The use of ratios and comparisons in auditing

In the F8 exam you can be asked to compute and interpret key ratios used in analytical procedures at both the audit planning stage and when collecting audit evidence. Ratios and comparisons can be used to identify where the accounts might be wrong and where additional auditing effort should be spent.

Calculating a ratio is easy, usually little more than dividing one number by another. Indeed, the calculations are so basic they can be programmed into a spreadsheet. The real skill comes in interpreting the results and using that information to carry out a better audit. Saying that a ratio has increased because the top line in the calculation has increased (or the bottom line decreased) is rather pointless: this is simply translating the calculation into words. Use the mnemonic RATIO to remind yourself to keep asking:

• R Why has this change occurred?
• A Is the change real or simply an artefact, an accident of calculation?
• T What can be done to test our conclusions? What other work should we do?
• I What does this change mean? Liquidity crisis? Poor management etc?
• Other information. Is this consistent with other information?
  

You don’t have to set out these queries formally in your answers, but the five classes of questions should always be at the back of your mind. Note that quoting RATIO and saying what the letters stand for will get you no marks.

There is a huge variety of businesses and this diversity will be reflected in their financial statements. To judge whether a figure or ratio is worth investigating, it is absolutely necessary to compare it to its equivalent in either the same company in the previous period, or other companies in the same industry. Comparisons provide benchmarks.

To look at some of the techniques and interpretations, we will use the financial statements of Ocset Plc, shown below.

Comparison of two consecutive years

Perhaps the first thing to do is simply to compare the two sets of financial statements. Here we have results from 2009 and 2008. So look down the figures, just comparing like with like, and see what queries or hypotheses you might be able to generate. The mnemonic RATIO will be used formally for the first comparison. Here are some first thoughts:

Non-current assets: intangible	Substantial increase in goodwill. Reason: acquisition?. Is it real or an artefact? How can the amount be checked, verified and tested? Implications: What was bought? How paid for? What type of business? Is this consistent with other information, such as additional non-current assets, increased finance and so on? Who audits it? When was it bought
Non-current assets: tangible	Substantial increase. Some might be because of the acquisition, some might be organic. How paid for? How can we test it?
Inventory	Relatively small increase. Will be interesting to compare to sales
Receivables	Relatively small increase. Will be interesting to compare to sales
Cash	Large increase. Why? Where has that come from?
Trade payables	About a 15 – 20% increase. Why? Large compared to receivables and cash. Compare to cost of sales later. How can we verify these liabilities? It might be an accident (artefact) of timing, for example, when the payables processing was just after year end.
Short term borrowings	Doubled, but could be brought back to 2008 levels by using some of the cash. Why have cash and an overdraft at the same time?
Net current assets/liabilities	About the same both years. Alarmingly, both years show net current liabilities. However, the business has survived a year like this.
Share capital	No material change
Reserves	Increased by retained profit
Long term liabilities	Substantial increase. Presumably, this is a major source of funding for non-current assets. Expect an increase in financing costs. Need to verify that the liabilities are indeed long-term.
Revenue	Very substantial increase (around 15%). How much is organic and how much because of acquisition? We would expect changes in inventory and payables.
Cost of sales	An increase roughly in line with the increase in sales.
Commercial and administrative costs	Substantial increase. Perhaps temporary after the takeover and before rationalisation. Might indicate poor cost control.
Tax and dividends	Fairly consistent.

If you were now told that the financial statements are modelled on a supermarket business, then you might be able to make more sense of some of the figures – particularly the net current liabilities. Supermarkets have low receivables and low inventory (it’s perishable) yet can squeeze their suppliers hard. They can therefore survive well on large trade payables confident that inventory will steadily turn into cash. However, now that we know we are dealing with a supermarket, we should be interested in why they have substantial receivables at all.

Ratio analysis

Ratio analysis is useful because it allows you to see if two figures have moved consistently with one another. You should be concerned if they haven’t.

There are three main groups of ratios: profitability, liquidity and risk.

