Welcome to the Financial Health Check-up!
Ever wondered how a business owner knows if they are actually doing well? It’s not just about having money in the bank. In this chapter, we learn how to use Analysis of Accounting Statements to look "under the hood" of a business. Think of these ratios as a medical report for a company—they tell us if the business is healthy, growing, or in need of some serious help!
Don't worry if these formulas seem like a lot at first. Once you see the patterns, they become much easier to remember!
1. Profitability Ratios: "Are we making enough money?"
These ratios measure how good a business is at turning its sales into actual profit. We usually express these as a percentage (%).
Gross Profit as a Percentage of Revenue (Gross Profit Margin)
This shows how much "buying and selling" profit we make for every \$1 of sales, before we pay for things like rent or electricity.
Formula: \( \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \)
Example: If you sell a shirt for \$20 that cost you \$12 to buy, your Gross Profit is \$8. Your margin is \( \frac{8}{20} \times 100 = 40\% \).
Percentage Mark-up
Struggling with the difference between Margin and Mark-up? You aren't alone! While Margin looks at profit compared to the selling price, Mark-up looks at profit compared to the cost price.
Formula: \( \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100 \)
Memory Aid: Mark-up is on Making/Buying (Cost). Margin is on Money coming in (Revenue).
Profit for the Year as a Percentage of Revenue
This is the "final" profit after all expenses have been paid. It shows how well the business manages its overheads (like rent, wages, and advertising).
Formula: \( \frac{\text{Profit for the Year}}{\text{Revenue}} \times 100 \)
Return on Capital Employed (ROCE)
This is often considered the most important ratio. It tells investors how much profit they are getting back for every dollar they have "tied up" in the business.
Formula: \( \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100 \)
Quick Review: Capital Employed is the total long-term investment in the business (Owner's Capital + Non-current Liabilities).
Key Takeaway: If profitability ratios are falling even though sales are rising, it means expenses are growing too fast!
2. Liquidity Ratios: "Can we pay our bills?"
Liquidity is all about Cash Flow. A business can be making a profit but still go bankrupt if it can't pay its electricity bill or its staff on time. These are expressed as a ratio (e.g., 2:1).
Current Ratio
This compares everything we own that is "liquid" (Current Assets) to everything we owe soon (Current Liabilities).
Formula: \( \frac{\text{Current Assets}}{\text{Current Liabilities}} \)
Ideal: Usually around 1.5:1 to 2:1. If it's 2:1, it means you have \$2 for every \$1 you owe. Great!
Liquid (Acid Test) Ratio
This is a "tougher" version of the current ratio. It ignores Inventory because you can't always sell stock quickly in an emergency. Imagine trying to pay a debt today—you can't give the bank a pile of unsold t-shirts!
Formula: \( \frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}} \)
Ideal: Around 1:1 is considered healthy.
Did you know? A business with a very high current ratio (like 5:1) might actually be inefficient. It means they have too much cash sitting around doing nothing instead of being invested!
3. Efficiency and Asset Usage Ratios
These ratios show how hard the business is working its assets to generate results.
Inventory Turnover
This measures how many times a business sells and replaces its stock in a year. A higher number is usually better!
Formula: \( \frac{\text{Cost of Sales}}{\text{Average Inventory}} \) (Result in "times" per year)
Note: To find Average Inventory, use: \( \frac{\text{Opening Inventory + Closing Inventory}}{2} \).
Trade Receivables Collection Period
This tells us how many days it takes, on average, for our customers to pay us back for goods they bought on credit.
Formula: \( \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \text{ days} \)
Analogy: If you lend your friend \$10 and it takes them 50 days to pay you back, your collection period is 50 days. If you need that money to buy lunch tomorrow, you're in trouble!
Trade Payables Payment Period
This shows how long we take to pay our suppliers. Paying too fast hurts your cash; paying too slow might make your suppliers angry!
Formula: \( \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \text{ days} \)
Non-current Assets to Revenue
This shows how much sales revenue is generated for every \$1 of fixed assets (like machinery or buildings) the business owns.
Formula: \( \frac{\text{Revenue}}{\text{Non-current Assets}} \)
Key Takeaway: Efficient businesses keep their inventory moving fast and collect their cash from customers quickly.
4. Appraising and Making Projections
Calculating ratios is just the first step. The real "Accounting" happens when you interpret them.
How to Appraise a Business:
1. Trend Analysis: Compare this year's ratios to last year's. Is the business getting better or worse?
2. Inter-firm Comparison: Compare the business to its competitors. A 10% profit margin might be great for a supermarket but terrible for a luxury jewelry store!
3. The "Big Picture": Look at how ratios link together. For example, if you offer customers a longer time to pay (higher Receivables Period), your Sales might go up, but your Cash (Liquidity) might go down.
Making Future Projections
Businesses use these ratios to plan for next year. If you know your Gross Profit Margin is always 25%, and you want to make \$50,000 profit next year, you can work backward to calculate exactly how much Revenue you need to achieve.
Common Mistake to Avoid: Don't just list the numbers in your exam answers. Use words like "improved," "deteriorated," "efficient," or "liquid" to show you understand what the numbers actually mean for the business!
Quick Review Box
Profitability: Measures success in making money (Margins, ROCE).Liquidity: Measures the ability to pay debts (Current Ratio, Acid Test).
Efficiency: Measures how well assets are managed (Turnover, Collection periods).
Projections: Using past ratios to predict and plan for future performance.