Cambridge IGCSE0450

Analysis of accounts

Business Studies 0450 Chapter Notes

What this chapter covers

Analysis of accounts - ProfitabilityAnalysis of accounts - LiquidityAnalysis of accounts - How to interpret the financial performance of a business by calculating and analysing profitability ratios and liquidity ratiosAnalysis of accounts - Why and how accounts are used
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In this chapter

  1. 1Introduction to Ratio Analysis
  2. 2Profitability: Gross Profit Margin
  3. 3Profitability: Net Profit Margin
  4. 4Performance: Return on Capital Employed
  5. 5Liquidity: The Current Ratio
  6. 6Liquidity: The Acid Test Ratio
  7. 7Interpreting Ratios and Their Limitations

1. Introduction to Ratio Analysis

Ratio analysis is a powerful tool used to understand a business's financial health and performance. It involves taking figures from the main financial statements (the Profit and Loss Account and the Balance Sheet) and comparing them to create ratios. These ratios provide much more insight than looking at single figures in isolation. For example, knowing a business made $1 million profit is useful, but knowing it made that profit from just $2 million of capital is much more impressive than if it used $20 million of capital. Ratios help us to monitor performance over different time periods and to compare a business against its competitors.

Key term

Ratio Analysis: A method of assessing a firm's financial performance by comparing two or more figures from its financial statements.

Worked example 14 marks

Identify two stakeholder groups who would be interested in the financial ratios of Sunset Cove Ltd and explain why.

  1. 1

    Step 1: Identify the first stakeholder group, for example, 'Investors' or 'Shareholders'.

  2. 2

    Step 2: Explain their interest. Investors use ratios, particularly profitability ratios like ROCE, to assess the return on their investment and decide whether to buy, hold, or sell shares.

  3. 3

    Step 3: Identify the second stakeholder group, for example, 'Banks' or 'Lenders'.

  4. 4

    Step 4: Explain their interest. Banks use liquidity ratios, like the Current Ratio, to assess the business's ability to repay its short-term debts and loans, helping them decide whether to lend money.

Recap

  • Ratio analysis compares figures from financial statements to assess performance.
  • It is used to monitor a business's performance over time (trend analysis).
  • It is also used to compare performance with other businesses (inter-firm comparison).
  • Key users of ratios include managers, investors, banks, and suppliers.
  • There are two main types of ratios: profitability ratios and liquidity ratios.

Quick check

  1. State two reasons why a business would use ratio analysis.2 marks

2. Profitability: Gross Profit Margin

The Gross Profit Margin (GPM) is a profitability ratio that measures how much profit a business makes on its sales before accounting for overheads and other indirect costs. It shows the relationship between gross profit and the revenue generated from sales. A high GPM is desirable as it indicates the business has good control over its direct costs (cost of sales) relative to its selling price. The calculation is: (Gross Profit / Revenue) x 100.

Gross Profit Margin (%) = (Gross Profit / Revenue) x 100

Key term

Gross Profit Margin: A ratio that measures gross profit as a percentage of revenue, indicating the profitability of sales before overheads.

Examiner insight

Examiners reward students who not only calculate the ratio correctly but also provide a reasoned comment on what the change in the ratio means for the business.

Common pitfall

Using the Net Profit figure instead of the Gross Profit figure in the calculation.

Worked example 15 marks

Using the Profit and Loss Account for Sunset Cove Ltd, calculate the Gross Profit Margin for Year 1 and Year 2. Comment on the change.

  1. 1

    Step 1: State the formula: Gross Profit Margin = (Gross Profit / Revenue) x 100.

  2. 2

    Step 2: Calculate for Year 1: ($60m / $150m) x 100 = 40%.

  3. 3

    Step 3: Calculate for Year 2: ($100m / $200m) x 100 = 50%.

  4. 4

    Step 4: Comment on the change: The Gross Profit Margin increased from 40% to 50%. This is a significant improvement, suggesting that in Year 2, Sunset Cove Ltd was more effective at controlling its cost of sales relative to its turnover, or it was able to increase its prices without a proportional increase in direct costs.

