ANALYSIS OF
ACCOUNTS
Section 5 Chapter 26
Analysis of published accounts
The company accounts or financial
statements contain a great deal of
information.
These published accounts of limited
companies are made available to all those
interested in the performance of the
business. There are many stakeholders
who will analyse company accounts.
An ‘analysis of accounts’ means using the
data contained in the accounts to make
some useful observations about the
performance and financial strength of the
business.
Without ‘analysis of accounts’ it is often
impossible to tell whether a business is:
• performing better this year than last year
• performing better than other businesses.
Key Terms:
Capital employed – is
shareholders’ equity plus noncurrent liabilities and is the total
long-term and permanent
capital invested in a business.
The concept and importance of profitability
Profit is an amount of money the business has made after all
costs have been taken off revenue.
However, profitability is different to profit. It is the measurement
of the profit made relative to either:
• the value of sales achieved
• the capital invested in the business.
Profitability is measured in percentage form, and is therefore a
measure of efficiency and can be used to compare the
business’s performance over a number of years and also to
compare its performance with that of other businesses.
It is important to:
• investors when deciding which business to invest in
• directors and managers of the business to assess if the
business is becoming more or less successful over time. This
might lead to the directors or managers needing to change the
operations of the business to improve profitability.
Key Terms:
Profitability – is the
measurement of the profit made
relative to either the value of
sales achieved or the capital
invested in the business.
Profitability Ratio – Return on capital employed
This means that, in 2018, the company made a return on the capital
employed in the business of 26.3 per cent. The higher this result, the more
successful the managers are in earning profit from capital used in the
business. If this percentage increases next year, it means that the managers
are running the business more efficiently – making higher profits from each
dollar invested in the business.
Profitability Ratio – Gross profit margin
ABC Computing Ltd made a gross profit in 2018 of $400 million. Revenue
was $1300 million.
This means that on every $1 worth of goods sold, the company made on
average 30.8 cents gross profit.
If this percentage increases next year it would suggest that:
• prices have been increased by more than the cost of sales has risen
• costs of sales has been reduced. Possibly a new supplier is being used or
managers have negotiated lower cost prices.
Profitability Ratio – Net profit margin
ABC Computing Ltd made a net profit of $280m in 2018.
The company made 21.5 cents net profit on each $1 worth of sales. This is
lower than the gross profit margin because all other expenses including
interest have been deducted from gross profit to arrive at net profit before tax.
The higher this result, the more successful the managers are in making net
profit from sales.
Profitability Ratios – what do they tell us
Ratio results
Observation
Analysis
Gross profit margin:
2017 – 20%
2018 – 24%
This means that the
gross profit on each $1
of sales has increased.
The business is more successful at converting sales
into profit. Either the price of goods has increased
(by more than costs) or the cost of sales has fallen
(but price has not been reduced at all or not by as
much).
Net profit margin:
2017 – 14%
2018 – 12%
This means that the net
profit on each $1 of
sales has fallen – even
though gross profit has
increased.
The business is less successful at converting sales
into net profit. The overheads/fixed costs of the
business must have increased significantly during the
year – reducing the company’s net profit compared
to revenue.
Return on capital
employed:
2017 – 10%
2018 – 6%
The profit made for
each $1 invested in the
business has fallen.
This must be because either net profit has fallen or
capital employed has increased. If capital employed
has increased, this could mean that the managers of
the business have invested more, hoping to make
higher profit in future.
Activity - ABC Computing Ltd - profitability
ABC Computing Ltd – 2017 accounts $m
summary
Ratio Analysis
2018 results
Revenue
1200
Return on capital employed
26.3%
Gross Profit
450
Gross profit margin
30.8%
Net Profit
220
Net profit margin
21.5%
Capital employed
965
• Using the 2017 accounting information for ABC Computing Ltd, calculate:
• Return on capital employed
• Gross profit margin
• Net profit margin
• Refer to your results. Do you feel that the company performed better in 2017 or
2018? Give reasons for your answer.
The concept and importance of liquidity
Liquidity is the ability of a business
to pay back its short-term debts. If
a business cannot pay its suppliers
for materials that are important to
production or if the business
cannot repay an overdraft when
required to, it is said to be illiquid.
The businesses it owes money to
may force it to stop trading and sell
its assets so that the debts are
repaid.
Key Terms:
Liquidity – is the ability of a
business to pay back its shortterm debts.
Illiquid – means that assets are
not easily convertible into cash.
Liquidity Ratio – Current ratio
ABC Computing Ltd had current assets valued at $125 million in 2018 and
current liabilities of $100 million at the end of 2018.
This result means that the business could only just pay off all of its short-term
debts from current assets. 1.25 is an acceptable result but a really ‘safe’
current ratio would be between 1.5 and 2. If the current ratio is less than 1, it
would mean that the business could have real cash flow problems. It could
not pay off its short-term debts from current assets. If the current ratio is very
high, say over 2.0, it could mean that too much working capital is tied up in
unprofitable current assets. The current ratio is useful but it assumes that all
current assets could be turned into cash quickly. This is not always the case.
For example, it might be very difficult to sell all inventories in a short period of
time.
Liquidity Ratio – Acid test ratio
ABC Computing Ltd had $50 million of inventories at the end of 2018. Its acid
test ratio can now be calculated:
A result of 1 would mean that the company could just pay off its short-term
debts from its most liquid assets. This is usually considered to be an
acceptable acid test result. This result of 0.75 means that ABC Computing
cannot do this. This might be worrying for the management and steps may
have to be taken to improve the liquidity of the business – for example,
reduce the level of inventories by selling some for cash.
Liquidity Ratios – what do they tell us
Ratio results
Observation
Analysis
Current ratio
1.0 – 2018
Current ratio
1.5 – 2017
The current ratio has
fallen between 2017
and 2018.
This could be because the business has bought and
used many more supplies, but not yet paid for them.
It could also be because the business has used cash
to pay for fixed assets. The business has low
liquidity and needs to increase current assets or
reduce current liabilities.
Current ratio
1.75 – 2018
Acid test ratio
0.5 – 2018
The current ratio is
acceptable and much
higher than the acid
test ratio in 2018.
The acid test ratio might be too low – the business
might be at risk of not being able to pay its shortterm debts from its liquid assets – cash and accounts
receivable (debtors). The great difference between
the two results is because of a relatively high level of
inventories.
Activity - ABC Computing Ltd - liquidity
ABC Computing Ltd – 2017 accounts $m
summary
Ratio Analysis
2018 results
Current assets
135
Current ratio
1.25
Inventories
40
Acid test ratio
1
Current liabilities
95
• Using the 2017 accounting information for ABC Computing Ltd, calculate:
• Current ratio
• Acid test ratio
• Do you think the management of ABC Computing should be satisfied with the
liquidity of the company? Justify your answer using your results from above and
the table provided.
Users of accounts
Users of accounts summary page
Limitations of using accounts and ratio analysis
•
Managers will have access to all accounts data – but external users will
only be able to use the published accounts, which contain only data required
by law.
• Ratios are based on past accounting data and may not indicate how a
business will perform in the future.
• Accounting data over time will be affected by inflation (rising prices), and
comparisons between years may be misleading.
• Different companies may use slightly different accounting methods, for
example in valuing their fixed assets. These different methods could lead to
different ratio results, therefore making comparisons difficult.
Ratio Analysis
RATIO ANALYSIS PRACTICE
CASE
STUDY
ACTIVITY