Analysis of accounts-ratios
How to interpret financial statements
- a business must check its performance regularly as this can help to;
i.
identify its strengths and weaknesses so that it can decide which , if any, of its
policies or strategies need to be changed
ii. show whether the business is meeting its objectives
iii. improve future business performance
- the performance of a business will be of interests to its internal and external
stakeholders
Measuring business performance
- the main objective of all businesses in the private sector is to make profits and
profitability is an important indicator of how the business is performing
- however, a business can not depend solely on profit to survive but it must also have
enough cash to pay its short-term liabilities
- the business also need cash in reserve so that it can pay any unexpected expenses
- the information on income statement ans statements of financial position can be
analysed using profitability and liquidity ratios
- this provides stakeholders with important information to help them assess both the
profitability and the liquidity of a business and help to improve their decision making
Profitability
- this involves how to calculate and use the following ratios to analyse a business’s
profitability through;
i.
gross profit margin
ii. profit margin
iii. return on capital employed
2012
2013
$000
$000
Revenue
420
500
Gross profit
189
240
Profit before interest and tax
63
70
Capital employed
120
120
Gross profit margin- is a ratio between gross profit and revenue.Gross profit margin
ratios shows gross profit as a percentage of revenue. The ratio tells us how much
gross profit is earned per $1 of revenue
Gross profit margin (2012) =
푔푟�
푝푟�
푟푒푣푒 푒
189
� 100
420
� 100
= 45.5%
* this result tells us that every $1 worth of goods sold the company made an average
of $0.45 gross profit
- a business can improve its gross profit margin by;
a.
increasing revenue without a similar increase in cost of sales - this may be
achieved through an increase in price
b. reducing cost of sales without a similar decrease in revenue- this can be
achieved by buying cheaper supplies
Profit margin- is a ratio between profit before tax and revenue
- this shows profit as a percentage of revenue. Tells us how much profit is earned per
$1 of revenue
푃푟�
푚푎푟푔
(ퟐퟎ ퟐ) =
63
� 100
420
푝푟�
푟푒푣푒 푒
� 100
= 15%
* this result tells us that every $1 of revenue earned $0.15 of profit
- this ratio measures the performance of the business in converting revenue into profit
- since profit is the difference between revenue and total costs , it is;
profit = revenue - (cost of sales + expenses)
- to improve profit margin a business can;
i.
improve gross profit margin
ii. reduce expenses
- both profit margin and the gross profit margin can be used to measure how well the
business adds value and control costs
Adding value- selling a product for more than it cost to produce it
- any improvements in the gross profit margin from one year to the next indicates
improved added value
- since profit before tax will always be lower than gross profit, it means the
percentage profit margin will always be lower than the percentage gross profit margin
- the difference between the two shows the effect of expenses on business profits
Return on capital employed (ROCE)- is the ratio between profit before tax and
capital employed. It is used to measure efficiency
- it shows profit before tax as a percentage of capital employed. It tells how much
profit is earned for every $1 invested in the business
Capital employed- is the amount invested in the business by the owners. long term
borrowing such as debentures, should also be included as capital employed
- the money is usually borrowed to purchase profit earning assets such as buildings
and machinery
Return on capital (ퟐퟎ ퟐ) =
푝푟�
푐푎푝 푎 푒푚푝 �푒
63
� 100
120
� 100
= 52.5%
* this measure tells us that every $1 of capital invested earned a return to the
shareholders of $0.525.If it increases next it means the business is running efficiently
Liquidity- is the ability of a business to pay its short term debts
- if a business does not have enough cash to pay for its immediate expenses or short
term liabilities (business debts), and has no access to cash from internal or external
sources, it will not be able to continue trading
- a business’s liquidity is its access to cash
- current assets are important to a business because they indicate how much cash a
business has access to in order to meet its short term liabilities
- liquidity of a business can be monitored through the following ratios;
a.
current ratio
b. acid test ratio
2012
2013
$000
$000
Current assets
60
50
Current assets-Inventories
20
30
Current liabilities
40
30
Current ratio- is the ratio between current assets and current liabilities
퐶푟푟푒 푟푎 � =
푐푟푟푒 푎
푐푟푟푒 푎푏
퐶푟푟푒 푟푎 �(2012) =
60
40
푒
푒
= 1.5:1
* it shows that for every $1 of current liabilities the business has $1.5 of current assets.
