Analysis of accounts
Contents: 9 sections
One business, five ratios
Ratios turn raw figures into something comparable. A profit of $72,000 tells you nothing on its own, because it might have come from $200,000 of sales or from $20 million. A ratio sets the profit beside the thing that produced it.
Cambridge publishes a list of formulas and ratios with the 0264 syllabus, which the old Business Studies syllabus never printed. The five below appear there in these forms.
Every calculation here uses one business, so you can see how the five results connect. Its figures for the last two years:
| Last year $ | This year $ | |
|---|---|---|
| Revenue | 400,000 | 480,000 |
| Cost of sales | 232,000 | 288,000 |
| Gross profit | 168,000 | 192,000 |
| Expenses | 98,000 | 120,000 |
| Profit | 70,000 | 72,000 |
| Inventory | 21,000 | 40,000 |
| Trade receivables | 30,000 | 35,000 |
| Cash | 19,000 | 15,000 |
| Current assets | 70,000 | 90,000 |
| Current liabilities | 35,000 | 50,000 |
| Capital employed | 280,000 | 360,000 |
Profitability
Profitability is how much profit a business makes in relation to its size: its sales, or the capital put into it. It is what lets a corner shop and a chain be judged on the same terms.
Gross profit margin
Gross profit margin = (gross profit / revenue) x 100
This year: gross profit margin = (192000 / 480000) x 100 = 40%
Last year: gross profit margin = (168000 / 400000) x 100 = 42%
Read it as money: every $100 of sales now leaves $40 to cover expenses, where last year it left $42. Only two things move this ratio, so pick one. Either the selling price has fallen, perhaps a discount used to win the sales, or the cost of sales per unit has risen.
Profit margin
Profit margin = (profit / revenue) x 100
This year: profit margin = (72000 / 480000) x 100 = 15%
Last year: profit margin = (70000 / 400000) x 100 = 17.5%
Profit margin sits below gross profit margin because expenses come off in between, so the gap between the two is where the expenses live. Last year the gap was 42 - 17.5 = 24.5 percentage points; this year it is 40 - 15 = 25 percentage points. The fall is therefore not only about the cost of the goods: expenses grew from $98,000 to $120,000 while revenue rose by a fifth.
Return on capital employed
Return on capital employed (ROCE) = (profit / capital employed) x 100
This year: ROCE = (72000 / 360000) x 100 = 20%
Last year: ROCE = (70000 / 280000) x 100 = 25%
ROCE is the ratio an owner or investor cares about most, because it answers the question they actually asked: for every $100 put in for the long term, how much profit came back? Twenty dollars this year, twenty five last year.
It also exposes the year most sharply. Capital employed rose by 360000 - 280000 = $80,000 and profit by only 72000 - 70000 = $2,000, so the expansion has returned almost nothing and ROCE has fallen by 5 percentage points. Compare that with what the money could earn elsewhere: if a bank deposit pays 4%, 20% is worth having, but capital borrowed at 8% has to beat 8%.
Liquidity
Liquidity is whether a business can pay what it owes in the next twelve months. A business can fail the liquidity test while passing the profitability one, which is how profitable firms run out of money.
Current ratio
Current ratio = current assets : current liabilities, or current assets / current liabilities
Cambridge accepts the answer as a ratio to 1 or as a number, so 1.8 : 1 and 1.8 both score.
This year: current ratio = 90000 / 50000 = 1.8, so 1.8 : 1
Last year: current ratio = 70000 / 35000 = 2, so 2 : 1
The business holds $1.80 of short-term assets for every $1 it owes in the short term, down from $2. Between about 1.5 : 1 and 2 : 1 is usually treated as comfortable. Below 1 : 1 it cannot cover its current liabilities at all. Well above 2 : 1 is no triumph either, because cash and stock sit idle.
Acid test ratio
Acid test ratio = (current assets - inventory) : current liabilities, or (current assets - inventory) / current liabilities
Again the answer may be a ratio to 1 or a number.
This year: acid test = (90000 - 40000) / 50000 = 50000 / 50000 = 1, so 1 : 1
Last year: acid test = (70000 - 21000) / 35000 = 49000 / 35000 = 1.4, so 1.4 : 1
Inventory comes out because it is the current asset least likely to turn into cash quickly. Unsold stock has to find a buyer, and stock that is not selling may never find one at full price. The acid test asks the harder question: could the business pay its bills without selling another thing?
The two together say more than either alone. The current ratio slipped from 2 : 1 to 1.8 : 1, which looks mild. The acid test fell from 1.4 : 1 to 1 : 1, far steeper, and the figures show why: inventory nearly doubled, from $21,000 to $40,000, while sales rose 20%.
