What Is Analysis of Accounts?
Analysis of accounts means examining financial statements and using financial ratios to assess the performance and financial position of a business.
→ The two important areas in this topic are:
→ Profitability – how effectively the business generates profit
→ Liquidity – whether the business can pay its short-term debts
→ Financial information can be used by both internal and external users to make business decisions.
Profitability
Profitability is the ability of a business to generate profit from its sales and the capital invested in it.
→ A business can make a profit but still have poor profitability if the profit is small compared with its sales or the amount of capital invested.
→ Profitability ratios help managers and other users assess how effectively the business is generating profit.
Gross Profit Margin
Gross profit margin shows gross profit as a percentage of revenue.
Formula:
Gross Profit Margin (%) = Gross Profit ÷ Revenue × 100
Example
→ Revenue = $200,000
→ Gross profit = $80,000
Gross profit margin = $80,000 ÷ $200,000 × 100
= 40%
→ This means the business makes $40 gross profit for every $100 of revenue.
Interpreting Gross Profit Margin
→ A higher gross profit margin generally means the business is keeping more of its revenue after paying the cost of sales.
→ A lower gross profit margin means a smaller proportion of revenue remains after the cost of sales.
Reasons for a Change
Gross profit margin may increase because:
→ selling prices have increased
→ cost of sales has decreased
→ cheaper suppliers have been found
→ production has become more efficient
Gross profit margin may decrease because:
→ raw material costs have increased
→ supplier prices have increased
→ selling prices have fallen
→ production has become less efficient
→ The ratio should be compared with previous years or similar businesses before drawing a conclusion.
Profit Margin
Profit margin shows profit as a percentage of revenue.
Formula:
Profit Margin (%) = Profit ÷ Revenue × 100
Example
→ Profit = $30,000
→ Revenue = $200,000
Profit margin = $30,000 ÷ $200,000 × 100
= 15%
→ This means the business makes $15 profit for every $100 of revenue.
Interpreting Profit Margin
→ A higher profit margin generally means the business is keeping more profit from its revenue after all relevant expenses have been deducted.
→ A lower profit margin means a smaller proportion of revenue becomes profit.
Reasons for a Change
Profit margin may increase because:
→ expenses have been reduced
→ selling prices have increased
→ revenue has increased without a similar increase in costs
→ the business has become more efficient
Profit margin may decrease because:
→ wages have increased
→ rent or advertising costs have increased
→ interest costs have increased
→ cost of sales has increased
→ selling prices have fallen
Return on Capital Employed (ROCE)
ROCE measures the profit generated compared with the capital invested in the business.
Formula:
ROCE (%) = Profit ÷ Capital Employed × 100
Example
→ Profit = $50,000
→ Capital employed = $250,000
ROCE = $50,000 ÷ $250,000 × 100
= 20%
→ This means the business generated a 20% return on the capital employed.
Interpreting ROCE
→ A higher ROCE generally indicates that the business is generating a greater return from the capital invested.
→ A lower ROCE indicates a lower return on the capital employed.
→ ROCE can be particularly useful when owners or investors are considering whether the return generated by the business justifies the capital invested.
Comparing ROCE
→ ROCE can be compared with:
→ previous years
→ other businesses
→ the return that could be earned from alternative investments
→ If ROCE falls over time, managers may investigate why the business is generating a lower return from its capital.
Comparing Profitability Ratios
| Ratio | Formula | What It Shows |
|---|---|---|
| Gross profit margin | Gross profit ÷ Revenue × 100 | Profit after cost of sales |
| Profit margin | Profit ÷ Revenue × 100 | Profit after relevant expenses |
| ROCE | Profit ÷ Capital employed × 100 | Return generated from capital invested |
Liquidity
Liquidity is the ability of a business to pay its short-term debts when they become due.
→ A business needs sufficient liquid assets to meet its current liabilities.
→ Poor liquidity can lead to difficulty paying suppliers, employees and other short-term obligations.
→ A business can be profitable but still have poor liquidity.
Example:
→ A business may have made a large profit from credit sales.
→ However, if customers have not yet paid, the business may not have enough cash to pay its suppliers.
Current Ratio
The current ratio compares current assets with current liabilities.
Formula:
Current Ratio = Current Assets ÷ Current Liabilities
Example
→ Current assets = $150,000
→ Current liabilities = $75,000
Current ratio = $150,000 ÷ $75,000
= 2 : 1
→ This means the business has $2 of current assets for every $1 of current liabilities.
Interpreting Current Ratio
→ A higher current ratio generally indicates a stronger ability to meet short-term liabilities.
→ A very low current ratio may indicate potential liquidity problems.
→ However, a very high current ratio may indicate that resources are not being used efficiently.
For example:
→ Too much inventory may be difficult to sell.
→ Too much money owed by customers may indicate slow collection of debts.
Acid Test Ratio
The acid test ratio is a stricter measure of liquidity because it excludes inventory from current assets.
Formula:
Acid Test Ratio = (Current Assets − Inventory) ÷ Current Liabilities
Example
→ Current assets = $150,000
→ Inventory = $50,000
→ Current liabilities = $75,000
Acid test ratio = ($150,000 − $50,000) ÷ $75,000
= $100,000 ÷ $75,000
= 1.33 : 1
→ The business has $1.33 of liquid current assets for every $1 of current liabilities.
