Analysis and communication of accounting information

Welcome to the World of Ratio Analysis!

Ever wondered how investors decide which company is a "winner" and which one might be headed for trouble? They don't just look at the total profit; they dig deeper. This chapter is all about Analysis and communication of accounting information. Think of yourself as a "business doctor" – you are going to learn how to perform a health check on a company using special tools called accounting ratios.

Don't worry if numbers seem a bit scary at first. We will break everything down step-by-step. By the end of these notes, you'll be able to look at a set of accounts and tell a story about how well that business is actually doing!

1. Who Wants to Know? (Users of Accounting Information)

Before we start the math, we need to know who is reading these reports. Different people (stakeholders) look at financial statements for very different reasons.

Key Stakeholders and Their Interests

• Owners (Shareholders): They want to know if their investment is growing and how much profit (dividends) they will receive.
• Managers: They use the info to plan for the future and check if the business is meeting its targets.
• Employees: They care about job security and whether the business can afford to give them a pay raise.
• Lenders (Banks): They want to be 100% sure the business can pay back loans and interest on time.
• Suppliers: They want to know if they will be paid for the goods they sold on credit.
• Customers: They want to know if the business will stay open so they can get spare parts or service for things they bought.
• Government: They want to make sure the right amount of tax is being paid.

Analogy: Imagine a school report card. You (the student) care about your grades; your parents care about your future; your teachers care about your progress; and the school board cares about the overall school ranking. Everyone looks at the same "report," but for different reasons!

Quick Review: Stakeholders are any group or individual who has an interest in the performance and activities of a business.

2. Measuring Success: Profitability Ratios

Profitability ratios help us see how "efficient" a business is at generating profit relative to its sales or the money invested in it.

Gross Profit Margin

This shows how much "gross profit" is made for every \$1 of sales. It helps us see if the business is managing its Cost of Sales well.

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

Mark-up

While the margin looks at profit relative to sales, Mark-up looks at profit relative to the cost of the items.

\( \text{Mark-up} = \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100 \)

Profit Margin (Operating Profit Margin)

This is the "bottom line." It shows how much profit is left over after all expenses have been paid.

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

Return on Capital Employed (ROCE)

This is often considered the most important ratio. it tells us how much profit the business generates from all the money invested in it.

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

Note: Capital Employed = Non-current Liabilities + Equity.

Expenses to Revenue Ratio

This shows what percentage of our sales income is being "eaten up" by operating expenses.

\( \text{Expenses to Revenue} = \frac{\text{Operating Expenses}}{\text{Revenue}} \times 100 \)

Did you know? A business can have a high Gross Profit Margin but a low Profit Margin if their rent and electricity bills (expenses) are too high!

Key Takeaway: Profitability ratios help us understand if the business is actually making a good return or just "staying busy."

3. Can We Pay the Bills? (Liquidity Ratios)

Liquidity is all about cash. A business can be profitable but still go "bust" if it runs out of cash to pay its immediate bills.

Current Ratio

This compares what we own in the short term (Current Assets) to what we owe in the short term (Current Liabilities).

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

Ideal: Usually between 1.5 : 1 and 2 : 1.

Acid Test Ratio (Liquid Ratio)

This is a "tougher" test. It removes Inventory (stock) from Current Assets because inventory can be hard to sell quickly in an emergency.

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

Ideal: Usually 1 : 1.

Memory Aid: Think of the Acid Test as the "Quick" test. It only looks at things that are already cash or can become cash almost instantly (like money owed by customers).

Common Mistake: Many students think a very high Current Ratio (like 5:1) is great. Actually, it might mean the business is "lazy" and has too much cash sitting around doing nothing!

4. Working Hard or Hardly Working? (Efficiency Ratios)

Efficiency ratios show how well the business manages its resources, like its stock and its customers' debts.

Non-current Asset Turnover

How much revenue are we generating for every \$1 spent on big assets like machinery and buildings?

\( \text{Non-current Asset Turnover} = \frac{\text{Revenue}}{\text{Total Net Book Value of Non-current Assets}} \)

Trade Receivables Turnover (Days)

How long does it take, on average, for our customers to pay us?

\( \text{Trade Receivables Turnover} = \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \text{ days} \)

Trade Payables Turnover (Days)

How long do we take to pay our suppliers?

\( \text{Trade Payables Turnover} = \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \text{ days} \)

Inventory Turnover

We can measure this in times (how many times we emptied the warehouse) or days (how long items sit on the shelf).

\( \text{Rate of Inventory Turnover (times)} = \frac{\text{Cost of Sales}}{\text{Average Inventory}} \)

\( \text{Inventory Turnover (days)} = \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365 \text{ days} \)

Pro-tip: If your customers take 60 days to pay you (Receivables), but your suppliers want their money in 30 days (Payables), you might have a big cash flow problem!

Quick Review: Efficiency ratios tell us if the "engine" of the business is running smoothly or if it's getting clogged up with old stock and unpaid debts.

5. Evaluating and Improving Performance

Once you calculate a ratio, you must interpret it. A 10% profit margin isn't "good" or "bad" until you compare it to:

• Previous Years: Is the business getting better or worse?
• Competitors: Are we doing better than the shop next door?
• Industry Benchmarks: What is normal for this type of business?

How to Improve Ratios?

• To improve Profitability: Increase selling prices, find cheaper suppliers, or cut down on wasted expenses (like turning off the lights!).
• To improve Liquidity: Sell off excess stock, chase up customers who haven't paid, or negotiate longer payment terms with suppliers.
• To improve Efficiency: Introduce a "Just-in-Time" inventory system or offer discounts to customers who pay early.

6. The Limitations of Accounting Information

Don't be fooled! Ratios are helpful, but they don't tell the whole story. Here are some reasons why:

• Historic Data: Financial statements look at the past. They don't guarantee what will happen in the future.
• Inflation: Rising prices can make profits look better than they actually are.
• Window Dressing: Businesses might "tweak" their accounts just before the year ends to look better (e.g., delaying a purchase).
• Non-financial Factors: Accounts don't show the morale of the staff, the quality of the management, or the impact on the environment.
• Different Policies: Two companies might use different methods to calculate depreciation, making them hard to compare.

Key Takeaway: Ratios are a starting point for an investigation, not the final answer. Always look at the "big picture"!

Don't worry if these formulas seem like a lot to memorize. The more you practice "diagnosing" businesses with them, the more natural they will feel. You've got this!