Analysis of accounts

Welcome to Analysis of Accounts: Decoding the Numbers!

Hello future business experts! Don't worry if financial accounts seem like a maze of numbers. This chapter, Analysis of Accounts, is like learning to read a secret code. You already know how to prepare the Income Statement and Statement of Financial Position (Balance Sheet), but now we learn how to truly understand what those documents are telling us about the business's health.

Why is this important? Managers, owners, banks, and suppliers all use this analysis to make vital decisions. By the end of these notes, you’ll be able to calculate and interpret the crucial ratios that determine if a business is successful, safe, and sustainable!

Quick Review: The Two Main Financial Documents

• Income Statement (Profit & Loss): Shows the firm's PROFITABILITY over a period (usually one year).
• Statement of Financial Position (Balance Sheet): Shows the firm's WEALTH (Assets and Liabilities) at a specific point in time.

Section 1: The Purpose of Analysis and Stakeholder Needs

Analysing accounts means using ratio analysis. Ratios allow us to compare two figures from the accounts to get a meaningful percentage or proportion. They turn raw numbers into actionable information.

Who Cares About Account Analysis? (Stakeholders)

Different groups (stakeholders) look at the accounts for different reasons:

Owners and Shareholders

They want to know: "How profitable is the business?"
They focus primarily on profitability ratios to judge if their investment is earning a good return. They also check liquidity to ensure the business won't suddenly collapse.

Banks and Lenders

They want to know: "Will the business pay back its loans?"
They focus heavily on liquidity ratios and the overall debt level to assess risk before approving loans or overdrafts.

Suppliers (Trade Payables)

They want to know: "Will the business pay us for the goods we sold them on credit?"
Like lenders, they are interested in liquidity and the ability of the firm to cover its short-term debts.

Employees and Managers

They want to know: "Is the business secure enough for my job to be safe? Can I expect a bonus or pay rise?"
They look at profitability for future prospects and liquidity for survival.

Section 2: Assessing Profitability

Profitability ratios measure how effectively a business converts sales into profit or generates returns from capital invested. The higher these ratios, the better!

1. Gross Profit Margin (GPM)

The GPM tells us what percentage of revenue is left after paying for the goods or services sold (Cost of Goods Sold). It is a measure of how efficiently the firm manages its purchases and pricing.

The Formula:

\(\text{GPM} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100\%\)

Interpretation:

• If GPM is 40%, it means that for every \(\$1\) of sales, \(\$0.40\) is Gross Profit.
• High GPM is usually good! It means the business has a strong markup (selling price is much higher than cost price).
• Low GPM could indicate that the business is charging low prices (maybe due to strong competition) or that the cost of supplies has increased rapidly.
• How to improve GPM: Increase selling prices (if demand is inelastic) or find cheaper suppliers to lower the cost of goods sold.

2. Profit Margin (Net Profit Margin - NPM)

The Profit Margin tells us what percentage of revenue is left after all expenses (running costs, overheads, etc.) have been deducted. It is the ultimate measure of overall efficiency.

The Formula:

\(\text{Profit Margin} = \frac{\text{Profit for the year}}{\text{Revenue}} \times 100\%\)

Interpretation:

• If Profit Margin is 15%, it means that for every \(\$1\) of sales, \(\$0.15\) is Profit for the year.
• Comparing GPM and Profit Margin: If the GPM is high but the Profit Margin is low, this means the firm is spending too much on its operating expenses (rent, wages, advertising). Management needs to cut overheads!
• How to improve Profit Margin: Reduce overhead expenses (e.g., lower rent, cut utility costs) or increase revenue while keeping expenses constant.

3. Return on Capital Employed (ROCE)

ROCE measures how efficiently a business uses its capital to generate profits. It shows the percentage return the business generates on the total capital invested in it.

The Formula:

\(\text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100\%\)

Where \(\text{Capital Employed} = \text{Non-current liabilities} + \text{Shareholders' equity}\) (or \(\text{Total Assets} - \text{Current Liabilities}\)).

