5.5 – Analysis of Accounts

The data contained in the financial statements are used to make some useful observations about the performance and financial strength of the business. This is the analysis of accounts of a business. To do so, ratio analysis is employed.

Ratio Analysis

• Profitability Ratios: profitability is the ability of a company to use its resources to generate revenues in excess of its expenses. These ratios are used to see how profitable the business has been in the year ended.
  • Return on Capital Employed (ROCE): this calculates the return (net profit) in terms of the capital invested in the business (shareholder’s equity + non-current liabilities) i.e. the % of net profit earned on each unit of capital employed. The higher the ROCE the better the profitability is. The formula is:
    
  • Gross Profit Margin: this calculates the gross profit (sales – cost of production) in terms of the sales, or in other words, the % of gross profit made on each unit of sales revenue. The higher the GPM, the better. The formula is:
    
  • Net profit Margin: this calculates the net profit (gross profit-expenses) in terms of the sales, i.e. the % of net profit generated on each unit of sales revenue. The higher the NPM, the better. The formula is:
    
• Liquidity Ratios: liquidity is the ability of the company to pay back its short-term debts. It if it doesn’t have the necessary working capital to do so, it will go illiquid (forced to pay off its debts by selling assets). In the previous topic, we said that working capital = current assets – current liabilities. So a business needs current assets to be able to pay off its current liabilities. The two liquidity ratios shown below, use this concept.
  • Current Ratio: this is the basic liquidity ratio that calculates how many current assets are there in proportion to every current liability, so the higher the current ratio the better (a value above 1 is favourable). the formula is:
    
  • Liquid Ratio/ Acid Test Ratio:  this is very similar to current ratio but this ratio doesn’t consider inventory to be a liquid asset, since it will take time for it to be sold and made into cash. A high level of inventory in a business can thus cause a big difference between its current and liquidity ratios. So there is a slight difference in the formula:
    

Uses and users of accounts

• Managers: they will use the accounts to help them keep control over the performance of each product or each division since they can see which products are profitably performing and which are not.
  • This will allow them to take better decisions. If for example, product A has a good gross profit margin of 35% but its net profit margin is only 5%, this means that the business has very high expenses that is causing the huge difference between the two ratios. They will try to reduce expenses in the coming year. In the case of liquidity, if both ratios are very low, they will try to pay off current liabilities to improve the ratios.
  • Ratios can be compared with other firms in the industry/competitors and also with previous years to see how they’re doing. Businesses will definitely want to perform better than their rivals to attract shareholders to invest in their business and to stay competitive in the market. Businesses will also try to improve their profitability and liquidity positions each year.
• Shareholders: since they are the owners of a limited company, it is a legal requirement that they be presented with the financial accounts of the company. From the income statements and the profitability ratios, especially the ROCE, existing shareholders and potential investors can see whether they should invest in the business by buying shares. A higher profitability, the higher the chance of getting dividends. They will also compare the ratios with other companies and with previous years to take the most profitable decision. The balance sheet will tell shareholders whether the business was worth more at the end of the year than at the beginning of the year, and the liquidity ratios will be used to ascertain how risky it will be to invest in the company- they won’t want to invest in businesses with serious liquidity problems.
• Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position and debts of the business. They will only be ready to supply to the business if they will be able to pay them. If there are liquidity problems, they won’t supply the business as it is risky for them.
• Banks: Similar to how suppliers use accounts, they will look at how risky it is to lend to the business. They will only lend to profitable and liquid firms.
• Government: the government and tax officials will look at the profits of the company to fix a tax rate and to see if the business is profitable and liquid enough to continue operations and thus if the worker’s jobs will be protected.
• Workers and trade unions: they will want to see if the business’ future is secure or not. If the business is continuously running a loss and is in risk of insolvency (not being liquid), it may shut down operations and workers will lose their jobs!
• Other businesses: managers of competing companies may want to compare their performance too or may want to take over the business and wants to see if the takeover will be beneficial.

Limitations of using accounts and ratio analysis

• Ratios are based on past accounting data and will not indicate how the business will perform in the future
• Managers will have all accounts, but the external users will only have those published accounts that contain only the data required by law- they may not get the ‘full-picture’ about the business’ performance.
• Comparing accounting data over the years can lead to misleading assumptions since the data will be affected by inflation (rising prices)
• Different companies may use different accounting methods and so will have different ratio results, making comparisons between companies unreliable.

Notes submitted by Lintha

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