Profitability ratios

		2009	2008
Gross profit percentage	Gross profit x 100Sales revenue	4,218 x 100 = 7.8%54,327	3,230 x 100 = 6.8%47,198
Comments on GP% This is a significant increase (15%) and an impressive performance in recessionary times. Apart from accounting errors, possible explanations include: A different sales mix (possibly because of the acquisition implied by the increase in goodwill). Squeezing better prices from suppliers (test by looking at correspondence?). Better inventory management and less wastage. Test inventories carefully.
Net profit percentage	Operating profit x 100Sales revenue	3,206 x 100 = 5.9%54,327	2,450 x 100 = 5.2%47,198
Comments on NP% Reasonably good cost control has been maintained despite the substantial increase in sales. To test this, it is worth comparing the commercial and administrative costs to sales.
Operating expenses to sales	Operating expensesx100Sales	1,012 x 100 = 1.86%54,327	780 x 100 = 1.65%47,198
Comments on operating expenses These costs are low compared to revenue. Does that make sense, or we worry about expenses being understated? Supermarkets rely on high volumes and low margins and this could explain the relatively low operating costs:revenue ratio, indicating that huge volumes of sales are efficiently pushed through the business. However, efficiency of the operation has deteriorated and it is important to try to determine why this has happened. Obvious causes are: The operations of the acquired business are not as efficient as the holding company’s. Disruption costs arising from the takeover. Overstretched management. These theories need to be tested. There might be other implications too. If management hopes to reduce operating expenses, are they, for example, planning warehouse closures and redundancies? Is some sort of provision needed?
Return on capital employed	Operating profit x 100Capital employed	3,206 x 100 = 11.8%27,165	2,450 x 100 = 12.020,417
Comments on ROCE It is important to realise that this is this first ratio we have calculated that makes use of a balance sheet figure. Balance sheet figures are taken at only one point in time, and this can lead to distortions in the ratios. Changes might be little more than artefacts arising from accidents of timing. Compare where capital was raised and an expansion took place in the first month of the period, to where this happened in the last month of the year. The final capital of both companies will include the additional finance, but only the first company is likely to get a significant increase in its operating profit. The second company’s ROCE is likely to show a decline from one year to the next. This effect may have caused the decrease in ROCE seen in Ocset Plc and it would be useful to know when any expansion or acquisition took place.
Asset turnover	Sales revenue x 100Capital employed	54,327 = 2.027,165	47,198= 2.320,417
Comments on asset turnover This shows how many $ of sales are generated by each $ of assets. It’s sometimes described as ‘how hard the organisation works its assets’. The decline in the ratio shows that although capital (and therefore assets) have increased, sales have not increased proportionately – but that could simply be just an artefact caused by the date of the asset increase.
Note: ROCE = Net profit% x Asset turnover		11.8% = 5.9% x 2.0	12.0 = 5.2% x 2.3

Liquidity ratios

		2009		2008
Current ratio	Current assets Current liabilities	9,209 = 0.7312,582		5,889 = 0.629,362
Comments on the current ratio Normally current assets are used to pay the current liabilities. A current ratio of less than one is often regarded as alarming as there might be going-concern worries, but you have to look at the type of business before drawing conclusions. In a supermarket business, inventory will probably turn into cash in a stable and predictable manner, so there will always a supply of cash available to pay the liabilities. The company survived 12 months from the date of the 2008 balance sheet until the present one (and the current ratio has improved), so there should be no particular alarm.
Quick (or acid test) ratio	Current assets (except inventory)Current liabilities		9,209 – 2,66912,582 = 0.52		5,889 – 2,430    9,362= 0.37
Comments on the quick ratio The quick ratio is useful when inventory is turned over slowly, as the payment of current liabilities will depend on receivables and cash. A quick ratio of less than one is often worrying, but it again depends on the business and comparatives. Here the quick ratio is much more generous on the 2009 balance sheet than on the 2008 one. Why? Has interest income increased too?
Receivable collection period	Receivables   Sales/day	1,798   = 1254,327/365		1,311     = 1047,198/365
Comments on the receivables collection period In a supermarket, most sales are for cash, and comparing receivables to sales that have no impact on receivables is rather pointless. It would be much better if sales could be split into cash and credit sales and the true collection period for credit sales worked out. However, there does seem to have been a disproportionate increase in the collection period. Possible reasons are: A different sales approach – perhaps offering customers credit facilities. A different range of products – perhaps offering customers a credit card. Look at board minutes. Poor management so that credit control deteriorates. Economic problems causing customers to pay more slowly – and presumably an increased risk of bad debts. There might be implications for the bad debt provision. We should check other information too. For example, if debtors are taking longer to pay (or a credit card is offered), is the company earning interest on the balances? A receivables circularisation will be important to test the accuracy of the receivables figure.
Payables payment period	Payables             Cost of sales/day		8,522   = 6250,109/365		7,277     = 6043,968/365
Comments on the payables payment period There’s nothing remarkable here. The increase could be evidence of pressurising suppliers and could be consistent with the improvement in gross profit percentage. We should check that there will be no future supply difficulties (correspondence, board minutes) and assess whether the company is losing valuable discounts.
Days of inventory	Inventory  Cost of sales/day	2,669     = 19.450,109/365		2,430     = 20.243,968/365
Comments on the days of inventory This is a 4% fall and would appear to suggest tight inventory control. However, always go through (at least in your mind) the RATIO list. Reason – accidental or deliberate? How was the decrease achieved? It could be an artefact. For example, where a weekend falls with respect to the year end. Inventory always needs to be carefully verified – existence, quantity valuation etc. Implications. If there a fewer days of inventory, are customer service levels being adversely affected? Is stock wastage reduced? Other information. For example, has the company invested in new IT systems which allow better inventory control? Has the distribution system changed? Have more trucks been bought to allow the company to operate with lower inventory?

