Lesson 26

ANALYSIS OF PUBLISHED ACCOUNTS

• Published accounts of limited companies are made available to all those interested in the performance of the
business.

• Without analyzing accounts, it is often impossible to tell whether a business is:

 Performing better this year than last year

 Performing better than other businesses

• It is essential to use more than one figure from the accounts when trying to assess how a business is performing
Comparing two figures from the accounts in this way is called ratio analysis

• Most of these ratios are used to measure and compare profitability and liquidity of a business.

1) PROFITABILITY
Profitability is the measurement of the profit made relative to either;

i) The value of sales achieved

ii) The capital invested in the business

 Profitability is measured in a percentage form

 Profitability can be used to measure the efficiency of the business
 It can be used to compare the business’s performance over a number of years and also to compare its performance
with other similar businesses.

2) LIQUIDITY
Liquidity is the ability of a business to pay back its short-term debts.

There are 3 common profitability ratios

1) Return on capital employed (ROCE)

2) Gross profit margin

 3) Net profit / profit margin ratio

1) Return on capital employed

• Return on capital employed (ROCE) is a financial ratio companies use to measure their performance.

• ROCE is a financial ratio that shows if a company is doing a good job of generating profits from its capital

• ROCE is an indicator of a company's efficiency because it measures the company's profitability after factoring in
the capital used to achieve that profitability.

• Investors and analysts often use ROCE as a useful tool when researching a company as a possible investment.

• ROCE is particularly effective in comparing companies in capital-intensive industries

2021 2020

Net profit = $280 Net profit = $240

Capital employed = $1500 Capital employed = $1800

ROCE = ROCE =

• When the percentage is increasing, it means that the managers are running the business effectively by making
higher profits from each dollar invested in the business

2) Gross profit margin

The gross profit margin shows the amount of profit made before deducting selling, general, and administrative costs

2021 2020

Revenue = $1900 Revenue = $1800

Cost of sales = $1100 Cost of sales = $1080

Gross profit = $ 800 Gross profit = $ 720

Gross profit margin = Gross profit margin =

• This means that on every $1 worth of goods sold, the company made on average,
2021 = 42.1%

2020 = 40% of gross profit

• But, do not forget that this is before other expenses have been deducted and is not the final profit of the company.

• Since the percentage has increased in 2021, it would suggest that,

i) Prices have been increased by more than the cost of sales has risen or,

ii) Costs of sales has been reduced

3) Net profit margin/ profit margin

• The net profit margin, measures how much net income or profit is generated as a percentage of revenue

2021 2020

Revenue = $1900 Revenue = $1800

Cost of sales = $1100 Cost of sales = $1080

Gross profit = $ 800 Gross profit = $ 720

Expenses = $ 300 Expenses = $ 400

Net profit =$ 500 Net profit =$ 320

Net profit margin = Gross profit margin =

• The company made,

2021 = 26.3%

2020 = 17.8% net profits 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
 • Liquidity is the ability of a business to pay back its short term debts.

• Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term
obligations, and to what degree.

• Sometimes situations occur in businesses where, they have no ability to repay their liabilities.

• At that time, illiquid occurs. Illiquid means, business will not be able to easily and quickly sell or exchange assets
for cash without a substantial loss in value.

If businesses own money and their liquidity is extremely low, it may force to stop trading and sell its assets so that the
debts can be repaid

There are 2 common liquidity ratios

1) Current ratio

2) Acid test ratio

1) Current ratio

• The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-
term obligations that are due within a year.

• The ratio considers the weight of total current assets versus total current liabilities.

• It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle
debt and payables. The current ratio formula can be used to easily measure a company’s liquidity.

If a business holds:
• Cash = $25 000
• Inventory = $15 000
• Short-term debt = $5 000
• Accounts payables = $15 000

Current assets =
Current liabilities =
Current ratio =

• Current ratio is 2 : 1, means that the business has $2 of current assets for every $1 of current liabilities
 • A safe current ratio would be between 1.5:1 and 2:1

• A rate of more than 1 suggests financial well-being for the company. 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

• However, a very high current ratio may indicate that a company is leaving excess cash unused rather than
investing in growing its business or too much working capital is tied up in unprofitable current assets.

There is a limitation of current ratio

• The current ratio is useful, but it assumes that all current assets could turned into cash quickly. This is not always
possible.

Example: it might be very difficult to sell all inventories in a short period of time. For this reason a second liquidity ratio
is used.

2) Acid test ratio

• Not all assets can be turned into cash quickly or easily. Some notably raw materials and other stocks must first
be turned into final product, then sold and the cash collected from debtors.

• The Acid Test Ratio sometimes also called the Quick Ratio; therefore, adjusts the Current Ratio to eliminate
certain current assets that are not already in cash form.

• The tradition is to remove inventories from the current assets total, since inventories are assumed to be the
most illiquid part of current assets – it is harder to turn them into cash quickly.

Some care has to be taken interpreting the acid test ratio

• The value of inventories a business needs to hold will vary considerably from industry to industry.

For example, you wouldn't expect a firm of lawyers to carry much inventory, but a major supermarket needs to carrying
huge quantities at any one time.

• An acid test ratio for Keells or Cargils would indicate a very low figure after taking off the value of inventories
but leaving in the very high amounts owed to suppliers (trade creditors). However, there is no suggestion that
either of these two businesses has a problem being able to pay its debts!

If a business holds:

• Cash = $25 000

• Inventory = $5 000

• Short-term debt = $4 000

• Accounts payables = $15 000

Current ratio =

Acid test ratio is 1.05 : 1, means that the business has $1.05 of liquid/quick assets for every $1 of current
liabilities
 • Generally, the higher the ratio, the better the company’s liquidity and overall financial health. A ratio of 2
implies that the company owns $2 of liquid assets to cover each $1 of current liabilities.

• However, it’s important to note that an extremely high quick ratio (for example, a ratio of 10) is not considered
favorable, as it may indicate that the company has excess cash that is not being wisely put to use growing its
business

• A result of 1 would mean that the company could just pay off its short term debtors from its most liquid assets.
This could usually considered to be an acceptable acid test ratio.

• If the result of the ratio is less than 1, necessary step should be taken to improve the liquid of the business

Example: reduce the level of inventory by selling some for CASH

Why and how accounts are used (refer text book – page 316,317)

• Managers – helps in decision making

• Shareholders – to decide whether to invest

• Creditors – indicates the ability to pay back

• Banks – to decide whether to lend

• Government – to charge tax

• Workers and trade unions – to check if the company is secure or not

• Other businesses - to consider a bid to takeover or to compare performance.

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 and comparisons between years may be misleading
 Different companies may use slightly different accounting methods, which could lead to different ration results,
making comparisons difficult.