- This means it has access to more cash than it needs to meet its short term liabilities
and has spare cash to pay any unexpected expenses
- as a general rule,
i.
the current ratio must be no less than 1.5:1, otherwise there is risk of running out
of cash
ii. should be no greater than 2:1, since it suggests that the business has too much
cash tied up in unprofitable assets
Acid test ratio
illiquid- it means that assets are not easily convertible into cash
- the main problem with the current ratio as a measure of liquidity is that some current
assets are more difficult to turn into cash than others.
- Inventories are the least liquid of the current assets because;
a.
the finished goods inventories have to be sold
b. when they are sold on credit, the business has to wait for customers to pay
- the acid test excludes inventories from current assets
- it shows the most liquid current assets as a ration of current liabilities
- for this reason acid test is considered to be a better measure of a business’s liquidity
퐴푐 푒 푟푎 � =
(푐푟푟푒 푎
푒 −
푐푟푟푒 퐴푐 푒 푟푎 �(ퟐퟎ ퟐ) =
푎푏
푣푒 �푟 푒 )
푒
(60 − 40)
40
=1:1
* an acid test of 1:1 is generally satisfactory, if it is lower than this there is a risk of
the business not having enough cash to pay its short term liabilities
- if it is too high then cash is being tied up in unprofitable assets
Profitability vs Liquidity
- profitability and liquidity are essential for the long term survival of any business,
large or small
- a business needs sufficient liquidity to be able to pay its debts, however it must also
not keep large amounts of cash which could have been used more profitably e.g the
cash could have been used to develop new products which could increase profitability
Benefits and limitations of ratio analysis
Benefits
Limitations
- users can compare ratios over time and identify - ratios compare past data. Users of accounts trends
stakeholders - are much more interested in what the
future holds for the business
- users can compare results with similar businesses to - financial statements do not include all the strengths
see how well a business is doing against competitors
and weaknesses of a business, for example the quality
and skills of employees. These factors are also likely to
affect business performance, especially profitability
- users can easily identify important information, such - income statements and statements of financial
as profitability and liquidity, without having to look at positions are not always prepared in the same way by
all of the financial statements
different businesses. Therefore, the ratios do not
compare like with like
- businesses are affected by external factors- such as
legislation, exchange rates and economic factors - but
these will not be shown in the financial statements
Why and how accounts are used
- both internal and external stakeholders are interested in the financial statements of a
business. The main uses of financial statements,
Stakeholder
Owner/
shareholders
Uses
- want to know whether they are getting a good return on their investment
- they compare the dividends they received from the previous years with those of that
current year and also the returns they might get if they have invested their money
somewhere else
Potential investors
- interested in the profits of the business and the return that they might expect to receive
from their investment
Managers
- want to know if financial objectives have been achieved e.g meeting revenue targets, how
well costs have been controlled, are profits rising,
- want to know how much has been retained in the business and how much is available to
finance business activities such as purchase of machinery
Employees
- interested in the profitability of the business, since a business which makes more profits
there will be high levels of job security
- employees with the support of trade unions can use business figures to support their claim
for higher wages
Trade payables
- suppliers will want to know if the business has sufficient cash to pay its debts when they
become due or interested in the liquidity of the business
- also want to know if there will be continuous supply of raw materials to the business, if it
is making profits, which could be used for expansion purposes
Lenders
- banks and other lenders want to know that they will receive the interests on any money
they have loaned to the business
- also want to know if the business will be able t repay its borrowing when it becomes due
Government
- companies pay taxes on their profits. The higher the profits, the higher the tax revenue
received by the government
- a business which is doing well, will provide more employment and this will reduce the
government spending on support for the unemployed
Customers
- they want to know that the business will continue to supply them with goods and services
which meet their needs and wants
Limitations of using Accounting ratios
i.
managers will have access to all accounting data but external users will only be
able to use the published accounts which contain only data required by law
ii. ratios are based past accounting data may not indicate how a business will
perform in the future
iii. accounting date over time will be affected by inflation (rising prices) and
comparisons between years may be misleading
iv. different companies may use slightly different accounting methods e.g valuing
their fixed assets, and these differences may lead to different ratio results amking
comparisons difficult
Interpreting financial statements