is reached. If a company is small, therefore, particularly those owned and run by its directors, it may help to add back these amounts before calculating net profitability. That gives an insight into the viability of the company from the owner-director's perspective.

net profit + director's remuneration and pension

x 100 turnover

This is less useful for a large or listed company because its directors may not be shareholders and, if not, their remuneration costs are simply another operational cost to the company.

Example



In the example above, if Mary's business was a small company, the viability of the company from her perspective is transformed by the company paying her remuneration of, say, £100,000 annually.

A sole trader whose net profit is £25,000 and whose turnover is £100,000 has a net profit rate of 25%.

A small company, net profit of £250,000 and turnover £1,000,000, pays directors' remuneration and pensions totalling £300,000 so has a net profit rate of 55%.

Significance

The proprietor of a business judges the success of the business and the wisdom of their commercial decisions on whether they are wealthier as a result. The net profitability figure helps check that.

The effect of evasion may be more marked by reference to the net profit rate than the gross profit margin rate because it's a smaller figure and because it reflects any problems that may derive from either or both the trading and the expenses (the profit and loss) accounts.

How has the rate changed over the AP? Has turnover increased but have net profits gone down? The trader may appear to have taken additional risks for little reward. They're unlikely to be willing to do that for a prolonged period.

A low net profitability might suggest overstated expenses or errors in the trading account. If the figures aren't credible, are the true results being deliberately suppressed?

As with any ratio, consider the result to see if it makes sense. In a high-turnover retail trade you expect to see a low rate. However, a low rate in a capital-intensive business with a slow turnover of goods is unusual because the trader would generally be unwilling to tie up large amounts of capital for a small return.

You should always ask the business owner for an explanation if the net profit rate is falling.

Example



1.1.3 Debtors ratio

The debtors ratio is intended to test how well a business is managing its trade debtors.

Trade debtors are customers who owe money for goods or services provided by the business. A business with trade debtors sells goods or services on credit. The business supplies the goods or the service and then issues an invoice which the customer is expected to pay within a certain period. The debtors ratio, or the 'debtors collection period' ratio, measures the average amount of time its debtors take to pay the business.

Cash businesses generally receive payment on production of the goods or services and are unlikely to have trade debtors. So, if a business is predominantly a cash business this ratio has little significance. It is worth considering if debtors are more than about 5% of sales.

A potential risk arises if trade debtors are unexpectedly absent or present. Therefore, it is vital to know the exact nature of trade.



Formula

The formula for calculating the debtors ratio is

closing trade debtors x 365 credit sales for year

The fraction is multiplied by 365 to give the average number of days the trade debtors take to pay. If the period of account is more, or less, than 365 days you use the number of days actually in the period of account.

The debtors figure in a balance sheet, or in the Standard Accounts Information (SAI) in an SA return, may include prepayments and other non-trade debtors. For a large business, the information is usually set out separately in the accounts. But if you can't isolate trade debtors, use the total debtors figure. The important thing is to be consistent from period-to–period.

The figure for turnover includes all sales, whether cash, credit or both. Unless you have an analysis of the breakdown between cash and credit sales, assume that all sales are credit sales.

Try the next activity.



Activity four Vera owns a wholesale business with credit customers. For the APE 31 October, her SAI entries were

turnover – £205,000

closing trade debtors – £24,000.

What is her debtors ratio?



Response Vera's debtors ratio is 43 days, calculated as follows.

£

24,000 x 365 = 43 205,000

Significance

Once you have calculated the debtors ratio, decide whether it is in line with your expectations. In a well-run business there is close control over debtors both in terms of managing settlement and ensuring that there are few bad debts.

Every business needs adequate liquid resources to maintain its day-to-day cash flow. The word 'liquid' means readily converted to cash. A business's liquidity is its ability to meet demands for payments either from available cash, or by converting an asset to cash. Liquid assets are the current assets as follows.

Cash.

Debtors (including trade debtors).

Stock, which is the least liquid of current assets because it must be sold and paid for.

If the debtors ratio is unexpectedly high it can highlight problems with cash flow and perhaps the overall management of the business.

Generally, the debtors ratio is around 40 days so Vera's result of 43 days initially seems acceptable.



Historically, the figure of 40 days was based on most payments being made by cheque.

Standard credit terms are 30 days, and most businesses take advantage of these terms to pay as late as possible to help with their own cash flow.

Cheques would frequently have been posted, which would increase the time before payment was received.

Most businesses now pay, and are paid, by electronic transfer. However, the reluctance to settle an account before the due date may still exist so 40 days remains an acceptable result.

Forty days also equates to a rule of thumb that, in a well-managed business, the average collection period should be no greater than the net terms of trading plus one-third.

For example, if a business asks for payment of debts within 30 days, the average collection period should be around 40 days.

However, theory and practice can differ. For example, although invoices issued to credit customers may state payment within 30 days, recent experience shows that the average time taken to pay debts is around 60 days.

It is important to establish when a business invoices its customers as that may distort the figures.

Suleiman issues all his invoices at the end of the month with terms of 30 days from the date of invoice. He made a sale to Leanne on the first day of the month, which effectively gave her 60 days credit – 30 days credit before the invoice is issued and then 30 days from the date of invoice.

So, Suleiman's debtors ratio is likely to be more than 40 days, but this is quite acceptable for his business.

The trend of debtors ratios over the years is also important. Any variations must be considered and whilst there could be legitimate reasons for any fluctuations, they can indicate potential risk.

Example



Short collection periods

A short collection period might indicate any of the following.

The business is very efficient at collecting its debts.

If the period is particularly short, the business may be factoring its debts. This means that the debts are sold to a collection agency known as a factor. The factor pays the business straight away and then recovers that by collecting the debts for itself. The factor charges the business for taking on its debts. This charge may be obvious in the accounts as a debit for factoring costs.

