5.5: Analysis of Accounts Notes:

What Is Analysis of Accounts?

• Analysis of accounts = using data from financial statements to judge performance and financial strength.

• One figure alone is meaningless — comparisons over time and with competitors are essential.

• Helps answer: Is the business improving? Is it better than rivals? Is it efficient? 

Key Definitions

• Capital employed = shareholders’ equity + non‑current liabilities.

• Profitability = profit relative to sales or capital invested.

• Liquidity = ability to pay short‑term debts. 

Why Profitability Matters

• Profitability shows how efficiently a business turns sales or investment into profit.

• Important for:

  1. Investors choosing where to invest.

  2. Managers assessing performance over time.

  3. Comparing with competitors. 

Profitability Ratios

Return on Capital Employed (ROCE)

• Shows how efficiently capital is used to generate profit.

• Higher = better.

• Must compare with previous years and competitors. 

Gross Profit Margin

• Shows how well the business controls cost of sales or increases prices.

• Higher margin may mean:

  1. Higher prices

  2. Lower cost of sales (cheaper suppliers, efficiency) 

Net Profit Margin

• Shows how well the business controls overheads and all expenses.

• Lower net margin despite higher gross margin = overheads rising. 

Interpreting Profitability Ratios

Example:

• Gross margin ↑

• Net margin ↓

• ROCE ↓

• This means:

  • Business improved converting sales into gross profit.

  • But overheads increased → net profit fell.

  • Capital employed increased or net profit fell → ROCE worsened. 

Liquidity

Definition

• Liquidity = ability to pay short‑term debts.

• Illiquid = cannot convert assets to cash quickly → risk of failure. 

Liquidity Ratios

Current Ratio

• Interpretation:

• Ideal: 1.5 – 2.0

  • <1 = cannot cover short‑term debts

  • 2 = too much money tied in inventory or receivables 

Acid Test Ratio

• Interpretation:

• Ideal: 1

  • <1 = may struggle to pay debts without selling inventory

  • Much lower than current ratio = too much inventory held 

Interpreting Liquidity Ratios

Example:

• Current ratio fell from 1.5 → 1.0

• Acid test ratio low (0.5–0.75)

• Meaning:

  • Liquidity worsening.

  • Too much inventory.

  • Risk of not paying short‑term debts. 

Users of Accounts & Why They Use Them

• Managers - Control performance, decide pricing, expansion, closures, compare ratios.

• Shareholders - Check profitability, business value, liquidity before investing.

• Creditors - Assess ability to repay debts.

• Banks - Decide whether to lend more.

• Government - Check tax payments, monitor economic health.

• Workers/Unions - Judge job security and whether pay rises are affordable.

• Other businesses - Compare performance or consider takeover bids.

Limitations of Ratio Analysis

• Uses past data → may not reflect future.

• Inflation distorts comparisons.

• Different accounting methods reduce comparability.

• Published accounts lack internal detail.

• Ratios alone cannot explain why results changed. 

How Ratios Help Decision‑Making

• Managers and investors use ratios to decide:

  • Whether to invest or lend.

  • Whether profitability is improving.

  • Whether liquidity is safe.

  • Whether costs need reducing.

  • Whether inventory levels are too high. 

NOTES DONE BY FARIDA SABET

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