Accounting (9215) | Appraising business performance by using financial statements and ratios

Welcome to Financial Detective Training!

Hello! This chapter is where accounting gets really exciting. Instead of just recording numbers, we learn how to use them to tell a story about a business. Think of yourself as a detective, using clues from the financial statements to figure out if a company is successful, healthy, or heading for trouble.

Our goal is to understand business performance by using simple calculations called ratios. Don't worry if the formulas look scary—they are just ways to compare two figures to get a meaningful percentage or number!

Why is Appraising Performance Important?

• Owners/Shareholders: They want to know if their investment is safe and profitable.
• Managers: They use performance analysis to identify weaknesses and make better decisions.
• Banks/Lenders: They want assurance that the business can repay its loans (financial health).

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Section 1: The Foundation – What Ratios Are

1.1 Understanding Ratios

A ratio is a mathematical relationship between two different items, usually taken from the Statement of Profit or Loss (SoPL) or the Statement of Financial Position (SoFP).

Analogy: Imagine you are cooking. You need to know the ratio of flour to water. If you compare the profit (output) to the sales (input), you find out how efficient your "recipe" is!

1.2 Purposes of Ratio Analysis

• Trend Analysis (Time Series Comparison): Comparing this year's results with previous years (e.g., is the Net Profit Margin improving or declining?).
• Inter-firm Comparison (Benchmark Comparison): Comparing the business's results with its competitors or industry averages (e.g., is our margin better than the average bakery?).
• Setting Targets: Helping managers set realistic goals for future performance.

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Section 2: Profitability Ratios (Are We Making Enough Money?)

These ratios measure how effective the business is at turning sales into profit. High profitability is the main goal for most businesses.

2.1 Gross Profit Margin (GPM)

The GPM tells us what percentage of sales revenue is left over after paying for the Cost of Sales. It shows the efficiency of purchasing, pricing, and production.

Formula: \[ \text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue (Sales)}} \times 100 \]

• Interpretation: A higher GPM is better.
• What causes it to fall? Selling goods at a lower price (perhaps due to competition) or the cost of buying/producing goods increasing.

2.2 Net Profit Margin (NPM)

The NPM tells us what percentage of sales revenue is left over after paying all operating expenses (Gross Profit minus Expenses). This is the true measure of overall business efficiency.

Formula: \[ \text{Net Profit Margin} = \frac{\text{Net Profit}}{\text{Revenue (Sales)}} \times 100 \]

• Interpretation: A higher NPM is better.
• Key Difference: If GPM is high but NPM is low, it means the business is spending too much on Expenses (like rent, wages, or advertising).

2.3 Return on Capital Employed (ROCE)

ROCE is arguably the most important profitability ratio. It measures the profit generated compared to the total funds invested in the business (Capital Employed). It answers the question: "How much return are we getting on the money we invested?"

Prerequisite Concept: Capital Employed is the total long-term investment in the business.
\[ \text{Capital Employed} = \text{Owner's Capital (Equity)} + \text{Non-Current Liabilities (Long-term Loans)} \]

Formula: \[ \text{ROCE} = \frac{\text{Net Profit}}{\text{Capital Employed}} \times 100 \]

• Interpretation: This result must be compared to the rate of return available elsewhere (like bank interest rates). If ROCE is 10% and you could earn 5% easily in a savings account, 10% looks good. If ROCE is 4% and bank interest is 5%, the business is failing to utilize the investment effectively.

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Section 3: Liquidity Ratios (Can We Pay Our Bills?)

Liquidity measures the ability of a business to meet its short-term debts. A profitable business can still fail if it cannot pay its immediate creditors!

3.1 The Current Ratio

This ratio compares the business's total Current Assets (things convertible to cash within 12 months, like inventory and debtors) to its Current Liabilities (debts due within 12 months, like creditors and bank overdrafts).

Formula: \[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]

• Interpretation: The result is expressed as \(x:1\).
• Ideal Range: Most analysts suggest an ideal range is between 1.5:1 and 2:1.
• If the ratio is 2:1, it means the company has \$2 of assets for every \$1 of debt. This is good protection.
• Warning: If the ratio is too high (e.g., 4:1), it suggests the business is holding too much idle cash or too much slow-moving inventory.

3.2 The Acid Test Ratio (Quick Ratio)

The Acid Test is a tougher measure of liquidity. It ignores Inventory (Stock) because inventory can be difficult or slow to convert into cash, especially if it is perishable or specialized.

Formula: \[ \text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \]

• Interpretation: The result is expressed as \(x:1\).
• Ideal Range: Analysts usually look for a ratio of 1:1 or slightly higher.
• A 1:1 ratio means the business can instantly cover its short-term debts without needing to sell any existing inventory.
• Memory Trick: Think of the Acid Test as removing the "sugar coating" (inventory) to see the true quick cash position.

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Section 4: Efficiency/Activity Ratios (Are We Using Resources Wisely?)

These ratios measure how well the business is managing its assets, especially the speed at which it converts resources into cash.

4.1 Rate of Inventory Turnover

This ratio measures how many times, on average, a business sells and replaces its inventory during an accounting period.

Formula (Times per Year): \[ \text{Inventory Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}} \]

Prerequisite Concept:
\[ \text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} \]

• Interpretation: A higher turnover rate is usually better, as it means inventory is not sitting around getting old or obsolete.
• Example: If the turnover is 12 times, the average item sits in the warehouse for one month (12 months / 12 times).
• Warning: An extremely high turnover rate might mean the business is not holding enough inventory and could run out of stock (stockouts), leading to lost sales.

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Section 5: Interpretation and Communication of Results

Calculating the ratio is only half the job. The real skill is interpreting the result and communicating what it means for the future of the business.

5.1 The Importance of Comparison

A single ratio figure (e.g., NPM is 12%) is meaningless on its own. It must be compared:

1. Historical Data: How does this year's 12% compare to last year's 10%? (Conclusion: Performance is improving.)
2. Industry Averages: If the industry average is 15%, then 12% is poor. (Conclusion: Competitors are managing costs better.)
3. Planned Targets: Was the goal 13%? If so, the business failed to meet the target.

5.2 Common Weaknesses and Solutions

Ratio Issue	Meaning	Possible Action to Improve
Low ROCE	The investment isn't generating enough profit.	Increase prices, reduce operating expenses, or reduce capital employed (e.g., sell off unused non-current assets).
Falling GPM/NPM	Profitability is declining.	Negotiate better prices from suppliers (GPM), or cut wasteful expenses (NPM).
Low Acid Test Ratio (<1:1)	Risk of being unable to pay immediate debts.	Speed up collection from debtors, negotiate longer payment terms with creditors, or secure short-term financing.

5.3 Limitations of Ratio Analysis

Ratios are powerful, but they are not perfect. When interpreting results, remember their limitations:

• Historical Data: Ratios use past figures; they don't guarantee future performance.
• Non-financial Factors: Ratios ignore crucial aspects like staff morale, quality of management, customer service, or political stability, all of which impact performance.
• Accounting Policies: Businesses use different depreciation methods or inventory valuation techniques, making direct comparison difficult.
• Inflation: Comparing figures across many years might be misleading if inflation has significantly changed the value of money.