Business (9609) | Analysis of published accounts

Welcome to Analysis of Published Accounts (10.2)!

Hello! This chapter is where the rubber meets the road in Finance and Accounting. Financial statements (like the Statement of Profit or Loss and the Statement of Financial Position) give us raw numbers, but they don't tell the whole story.

This section teaches you how to use ratio analysis to become a financial detective. You will learn to calculate key metrics, understand what they mean, and use them to judge a business's health, profitability, and risk. This is vital for all A-Level questions involving decision-making and evaluation!

Analogy Time! The Business Health Check

Think of a business's financial statements as a patient's medical chart (temperature, weight, blood pressure). Ratios are the *analysis* performed by the doctor. If the doctor only sees the temperature is high (low profit), they don't know why. But ratios show them if the patient is suffering from severe debt (high gearing) or if they can't pay their bills quickly (low liquidity).

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1. The Purpose and Users of Ratio Analysis

Ratio analysis is the calculation and comparison of quantitative data to assess the financial and operational performance of a business.

Why do we use ratios?

• Comparison: Ratios allow us to compare a business’s performance over time (trend analysis) or against competitors (benchmarking).
• Decision-making: They help stakeholders make informed decisions (e.g., Should I invest? Should I lend money? Should I work for this company?).
• Assessment: They reveal the underlying reasons for success or failure.

Who uses published accounts and ratios?

Different stakeholders look at different ratios, depending on their interest:

• Shareholders/Investors: Interested in profitability (ROCE, margins) and investment returns (P/E ratio, dividend yield).
• Managers: Interested in everything, especially efficiency and liquidity, to manage day-to-day operations.
• Lenders/Banks: Interested in long-term risk (gearing) and short-term ability to repay loans (liquidity ratios).
• Suppliers: Interested in whether the business can pay its invoices quickly (trade payables turnover).

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2. Liquidity Ratios (Short-Term Survival) (10.2.1)

Liquidity measures a business's ability to meet its short-term debts (liabilities) as they fall due. In simple terms: Does the business have enough immediate cash or near-cash items to cover its bills?

Current Ratio (Working Capital Ratio)

This ratio compares the assets a firm expects to turn into cash within one year (current assets) against the debts it must pay within one year (current liabilities).

Formula:

$$ \text{Current Ratio} = \frac{\text{Current assets}}{\text{Current liabilities}} $$

Interpretation:

• Ideal Range: 1.5 : 1 to 2 : 1
• A ratio of 2:1 means the business has $2 of current assets for every $1 of current liabilities. This is generally safe.
• Ratio too low (e.g., 0.8:1): The business is illiquid and may struggle to pay its immediate debts. Risk of short-term failure.
• Ratio too high (e.g., 4:1): The business may be inefficiently holding too much cash or inventory, which could be better invested elsewhere.

Acid Test Ratio (Quick Ratio)

This is a stricter measure of liquidity because it excludes inventory (stock). Why? Because inventory can sometimes take a long time to sell or might become obsolete (out of date). It is harder to convert inventory quickly into reliable cash.

Formula:

$$ \text{Acid Test Ratio} = \frac{\text{Current assets - Inventory}}{\text{Current liabilities}} $$

Interpretation:

• Ideal Range: 1 : 1
• A ratio of 1:1 means that even if the business sells no more inventory, it can still pay off all its short-term debts using cash, receivables, etc.

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3. Profitability Ratios (Measuring Success) (10.2.2)

Profitability measures how effectively a business is converting its sales and assets into profit. These ratios are crucial for shareholders.

Return on Capital Employed (ROCE)

ROCE is arguably the most important profitability ratio. It measures the profit generated from the total long-term funds invested in the business.

Key Concept: Capital Employed

Capital Employed is the total funds tied up in the business.
$$ \text{Capital Employed} = \text{Issued shares} + \text{Reserves} + \text{Non-current liabilities} $$

Formula:

$$ \text{ROCE} (\%) = \frac{\text{Profit from operations}}{\text{Capital employed}} \times 100 $$

Interpretation:

• What is a good ROCE? It must be higher than the interest rate the business would pay on a bank loan, and higher than the return offered by rival businesses or safe investments.
• A higher ROCE is always better, indicating effective use of long-term funds.

Gross Profit Margin (GPM)

This shows the percentage of revenue remaining after deducting the Cost of Sales (the direct costs of producing the goods/services).

Formula:

$$ \text{Gross Profit Margin} (\%) = \frac{\text{Gross profit}}{\text{Revenue}} \times 100 $$

The GPM indicates pricing strategy and purchasing/production efficiency.

Operating Profit Margin (OPM or Profit Margin)

This shows the percentage of revenue remaining after deducting *all* operating expenses (Cost of Sales + operating expenses like admin and salaries).

Formula:

$$ \text{Operating Profit Margin} (\%) = \frac{\text{Profit from operations}}{\text{Revenue}} \times 100 $$

OPM reflects overall managerial efficiency in controlling both production costs and overheads.

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4. Financial Efficiency Ratios (How Fast Things Move) (10.2.3)

These ratios look at how efficiently the business manages its working capital components (inventory, debtors, creditors). Results are often calculated in days or times.

Rate of Inventory Turnover (Times)

This measures how many times per year the business sells and replaces its average level of stock.

Formula:

$$ \text{Rate of inventory turnover (times)} = \frac{\text{Cost of sales}}{\text{Average inventory}} $$

Note: Average Inventory is usually \( (\text{Opening Inventory} + \text{Closing Inventory}) / 2 \). Use Cost of Sales, not Revenue, as inventory is valued at cost price.

