3.5 Accounts analysis

3.5.1 Calculating and analysing accounting ratios

Definitions and formulas of key accounting ratios (these formulas will be provided in the exam):

  • Gross profit margin - The percentage of sales revenue that exceeds the cost of goods sold.

    • Formula:  Gross Profit Margin = (Gross Profit ÷ Revenue ) × 100

  • Operating profit margin - The percentage of sales revenue left after deducting all operating expenses.

    • Formula:  Operating Profit Margin = (Operating Profit ÷ Sales Revenue ) × 100

  • Markup - The percentage added to the cost of a product to determine its selling price.

    • Formula: Markup = (Profit Per Item ÷ Cost Per Iem) × 100

  • Return on capital employed (ROCE) - A financial ratio that is used to measure the profitability of a company and the efficiency with which it uses its capital.

    • Formula: ROCE = (Operating Profit ÷ Capital Employed) × 100

  • Current ratio - A figure that assesses the business's ability to pay its short-term liabilities with its short-term assets.

    • Formula: Current Ratio = Current Assets ÷ Current Liabilities

  • Acid test ratio - A stricter measure of liquidity than the current ratio which excludes inventory from current assets.

    • Formula: (Current Assets - Inventory) ÷ Current Liabilities

3.5.2 Liquidity

The Concept of Liquidity

Definition: Liquidity is the ability of a business to pay its short-term debts.

  • Liquidity measures how quickly a business can convert its current assets into cash.

  • Cash flow is crucial to a business's survival. If a business does not have an adequate amount of cash to pay short-term debts it will become illiquid, insolvent and stop operating.

The Importance of Liquidity

Liquidity is important to a business in order to:

  • Ensure solvency: A business requires sufficient liquidity to pay its suppliers, wages, and other immediate expenses.

  • Prevent insolvency: If a business lacks liquidity, it may face cash flow issues, preventing operation. This could lead to insolvency (being unable to pay off debts).

  • Maintain credibility: Good liquidity helps a business maintain strong relationships with suppliers and investors. This is because it provides a sense of trust in the business’s ability to meet financial commitments.

Comparisons with Previous Years and/or with Other Business Organisations

Comparisons with previous years - Liquidity ratio comparisons between previous years can be used to determine whether a business's ability to fulfil short-term obligations is improving or not.

Comparisons with other business organisations - Comparing liquidity ratios with competitors may help determine whether a business’s liquidity is in keeping with industry standards or if it is at risk in comparison to other businesses.

3.5.3 The use of financial documents

The use of financial documents to assess the performance of the business and inform decision-making:

Assessing Business Performance

  • Financial documents help managers track performance and identify areas for improvement.

  • Owners and shareholders can assess the profitability and the potential for growth the their business.

  • A balance sheet shows the current ratio which allows businesses to evaluate their ability to meet short-term obligations.

  • By comparing financial documents from different years, businesses can track sales and profit.

Informing Decision-Making

  • Financial documents help determine whether the business has enough cash or retained profit to invest in growth projects.

  • Financial documents can help a business understand profit margins and costs when setting competitive pricing.

  • Financial documents help a business understand when or if it should seek external funding.

  • Financial documents can help managers track performance and make informed decisions to achieve business objectives.