Debtors could be understated. Perhaps the trader has created a debtors reserve and netted it off against sales. A debtors reserve is a provision made in the accounts towards potential bad debts. In effect these potentially bad debts are moved from the debtors account to the debtors reserve. This has the effect of reducing both the debtors and sales figures so they are both understated. You can find out more about the bookkeeping involved in the Bookkeeping module.

Sales may be post-dated. This means that credit sales made towards the end of the period are not recorded until the next period. That reduces both the sales and debtors for the period so deferring tax or duty but it means that the sales and debtors for the following period are overstated. To camouflage that, the business must then repeat the practice year-after–year. You can find out more about this in the manual Business Compliance Checks – Records Examination. The debtors ratio can be a useful way of indicating what the trader is doing. The following two activities demonstrate this.



Activity five Fossets Engineering produces accounts with the following entries.

£

Closing debtors 150,000

Sales 2,000,000

What is the debtors ratio?

You can accept that all sales are credit sales.



Response The debtors ratio using the figures in the accounts is 27 days, calculated as follows.

£

150,000 x 365 = 27 days 2,000,000



Activity six In activity five you calculated the debtors ratio for Fossets Engineering using the figures in the accounts. The ratio was 27 days, which was lower than you expected. You examine the records and meet the business owners, Iona and Marshall, and establish that they've been post-dating sales. They've rolled £50,000 of last year's sales into this year and they've post-dated £60,000 of this year's sales to next year.

Using this information, re-calculate the debtors ratio.



Response You should have re-calculated the debtors ratio as follows.

Closing trade debtors should be increased by £60,000. So the figure should be

£

150,000

Plus 60,000

Equals 210,000

Sales should be adjusted for £50,000 included from the previous year and £60,000 post-dated to the following year. So sales should be

£

2,000,000

Less 50,000

Plus 60,000

Equals 2,010,000

The debtors ratio is revised to 38 days as calculated below.

£

210,000 2,010,000

x 365 = 38 days

As you can see, the omission of debtors has a greater effect on the ratio than the omission of the related sales, because sales are omitted from the year's total sales, whereas the debtors have been omitted from the value of debtors at the close of business on the final day of the AP.



Long collection periods

A long collection period may indicate any of the following.

The business is inefficient at collecting its debts. This is unusual because most traders are anxious to collect what is owed to them. Uncollected debts cost the business money.

The sales figures are understated. However, unless almost all sales are on credit, the understatement would have to be large to have a significant effect on the ratio.

The trader sells goods to a much larger business. Large companies can be slow to pay smaller suppliers.

The debtors figure has been increased to cover cash extraction. One way to do this is to show debts that have actually been paid as still outstanding.

An increase in the debtors ratio could be due to a new policy on the period of credit offered to customers. This may be to gain new customers, or increase sales from existing customers. A longer credit period increases the funding required for working capital.

A reduction in debtor days may be as a result of poor control in the past and a tightening of procedures. This can cause a reduction in sales.

The result produced by the debtors ratio can be used in isolation as described above. However, it also has relevance when used as part of a review of the business cash flow. To do this, you must also consider the creditors ratio, which you look at next.



1.1.4 Creditors ratio

The creditors ratio, or creditors collection period ratio, measures the average number of days the business has taken to pay its suppliers.

This ratio applies to most businesses purchasing goods on credit terms. Unless you know that the business makes substantial non-credit purchases, you can assume that all purchases are on credit for the purpose of computing this ratio.

Formula

The formula for calculating the creditors ratio is

closing trade creditors x 365 credit purchases for year

Just as for the debtors ratio, multiplying the fraction by 365 gives the result as the number of days the business takes to pay its creditors. If the period of account is more, or less, than 365 days, use the actual number of days in the period of account.

Sometimes the accounts or the SAI show an overall figure for creditors which includes both trade creditors and other creditors. It may also include outstanding bills. If you can't isolate the trade creditors figure, use the total creditors figure. The important thing is consistency.

In addition, you may have only a figure for cost of goods sold rather than purchases. The formula for the creditors ratio ideally uses the purchases figure. You arrive at the purchases figure by using the cost of goods sold and stock information from the current and previous year balance sheets. Remember to adjust the purchases figure for any work in progress.

The important point is to use the same basis for your calculation for each year when looking at trends. If you use CoGS, total creditors or total purchases in the computation for one year, use the same basis for all periods you are comparing.



For the Golden Lion public house, you calculate the purchases as follows.

£


Plus Closing stock 5,500

Less Opening stock 4,500

Purchases 102,500

Unless you have an analysis of the breakdown between cash and credit purchases, assume that all purchases are credit purchases.




Activity seven Peggy runs an off licence. Her accounts for the APE 31 March show the following.

£


Opening stock 14,500

Closing stock 15,000

Trade creditors 17,000

What is Peggy's creditors ratio?



Response Purchases are calculated as follows.

£


Plus Closing stock 15,000

Less Opening stock 14,500

Equals Purchases 130,000

Peggy's creditors ratio is 48 days, calculated as follows. £

17,000 x 365 = 48 days 130,000

As the figures for closing stock in this and the previous AP varied by only a few hundred pounds, you may decide it's not worthwhile to work out the actual figure of purchases. Remember to be consistent though.

Significance

As with debtors, the creditors ratio is usually around 40 days. So Peggy's ratio of 48 days seems acceptable.



Short payment period

A short payment period can indicate one of the following.

The business has to pay its debts quickly. Consider why. Is it not considered viable by its suppliers? Is it the trade norm? Find out about the precise nature of trade to help you with this.

Trade creditors are understated. If so, your main concern is that the trader may also have suppressed purchases. If the trader has omitted purchases from the accounts, they can also omit the sales relating to them. If sales but not purchases are reduced, it distorts the GP margin percentage.