Why Exclude Inventory?
→ Inventory cannot always be converted into cash immediately.
→ It may take time to sell.
→ Some inventory may become damaged, obsolete or difficult to sell.
→ The acid test therefore provides a stricter view of the business’s ability to meet short-term debts.
Comparing Liquidity Ratios
| Ratio | Formula | Main Purpose |
|---|---|---|
| Current ratio | Current assets ÷ Current liabilities | Measures overall short-term liquidity |
| Acid test ratio | (Current assets − Inventory) ÷ Current liabilities | Measures liquidity without relying on inventory |
Users of Accounts
Financial statements and ratio analysis are used by both internal and external stakeholders.
Internal Users
Internal users are people within the business who use financial information to make decisions.
Owners
Owners may include:
→ sole traders
→ partners
→ shareholders
They may use accounts to:
→ assess profitability
→ decide whether to invest more money
→ decide whether to expand
→ assess the return from the business
→ decide whether to continue operating
Managers
Managers use financial information to:
→ monitor performance
→ identify changes in costs and revenue
→ make pricing decisions
→ control expenses
→ plan future investments
→ identify liquidity problems
Example:
→ If profit margin has fallen, managers may investigate whether costs have increased or selling prices have become too low.
Employees
Employees may use financial information to assess:
→ the financial stability of the business
→ job security
→ the possibility of wage increases
→ future employment opportunities
→ If a business is performing poorly, employees may be concerned about future employment.
External Users
External users are people or organisations outside the business who have an interest in its financial performance.
Suppliers
Suppliers may use accounts to decide whether to:
→ provide goods on credit
→ increase or reduce credit limits
→ require payment sooner
→ continue supplying the business
Example:
→ A supplier may be more willing to offer 60 days of trade credit to a financially stable business.
Government
Government may use financial information to:
→ assess tax liabilities
→ monitor compliance with financial regulations
→ understand the performance of businesses in the economy
Lenders and Banks
Banks may analyse accounts before deciding whether to lend money.
They may consider:
→ profitability
→ liquidity
→ existing liabilities
→ ability to repay loans
→ If a business has weak profitability and poor liquidity, a bank may consider lending to be more risky.
How Users Make Decisions
Deciding Whether to Invest
An investor may examine:
→ profit margin
→ ROCE
→ changes in profitability over time
→ existing liabilities
→ future prospects
→ A profitable business with a strong return may attract investment, but investors will also consider risk and future performance.
Deciding Whether to Lend
A bank may examine:
→ profitability
→ current ratio
→ acid test ratio
→ existing loans
→ ability to generate sufficient cash
→ The bank needs to assess whether the business is likely to repay the loan and interest.
Deciding Whether to Give Trade Credit
A supplier may examine:
→ liquidity
→ profitability
→ existing liabilities
→ If the business appears able to pay its bills, the supplier may be more willing to offer credit.
Limitations of Accounts and Ratio Analysis
Financial statements and ratios are useful, but they do not provide a complete picture of a business.
Based on Historical Information
→ Accounts mainly show what has happened in the past.
→ Past performance does not necessarily indicate future performance.
Ratios Need Comparison
→ A ratio on its own provides limited information.
→ It is more useful when compared with:
→ previous years
→ competitors
→ industry averages
Different Accounting Methods
→ Businesses may use different accounting policies.
→ This can make comparisons between businesses more difficult.
Inflation
→ Changes in prices over time can affect the value of assets, costs and profits.
→ This can make comparisons between different years less reliable.
Non-Financial Factors Are Ignored
Accounts do not fully measure factors such as:
→ employee motivation
→ customer satisfaction
→ product quality
→ brand reputation
→ management skills
→ customer loyalty
Accounts May Not Show the Full Situation
→ A business may have strong financial results but face a major new competitor or changing customer preferences.
→ These future threats may not be visible in existing financial ratios.
Ratios Can Be Manipulated
→ Businesses may make accounting decisions that affect reported figures.
→ This can make the financial position appear better than it might otherwise seem.
Seasonal Businesses
→ Businesses with strong seasonal patterns may have very different financial positions at different times of the year.
→ A statement of financial position prepared at one date may not represent the business’s usual position.
Using Ratio Analysis Effectively
When analysing accounts:
→ Calculate the ratio correctly.
→ Explain what the ratio means.
→ Compare it with previous results or relevant businesses.
→ Identify possible reasons for the change.
→ Consider the effect on the business.
→ Use other financial and non-financial information before making a decision.
Example of Analysis
A business’s profit margin falls from 18% to 12%.
→ The business is making less profit from each $100 of revenue.
→ Possible reasons include higher expenses, higher cost of sales or lower selling prices.
→ Managers should investigate the cause before deciding what action to take.
At the same time, its current ratio falls from 2.0:1 to 1.1:1.
→ This suggests that the business has less current assets available relative to its current liabilities.
→ The combination of falling profitability and weaker liquidity may require closer financial management.