Analysis of accounting statements

Welcome to the World of Ratio Analysis!

Ever wondered how investors know if a business is doing well just by looking at a bunch of numbers? It’s not magic—it’s Ratio Analysis! Think of ratios as a "medical check-up" for a business. Instead of checking blood pressure and heart rate, we check things like profit levels and cash flow. In this chapter, you’ll learn how to turn standard financial statements into powerful tools for making decisions. Don't worry if the formulas look scary at first; once you understand the "why" behind them, they become much easier!

1. Profitability Ratios: Are we making enough money?

These ratios tell us how successful a business is at generating profit relative to its sales or the money invested in it.

Gross Profit as a Percentage of Revenue (Gross Profit Margin)

This shows how much "gross profit" we keep for every $1 of sales after paying for the goods themselves.

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

Example: If your Revenue is \$100 and your Gross Profit is \$40, your margin is 40%. This means for every \$1 you sell, you have 40 cents left to cover your other expenses.

Percentage Mark-up

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

Formula: \( \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100 \)

Memory Aid: Think of "Mark-up" as "Profit on top of Cost." If you buy a soda for \$1.00 and sell it for \$1.50, your profit is \$0.50. Your mark-up is 50%.

Profit for the Year as a Percentage of Revenue

This is the "bottom line." It shows what percentage of sales actually becomes clear profit after all expenses (like rent, wages, and electricity) are paid.

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 us how hard the money invested in the business is working.

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

(Note: Capital Employed = Total Assets - Current Liabilities OR Owner's Capital + Non-current Liabilities)

Quick Review:
- High Profitability: Good! It means the business is efficient.
- Declining Profitability: Bad! It might mean costs are rising or prices are too low.

2. Liquidity Ratios: Can we pay our bills?

Liquidity is all about cash. A business can be making a profit but still go bankrupt if it doesn't have enough cash to pay its immediate debts.

Current Ratio

This compares everything we own that can be turned into cash within a year (Current Assets) to everything we owe within a year (Current Liabilities).

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

Ideal: A ratio of 1.5:1 or 2:1 is usually seen as healthy.

Liquid (Acid Test) Ratio

This is a "tougher" test. It removes Inventory (Stock) from the calculation because inventory is the hardest current asset to turn into cash quickly. You can't pay a bill with a warehouse full of unsold shoes!

Formula: \( \frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}} \)

Ideal: A ratio of 1:1 is the target here.

Common Mistake: Don't assume a very high ratio (like 10:1) is good. It might mean the business has too much cash sitting idle and not being used to grow!

3. Efficiency (Asset Usage) Ratios: How well are we using our resources?

These ratios look at how "busy" the business assets are.

Non-current Assets to Revenue

This shows how many dollars in sales are generated by every dollar invested in fixed assets (like machinery or buildings).

Formula: \( \frac{\text{Revenue}}{\text{Non-current Assets}} \)

Inventory Turnover

This measures how many times a year a business sells and replaces its inventory. The faster, the better!

Formula (in times): \( \frac{\text{Cost of Sales}}{\text{Average Inventory}} \)
(Average Inventory = \( \frac{\text{Opening Inventory + Closing Inventory}}{2} \))

Trade Receivables Collection Period

How long does it take for our customers to pay us back?

Formula: \( \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \text{ days} \)

Trade Payables Payment Period

How long do we take to pay our suppliers?

Formula: \( \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \text{ days} \)

Analogy: Imagine you lend a friend money. The "Receivables Period" is how long you wait to get your money back. The longer it is, the less cash you have in your pocket!

4. Appraising Statements & Projections

Ratios are useless on their own. To understand them, we must compare them to:

1. Previous Years: Is the business getting better or worse?
2. Competitors: Are we doing better than the shop down the street?
3. Industry Standards: Is a 10% profit normal for a supermarket?

Making Future Projections

Business owners use these ratios to plan for the future. For example, if a Sole Trader knows their Gross Profit Margin is always 25%, and they want to make \$50,000 profit next year, they can calculate exactly how much they need to sell.

Step-by-Step for Projections:
1. Identify the target profit.
2. Use the historical ratio (e.g., Margin) to work backward.
3. Calculate the required Revenue or Cost of Sales.

Key Takeaways for Exam Success

1. Always show your workings: Even if the final answer is wrong, you can get marks for the formula!
2. Watch your units: Profitability ratios are usually %, Liquidity ratios are :1, and turnover is either times or days.
3. Be critical: If the Liquid Ratio is low, don't just say "it's bad." Explain why—the business might struggle to pay its suppliers on time.
4. Average Inventory: If the question gives you both opening and closing inventory, always calculate the average for the turnover ratio.

Don't worry if this seems tricky at first! Like any language, the more you "speak" accounting ratios, the more natural they will feel. Happy calculating!