## **Learning Outcomes**

After studying this article, you will be able to explain how ratio analysis is used to interpret financial statements and assess performance. You will understand the importance of comparability in ratio analysis, recognise how external factors and differences in accounting policies can limit interpretation, and identify steps to improve the usefulness of ratio comparisons.

## **ACCA Financial Reporting (FR) Syllabus**

For ACCA Financial Reporting (FR), you are required to understand both the uses and critical limitations of ratio analysis in interpreting financial statements. Focus your revision on:

- Interpreting financial statements using ratio analysis, including profitability, liquidity, and gearing ratios
- Discussing the impact of changes in accounting policies and differences in accounting frameworks between entities on comparability
- Identifying and evaluating external factors that can influence financial ratios and their interpretation
- Recognising the limitations of financial information due to historical cost, seasonality, and manipulation

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Why is it misleading to compare ratios between companies that use different inventory valuation methods?
2. How might a major change in government policy impact the financial ratios of a company?
3. True or false? Two businesses in the same sector but in different countries are always directly comparable through ratio analysis alone.
4. List one example of an external factor—other than economic downturn—that can affect interpretation of a company’s current ratio.

## **Introduction**

Ratio analysis is a key tool for assessing financial performance. Ratios allow you to compare results across different periods, between companies, and against industry benchmarks. However, true comparability is not always straightforward. Financial statements may be prepared using different accounting policies, and companies operate under varying external conditions. These factors can distort or limit the conclusions drawn from ratio analysis. High exam marks depend on not just calculating ratios but critically interpreting them in context.

> **Key Term: Ratio analysis**
> The process of calculating and interpreting relationships between financial statement figures to assess performance, position, and trends.
>
> **Key Term: Comparability**
> The quality of financial information that allows users to identify similarities and differences between entities or across periods.

## **The Importance of Comparability**

For ratios to support sound decision-making, users need credible comparison points—either between entities or across time. However, real-world comparability is often undermined by factors such as:

- Changes in accounting policies within an entity
- Use of different accounting frameworks (e.g. IFRS vs. local GAAP)
- Application of alternative estimation techniques (e.g. depreciation, inventory costing)

When ratios are compared, it is essential to check that the figures are drawn from consistent accounting bases.

### **Worked Example 1.1**

Company A values its inventory using FIFO, while Company B uses weighted average cost. In a year of rising prices, Company A reports a gross profit margin of 27%, and Company B reports 23%. Which company is actually more profitable?

> **Answer:**  
> The difference in gross profit margin may be due to the inventory method, not core performance. FIFO increases profit in times of inflation. The companies are not directly comparable unless adjusted for inventory policies.

## **External Factors Affecting Ratio Interpretation**

Even where accounting policies are consistent, external environmental differences can affect the interpretation of ratios. Key external influences include:

- Economic conditions (e.g. inflation, recession)
- Legislation and regulation (tax changes, industry rules)
- Seasonality or cyclical factors (retailers with pre-holiday peaks)
- Changes in technology or consumer behaviour
- Changes in financial markets (interest rate shifts, currency movements)

External shocks or environments can cause short-term distortions or mask genuine performance improvements or declines.

### **Worked Example 1.2**

Retailer X and Retailer Y have identical current ratios at their year-ends. However, Retailer X’s year-end is just after Christmas (peak sales, low inventory), while Retailer Y’s is in August (low season). Can their liquidity be validly compared?

> **Answer:**  
> No. Seasonal effects such as high sales can reduce inventory and inflate liquidity at certain dates. Comparing ratios at different points in seasonal cycles is misleading.

## **The Impact of Accounting Policy Differences**

Different accounting decisions can change the denominator or numerator of common ratios. Examples include:

- Different methods of depreciation calculation
- Capitalising vs. expensing development costs
- Recognition of revaluation gains for PPE or investment property
- Provisions for bad debts under different criteria

Ratio trends are only meaningful if they reflect like-for-like figures.

> **Key Term: Accounting policy**
> The specific principles and rules applied by an entity in preparing its financial statements.

### **Worked Example 1.3**

Company Z revalues its land and buildings in 20X7, whereas Company Q does not. Both report return on capital employed (ROCE) for 20X7. Which company's ROCE is higher, and is the comparison reliable?

> **Answer:**  
> Company Q will likely have a higher ROCE as assets are at cost. However, this is unreliable—different asset values mean the ratios do not measure ‘return’ on a comparable capital base.

## **Exam Warning**

> A common exam error is to interpret ratio changes without reference to external or accounting factors. Calculation alone is not enough; marks depend on clear analysis and evidence-based discussion of comparability and context.

## **Revision Tip**

> When asked to interpret ratios, always check the notes to the financial statements for information on policy changes and be alert for major external events during or after the reporting period.

## **Summary**

Ratios are a starting point for interpreting financial reports. However, their usefulness depends on the comparability of both the applied accounting policies and the business environment. Always look beyond the numbers—understand what has changed between periods or across firms, and explain how these changes or external events could affect your analysis.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Explain why comparability is essential to useful ratio analysis
- Identify how differences in accounting policies and frameworks can limit ratio interpretation
- Recognise external factors, such as seasonal trends or legislation, that can distort ratios
- Apply adjustments or additional analysis where ratios lack comparability
- Highlight the importance of discussing both internal and external factors in exam answers

## **Key Terms and Concepts**

- Ratio analysis
- Comparability
- Accounting policy

Ratio analysis and interpretation - Comparability and external factors