Recap

  • Gross Profit Margin measures profitability from basic trading activities.
  • The formula is (Gross Profit / Revenue) x 100.
  • A higher GPM is generally better.
  • An improving GPM suggests better control over the cost of sales or higher selling prices.
  • This ratio ignores the impact of overheads on profitability.

Quick check

  1. If a business has revenue of $500,000 and cost of sales of $300,000, what is its Gross Profit Margin?2 marks

3. Profitability: Net Profit Margin

The Net Profit Margin (NPM) is another key profitability ratio. It measures the percentage of revenue that is left after ALL costs, including overheads and tax, have been deducted. It gives a clear picture of the overall profitability of the business from all its activities. A healthy NPM shows that a business is efficient at controlling both its direct costs and its indirect (overhead) costs. The calculation is: (Net Profit / Revenue) x 100. For comparison purposes, it's common to use Net Profit Before Tax.

Net Profit Margin (%) = (Net Profit / Revenue) x 100

Key term

Net Profit Margin: A ratio that measures net profit as a percentage of revenue, indicating the overall profitability after all costs are deducted.

Common pitfall

Forgetting to specify whether the net profit figure used is before or after tax, as this can affect comparisons.

Worked example 15 marks

Using the Profit and Loss Account for Sunset Cove Ltd, calculate the Net Profit Margin (before tax) for Year 1 and Year 2. Comment on the change.

  1. 1

    Step 1: State the formula: Net Profit Margin = (Net Profit Before Tax / Revenue) x 100.

  2. 2

    Step 2: Calculate for Year 1: ($45m / $150m) x 100 = 30%.

  3. 3

    Step 3: Calculate for Year 2: ($80m / $200m) x 100 = 40%.

  4. 4

    Step 4: Comment on the change: The Net Profit Margin increased from 30% to 40%. This shows that the overall profitability of the resort has improved significantly. As the GPM also improved, it shows the business has been successful in increasing prices or controlling direct costs, and has also managed its overheads effectively despite the expansion.

Recap

  • Net Profit Margin measures the final profitability after all expenses.
  • The formula is (Net Profit / Revenue) x 100.
  • It provides a view of how well a business manages its overheads.
  • Comparing NPM to GPM can reveal where costs are changing.
  • A rising NPM is a strong indicator of improving financial performance.

Quick check

  1. What is the key difference between Gross Profit Margin and Net Profit Margin?2 marks

4. Performance: Return on Capital Employed

Return on Capital Employed (ROCE) is arguably the most important profitability ratio. It measures how efficiently a business is using its long-term funds (capital employed) to generate profit. Capital employed is the total money invested in the business from shareholders and long-term loans. A higher ROCE is better, as it shows the business is generating more profit for every dollar of capital invested. It is a key indicator for investors looking for the best return on their money. The formula is: (Net Profit Before Tax / Capital Employed) x 100.

Capital Employed = Shareholders' Funds + Non-current Liabilities

Return on Capital Employed (ROCE) (%) = (Net Profit Before Tax / Capital Employed) x 100

Key term

Return on Capital Employed (ROCE): A ratio that measures a company's profitability and the efficiency with which its capital is used to generate that profit.

Examiner insight

High marks are given for answers that compare a company's ROCE to a risk-free alternative, like a bank savings account, to evaluate if the business is a good investment.

Worked example 15 marks

The capital employed for Sunset Cove Ltd was $265m in Year 1 and $380m in Year 2. Using the P&L account, calculate the ROCE for both years and comment on the performance.

  1. 1

    Step 1: State the formula: ROCE = (Net Profit Before Tax / Capital Employed) x 100.

  2. 2

    Step 2: Calculate for Year 1: ($45m / $265m) x 100 = 16.98%.

  3. 3

    Step 3: Calculate for Year 2: ($80m / $380m) x 100 = 21.05%.

  4. 4

    Step 4: Comment on the performance: The ROCE improved from 16.98% to 21.05%. This is a very positive sign. It means that despite the large increase in capital employed for the expansion (from $265m to $380m), the business generated profit even more efficiently. For every $100 of capital invested, it generated $21.05 of profit in Year 2, up from $16.98 in Year 1.