Long payment period

A long payment period indicates any of the following.

The business is strong enough in the market to influence its credit terms.

The suppliers are inefficient at collecting debts. For the same reasons as with debtors, this is less likely.

The purchases figure is understated but the trader hasn't also concealed the associated creditors.

Trade creditors are overstated. If so, the trader may have antedated purchases. That means they have included purchases, with their related creditors, made at the beginning of the AP in the accounts for the previous AP. You saw the effects of postdating sales in activity six and you can find out more about antedating and postdating sales and purchases in the manual Business Compliance Checks – Records Examination.



Cash flow

Also consider how the business' creditors ratio compares with its debtors ratio. Take into account the nature of the trade and whether there is likely to be a marked difference between the terms given by the business suppliers and the terms it offers its own customers.

Debtors and creditors ratios are linked. Changes in one can affect the other. The position that businesses like to achieve is where payment is received from customers before suppliers require payment because this, obviously, eases their cash flow position.

If a business decides to offer better credit terms to customers, it may try and obtain better terms from suppliers to offset the cash-flow disadvantage. That may be done through agreement or by simply deciding to pay suppliers late. The latter method carries the risk of being refused supplies in future. Non-payment to suppliers is a quick way to obtain an immediate cash flow benefit.

It is unlikely for the number of debtors days to increase and the number of creditor days to fall. This has serious cash flow implications.

If the debtors ratio is lower than the creditors ratio that means that, on average, money appears to be coming in to the business more quickly than it is going out of it.

Part or all of the potential difference may have been used to fund other expenditure such as wages or equipment. Alternatively, it could have been used to clear an overdraft or loan, or is shown as cash in hand or at the bank. If there's no evidence of that, ask what has happened to the apparent difference.

Be careful if you have used figures which include, for example, prepayments in the debtors ratio or other creditors in the creditors ratio. Because of the effect of figures you can't quantify, an apparent difference in payment terms may not, in reality, exist. You must confirm the results with the business.



The difference between the time that debtors take to pay and how long the trader takes to pay their own suppliers can depend on complex factors so, on its own, it is unlikely to present a high enough risk to select a business for a compliance check.

1.1.5 Creditors to closing stock

The creditors to closing stock ratio measures the extent to which creditors are funding stock, and therefore the business itself. This can also be called simply the creditors to stock ratio.

Formula

The formula for calculating the creditors to closing stock ratio is

trade creditors closing stock

Ken trades as a baker. For the APE 30 June, his trade creditors are £3,700 and his closing stock is valued at £1,200.

His creditors to closing stock ratio is

£ 3,700

= 3.08 1,200

If an accountant is acting, they may convert the ratio into a percentage by multiplying the result produced by the formula by 100. Ken's ratio, expressed this way, is 308%.

Example



Significance

The significance of the result depends on the nature of the trade.

Most businesses with a regular turnover of stock have creditors to stock ratio of around one. That's because creditors usually want to be paid for goods already supplied before they supply more goods. Normally a business only owes money for what it has in stock or sold recently.

As his creditors are 3.08 times as much as his stock, Ken's creditors are funding 308% of his stock Ken's creditors are funding all his stock on hand and a large amount that's already been sold.

How significant the result of the ratio is depends on the nature and conditions of the trade.

Darren sells sweets from a railway-station kiosk. His fast turnover of stock means his creditors to stock ratio is around 1.2. So, creditors are funding 120% of stock – effectively all the current stock and some of what has already been sold.

Evelyn manufactures dining room furniture. She has large stocks of material awaiting or undergoing processing. Some of this stock-holding has been paid for by borrowing. Her creditors to stock ratio is around 0.6. In other words creditors are funding only about 60% of her stock.

A ratio which seems to be too high points to either overstated creditors or undervalued stock - or even some of each.

A low ratio indicates the opposite – understated creditors or overvalued stock, or little of both.

It's useful to compare this ratio with the conclusions from other accounting ratios, particularly Stock to CoGs which you look at shortly.

Example 1

Example 2



The creditors to stock ratio can be significant as the under or over-valuation of closing stock presents a major risk for many businesses. If closing stock is understated, that causes the profits to be understated. The creditors to stock ratio can highlight whether the value of stock in the accounts is a risk.

Low creditors to stock ratio

For businesses with a slow turnover, such as furniture stores or jewellery shops, the ratio could be much less than one. That is normal for that type of business because the stock is likely to take a while to sell and be in the shop for some time after the business paid for it.

If you come across a ratio that seems too low for the type of trade, then it is possible that the trade creditors are under stated and/or closing stock is over stated.

High creditors to stock ratio

A ratio much higher than one is unusual as it would mean that creditors were funding the business.

You must know the type of business you're looking at to decide how likely that may be. The example that follows explains this.



Jackson knows where he can quickly sell 50 T-shirts at a profit, but he doesn't have the money with which to buy the T-shirts. He manages to persuade Elliot, who produces T-shirts, to let him have 50 T-shirts on credit. Each T-shirt costs £1 so Elliot is Jackson's trade creditor for £50.

Jackson sells all the T-shirts at £2 each but he banks all the proceeds and doesn't pay Elliot.

A month later Elliot lets Jackson have another 50 T-shirts on credit. Jackson sells them all for £2 each but still doesn't pay Elliot.

At this stage Jackson has sold 2 months' worth of stock for which he has paid nothing to his supplier.

Is it likely that Elliot would hand over a third lot of T-shirts without receiving payment for the T-shirts provided in the first month? Probably not. He effectively funded Jackson's business.

After Jackson received the second batch of T-shirts, his stock on hand would be valued at

T-shirts in stock 50

Cost per T-shirt £1

Closing stock £50

He would owe Elliot

T-shirts purchased 100

Cost per T-shirt £1

Trade credit £100

So Jackson's creditors to stock ratio would be

£

50100 = 2

Example



This is an unlikely situation for most businesses.

