Analysis of accounts
Businesses produce financial statements (Income Statement and Balance Sheet) to record their performance. However, raw numbers are difficult to interpret in isolation. Ratio analysis converts these figures into meaningful percentages or ratios to:
- Evaluate Performance: Compare profitability and liquidity over time or against competitors.
- Support Decision-Making: Help different users (investors, lenders, managers) decide whether to lend, invest, or manage the business.
- Identify Trends: Spot improving or declining financial health.
Profitability is the ability of a business to generate profit relative to its revenue, assets, or capital employed. It measures how efficiently the business uses its resources to earn money.
- Importance: High profitability attracts investors, allows for reinvestment, and provides a buffer against economic downturns.
Liquidity is the ability of a business to pay off its short-term debts (current liabilities) as they fall due. It measures cash flow health, not long-term survival.
- Importance: A profitable business can still fail if it runs out of cash (illiquid). Liquidity ensures suppliers are paid and operations continue smoothly.
This measures the efficiency of production/purchasing. It shows the percentage of revenue left after paying for the Cost of Sales (direct costs).
\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100
- Where:
- Gross Profit = Revenue - Cost of Sales
- Revenue = Total sales income
This measures overall efficiency, including all operating expenses (rent, salaries, marketing).
\text{Profit Margin} = \frac{\text{Net Profit}}{\text{Revenue}} \times 100
- Where:
- Net Profit = Gross Profit - Operating Expenses
This measures the efficiency of all capital invested in the business (both long-term and short-term). It is often considered the most important profitability ratio.
\text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100
- Where:
- Operating Profit = Profit before interest and tax (often found in the Income Statement)
- Capital Employed = Total Equity + Non-Current Liabilities (Long-term loans) OR Total Assets - Current Liabilities
This measures the ability to pay short-term debts using all current assets (including inventory, which may take time to sell).
\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}
- Where:
- Current Assets = Cash + Trade Receivables + Inventory
- Current Liabilities = Trade Payables + Short-term loans
This is a stricter test of liquidity. It excludes Inventory because inventory cannot always be quickly converted to cash.
\text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}
- Where:
- Current Assets - Inventory = Liquid Assets (Cash + Trade Receivables)
| Decision Based on Results |
|---|
| Whether to invest or hold shares. High ROCE suggests good returns compared to other investments. |
| Whether to lend money. They check if the business can repay interest and principal. Low liquidity = high risk of default. |
| Whether to supply goods on credit. If the Acid Test is low, they may demand cash-on-delivery to avoid bad debts. |
| To monitor performance, identify cost issues (low Gross Margin), or manage cash flow (low Liquidity). |
Scenario:
Company JTA provides the following financial data for the year ended 31 December 2024:
- Revenue: 500,000</li> <li><strong>Cost of Sales:</strong>300,000
- Operating Expenses: 80,000</li> <li><strong>Total Assets:</strong>600,000
- Non-Current Liabilities (Long-term Loan): 200,000</li> <li><strong>Current Liabilities:</strong>100,000
- Inventory: $50,000
Step 1: Calculate Key Figures
- Gross Profit = Revenue - Cost of Sales = 500,000-$ 300,000 = <strong>200,000
- Net Profit (Operating Profit) = Gross Profit - Operating Expenses = 200,000-$ 80,000 = <strong>120,000
- Capital Employed = Total Assets - Current Liabilities = 600,000-$ 100,000 = <strong>500,000 (Alternatively: Equity + Non-Current Liabs. If Equity is not given, use the Asset-Liability method).
Step 2: Calculate Ratios
Gross Profit Margin:
\frac{200,000}{500,000} \times 100 = \mathbf{40%}Profit Margin:
\frac{120,000}{500,000} \times 100 = \mathbf{24%}ROCE:
\frac{120,000}{500,000} \times 100 = \mathbf{24%}Current Ratio:
- Current Assets = Total Assets - Non-Current Assets (Assume all assets are current for simplicity in this basic example, or derive from Balance Sheet structure). Let's assume Current Assets = 150,000 (derived from CA + Inventory logic if needed, but here we use the provided CA figure directly if available. In this scenario, let's assume <strong>Current Assets</strong> =150,000).
\frac{150,000}{100,000} = \mathbf{1.5 : 1}
- Current Assets = Total Assets - Non-Current Assets (Assume all assets are current for simplicity in this basic example, or derive from Balance Sheet structure). Let's assume Current Assets = 150,000 (derived from CA + Inventory logic if needed, but here we use the provided CA figure directly if available. In this scenario, let's assume <strong>Current Assets</strong> =150,000).
Acid Test Ratio:
\frac{150,000 - 50,000}{100,000} = \frac{100,000}{100,000} = \mathbf{1.0 : 1}
Correction: Profitability ratios (Gross Margin, Profit Margin, ROCE) must be expressed as percentages. If you calculate 0.24, you must write 24%. The markscheme requires the % sign or the multiplication step.
Correction: ROCE uses Operating Profit (profit before interest and tax) because it measures operational efficiency regardless of how the business is financed. Do not subtract interest expenses.
Correction: The Acid Test excludes inventory. If you include it, you have calculated the Current Ratio, not the Acid Test. Use: (Current Assets - Inventory) / Current Liabilities.
Do not just list ratios. You must compare them. For example: 'Although the Profit Margin is high, the Acid Test Ratio of 0.5 suggests liquidity issues. Therefore, I recommend against lending because the business may default on short-term debts despite being profitable.'
Why this works: Examiners award marks for application. Linking a profitability strength to a liquidity weakness shows deep understanding.
Ensure you clearly state your 'Capital Employed' figure. If the question does not give Equity, use: Total Assets - Current Liabilities. Explicitly writing this formula helps secure method marks even if the final number is wrong.
Calculation: ((500,000 -300,000) \div 500,000)\times$ 100 = 40% [1]
Calculation: (120,000 \div500,000) \times 100 = 24% [1]
Calculation: (150,000 -50,000) \div $100,000 = 1.0 : 1 [1]