Recap

  • ROCE measures the return generated from the long-term capital invested in a business.
  • Capital Employed is the sum of Shareholders' Funds and Non-current Liabilities.
  • The ROCE formula is (Net Profit Before Tax / Capital Employed) x 100.
  • A higher ROCE indicates more efficient use of capital.
  • Investors often compare the ROCE of a business to the interest rates available from a bank to judge if the investment is worthwhile.

Quick check

  1. A firm has net profit before tax of $50,000 and capital employed of $400,000. What is its ROCE?2 marks

5. Liquidity: The Current Ratio

Liquidity refers to a business's ability to pay its short-term debts (those due within one year). The Current Ratio is a liquidity ratio that compares a firm's current assets (cash, receivables, inventory) with its current liabilities (payables, overdrafts). It answers the question: 'Does the business have enough short-term assets to cover its short-term debts?'. A ratio between 1.5 and 2.0 is often considered ideal. A ratio below 1 suggests the business may struggle to pay its debts (a liquidity crisis), while a very high ratio might mean too much cash is tied up in unproductive assets.

Current Ratio = Current Assets / Current Liabilities

Key term

Liquidity: The ability of a business to pay its short-term debts as they fall due.

Common pitfall

Stating that a higher current ratio is always better. A very high ratio can be a negative sign that a business is not using its assets efficiently.

Worked example 15 marks

Sunset Cove Ltd's balance sheet shows current assets of $40m and current liabilities of $25m in Year 1. In Year 2, current assets were $60m and current liabilities were $30m. Calculate the current ratio for both years and comment on the hotel's liquidity.

  1. 1

    Step 1: State the formula: Current Ratio = Current Assets / Current Liabilities.

  2. 2

    Step 2: Calculate for Year 1: $40m / $25m = 1.6.

  3. 3

    Step 3: Calculate for Year 2: $60m / $30m = 2.0.

  4. 4

    Step 4: Comment on liquidity: The current ratio improved from 1.6 to 2.0. In Year 1, the hotel had $1.60 of current assets for every $1 of current liabilities. By Year 2, this increased to $2.00 for every $1. Both figures are in a healthy range, but the improvement shows the business is in a stronger position to meet its short-term financial obligations in Year 2.

Recap

  • The Current Ratio is a measure of liquidity.
  • It compares current assets to current liabilities.
  • A result between 1.5 and 2.0 is generally considered safe.
  • A ratio below 1 indicates potential cash flow problems.
  • A very high ratio might suggest inefficient use of assets.

Quick check

  1. A business has current assets of $75,000 and current liabilities of $50,000. What is its current ratio?1 mark

6. Liquidity: The Acid Test Ratio

The Acid Test Ratio, also known as the Quick Ratio, is a stricter test of liquidity than the current ratio. It works in a similar way but removes inventories (stock) from current assets before making the comparison. This is because inventories can be difficult to sell quickly to raise cash, especially in an emergency. The acid test ratio therefore gives a more cautious view of a firm's ability to pay its immediate debts. An ideal ratio is considered to be around 1.0. This means the business has $1 of liquid assets for every $1 of current liabilities.

Acid Test Ratio = (Current Assets - Inventories) / Current Liabilities

Key term

Acid Test Ratio: A strict liquidity ratio that measures a firm's ability to meet its short-term debts without relying on the sale of inventories.

Common pitfall

Forgetting to subtract the value of inventories from current assets before dividing by current liabilities.

Worked example 15 marks

In Year 1, Sunset Cove Ltd had current assets of $40m, inventories of $10m, and current liabilities of $25m. In Year 2, current assets were $60m, inventories were $15m, and current liabilities were $30m. Calculate the acid test ratio for both years and comment on the change.

  1. 1

    Step 1: State the formula: Acid Test Ratio = (Current Assets - Inventories) / Current Liabilities.

  2. 2

    Step 2: Calculate for Year 1: ($40m - $10m) / $25m = $30m / $25m = 1.2.

  3. 3

    Step 3: Calculate for Year 2: ($60m - $15m) / $30m = $45m / $30m = 1.5.

