Sample Notes: Analysis of Accounts

O Level and IGCSE Business Studies – Detailed Notes

Chapter 5.5: Analysis of Accounts

Profitability

Concept of Profitability

• Profitability is a measure of how efficiently a business can generate profit from its sales and capital.
• It is not just about earning revenue but how much profit remains after covering costs.
• Higher profitability indicates better performance and stronger financial health.

Importance of Profitability

• Shows whether a business is viable in the long run.
• Attracts investors and shareholders.
• Helps in setting prices and managing costs.
• Essential for internal decision-making.
• Influences dividend payments in companies.

Liquidity

Concept of Liquidity

• Liquidity refers to a business’s ability to pay its short-term debts as they become due.
• A business is liquid if it can quickly convert its assets into cash.

Importance of Liquidity

• Ensures survival during cash flow shortages.
• Allows timely payment to creditors, suppliers, and employees.
• Poor liquidity can lead to insolvency, even if the business is profitable.
• Investors and banks assess liquidity before lending.

Interpreting Financial Performance

Profitability Ratios

Gross Profit Margin (GPM)

• Formula:
  Gross Profit Margin = (Gross Profit / Revenue) × 100
• Purpose:
  Measures how efficiently a business produces or buys its goods.
• High GPM suggests low cost of goods sold or strong pricing power.
• Low GPM may indicate rising costs or low pricing strategy.

Profit Margin (Net Profit Margin)

• Formula:
  Profit Margin = (Net Profit / Revenue) × 100
• Purpose:
  Measures how much of the revenue remains as final profit after all expenses.
• High profit margin reflects good control over operating costs.
• Low margin might be due to high overheads or poor cost management.

Return on Capital Employed (ROCE)

• Formula:
  ROCE = (Net Profit / Capital Employed) × 100
• Purpose:
  Measures how efficiently a business generates profit from its capital.
• Capital Employed = Total assets – current liabilities
• High ROCE indicates good return on investment; investors favour high ROCE values.

Liquidity Ratios

Current Ratio

• Formula:
  Current Ratio = Current Assets / Current Liabilities
• Ideal benchmark: Around 1.5 to 2
• Below 1 may indicate liquidity problems.
• Too high (e.g., above 2.5) may suggest inefficiency — too much idle cash or inventory.

Acid Test Ratio (Quick Ratio)

• Formula:
  Acid Test Ratio = (Current Assets – Inventories) / Current Liabilities
• Ideal benchmark: Around 1
• Measures liquidity without relying on inventory (which may not be quickly converted to cash).
• More conservative than current ratio.
• If below 1, the business may struggle to meet short-term debts without selling stock.

Why and How Accounts Are Used

Users of Financial Accounts

Using Ratios for Decision-Making

Investor Decisions

• May invest if:
  • ROCE is high (indicates good return on funds).
  • Profit margins are rising (suggests growing efficiency).
  • Liquidity ratios are healthy (company can pay debts).

Lender Decisions

• May offer loans if:
  • Current or acid test ratios are strong (business can repay).
  • Accounts show positive cash flow and profitability.

Managerial Use

• Managers use ratios to:
  • Identify cost inefficiencies.
  • Adjust pricing or operations.
  • Monitor performance over time.
  • Set financial targets.

Employee Use

• Profitability and performance indicate the security of jobs, chances of promotion, and bonus potential.

Real-Life Example (Simplified)

Company X Financial Summary:

• Revenue: Rs. 1,000,000
• Cost of Sales: Rs. 600,000
• Gross Profit: Rs. 400,000
• Expenses: Rs. 250,000
• Net Profit: Rs. 150,000
• Capital Employed: Rs. 500,000
• Current Assets: Rs. 300,000
• Inventories: Rs. 50,000
• Current Liabilities: Rs. 200,000

Ratio Calculations:

• Gross Profit Margin = (400,000 / 1,000,000) × 100 = 40%
• Net Profit Margin = (150,000 / 1,000,000) × 100 = 15%
• ROCE = (150,000 / 500,000) × 100 = 30%
• Current Ratio = 300,000 / 200,000 = 1.5
• Acid Test Ratio = (300,000 – 50,000) / 200,000 = 1.25

Interpretation:

• Company X has strong profitability and healthy liquidity.
• Likely to attract investors and receive bank loans.
• Managers can plan for expansion and bonuses may be possible for employees.