Business (9225) | Analysing the financial performance of a business

Welcome to Analysing Financial Performance!

Hi there! Don't worry if the word 'Finance' makes you a little nervous. This chapter is like giving a business a health check-up. Just as a doctor uses tests (like blood pressure or temperature) to see how healthy you are, we use financial ratios to see how healthy a business is!

In this section, you will learn how to read the numbers a business produces and turn them into meaningful stories. This is a critical skill for any successful manager or investor!

1. The Purpose of Financial Analysis: Who Cares?

Financial analysis isn't just about crunching numbers; it’s about making better decisions. We use financial performance analysis to answer two main questions:

1. How profitable is the business? (Are we earning enough?)
2. How stable is the business? (Can we pay our bills and manage debt?)

H5. Key Stakeholders and Their Needs

Different people look at the accounts for different reasons:

• Owners / Shareholders: They want high profitability (Return on Capital Employed) and growth. They want to know their investment is safe.
• Managers: They need to know where the business is performing well (e.g., high gross profit) and where costs need cutting (e.g., high operating expenses). They use ratios for setting targets.
• Lenders / Banks (Creditors): They are mainly interested in liquidity (can the business pay back the loan in the short term?) and gearing (how risky is the business long term?).
• Employees: They care if the business is profitable and stable enough to guarantee their jobs and future pay rises.

Key Takeaway: Ratios translate raw financial data into clear performance metrics that different stakeholders can use.

2. The Data Sources

To calculate ratios, we need data from two main financial reports:

H5. 1. Statement of Comprehensive Income (The Profit and Loss Account)

This statement shows the business’s performance over a period of time (e.g., one year). It tells us how much revenue was generated and what costs were incurred to find the final profit figures.

H5. 2. Statement of Financial Position (The Balance Sheet)

This is a snapshot of the business's assets (what it owns) and liabilities (what it owes) at a specific point in time. It is crucial for calculating liquidity and gearing ratios.

3. Profitability Ratios

Profitability ratios measure how efficiently a business is turning its sales into profit. A higher percentage is always better here!

H4. 3.1 Gross Profit Margin (GPM)

This measures the profit made *before* overheads (operating expenses) are taken into account. It focuses on the efficiency of purchasing, production, and pricing.

Formula:

\[ \text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \]

Example: If the GPM is 40%, it means that for every \$1 of sales, the business makes 40 cents of profit after paying for the goods it sold.

H4. 3.2 Profit Margin (or Net Profit Margin)

This measures the final percentage of profit made after *all* expenses (including rent, wages, interest, etc.) have been deducted.

Formula:

\[ \text{Profit Margin} = \frac{\text{Profit for the year}}{\text{Revenue}} \times 100 \]

Did you know? If the Gross Profit Margin is high but the Net Profit Margin is low, it suggests the business has a serious problem controlling its overhead expenses (like administrative costs or rent).

H4. 3.3 Return on Capital Employed (ROCE)

This is one of the most important profitability ratios. It measures how effectively the total long-term investment (the capital employed) is generating profit.

Analogy: Imagine you invest \$10,000 in a savings account. ROCE tells you the percentage return you get on that \$10,000.

Formula:

\[ \text{ROCE} = \frac{\text{Profit before Interest and Tax (PBIT)}}{\text{Capital Employed}} \times 100 \]

Remember: Capital Employed is the total long-term funds invested in the business (Share Capital + Reserves + Non-Current Liabilities).

4. Liquidity Ratios

Liquidity ratios measure the business’s ability to meet its short-term debts. In simple terms: Does the business have enough cash or quickly convertible assets to pay the bills due in the next 12 months?

H4. 4.1 The Current Ratio

This ratio compares all current assets (things that turn into cash within one year) with all current liabilities (debts due within one year).

Formula:

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

Interpretation (The Rule of Thumb):

• An ideal current ratio is usually considered to be 2:1 (or 2.0).
• This means the business has \$2 of current assets for every \$1 of current liabilities. This gives a good safety buffer.
• If the ratio is too low (e.g., 0.8:1), the business is in danger of being unable to pay its short-term debts (illiquidity).
• If the ratio is too high (e.g., 4:1), it suggests the business is holding too much idle cash or inventory, which is inefficient.

H4. 4.2 The Acid Test Ratio (or Quick Ratio)

This is a stricter test of immediate liquidity. It removes inventory (stock) from the current assets because stock can sometimes take a long time to sell and convert into cash.

Formula:

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

Interpretation (The Rule of Thumb):

• An ideal acid test ratio is generally 1:1 (or 1.0).
• This means the business can cover all its immediate short-term debts without needing to sell any of its stock.

Common Mistake to Avoid: A struggling student might forget to subtract Inventory for the Acid Test. Remember, you subtract stock because it's not guaranteed to sell quickly!

Key Takeaway: Liquidity (L) measures if the business has enough liquid assets (L) to survive in the short term.

5. The Gearing Ratio (Solvency)

The Gearing Ratio measures the long-term financial health of a business. It shows how much of the total capital employed comes from external debt (borrowed money like loans or mortgages) compared to money provided by the owners (equity).

H4. Measuring Financial Risk

Banks and investors use gearing to measure financial risk.

Formula:

\[ \text{Gearing Ratio} = \frac{\text{Non-Current Liabilities (Long-term debt)}}{\text{Capital Employed}} \times 100 \]

Interpretation:

• High Gearing (e.g., over 50%): The business relies heavily on external loans. This is risky! If interest rates rise or profits fall, the business might struggle to pay interest and could become insolvent.
• Low Gearing (e.g., under 25%): The business is mainly financed by owners' funds. This is safer, but it might mean the business isn't taking advantage of profitable borrowing opportunities.

Encouraging Phrase: Gearing sounds complicated, but just remember: Gearing is about Getting Debt. High debt = High Gearing = High Risk.

6. Interpreting the Results and Limitations

Calculating ratios is only half the job; the analysis (the "A" in the chapter title) is the important part!

H4. How to Analyse Ratios Effectively

A single ratio result on its own tells you nothing. You must compare it against:

1. Past Performance (Trends): Compare this year's results to previous years. Is the Profit Margin rising or falling?
2. Industry Benchmarks: Compare your results to the industry average or key competitors. A 10% Profit Margin might be terrible in luxury retail but excellent in the supermarket industry.
3. Objectives: Compare the result to the business’s own stated financial targets.
4. Inter-firm Comparison (Ratios together): Look at ratios side-by-side. For example, high GPM but low Net Profit Margin suggests problems with operating expenses.

H4. Limitations of Financial Analysis

Ratios provide valuable insights, but they are not the whole story:

• Ratios are Historical: They look at the past, not the future. The business might have just bought new, efficient machinery which won't show up in the profits until next year.
• They Ignore Non-Financial Factors: Ratios don't measure the quality of management, employee morale, customer loyalty, or the state of the economy.
• Creative Accounting: Managers can sometimes use legal methods to present the accounts in the most favourable light (e.g., delaying bills until the next financial year), making ratios appear artificially good.
• Inflation/Deflation: Changing prices over time can make year-on-year comparisons tricky unless figures are adjusted.

Key Takeaway: Always look for reasons why a ratio is high or low, and never rely on just one ratio to judge a business's health.

Congratulations! You now have the essential tools needed to analyse a business’s financial health. Practice those formulas and remember: calculation is mechanical, but interpretation is the art of business analysis!