Interpretation:

• A higher turnover (more times) is generally better, indicating less stock is being held, reducing storage costs and risk of obsolescence.
• However, turnover that is too high might suggest the firm is running out of stock too often (stock-outs).

Trade Receivables Turnover (Days)

This is the average number of days it takes for customers (debtors) to pay the business.

Formula:

$$ \text{Trade receivables turnover (days)} = \frac{\text{Trade receivables}}{\text{Credit sales}} \times 365 \text{ days} $$

(If credit sales are not given, use total revenue for an estimate, but be aware this is less accurate).

Interpretation:

• A shorter period is usually better, as cash comes in faster.
• If the result is 60 days, but the company’s policy is 30-day credit, this shows a serious efficiency problem in collecting debts.

Trade Payables Turnover (Days)

This is the average number of days the business takes to pay its suppliers (creditors).

Formula:

$$ \text{Trade payables turnover (days)} = \frac{\text{Trade payables}}{\text{Credit purchases}} \times 365 \text{ days} $$

Interpretation:

• A longer period is often better, as the business is holding onto its cash for longer (free short-term finance).
• However, paying too late can damage relationships with suppliers, potentially leading to the loss of trade discounts or refusal of future credit.

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5. Gearing Ratio (Long-Term Structure and Risk) (10.2.4)

Gearing measures the proportion of a business's long-term funding that comes from debt (non-current liabilities). It indicates financial risk.

Formula:

$$ \text{Gearing} (\%) = \frac{\text{Non-current liabilities}}{\text{Capital employed}} \times 100 $$

Interpretation:

• High Gearing: Generally considered above 50%. The business relies heavily on loans (debt) rather than shareholder funds (equity). This means fixed interest payments are high, increasing risk if profits fall.
• Low Gearing: Generally below 25%. The business is largely funded by shareholders. This is safer, but the business may be missing opportunities to use cheaper debt to grow.

The risk associated with high gearing is often called financial leverage. In good times, high gearing magnifies profits (ROCE increases); in bad times, it magnifies losses.

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6. Investment Ratios (Return to Investors) (10.2.5)

These ratios are used by current and potential investors to assess how attractive the company is as an investment.

Price/Earnings Ratio (P/E Ratio)

This measures the current market price of a share relative to the profit earned per share. It shows how many years of current earnings it takes to recoup the share price.

Formula:

$$ \text{Price/Earnings Ratio} = \frac{\text{Market price per share}}{\text{Earnings per share}} $$

Interpretation:

• A high P/E ratio usually suggests that investors have high confidence in the company's future growth potential (i.e., they are willing to pay a high price today for future expected earnings).
• A low P/E ratio may indicate that the market views the share as undervalued or expects poor future performance.

Dividend Yield (%)

Measures the dividend payment per share as a percentage of the current market price per share. It shows the immediate cash return (income) from holding the share.

Formula:

$$ \text{Dividend Yield} (\%) = \frac{\text{Dividend per share}}{\text{Market price per share}} \times 100 $$

Investors seeking steady income prefer a high dividend yield.

Dividend Cover (Times)

This ratio indicates how easily the company can afford to pay its current dividend.

Formula:

$$ \text{Dividend Cover} = \frac{\text{Profit for the year}}{\text{Annual dividend}} $$

Interpretation:

• A cover ratio of 2 means that the profit earned is twice the amount paid out in dividends. This is generally considered safe.
• A ratio less than 1 (e.g., 0.8) means the company paid out more in dividends than it earned in profit that year—this is unsustainable and may signal future dividend cuts.

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7. Limitations of Ratio Analysis (10.4.2)

Ratios provide excellent insight, but they are not perfect. When evaluating a business, always consider these limitations:

1. Historical Data

Ratios are based on past performance (last year's accounts). They do not guarantee future performance. A business might look profitable today but have just launched a massive, risky project that will hit profits next year.

2. Inflation and Accounting Methods

• Different Stock Valuation: Businesses may use different inventory valuation methods (e.g., FIFO vs. LIFO), which can affect Cost of Sales and Gross Profit.
• Depreciation Methods: Using straight-line versus reducing balance depreciation methods results in different profit figures and asset values, making direct comparison difficult.
• Inflation: Comparing figures from different years without adjusting for inflation can distort trend analysis.

3. Lack of Qualitative Data

Ratios are purely quantitative. They ignore crucial factors like:

• The reputation of the management team.
• The quality of the product or customer service.
• The impact of environmental or ethical policies (CSR).
• Market conditions (e.g., a recession might make even poor ratios acceptable).

4. Need for Comparison (Context is Everything)

A ratio figure in isolation is meaningless. You must compare:

• Time series analysis: Compare the firm’s performance over several years.
• Benchmarking: Compare the firm’s ratios against industry averages or key competitors.

Example: An Inventory Turnover of 5 times seems low for a supermarket, but it might be excellent for a large manufacturing company that holds complex components.

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Key Takeaways for Evaluation (AO4)

• To achieve high marks, never just state a ratio is "good" or "bad." You must justify its importance and explain what the result means for a specific stakeholder.
• Always compare ratios over time and against competitors to provide a meaningful assessment.
• When advising a decision (e.g., whether to lend money), always balance quantitative results (ratios) with qualitative factors (the current economic climate, the experience of the management, future strategies).

Don't worry if calculating the ratios seems tricky at first. Practice, practice, practice! Focus on understanding the *meaning* of the answer, not just getting the correct number.