If you come across a similar situation, check whether the trade creditors figure is overstated and/or the stock valuation understated.

The next activity will help check your understanding.

Activity eight Ken is a baker whose creditors to stock ratio is 3.08. Is this a cause for concern? Give reasons for your answer.



Response Ken's creditors to stock ratio is a risk. It's unlikely that his creditors would be funding his business. Generally most businesses with a regular turnover of stock like Ken's bakery only owe money for approximately what is in stock. However it's possible that he keeps very little stock on hand but buys all his supplies on credit, paying suppliers monthly. In that case his creditors to stock ratio may be realistic.

Because his stock is perishable, there's unlikely to be more than a day's worth of finished stock on hand at any time, although he probably also has unprocessed, raw materials such as flour.

You don't know at this stage what Ken's purchases or CoGS figures are so his stock may be understated, or his trade creditors overstated but you should check both figures.

Next you consider the relationship between stock and CoGS. Two ways in which you can consider this relationship are

stock ratio

stock turnaround.

Both are equally valid.



1.1.6 Stock to cost of goods sold

The stock ratio measures the number of days' purchases on hand at the end of the financial period.

The stock turnaround measures the number of times the business turned over its stock in the period of account.

Formula

Stock ratio

The stock ratio is

closing stock x 365 CoGS

Multiply the fraction by the number of days in the period of account to express the result in days.

André's closing stock is £6,000 and his CoGs figure is £73,000. His stock ratio is therefore 30 days.

£

6,000 x 365 = 30 days 73,000

Example



Stock turnaround

The stock turnaround is

CoGS average value of stock held

You can find the average value of stock held by averaging the figures for opening and closing stock. So, if opening stock is £4,000 and closing stock £6,000, the average value is

2000,6000,4£ = £5,000

The stock turnaround is 14.6 times in the period of account. £

000,5000,73 = 14.6

Significance

A low stock ratio might suggest the following.

Undervaluation of stock.

Antedating of purchases.

An inflated CoGS figure to include non-trading items or fictitious invoices.

A low stock turnaround suggests the opposite.

Interpretation of the results depends on the nature of the trade. If a business sells perishable stock you expect a rapid turnover of stock and therefore a low stock ratio – that is just a few days' stock on hand at the end of the period of account. The stock turnaround should be high because purchases are frequent and most stock is sold within a few days. The business turns over its stock many times in a year.

If the results are unexpected, the risk is that stock valuation or the CoGS figure is inaccurate. Focus on these issues when examining the business records.



Another factor potentially affecting these ratios is the accounting date. For example, seasonal trades don't have consistent levels of stock throughout the year. If the accounting date is at a low point in the business cycle, stock levels may be lower than normal.

For some, very seasonal, businesses, take into account seasonal fluctuations by looking at the records for each month for a realistic view of stock figures.

Equally, for a shop selling perishable goods, if the accounting date falls on a Saturday and the shop is closed on Sundays and Mondays, stock levels may be lower than in previous periods.

If you do decide to check the stock valuation, you can ask a number of questions. They're listed on the following page. If there is an agent, they are likely to have covered the same questions when the accounts were prepared.



Questions about stock

To establish whether a stock valuation is correct, establish the following information.

When was the stock valued? The stock should be valued on the accounting date, but sometimes that isn't possible. If it was valued at some other time, what steps were taken to reconcile the stock value between the two dates.

Who measured the stock and what were their instructions?

Was all stock held by the business included in the valuation? For instance, was stock in warehouses or other shops accounted for? What about goods in transit?

How was stock counted? Was a physical count taken of each item or were estimates made? On what basis were estimates made?

What stock records are there? Ask to see them.

Have there been any changes since the previous period? For example, more storage space, or a new line added…or even diversification into different trade or emphasis?

If the amount of activity suggests that stock is being turned over more rapidly than is indicated by the trading account, there is a possibility that sales have been suppressed.

Also consider

has the level of closing stock been manipulated to maintain consistent profit margins?

have purchases ordered but not yet delivered been included in the purchases figures? If so, there may be an error caused by timing.

The following activity gives you the opportunity to consider the results produced by the stock ratio and stock turnaround.



Activity nine The results of businesses Andy's and Billy's for the year ended 31 March 2016 are as follows.

Business

Andy's

£

Billy's

£

Cost of goods sold 72,000 72,000

Stock at 31 March 2015 1,700 5,000

Stock at 31 March 2016 1,500 6,500

a) Calculate the stock ratio and stock turnaround for each business.

b) Consider the results of your calculations and decide whether each business is likely to trade in slow or fast moving stock. Give your reasons.



Response a)

Stock ratio

£ Andy's 1,500

x 365 = 7 days 72,000 Billy's 6,500

x 365 = 33 days 72,000

Stock turnaround

£ Andy's 72,000

= 45 times 1,600 Billy's 72,000

= 12 times 5,750

b) From these results, Andy's seems to trade in fast moving stock, possibly perishable goods. There is about 1 week's stock on hand and it turned over its stock 45 times in the year. That's almost once a week, allowing for fluctuations and holidays. This could be a business such as a fishmonger or a greengrocer.

The results for Billy's are different. The stock isn't fast moving, but neither is it particularly slow. The stock turned over about 12 times in the year, or once a month. There is about 1 month's stock on hand at the end of the year. This could apply to any number of types of trade, such as a clothes shop.



You may find it helps to compare the creditors to closing stock ratio with the stock to cost of goods sold ratio. Sometimes they may contradict each other.

Lazlo has trade creditors of £10,000 and stock of £3,000. £

000,3000,10 = Creditors to closing stock ratio of 3.33

The creditors are funding 333% of Lazlo's stock.

