Analysis of Accounts

Lesson Objectives: By the end of the lesson students should be able to:
 Define and state the importance of the concept of profitability and liquidity
 Interpret the financial performance of a business
 Enumerate the needs of different users of accounts and ratio analysis
 State the limitations of using accounts and ratio analysis

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.
To do so, ratio analysis is employed. There are 2 types of ratios:
1. 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.
Three commonly used profitability ratios are:
 Return on Capital Employed (ROCE): this calculates how profitable a
company is compared to the amount of money used. The higher the ROCE
the better the profitability is.
The formula is: Net profit X 100
Capital employed
 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: Gross profit margin (%) = Gross profit X 100
Revenue
  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: Net profit margin (%) = Net profit X 100
Revenue
One profitability ratio isn’t useful by itself. You need to use all the profitability
ratios and compare it with previous years of the business.
2. Liquidity Ratios: liquidity is the ability of the company to pay back its short-
term debts. 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). Two commonly used
liquidity ratios are:
 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: Current ratio = Current assets
Current liabilities
 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. It measures the ability of a company
to pay off its liabilities without depending on the sales of inventory.So
there is a slight difference in the formula:
Acid test ratio = Current assets - Inventories
Current liabilities
The acid test ratio is used to measure if a business is likely to survive in the
future
The good and bad values of these ratios:

Gross Profit
Margin (%)
No exact value, you must compare with: Competitor
Net Profit
businesses, previous years, the targets set by the business
Margin (%)

ROCE (%)

Current Ratio Should be above 1.5 to be safe

Uses and users of accounts

Managers
 They will have access to much detailed and frequent accounting
information
 They will help them keep control over the performance of each product
 They will be able to identify which business aspect is doing well and
which has a poor performance
 Help decision making
 Ratios are a quick way for managers to compare their ratios with other
businesses and previous accounts
Shareholders
 Shareholders and potential investors want to know how big profit/ loss the
company has made
 They will want to check the profitability and liquidity ratios and to decide
whether shareholders have to buy more shares or not.
 They will want to know the worth of the business
Creditors/ trade payable
 It will indicate the total value of debts the business has to pay back
 Liquidity ratios indicate the ability of the company to pay back its debts
Banks
 Risk of illiquid, no lending
Government
 To check the tax revenue, whether the firms are paying the right taxes
Workers and trade unions
 They will have to want to access whether the future of the company is
secure or not
 Access the profits to help unions improve wages and working conditions
of employees
Other businesses – competitors
 The managers will compare their profitability and liquidity with other
business
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.