Interpretation:

• A higher ROCE indicates more efficient use of capital.
• Investors compare ROCE to interest rates on bank deposits to see if investing in the business is worthwhile.
• How to improve ROCE: Increase operating profit by reducing costs, or reduce capital employed by paying off long-term debts or selling surplus non-current assets.

Section 3: Assessing Liquidity (Short-Term Survival)

Liquidity measures the ability of a business to pay its short-term debts (liabilities) as they fall due. A business can be profitable but still fail if it cannot pay its immediate bills! This is known as a cash flow crisis.

To calculate liquidity, we use figures from the Statement of Financial Position.

1. The Current Ratio

The Current Ratio compares all Current Assets (things the business owns that turn into cash within one year, like inventory, trade receivables, and cash) with Current Liabilities (money the business owes within one year, like bank overdrafts and trade payables).

The Formula:

\(\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}\)

The result is expressed as a ratio, e.g., 2:1.

Interpretation:

• The Ideal Range: Most analysts agree that a Current Ratio between 1.5:1 and 2:1 is healthy.
• 2:1: Means the business has \(\$2\) of current assets for every \(\$1\) of current liabilities. This is safe.
• 1:1 or less: This is dangerous! The business might not have enough cash or easy-to-sell assets to cover its immediate debts. Lenders will be very worried.
• Too High (e.g., 4:1): Although safe, it suggests the business is holding too much non-productive cash or inventory that could be better invested elsewhere. This shows poor efficiency.

2. The Acid Test Ratio (Quick Ratio)

The Acid Test Ratio is a stricter test of liquidity. It ignores Inventory (stock) because inventory can sometimes be difficult or slow to sell, especially if the business is in trouble. It tests the true "instant" ability to pay debts.

The Formula:

\(\text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}\)

Interpretation:

• The Ideal Ratio: Usually considered to be 1:1 or slightly higher.
• 1:1: Means the business has exactly enough highly liquid assets (cash and trade receivables) to pay off its immediate liabilities.
• 0.8:1: Means the business can only cover 80% of its immediate debts without relying on selling its existing stock. This is a warning sign.
• How to improve liquidity ratios: Sell surplus non-current assets for cash, delay unnecessary capital spending, or convert short-term debt into long-term loans.

Section 4: Analysing and Evaluating Ratio Results

Calculating ratios is only the first step. The real skill is in the analysis and evaluation—understanding what the numbers mean and recommending actions.

A. How to Interpret Ratios Effectively

A single ratio number on its own means very little. You must always compare it against other data:

1. Comparison Over Time (Trend Analysis)

• Compare this year's ratio with last year's ratio, and maybe the year before.
• Example: If the Profit Margin has dropped from 10% to 5% over three years, this is a clear negative trend, suggesting costs are increasing faster than revenue.

2. Comparison Against Competitors (Benchmarking)

• Compare the firm's ratio with that of similar businesses in the same industry.
• Example: If a firm's GPM is 30% but all competitors average 45%, the firm needs to investigate its purchasing or pricing strategy immediately.

3. Comparison Against Industry Norms (Ideal Ratios)

• Compare the ratio against the generally accepted "ideal" or average for the industry (like the 2:1 for Current Ratio).

B. Limitations of Using Accounts and Ratios

Ratios are powerful, but they are not the whole story. You must recognise what they don't tell you.

1. Inflation Effects: Ratios don't adjust for inflation. If revenue increased, part of the rise might be due to price inflation rather than selling more units.
2. External Factors: Ratios only show internal results. They don't explain why performance changed (e.g., a recession, a new government tax, or a major competitor entering the market).
3. Non-Financial Information: Ratios ignore crucial qualitative data, such as:
   • The quality of management.
   • Customer satisfaction and brand loyalty.
   • Employee motivation and labour turnover.
4. Different Accounting Methods: Businesses sometimes use slightly different ways to value assets or inventory, making direct comparison (benchmarking) difficult.

Congratulations! You now know how to look beyond the basic numbers and understand the true financial health of any business. This is a critical skill for any IGCSE business student!