Purchases are £80,000.

£

000,80000,3 x 365 = Stock ratio of 14 days

Lazlo has about a fortnight's worth of stock on hand so he probably buys stock quite regularly.

Is it likely that suppliers would provide goods so frequently without being paid by Lazlo? Stock may be understated but consider the particular circumstances of the business before reaching a conclusion.

Example



1.1.7 Expense to turnover ratio

An expense to turnover ratio compares, as the name suggests, key expenses to turnover. The skill is in selecting which items of expense to look at.

Sushil runs a freight-logistics business. Key expenses include fuel and, because the business is labour intensive, wages.

The name of the ratio depends on the expense you are examining. For example if you are comparing wages to turnover, refer to it as the wages ratio.

Formula

The formula for calculating the expense to turnover ratio is

expense x 100 turnover

Significance

An expense ratio looks at the relationship between the item of expense and turnover. It is a measure of the scale of the expense. The ratio is normally expressed as a percentage.

Hannah's turnover is £160,000 and her advertising expense is £30,000, so her advertising ratio is

£

000,160000,30 x 100 = advertising ratio of 18.75%

Consider the nature of trade and consult TIPs to see if it seems reasonable. If not, the expense may be overstated or the turnover is understated - or a bit of both.

When you interpret the result of an expense to turnover ratio expressed as a percentage, consider the trend over a number of periods. Try the activity that follows.

Example

Example



Activity ten Consider the information below. Calculate appropriate expense ratios and briefly highlight any concerns you have.

Judi runs a business which supplies door mats by mail order. The following is a sample of information from her profit and loss account.

Year ended 31/12/13 31/12/14 31/12/15

£ £ £

Turnover 560,000 585,000 615,000

Delivery costs 24,000 32,000 55,000

Bank charges 1,200 8,620 7,595

Rent paid 6,000 6,000 6,300

Wages 125,000 150,000 175,000



Response

Year ended 31/12/13 31/12/14 31/12/15

Delivery costs ratio

4.29% 5.47% 8.94%

Bank charges ratio

0.21% 1.47% 1.23%

Rent paid ratio

1.07% 1.03% 1.02%

Wages ratio

22.32% 25.64% 28.46%

Judi's turnover is increasing steadily. This may be the effects of inflation forcing her to raise prices, or she may have increased her sales. What was the effect on gross profit?

You would usually expect her key expenses to remain approximately proportionate to turnover. Remember though, that a one-off factor, or a sudden change can have a dramatic effect on profit and loss income or expenses.

Delivery costs

As Judi sells her products by mail-order, delivery is a key expense. As a percentage of turnover, courier costs have more than doubled. This could indicate

costs for each delivery have increased

Judi has changed her business strategy and now sells more mats at lower prices – increasing the number of individual deliveries

She has increased sales, but hasn't recorded all the takings, despite claiming the additional purchases.

Explore this further.



Response (cont) Bank charges

This is not, obviously, a key expense. However the sudden increase in 2014 indicates that Judi has increased borrowings. Is the additional turnover sufficient to justify these increased costs?

Has Judi had unauthorised, more expensive, overdrafts? If so, does this indicate that her business is struggling?

Was the borrowing to pay for something in particular? The premises costs are static so she probably hasn't moved – perhaps she's bought some new equipment.

Is it obvious where the increased bank costs arise? Could there be an undeclared account? The balance sheet should give information on long-term and short-term debts. Have they changed?

Does the level of any overdraft suggest that takings are not being banked and being suppressed?

You may get answers from Judi's balance sheet.

Rent paid

This looks quite static. It seems that rent increased from £500 per month in 2013 and 2014 to £525 in 2015. There's little point in a compliance check in working out an expense ratio on this type of fixed and predictable figure. Judi has to pay the rent even if she fails to make any sales.



Response (cont) Wages

The wages ratio has increased by just over 6%.

Does this reflect inflation, local staff shortages driving up wages or have new staff been recruited?

Turnover is increasing. If profits are growing at the same rate, perhaps the increase is to share increased prosperity with the employees.

If sales have not mirrored changes in expenses, are there suppressed sales?

You may have thought of other issues. The important thing is to identify areas of interest.

1.1.8 Employees to sales

Depending on the nature of the trade, look at the proportion of turnover generated by each employee.

Formula

The formula for calculating the employee to sales ratio is

sales = sales per employee number of employees

Myra employs three full-time employees who are paid a total of £78,000. Her turnover is £350,000, so the sales for each employee average

3000,350£

= sales per employee of £116,667

Example



Significance

The employees to sales ratio looks at the proportion of turnover generated by each employee. It helps you to decide whether it's realistic for the business to employ that number of staff to generate the level of declared sales. If the return for each staff member is not reasonable, consider why the business continues in that way. Are you getting the full and true picture?

If the figure is low, are sales being suppressed?

If it's high, are there off-record employees paid in cash? If there are off-record employees, are they generating further, unrecorded sales?

Remember to liaise with your employer compliance colleagues if you suspect payroll irregularities. There could be considerable amounts of PAYE income tax and NICs at stake.

In Myra's case, the employees are paid an average of £26,000. That appears reasonable, although, as always, consider the nature of the business and normal practice for that business before reaching a conclusion.

If possible consider this ratio in conjunction with the wages ratio – the sales compared with the total wages in the accounts. If you don't know the number of employees, you might have to just consider the wages ratio. Are the wages paid reasonable, given the sales generated? The BIU site can help you here.

If employees are paid more than the business owner, the returned sales and profit figures present a risk. Anyone who takes on the pressure of running a business and risking their own capital is usually unlikely to be prepared to benefit from the business to a lesser extent than their employees.

Next you look at the current ratio, also known as the short term liquidity ratio.



