Analysis of accounts

Welcome to the World of Account Analysis!

Ever wondered how a bank decides if a business is "healthy" or if a millionaire decides which company to invest in? They don't just look at the bank balance; they look at the stories the numbers tell. In this chapter, we will learn how to "read" financial accounts using Ratio Analysis. Don't worry if you find math a bit scary—we will take it one step at a time!

1. Profitability: More Than Just Making Money

Many students think profit and profitability are the same thing. They aren't!
Example: If Shop A makes \$100 profit from selling \$200 of goods, and Shop B makes \$100 profit from selling \$1,000 of goods, Shop A is much more profitable because it is more efficient at turning sales into profit.

What is Profitability?

Profitability measures how effectively a business uses its resources (like its sales or its invested money) to generate profit. It is usually expressed as a percentage.

Quick Review: Why is it important?
1. To see if the business is successful compared to last year.
2. To compare with competitors.
3. To help managers make decisions about raising prices or cutting costs.

Key Takeaway: Profit is a total amount (e.g., \$5,000), but profitability is a percentage (e.g., 20%) that shows efficiency.

2. Liquidity: Can You Pay the Bills?

A business can make millions in profit and still fail if it runs out of cash. This is called a liquidity problem.

What is Liquidity?

Liquidity is the ability of a business to pay back its short-term debts (current liabilities) using its short-term assets (current assets like cash and stock).

The "Empty Wallet" Analogy: Imagine you have a high-paying job (high profit), but your salary isn't paid until next month. If you need to buy a bus ticket today and have no cash in your pocket, you have a liquidity problem!

Key Takeaway: Liquidity isn't about how much you own; it's about how much cash or "near-cash" you have available right now to pay people you owe.

3. Measuring Performance: The Ratios

To analyze accounts, we use five main formulas. Let's break them down into Profitability Ratios and Liquidity Ratios.

A. Profitability Ratios

1. Gross Profit Margin

This shows how much "gross profit" a business makes for every \$1 of sales. It looks at how well the business manages its cost of sales (buying stock).

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

2. Profit Margin

This is the "big picture" ratio. It shows how much profit is left after all expenses (like rent and electricity) have been paid.

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

Note: "Profit" here refers to the profit for the year after all expenses are subtracted from Gross Profit.

3. Return on Capital Employed (ROCE)

This is the ultimate test for owners. It tells them: "For every \$100 put into the business, how many dollars of profit did we get back?"

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

Did you know? Investors compare ROCE to the interest rate in a bank. If a bank gives 5% interest and the business ROCE is only 3%, the investor might as well leave their money in the bank!

B. Liquidity Ratios

1. Current Ratio

This compares all current assets to all current liabilities. A result of 1.5 to 2.0 is usually considered healthy.

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

Example: If the answer is 2, it means the business has \$2 of assets for every \$1 it owes. Safe!

2. Acid Test Ratio

This is a "tougher" version of the current ratio. It ignores inventory (stock) because inventory can be hard to sell quickly in an emergency.

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

Common Mistake to Avoid: When calculating the Acid Test, don't forget to subtract the inventory value before dividing!

Quick Review Box:
- Profitability ratios use percentages (%).
- Liquidity ratios are expressed as a ratio (e.g., 2:1 or just 2).

4. Who Uses These Accounts?

Different people look at these numbers for different reasons. We call these people Stakeholders.

1. Managers: To check if they are meeting targets and to help make future plans (like cutting costs if the Profit Margin is falling).

2. Shareholders (Owners): They want to see the ROCE. Is their investment growing? Should they buy more shares?

3. Banks: They look at Liquidity Ratios. If a business has a low Acid Test ratio, the bank might refuse a loan because they are afraid the business can't pay it back.

4. Creditors (Suppliers): These are people the business owes money to for stock. They want to know the business is liquid enough to pay their invoices on time.

5. Employees: They might look at high profits to argue for a pay rise or to see if their jobs are secure.

Key Takeaway: No single number tells the whole story. Different users pick the ratios that matter most to their own interests.

Summary Checklist

Before you move on, make sure you can:
- Explain the difference between profit and profitability.
- Explain why liquidity is vital for survival.
- Calculate the 5 main ratios (Practice the formulas!).
- Identify at least 3 users of accounts and why they need them.

Don't worry if the formulas seem hard to memorize at first. Write them on sticky notes and put them around your room—you'll know them by heart in no time!