Chapter 25 - Analysis of Accounts (Uses and users of accounts ( Managers:…
Chapter 25 - Analysis of Accounts
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
Ratio analysis of accounts
These ratios are used to measure and compare profitability (or performance) and liquidity of a business
liquidity - the ability of a business to pay back its short-term debts.
Return on Capital Employed (ROCE)
= net profit / capital employed x 100
A financial ratio that measures a company's profitability and the efficiency with which its capital is used.
The higher this result, the more successful the managers are in making net profit from sales. compared with other years and other companies.
Gross Profit Margin
= Gross profit / sales revenue x 100
The difference between revenue and cost of goods sold divided by revenue.
If this percentage increases next year, prices have been increased by more than the cost of sales has risen or cost of sales has been reduced. Possibly a new supplier is being used or managers have negotiated lower cost prices.
Net Profit Margin
= net profit / sales revenue x 100
The percentage of revenue left after all expenses have been deducted from sales.
If the 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. compared with other years and other companies.
capital employed - Shareholders’ equity plus non-current liabilities and is the total long-term and permanent capital invested in a business.
Gross profit margin = 2012 - 20% 2013 - 24%
Observation = This means that the gross profit on each $1 of sales has increased
Analysis = The business is more successful at converting sales into profit. Either the piece of goods has increased (by more than costs) or the cost of goods sold has fallen (but price has not been reduced at all or not by as much)
Net profit margin = 2012 - 14% 2013 - 12%
Observation = This means that the net profit on each $1 of sales has fallen - even though gross profit margin has increased
Analysis = The business is less successful at converting sales into net profit. The overhead/fixed costs of the business must have increased significantly during the year - reducing the company's net profit compared to sales revenue
Return on capital employed = 2012 - 10% 2013 - 6%
Observation = The profit made for each $1 invested in the business has fallen
Analysis = 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.
Illiquid = Assets are not easily convertible into cash.
= Current assets / Current liabilities
A liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year.
"safe" current ratio is between 1.5 and 2. If current ratio is less than 1, it could mean business could have real cash flow problems (not able to pay off debts). If current ratio is over 2.0, it could mean too much working capital is tied up in unprofitable current assets. current ratio assumes all CA could be turned into cash quickly but its not always the case.
Acid Test Ratio
= Current assets - inventories / Current liabilities
Uses a firm's balance sheet data as an indicator of whether it has sufficient short-term assets to cover its short-term liabilities.
A result of 1 would mean company could pay off its short-term debts from its most liquid assets. Under 1, cannot do this. Business needs to improve liquidity by, for example, reduce level of inventories by selling some for cash.
1) Current Ratio = 1.0 - 2013 1.5 - 2012
Observation = The current ratio has fallen during 2013
Analysis = 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
2) Acid Test Ratio = 1.75 - 2013 0.5 - 2012
Observation = The current ratio is acceptable and much higher than the acid test ratio
Analysis = The acid test ratio is not too high or too low- the business is not at risk of not being able to pay its short-term debts from its liquid assets - cash and accounts receivable (debtors). The great difference between the two results is because of a relatively hight level of inventories.
Limitations of using accounts and ratio analysis
managers will have access to all accounts data - but the 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.
Uses and users of accounts
: they will be able to have much more detailed and frequent accounting information than any of the other groups.
They will use the accounts to help them keep control over the performance of each product or division of the business. Managers will able to identify which parts of business are performing well or poorly.
Managers use ratio to compare company's profit and liquidity
: limited companies are owned by shareholders and they have a legal right to receive the published accounts each year
They want to know from income statement, how big a profit or loss the company made. They want to know from the balance sheet, if the business is worth more at the end of the year than it was at the beginning. They will assess the liquidity of a business.
The higher the profitability ratio results are, the more likely shareholders will want to invest.
: these are other businesses which have supplied goods to the company without yet receiving payment
The balance sheet will show the total value of debts that company has to pay back and the cash position of the business.
Liquidity ratios, esp. compared to last year's, indicate the ability of a business to pay back all of its creditors on time.
If these results suggests a liquidity problem, suppliers may not supply goods on credit.
: these may have lent money to the company on a short- or long-term basis
If the business seems to be at risk of becoming illiquid, it is unlikely that a bank will be willing to lend more
The government and tax office will want to check on the
profit tax paid by the company.
If company is making a loss, this might be bad news for government's control of the whole economy, esp. if it means that workers' jobs may be lost.
Workers and trade unions
Workers and trade unions will want to assess whether the
future of the company is secure or not.
In addition, if managers are saying that "they can't afford to give a raise," it would be useful for them to assess whether the
profits of company is increasing or not.
- esp. those in the same industry
The managers of other companies may be considering a bid to take over the company or they may just wish to compare the performance of the business with that of their own.
Other businesses will compare their performance and profitability with others in the same industry.
: The measurement of the profit made relative to either the value of sales achieved or the capital invested in the business.