1.1.9 Current ratio

The current ratio, or short term liquidity ratio measures the liquidity of a business, that is how able a business is to meet its current liabilities.

The current ratio is of most use when you examine accounts of large businesses, especially those of a limited company. However, it can also help when considering a smaller trader's ability to pay outstanding business debts. This is sometimes described as the short-term liquidity position of the business.

Formula

The formula for calculating the short term liquidity of a business is

current assets = current ratio current liabilities

In this context the word 'current' means 'less than, or within, a year'. So current assets include cash on hand and at the bank, easily realisable investments, trade debtors and stock. Current liabilities include all creditors where payment is due within 1 year, such as bank overdrafts and short-term loans, and any other short-term payments due. The norm is 2:1.

Significance

Low ratio

If the current ratio is less than one, the business is unable to meet its liabilities from readily available funds. This is known as illiquid. A ratio just above one can also give cause for concern as there may be insufficient working capital for the business to function properly.

If a business seems to have been illiquid for some years, what action has the trader taken to improve things? On the face of it, the business is insolvent and shouldn't be able to continue trading.



One possible reason for any lack of concern is that the trader knows the actual profits of the business are greater than those shown by the accounts from which you have calculated these ratios.

A reducing ratio indicates reducing liquidity and could indicate approaching insolvency. If so, be alert to the risk that the business may try to obtain much needed cash by defrauding HMRC. Alternatively, if insolvency looks possible, is a compliance check a good use of resource?

Because the current ratio indicates the margin of financial safety within the business, you expect a ratio greater than one. A ratio less than this can indicate that the business may be unable to pay its debts on time. However, some businesses operate with ratios of less than one if they have low debtors figures but high creditors figures. Examples of this are large supermarket chains.

High ratio

A current ratio substantially greater than the norm of 2:1 can also give cause for concern. If a large proportion of the current assets is debtors and there is a long debtors' collection period, some of these debts may become bad. In this situation, the liquidity ratio is actually less healthy than it first appears.

If the figure is too high it could indicate poor management of debtors and stock, but it could also indicate that these figures in the accounts are incorrect. This is especially likely where accounts are not audited.

The current, or short term liquidity, ratio depends on the nature of the business and can also vary between traders in a similar business. If the business has high levels of stock and gives generous credit terms the current ratio would be higher than a business which generates a high proportion of cash sales from a large turnover.



You can also check whether a business can pay its outstanding debts without selling stock by using the quick ratio below. The norm is 1:1.

current assets – stock = quick ratio current liabilities

The quick ratio is another ratio used to assess liquidity. You may also hear it referred to as the acid test ratio.

This ratio recognises that stock takes time to convert into cash, both to find a buyer and to await payment. This ratio is more relevant when stock is slow moving.

Theoretically, an acceptable current ratio is two and an acceptable quick ratio is one, but these are just a guide. What is important is the trend. If the current and quick ratios remain fairly constant over a number of years, it indicates that the liquidity of the business is under control.

Fluctuating, low or high ratios are indicators of risk.




Activity eleven Flora's Bookshop has current assets amounting to £145,000, of which £80,000 is stock, and it has current liabilities of £112,000.

a) What is the current or short term liquidity ratio?

b) What is the quick ratio?

c) Do they appear to be reasonable?



Response The current or short term liquidity ratio is

£

current assets 145,000 = 1.29 current liabilities 112,000

The ratio is slightly over one but a bookshop is likely to maintain high levels of stock so it is probably reasonable. The norm for this ratio is 2:1.

The quick ratio is

£

current assets – stock 65,000

= 0.58 current liabilities 112,000

The norm for this ratio is 1:1.

Because of the high levels of stock, this may not be a cause for concern but you really need to view the trends over a few years.



1.1.10 Borrowing ratio

In considering liquidity, the ratio of loans to assets, the borrowing ratio, helps.

Formula

The formula for calculating the borrowing ratio is

outstanding loans = borrowing ratio net assets

Outstanding loans include both short and long term borrowings, so you include loans and bank overdrafts.

Significance

Banks and finance houses require security for their loans. If there's no security apparent in the balance sheet, it suggests that the trader may be using personal assets as security. This indicates the possibility of personal wealth possibly out of line with the profits shown in the accounts and tax returns.

Banks make extensive use of cash flow forecasting. Generally, a potential investor wants to see a borrowing ratio of no more than half to one. If a business is illiquid, the owner would have had to convince the lender that the business can generate enough income to repay the loan and the interest on it.

If a business has large loans but appears to be illiquid, ask to see the forecasts given to the lender. The figures given may not be the same as those given to HMRC.

Next, you learn about growth in assets as a pointer to how a business is performing.



1.1.11 Fixed asset utilisation

Fixed asset utilisation, or growth in fixed assets, is a pointer to how a business is performing.

Fixed assets are owned by the business, are not bought for resale and have some durability. That includes premises or machinery such as plant and motor vehicles.

If a business purchases more or replacement machinery, you expect to see an increase in sales.

On the other hand, if a business sells, eg, part of its production-line machinery without replacing it, it could be downsizing or it could indicate a change of trade. Either way find out the facts.

Formula

The formula for calculating fixed asset utilisation is

Sales = fixed asset utilisation fixed assets

So if a business has sales of £1,175,000 and fixed assets of £450,000, fixed asset utilisation is 2.61.

£ 1,175,000 = 2.61 450,000



Significance

What you include as fixed assets in this formula depends upon the nature of the business. If there has been no movement in property, focus on plant and machinery.

The ratio is bound to vary from year-to-year as assets are replaced. However, over a number of years, any significant change in the ratio could indicate a change in the nature of trade.

A significant decline in the ratio would indicate that the business had failed to capitalise on its investment in new assets. This could be because a poor business decision has been made, but it could also be because the profits generated by the new assets are not being fully declared. Compare this ratio with other ratios and information you hold.

