In this session we shall consider how students should approach questions that ask them to comment on financial ratios.
Commenting on Ratios
Many exams on financial statements include questions requiring students to comment on a set of ratios that the student may or may not have had to calculate.
When making comments on a set of ratios in an exam, it is best to take a structured approach as this will reduce the risk that easy marks are missed and also maximise the chance of scoring well. Suggestions as to how such questions can be approached are made below.
1 Comment on all the ratios provided
You must make comments on each ratio that you are provided with (or on each ratio you are asked to calculate) as there will be marks available for comments on each of them. In addition, it is likely that there will be a maximum number of marks available for commenting on each ratio so do not think that writing a huge amount on one ratio will compensate for not writing anything about other ratios.
It is a good idea to use a separate paragraph for each different ratio as this will reduce the risk that you forget to comment on any of them and it will also make it a little easier for the person marking the exam to identify the points raised that qualify for marks.
In addition, do not be concerned about repeating certain phrases or words (e.g. “the ratio has improved”) as you should not be penalised for doing so.
2 Make qualitative statements
When commenting on ratios state whether each ratio has improved or deteriorated if you are comparing different periods, or is better or worse if you are comparing a ratio against say, an industry average or competitor.
Try to avoid terms such as “gone up”, “gone down”, “increased”, “decreased”, “risen” or “fallen” as these terms do not tell a reader whether you understand the significance of the comparison and is perhaps the easiest way to lose marks on this type of question. Compare the following two statements:
- “The gross profit percentage has gone down from 20% last year to 15% this year”
- “The gross profit percentage has worsened from 20% last year to 15% this year”
Both statements contain similar information but the second tells the reader that you understand the implication of the comparison between the current and previous years’ gross profit percentage.
3 Explain what the ratio means
When commenting on the ratio you should explain what the ratio measures. For example:
- ” The worsening of the current ratio from 2.2:1 to 1.8:1 means that the company is less able to pay its debts as they fall due.”
- “The improvement in gearing from 42% to 35% means that the company is less financially risky due to the long-term debts that have now been repaid.”
If you find it difficult to explain what a particular ratio means, consider how the ratio is calculated, for example the Asset Turnover (Net Assets) ratio is calculated by dividing the company’s sales revenue by its net assets and must therefore tell us about the relationship between these two numbers.
4 Put the ratios into context
When commenting on a particular ratio you should ask whether the ratio can be linked to:
- Changes in other ratios (e.g. a change in the Inventory Holding Period (days) ratio will affect the Working Capital Cycle)
- Additional information provided about the company and the environment it operates in. For example, if the scenario mentions a reduction in materials prices this would affect the company’s Gross Profit Percentage
- Note that sometimes factors can exist that would have opposing effects on a ratio. For example, a business might increase its wage rates for production staff but at the same time see its raw materials costs fall. The change in wage rates would reduce the business’ gross profit percentage whilst the fall in materials prices would increase the gross profit percentage. If the business’ gross profit percentage had fallen we would say that the effect of the increased wage rates on the gross profit percentage had outweighed the effect of the fall in materials prices.
Question often ask for a recommendation to help a user make a decision about a company. For example, it might ask whether a shareholder should hold onto or sell their shares in a company or whether a loan or credit should be offered.
Any recommendation made must be based on the ratios you have previously commented upon. You should therefore summarise the ratios and explain why you believe your recommendation is correct.
Do not however, avoid making a recommendation by saying that you need more information. Such an answer would be highly unlikely to merit any marks.