The five results together
| Ratio | Last year | This year | What it says |
|---|---|---|---|
| Gross profit margin | 42% | 40% | Each $100 of sales leaves $2 less |
| Profit margin | 17.5% | 15% | Expenses grew faster than sales too |
| ROCE | 25% | 20% | An extra $80,000 of capital produced $2,000 more profit |
| Current ratio | 2 : 1 | 1.8 : 1 | Short-term debts still covered, with less room than before |
| Acid test ratio | 1.4 : 1 | 1 : 1 | Without selling inventory, it can only just cover them |
One story explains all five. The business chased growth, took on $80,000 more capital, accepted lower prices or higher costs to win the sales, and ended up with stock it has not sold. Revenue is up a fifth and the owners are no better off.
Users of accounts
| User | Internal or external | What they look for | The decision it feeds |
|---|---|---|---|
| Owners (sole traders, partners, shareholders) | Internal | ROCE and profit margin | Whether to stay in, put more in, or sell up |
| Managers | Internal | All five, against last year and against targets | Whether to change prices, cut expenses, or hold less stock |
| Employees | Internal | Profit and its trend | Whether jobs are secure, and whether a pay rise can be argued for |
| Suppliers | External | Current ratio and acid test | Whether to offer trade credit, how much, how long |
| Lenders and banks | External | Liquidity, existing borrowing, ROCE | Whether to lend, at what rate, against what security |
| Government | External | Profit and revenue | Tax due, and whether it qualifies for support |
Different users read the same accounts and reach opposite conclusions. A supplier asked for 60 days credit sees an acid test of 1 : 1, no cushion at all if stock stops moving, and insists on 30 days. A shareholder sees 20% ROCE, still better than a bank deposit, and stays in.
The limitations of accounts and ratio analysis
Ratios narrow a question; they do not answer it. Say so before recommending anything, because that is where the evaluation marks are.
- The figures are historic. They describe a year that has ended, and are often months old before anyone reads them. No ratio shows what happened afterwards.
- One year in isolation says almost nothing. A ROCE of 20% is neither good nor bad until it sits beside last year, a competitor, or the alternative use of the money.
- Ratios ignore everything that is not a number. The skill of the managers, the morale of the staff, the reputation of the brand, the state of the market, a rival about to open next door: none of it appears in the accounts, and all of it decides whether the business is worth lending to.
- Businesses classify costs differently. One firm puts delivery wages in cost of sales, another in expenses, so their gross profit margins do not measure the same thing.
- Comparing across industries misleads. A supermarket lives on a profit margin of 3% and enormous volume, a jeweller on 30% and few sales. Neither is failing.
- The figures can be flattered. A business chooses its year end, and one falling just after the busy season shows more cash and less stock than the same business would three months earlier. A one-off sale of a building lifts profit for a year and says nothing about trading.
Writing the interpretation for the marks
Examiners separate three things.
Knowledge is the ratio itself. "The acid test ratio is 1 : 1" is the calculation and the definition, and it is where most answers stop.
Analysis is the comparison and what follows from it. "The acid test has fallen from 1.4 : 1 to 1 : 1 because inventory nearly doubled to $40,000, so the business now depends on selling that stock to pay suppliers." That is one point taken forward, not a second ratio added.
Evaluation is saying which ratio matters more for the decision in front of this business, and why. A supplier asked for 60 days of credit should weigh the acid test above ROCE, because profitability over a year does not pay an invoice in March. An owner deciding whether to put in another $50,000 should weigh ROCE, because a return of 20% and falling is what their money buys. Naming the ratio that decides it, and what would change your mind, reaches the top band.
Common mistakes
- Dividing by the wrong figure. Both margins are divided by revenue; ROCE is divided by capital employed.
- Using gross profit in ROCE, or profit in the gross profit margin.
- Forgetting to multiply by 100, and giving 0.4 where the answer is 40%.
- Forgetting to take inventory off the current assets in the acid test.
- Saying a current ratio of 4 : 1 is excellent. It usually means idle cash and stock.
- Treating a high gross profit margin as proof of health, when expenses may swallow all of it.
- Calculating all five ratios and comparing none with last year.
- Saying a fall is bad without giving a reason it might have fallen.
- Writing that the accounts show everything, when they show none of the staff, customers or competitors.
- Ending with "the ratios are good and bad" instead of choosing which decides the question.
What the syllabus asks for on this topicSyllabus points
Syllabus points
- Explain the concept of profitability.
- Calculate and interpret gross profit margin, profit margin and return on capital employed (ROCE).
- Explain the concept of liquidity.
- Calculate and interpret the current ratio and the acid test ratio, as a ratio to 1 or as a number.
- Identify internal users: owners (sole traders, partnerships, shareholders), managers and employees.
- Identify external users: suppliers, government, lenders and banks.
- Explain how users use financial information to decide whether to lend to or invest in a business.
- Explain the limitations of using accounts and ratio analysis.
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