Any significant asset sale is likely to have implications for VAT, CT and IT.



1.1.12 Return on capital employed

A business owner has capital tied up in their business. Usually arriving through their capital account, this capital is then invested in the business in the form of fixed assets, stock etc. The return on capital employed (ROCE) ratio measures the return on that capital and allows comparison with the return on the same amount of capital placed in an investment account or employed in a similar business. Though, given the very low interest rates presently, this measure is less reliable than it had been a few years ago.

It measures the earning power of the total long-term investment from all sources within the business. The ratio provides a useful comparison between different traders in the same business area and the trader's previous results over a period of time.

The return on capital employed ratio is also referred to as return on capital, return on investment or return on net assets.

Formula

The formula for calculating ROCE is

net profit x 100 capital employed

In this context, net profit is the profit before interest, so, for an unincorporated concern, you may have to make an adjustment to the stated net profit to get that figure.

Capital employed is the value of the total assets less current liabilities as shown in the balance sheet. So relevant assets are included net of depreciation. You can use either the average of the opening and closing capital figures or the capital at the balance sheet date, but you need to be consistent from year to year comparison.

For companies, use the operating profit, which is the reported net pre-tax profit before any interest paid, and the shareholders' funds which should be shown on the balance sheet. Shareholders' funds are, in broad terms, the share capital and company reserves.



The values to be used in the formula are therefore as follows.

Sole traders and partnerships

Net profit Total assets less current liabilities

Companies

Operating profit before taxation Shareholders funds

Significance

What return is the trader getting on their investment and how does that compare with what the trader could obtain if they invested a similar amount elsewhere, say, in a bank account or on the stock market.

Duncan's return on capital employed is 15%. This means that every £100 of capital he has tied up in the business has generated £15 profit. This is the return on his investment. It seems a good result. Most investments wouldn't give such a return on capital.

If a trader could get a better return by investing their money, why be in business at all? There is a risk that the accounts are not showing the correct position. However, businesses can go through difficult times and although you could ask why anyone would continue trading when the return on capital is poor, perhaps the trader is hanging on for an upturn. Keep an open mind.

Example



If the capital has increased, consider

whether the business had the means to introduce the capital

whether capital was actually introduced or has it been used to hide suppressed sales when balancing the accounts? Is there any evidence to support or corroborate the introduction of capital? For example, an indication of investment income falling?

why capital has increased if the previous results were poor. Is the business still viable or could there be future insolvency?

Another point to consider is the type of assets held.

Sam and Jane are each sole traders and each has put £10,000 into their respective businesses. You have calculated their ROCE ratio and found that Sam has an 8% return while Jane has a 1.5% return. The average return on a bank or building society investment in the year under review was 3%.

You may decide that Jane's accounts pose a risk but Sam's don't.

However, 5 years later they both give up self-employment and dispose of their business assets. Jane initially spent £10,000 on a property which she sells for £15,000. She regains not only her initial investment but also an additional 50%.

Sam bought computer equipment which is now out of date and virtually worthless and only manages to obtain £1,000.

Would you now hold the same view as to whose accounts posed a risk?

Example



Bear in mind that the ratio doesn't take into account revaluations of assets such as depreciation, or property appreciation. Because you include the value of assets in the formula, any annual depreciation of assets in the balance sheet may increase the ROCE even though there has been no increase in profit. Of course a revaluation increasing the value in the balance sheet has the opposite effect. Revaluations, to increase the asset worth, most commonly affect land and buildings.

If you're comparing results against other businesses make sure that assets are valued consistently.

When considering ROCE, look at the results for director shareholders alongside their total remuneration package including pensions, benefits and any share options granted.




Activity twelve a) Eleanor makes a net profit of £60,000.

Her business balance sheet shows total assets of £300,000 and current liabilities of £50,000.

What is her ROCE?

b) Gruffydd Ltd makes a pre-tax operating profit of £400,000 after paying interest of £25,000. The shareholders funds were £1,300,000.

What is the company's ROCE?



Response a) The formula for calculating ROCE is


Eleanor's net profit is £60,000.

Her capital employed is

Total assets £300,000

Less current liabilities 50,000

£250,000

Therefore Eleanor's return on capital employed is

£60,000 x 100 = 24% £250,000

Eleanor's return on her capital is very good, so it justifies her investment and effort.

b) Gruffydd Ltd pre-tax operating profit is stated after the deduction of interest. Add this back to arrive at the operating profit before interest.

Operating profit before taxation x 100 shareholders' funds

425,000 x 100 = 32.69% 1,300,000

This return looks exceptionally good – perhaps suspiciously so?

This is the end of the new material in this chapter. Now read the review, then try the learning check that follows it.



Review

All ratios covered in this manual are shown in appendix A. You can calculate them from information in the accounts and use them to evaluate the credibility of the accounts figures and identify risks.

When you review accounts, consider which business ratios are relevant because not every ratio applies.

It is of concern if

individual ratios are out of line with similar businesses, or with their trend for earlier years

and

ratios seem to conflict with one another or, when taken together, they raise doubts about the credibility of the accounts.

Not all ratios are relevant in every case, but in general, the more complex the case, the wider the picture to be built up. Use ratios both in isolation and against each other to judge whether a uniform picture is presented and to highlight any concerns. Some ratios are useful only if they're compared over a number of years to establish the trend.

The ratios supplement other analysis of accounts. Some, such as gross profit margin percentage are usually relevant, but use others only according to their relevance to the particular business.

Now test your knowledge by doing the learning check that follows.



Learning check

1. State the formula for calculating each of the following accounting ratios.

a) GP margin percentage

b) Debtors ratio

c) Creditors ratio

d) Creditors to closing stock ratio

e) Stock ratio

f) Stock turnaround ratio



2. a) Why does HMRC use accounting ratios when reviewing accounts?

b) What should you remember when using them?

