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Checks and questions
Chapter 9 of 9 · explanatory only · no rates, thresholds or deadlines
Margins, working capital, reconciliation, and the questions a careful reader asks.
Reading accounts is not arithmetic; the arithmetic has already been done. It is interrogation. This final chapter collects the questions that get the most out of any set of figures, whoever prepared them.
9.1A few ratios, understood properly
A handful of ratios does almost all the useful work, provided each is read as a question rather than a verdict.
| Measure | How it is formed | The question behind it |
|---|---|---|
| Gross margin | Gross profit as a share of sales | Does the trade itself pay, before overheads? |
| Operating margin | Operating profit as a share of sales | Is the whole operation, overheads included, viable? |
| Current ratio | Short-term assets against short-term liabilities | Can what falls due soon be met from what arrives soon? |
| Debtor days | Receivables relative to daily sales | How long does money take to arrive after a sale? |
| Stock turn | Cost of sales relative to stock held | How much cash is sitting still on the shelves? |
| Gearing | Borrowing relative to the owner's stake | How much of this is funded by other people? |
None of these means anything in isolation. A margin is informative against the same business last year, or against the ordinary range for that trade; a single figure with nothing to compare it to is just a number.
9.2Working capital, the usual cause of trouble
Working capital is the money tied up in the gap between paying for things and being paid for them. Growth widens that gap: more sales means more stock bought and more invoices outstanding, all funded before any of it converts back into cash. This is why profitable businesses run out of money, and why rapid growth is a cash event before it is a profit event.
Three questions cover most of it. How long do customers take to pay, and is it lengthening? How much stock is held relative to what is actually sold? And how much of the apparent cash position is really supplier money not yet handed over?
9.3Testing the quality of the figures
- Does profit turn into cash over several years? One year's divergence is normal; a persistent gap between reported profit and cash from operations deserves an explanation.
- Is the year comparable? Changed year end, changed accounting policy, a one-off sale or an unusual item can each make a year look better or worse than the trade behind it.
- Are the balances reconciled? Cash agreeing to a statement, receivables agreeing to a list of customers, and payables to a list of suppliers is basic evidence that the figures are more than assertions.
- Do the notes match the headline? The detail behind a line often qualifies it substantially, which is precisely why it is in the notes.
- What is missing? An expected cost that does not appear anywhere, such as a business with staff and no wages line, is more informative than any figure present.
9.4Reading the tax line
The tax figure in a set of accounts rarely equals the profit multiplied by a headline rate, and the difference is usually mundane. Some costs are charged in the accounts but not allowed in the same period, or at all; assets are written down at one rate for accounting purposes and another for tax; and losses from earlier periods may reduce a current charge. Chapter 4 explains why those timing effects exist. A tax figure that differs from a simple percentage is a reason to read the reconciliation, not evidence of anything untoward.
9.5Habits that survive any change of rules
- Read the cash flow statement first. It is the hardest of the three to present favourably.
- Always compare with the previous period, line by line, and ask about every large movement.
- Trace one figure end to end each time, from the statements back to a document. It tests the whole trail from Chapter 5 in five minutes.
- Write down the questions you could not answer. The unanswered list is usually the most useful output of reading a set of accounts.