Risk ratios

A company’s indebtedness is obvious from financial statements, so the risk analysed by external users is normally the risk related to borrowing: the gearing risk,. Borrowing causes risk because interest has to be paid irrespective of profits made. A rise in interest rates or a fall in profit can make the payment of interest very difficult, and lead a business to receivership and liquidation. Risk from borrowing can also arise when capital repayment is required, either on demand (in the case of overdrafts) or at the end of a fixed term. It is very important to understand how any repayment could be financed.

		2009		2008
The gearing ratio	Long term loan finance x 100Equity finance	14,170 x 100 = 109%12,995		8,602 x 100 = 73%11,815
Comments on the gearing ratio The gearing ratio can also be defined in other ways, particularly comparing long term loan finance to total finance. As gearing increases so does the risk that the interest can’t be paid. But it is difficult to define a ‘safe’ level of gearing. For example, a property company with properties leased to tenants will have fairly predictable rental income. Such a company can probably safely sustain substantial borrowings (though could be in trouble if interest rates increased significantly). A company with volatile streams of income would have to keep its gearing lower as it must ensure that interest can be paid during the lean times. Supermarkets could be expected to have reasonably predictable income: people have to keep eating, so will keep buying food! The gearing ratio calculation shows that there is a large increase in the company’s gearing. You should consider: Reason: deliberate financial planning or problems? Is there any reason to suppose that the effect is temporary or an accident of timing? Loan agreements need to be verified for term and security If the loan period is relatively short, how will it be repaid? We would expect the amount of interest paid to increase (unless the additional loan was taken out very close to year end).
Interest cover	Operating profit before interest Interest		3,206  = 6.7478	2,450  = 9.8250
Comments on interest cover Interest cover shows how many times interest can be paid out of earnings. Neither of these ratios would give cause for concern. The fall from 2008 to 2009 is consistent with the rise in borrowing that was identified earlier. The interest amounts would have to be tested to see that they were reasonable, given interest rates and when the additional borrowings were made.

Conclusion

Ratio analysis and comparison are invaluable tools to help auditors understand what might have happened in a business. However, the initial calculation of ratios and percentage changes is easy and mechanical. The real skill comes in interpreting the results, and nearly always the results should give rise to more queries than they answer.

Ocset Plc
Balance Sheet		30/9/2009$ million		30/9/2008$ million
Non-current assets
Intangible – goodwill		4,027		2,336
Tangible		26,511		21,554
		30,538		23,890
Current assets and receivables
Inventory		2,669		2,430
Receivables		1,798		1,311
Cash and cash equivalents		4,742		2,148
		9,209		5,889
Current liabilities
Trade payables		8,522		7,277
Borrowings		4,060		2,085
		12,582		9,362
Net current liabilities		(3,373)		(3,473)
Total assets less current liabilities		27,165		20,417
Share capital		395		393
Reserves		12,600		11,422
Total equity		12,995		11,815
Non-current liabilities – borrowings		14,170		8,602
Total equity and long term liabilities		27,165		20,417
Income Statement		Y/e 30/9/2009$ million		Y/e 30/9/2008$ million
Revenue		54,327		47,198
Cost of sales		50,109		43,968
Gross profit		4,218		3,230
Commercial and administrative costs		(1,012)		(780)
Operating profit before financing		3,206		2,450
Financing income		116		187
Finance costs		(478)		(250)
(Loss)/profit before tax		2,844		2,387
Tax		(780)		(670)
(Loss)/profit after tax		2,064		1,717
Dividends		(886)		(870)
Transferred to reserves		1,178		847