📋 Chapter Study Notes: Accounts Analysis (Business Finance)

Welcome! This chapter is super important because it teaches you how to look beneath the numbers on a company’s financial reports. Think of accounts analysis as the way a doctor checks your vital signs (heart rate, temperature) to see how healthy you really are.
In this unit, we will learn how to calculate and interpret key ratios that tell the story of a business's success, efficiency, and stability. Don't worry if the numbers look intimidating—we’ll break them down step-by-step!

1. The Purpose of Accounts Analysis

Accounts analysis involves using financial statements (like the Statement of Comprehensive Income and the Statement of Financial Position) to calculate ratios. These ratios help us compare the business's performance over time (trend analysis) or compare it to competitors (inter-firm comparison).

1.1 Who is Interested in the Accounts? (Stakeholders)

Different groups of people, known as stakeholders, use accounts analysis for different reasons.

  • Owners/Shareholders: They want to know if the business is profitable and growing. Are they getting a good return on their investment? They focus heavily on profitability ratios.
  • Managers: They use analysis to assess the performance of different departments and identify areas where costs need to be cut or efficiency improved.
  • Banks/Lenders: They want to know if the business can afford to repay loans (both short-term and long-term). They focus on liquidity and gearing ratios.
  • Suppliers: They sell goods on credit and need assurance that the business is liquid enough to pay its invoices on time. They care about liquidity.
  • Employees: They look at the company’s stability and profitability to assess job security and the likelihood of future pay rises.
  • Government (Tax Authorities): They check profitability to ensure the correct amount of tax is being paid.

Quick Takeaway: Ratios turn complex financial data into simple percentages or comparison figures that help stakeholders make decisions.

2. Measuring Success: Profitability Ratios

Profitability Ratios measure how efficiently a business is generating profit from its sales or assets. A high profitability ratio generally indicates a successful, efficient business.

2.1 Gross Profit Margin (GPM)

The Gross Profit Margin (GPM) measures the profit made *before* operating expenses (overheads) are taken into account. It focuses on the efficiency of production and pricing strategy.

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

Example: If a company has \$100,000 in sales and \$40,000 in Gross Profit, the GPM is 40%. This means for every \$1 of sales, 40 cents is retained as gross profit.

  • If GPM is too low: The selling price might be too low, or the Cost of Goods Sold (COGS) might be too high (e.g., raw materials are expensive).
  • Improving GPM: Increase the selling price (if the market allows) or find cheaper suppliers.
2.2 Net Profit Margin (NPM)

The Net Profit Margin (NPM) measures the profit made *after* all costs (including all operating expenses, taxes, and interest) have been deducted. This is often seen as the true measure of a company's overall financial efficiency.

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

Did You Know? A business might have a great GPM but a terrible NPM. This usually indicates that the company's overheads (rent, salaries, utility bills) are too high!

  • If NPM is too low: The business needs to look closely at its overheads (the general running costs).
  • Improving NPM: Cut unnecessary expenses (e.g., reduce advertising spend, renegotiate rent, or reduce salaries).

Memory Aid: G vs. N
GPM = Focus on the Goods (production costs only).
NPM = Focus on Nothing left out (all costs included).

3. Measuring Short-Term Survival: Liquidity Ratios

Liquidity refers to a business’s ability to pay its short-term debts and running costs as they fall due. If a business is highly profitable but cannot pay its suppliers next week, it could face bankruptcy. This is known as being technically insolvent.

3.1 The Current Ratio

The Current Ratio compares the assets the business expects to turn into cash quickly (Current Assets) with the debts it must pay back quickly (Current Liabilities).

  • Current Assets (CA): Cash, debtors (money owed by customers), and inventory (stocks).
  • Current Liabilities (CL): Creditors (money owed to suppliers), short-term loans, and overdrafts.

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

Example: If CA = \$200,000 and CL = \$100,000, the Current Ratio is 2:1.

Interpretation of the Current Ratio

The ratio is expressed as a number (e.g., 2.0).

  • Benchmark (The Ideal): Most analysts agree that a Current Ratio between 1.5:1 and 2.0:1 is healthy.
  • If the ratio is too low (e.g., 0.8:1): This is dangerous! It means the business does not have enough liquid assets to cover its short-term debts. The business risks running out of cash.
  • If the ratio is too high (e.g., 3.5:1): Don't worry, a very high ratio isn't necessarily good! It suggests the business has too much cash sitting idle, or too much inventory that isn't being sold. This is inefficient.

Analogy: Imagine the Current Ratio is like checking your bank balance before payday. If your balance (\$100) is less than the bills you must pay this week (\$200), your ratio is 0.5:1 – you have a serious liquidity problem!

4. Measuring Risk: Gearing

While liquidity focuses on the short term, gearing assesses the long-term financial stability and risk of a business. It tells us how much of a business’s total capital is funded by borrowed money (loans) compared to owners’ equity (shareholders’ funds).

4.1 The Gearing Ratio

High gearing means the business relies heavily on loans (debt capital). Low gearing means the business relies more on equity (capital provided by owners/shareholders).

Calculation: \[ \text{Gearing Ratio} = \frac{\text{Long-term Liabilities}}{\text{Capital Employed}} \times 100 \]

Key Definitions:
Capital Employed = Shareholders' Funds (Equity) + Long-term Liabilities (Debt). This is the total money invested in the business.
Long-term Liabilities = Debts that must be repaid over a long period (e.g., bank loans, mortgages).

Interpretation of Gearing
  • High Gearing (e.g., over 50%): The business is considered highly geared. This is risky because the business must pay back large amounts of interest, regardless of whether it makes a profit. Banks may be reluctant to lend more money.
  • Low Gearing (e.g., under 25%): The business is considered lowly geared. This is safer because the business is less dependent on external lenders and has fewer fixed interest payments.

Common Mistake: Students sometimes think high gearing is always bad. While it is risky, high gearing can lead to greater profits for shareholders if the business earns more from the borrowed money than it pays in interest. This is known as "trading on equity."

5. Limitations of Accounts Analysis

Ratios are powerful tools, but they are not perfect. It’s important to understand their limitations:

  1. Historical Data: Ratios use figures from the past. The accounts only show what has already happened, not what will happen next year. (The past is not always an indicator of the future.)
  2. Non-Financial Factors: Ratios ignore crucial qualitative factors like staff morale, market reputation, quality of management, and global economic changes.
  3. Inter-Firm Comparison Issues: Comparing one business’s ratios to another can be misleading if the companies use different accounting policies or operate in different markets (e.g., comparing a supermarket to a tech firm).
  4. Inflation Effects: If ratios are compared over many years, high inflation can distort the real value of older figures.

Key Takeaway: Always use ratio analysis alongside other information (market research, qualitative data, and economic forecasts) to get a full picture of the business. Ratios provide the 'what,' but you need context to explain the 'why.'


Keep practicing those formulas, and you will soon become a financial detective! Good luck!