  4. 4

    Step 4: Comment on the change: The acid test ratio improved from 1.2 in Year 1 to 1.5 in Year 2. Both ratios are above the ideal 1.0 mark, which is excellent. The improvement shows that the resort's liquidity position is very strong, and it can comfortably cover its short-term debts even without selling any of its inventories (e.g. food and drink stock).

Recap

  • The Acid Test Ratio is a strict measure of liquidity.
  • It excludes inventories from current assets because they may not be easy to convert to cash.
  • The formula is (Current Assets - Inventories) / Current Liabilities.
  • A ratio of 1.0 or above is generally considered safe.
  • It gives a better indication of a firm's ability to handle a sudden financial crisis.

Quick check

  1. Why are inventories excluded from the acid test ratio calculation?2 marks

7. Interpreting Ratios and Their Limitations

Calculating ratios is only half the job. The real skill lies in interpreting what they mean. This is done by making comparisons. Firstly, you can compare a firm's ratios over time (e.g., Year 1 vs Year 2) to spot trends. This is called 'trend analysis'. Secondly, you can compare a firm's ratios with those of its competitors or with the industry average. This is 'inter-firm comparison'. However, it's crucial to remember that ratios have limitations. They are based on past data, which may not predict the future. Accounts can be manipulated ('window dressing') to make ratios look better. Most importantly, ratios are purely quantitative; they ignore vital qualitative factors like staff morale, customer service quality, and brand reputation.

Key term

Window Dressing: The manipulation of financial accounts by a business to present a more favourable impression of its performance and financial position.

Examiner insight

Evaluation questions often focus on the limitations of ratio analysis. Top students will always conclude that despite their limitations, ratios are a very useful tool when used alongside other information.

Worked example 14 marks

Explain two limitations of using ratio analysis to judge the performance of Sunset Cove Ltd.

  1. 1

    Step 1: State the first limitation. Ratios are based on historical data. The accounts for Year 1 and Year 2 show what has already happened, but they cannot guarantee that future performance will be as good. A new competitor or an economic downturn could change things quickly.

  2. 2

    Step 2: State the second limitation. Ratios ignore qualitative factors. The financial data doesn't tell us about the quality of the hotel's customer service, the skill of its managers, or its reputation with holidaymakers. These factors are crucial for long-term success but are not measured by financial ratios.

Recap

  • Ratio results should be compared over time to identify trends.
  • They should also be compared against competitors or industry averages.
  • A key limitation is that ratios are based on historical data and do not predict the future.
  • Financial accounts can be legally manipulated (window dressed) to make ratios look better.
  • Ratios ignore important non-numerical factors like brand image and employee morale.
  • Analysis should never be based on a single ratio; a range of ratios should be used.

Quick check

  1. What is meant by 'inter-firm comparison' in the context of ratio analysis?2 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define 'liquidity' and state the formula for the current ratio.3 marks
  2. Using the data for Sunset Cove Ltd, calculate the profit after tax for Year 2.2 marks
  3. Explain one reason why a business's gross profit margin might increase.2 marks
  4. A business has a current ratio of 0.8. Explain what this indicates about the business.3 marks
  5. Explain the difference between a profitability ratio and a liquidity ratio. Give one example of each.4 marks
  6. The managers of Sunset Cove Ltd are pleased with the increase in Net Profit Margin from 30% to 40%. Explain two reasons why their net profit margin might have improved.4 marks
  7. A competitor hotel has a ROCE of 15%. Using the calculated ROCE for Sunset Cove Ltd in Year 2 (21.05%), advise a potential investor which hotel appears to be the better investment. Justify your answer.5 marks
  8. Explain two limitations of using the financial accounts of Sunset Cove Ltd to assess its performance.4 marks
  9. A business has the following figures: Current Assets $120,000; Inventories $40,000; Current Liabilities $60,000. Calculate both the current ratio and the acid test ratio.4 marks
  10. Evaluate whether ratio analysis is the most important tool for managers when making decisions about the future of a business like Sunset Cove Ltd.6 marks

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