3. You are reviewing records for Emily, a management consultant. How helpful is it to compute her GP margin percentage? Give reasons for your answer.



4. An analysis of Jean's return shows a debtors ratio of 44 days and creditors ratio of 78 days. What does that indicate and what evidence would you look for in the return to help explain these figures?

5. Jean's return also shows closing stock of £20,000 and creditors of £17,000. Would it help to compute the creditors to closing stock ratio? Give reasons for your answer.



6. The return for a greengrocer's shop has a stock ratio of 35 days. What are your views on this?

7. Owain is a sole trader. His accounts show the following.

Wages £34,000.

Net profit £10,000.

The business has two employees.

Would these results give you any cause for concern? If so, why?



Learning check – answers

1. State the formula for calculating each of the following accounting ratios.

a) GP margin percentage

gross profit x 100turnover

b) Debtors ratio

trade debtors x 365credit sales

c) Creditors ratio

trade creditors x 365credit purchases

d) Creditors to closing stock ratio

trade creditors closing stock

e) Stock ratio

closing stock x 365cost of goods sold

f) Stock turnaround ratio

cost of goods sold average stock

This was covered in subchapter 1.1.



2. a) Why does HMRC use accounting ratios when reviewing accounts?

To identify potential concern. They also help to understand how the business operates.

b) What should you remember when using them?

It's important to remember, particularly at the start of a compliance check, that ratios identify potential concerns. You shouldn't confront the customer or agent with the results of your calculations until you have evidence to support them.


3. You are reviewing records for Emily, a management consultant. How helpful is it to compute her GP margin percentage? Give reasons for your answer.

GP margin percentage only has true significance when the business is involved in selling goods. A management consultant is a service profession. Consequently, GP margin percentage has little or no meaning when reviewing Emily's return.




4. An analysis of Jean's return shows a debtors ratio of 44 days and creditors ratio of 78 days. What does that indicate and what evidence would you look for in the return to explain these figures?

Jean is receiving funds more than 1 month before she has to pay for supplies. Therefore her cash flow position should be healthy. You may find evidence of that by identifying considerable cash expenditure on, say, wages or capital equipment, or substantial sums of money in the bank or in hand.

Alternatively, Jean may have used the money to reduce borrowings and the balance sheet liabilities should reflect that.

Finally, Jean could simply be taking high cash drawings.

If there's no evidence to support any of these possibilities, find out what Jean is doing with the surplus cash she had before settling her debts.


5. Jean's return also shows closing stock of £20,000 and creditors of £17,000. Would it help to compute the creditors to closing stock ratio? Give reasons for your answer.

As creditors are less than stock, creditors don't seem to be funding the business. It is obvious that the ratio is around one. Consequently, there would be nothing to be gained by computing the creditors to stock ratio.




6. The return for a greengrocer's shop has a stock ratio of 35 days. What are your views on this?

A greengrocer sells perishable goods. Consequently, unless the shop has a warehouse attached, or a wider product range than indicated by its known activities, you would expect stock to be no more than a few days' purchases. This presents a risk.


7. Owain is a sole trader. His accounts show the following.

Wages £34,000.

Net profit £10,000.

The business has two employees.

Would these results give you any cause for concern? If so, why?

On the face of it, more is being paid out in wages to the employees than is available to the proprietor for his drawings. If both employees earn roughly the same, they are each earning more than is available to the proprietor. That doesn't seem likely so make further enquiries.




Before moving on

If you have answered the learning check correctly, you will have successfully completed the learning outcomes and study objectives for this chapter, which you can see in the table below.

Learning outcomes Study objectives

You will To achieve this you need to be able to

be able to calculate common accounting ratios

understand the significance of common accounting ratios.

calculate common accounting ratios

describe their significance and interaction with each other.

If you had difficulty in achieving any of these objectives, have another look at the relevant parts of the chapter and try the learning check again. You should be confident that you have achieved them before moving on. There is also a space for you to note any points you might want to discuss with your line manager or tutor.



Notes

Business Compliance Checks – Accounting Ratios Appendix


Appendix A

Ratio Formula What it shows

Gross profit margin rate (GP margin%)

gross profit x 100 turnover

The profit margin on sales expressed as a percentage.

Net profit ratio

net profit x 100 turnover

How profitable the business is after expenses.

Debtors ratio

trade debtors x 365 credit sales

The time that the business takes to collect its trade debts.

Creditors ratio

trade creditors x 365 credit purchases

The time the business takes to pay its creditors.

Creditors to Closing stock

trade creditors

closing stock

The extent to which creditors are funding stock.

Stock ratio

closing stock x 365 cost of goods sold

How many days stock is on hand.

Stock turnaround

cost of goods sold

average stock value

The number of times the stock is sold on during the period of account.

Expenses to turnover ratio

item of expense x 100 turnover

The proportion of turnover needed to meet key expenses such as wages, fuel costs etc.

Employees to sales

sales

number of employees The proportion of turnover that each employee generates.

Current ratio or short term liquidity

current assets

current liabilities

Whether the business can pay its outstanding debts from current assets. The norm is 2:1.

Quick ratio or acid test ratio

current assets – stock

current liabilities

Whether the business can pay its outstanding debts without selling stock. The norm is 1:1.

Asset growth

sales

fixed assets

Indicates a growth in fixed assets. A significant change in the ratio could indicate a change in the nature of trade, or profits generated from new assets are not recorded.

Return on capital employed (ROCE)


Measures the return on capital to allow comparison with alternative forms of investment.

Borrowing ratio

outstanding loans

net assets

Indicates how the business is performing together with its ability to pay any liabilities.

Appendix Business Compliance Checks – Accounting Ratios


Business Compliance Checks Accounting Ratios

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