10.2 Analysis of published accounts

Learning objectives

Liquidity is the ability to convert available current assets/cash inflows into payment of short-term obligations on time. It matters for wages/suppliers/tax/debt continuity, credit/reputation and survival; a profitable business can still fail from cash timing.

Diagnose cash cycle and quality of components: inventory sale time/obsolescence, credit sales and collection, supplier/payment dates, cash buffer/overdraft, seasonality, forecast uncertainty and access to finance. Excess liquidity can mean idle cash/stock and weak return.

Method	Liquidity mechanism	Trade-off
Reduce/accelerate inventory	Releases cash and storage/obsolescence cost	Stockout, lost sales/scale or rush supply
Faster receivables: credit checks, invoicing, reminders, discount/factoring	Cash arrives earlier	Lost margin/customers, factoring fee/reputation
Negotiate longer payables	Delays cash outflow	Lost discount/trust/supply or higher price
Improve cash sales/margin/cost and phase investment	More internal cash / lower outflow	Demand, quality/capability or long-term growth harm
Sell idle assets, inject equity or refinance short debt long-term	Immediate cash or later repayment	Lost capacity, dilution, interest/fees and not a cure for weak operations

Do not maximise a ratio blindly or confuse profit with cash. Choose methods by root cause, speed, scale and impact on customers, suppliers, capacity, profit and long-run viability.

$Current ratio = Current assets / Current liabilities; Acid-test ratio = (Current assets - Inventory) / Current liabilities$

Current assets $0.6m and current liabilities$ 0.8m give current ratio 0.75:1. If inventory is $0.2m, acid test = ($ 0.6m − $0.2m) ÷$ 0.8m = 0.50:1. Ratios have no currency or percentage unit.

Compare over time, plan/industry/business model and underlying cash conversion. A fall may signal pressure, but a lean cash retailer can operate below a manufacturer's ratio; a high ratio may hide obsolete inventory, overdue receivables or idle cash. The acid-test gap reveals inventory dependence, not inventory quality.

Event	Immediate ratio caution
Collect receivable	Swaps current assets; totals/ratios usually unchanged
Pay current liability with cash	Both numerator and denominator fall; direction depends on starting ratio
Buy inventory for cash	Current ratio unchanged; acid-test numerator falls
Convert short-term loan to long-term	Current liabilities fall, ratios improve but interest/debt remains

A benchmark such as 2:1 or 1:1 is not a universal target. Interpret composition, timing and cash flows, not ratio alone.

Profitability is the ability to generate profit relative to revenue or resources invested. It funds reinvestment, resilience, debt service and owner return; distinguish it from absolute profit, cash flow and growth.

Improvement route	Mechanism	Risk/condition
Raise price/improve mix/differentiation	More gross profit per unit	Elastic demand, competitor/brand response and volume
Grow profitable volume	Spreads fixed cost and raises contribution	Capacity, working capital, promotion and cannibalisation
Lower input/process/waste cost	Raises gross/operating margin	Quality, supply, employees and resilience
Reduce/control operating expenses	Raises operating margin	Cutting R&D/training/service may damage future revenue
Use/sell/redeploy capital assets better	Raises ROCE through profit or lower capital employed	Capacity/flexibility/growth and one-off sale

Decompose weak ratio into price, volume/mix, unit cost, operating expense and capital utilisation; compare trend/benchmark and external factors; choose root-cause intervention; forecast customer/employee/cash/capacity effects; monitor sustainable margin and ROCE rather than one-year cuts.

Higher short-run margin from underinvestment can reduce future profitability. A smaller business can have higher margins but lower absolute profit; diagnose the relevant relationship.

Ratio	Cambridge formula	Primary question
Gross profit margin	Gross profit ÷ revenue × 100	How much sales value remains after cost of sales?
Profit margin / operating profit margin	Profit from operations ÷ revenue × 100	How much sales value remains after cost of sales and operating expenses?
ROCE	Profit from operations ÷ capital employed × 100	How effectively is long-term capital generating operating profit?

$Capital employed = Issued share capital + Reserves + Non-current liabilities$

Revenue $10.8m, cost of sales$ 6.4m, expenses $3.9m: gross profit$ 4.4m and operating profit $0.5m; GPM = 40.74%, operating margin = 4.63%. If capital employed$ 8m, ROCE = 6.25%.

If GPM falls, investigate selling price/mix and input/direct production cost. If GPM stable but operating margin falls, investigate operating expenses. ROCE can change because operating margin changes, asset/capital utilisation changes, or both. Compare like accounting definitions, time, industry and risk.

Use profit from operations—not gross profit or profit for year—for operating margin and ROCE under this syllabus. A higher ratio may arise from underinvestment or asset sale, so inspect causes.

Financial efficiency is how effectively working-capital resources are converted through operations into sales and cash. Inventory turnover and trade receivable/payable days expose cash-cycle speed, operating quality and relationship choices.

Area/improvement	Benefit mechanism	Trade-off
Inventory: forecast, JIT/reorder, range/slow-stock action, supplier/process reliability	Less cash/storage/obsolescence and faster turnover	Stockout, lost scale/sales and disruption
Receivables: credit checks/limits, clear terms/invoice, reminders, early discount/factoring	Faster cash and less bad debt	Lost customers/margin, admin/factoring cost
Payables: negotiate terms, schedule accurately, consolidate purchasing	Retains cash longer	Lost discount, price increase, supplier trust/supply
Process/data: ERP and cross-functional working-capital ownership	Visibility, fewer errors/delay and matched decisions	System/data/training cost and metric gaming

Compare trends, sector/business model, terms and demand/supply conditions; inspect aged inventory/receivables/payables and cash forecast. A long payable period may improve cash but signal distress; fast inventory may show efficiency or insufficient availability. Optimise total contribution, service, risk and relationships.

Faster is not universally better. Financial efficiency is not achieved by starving operations or suppliers of necessary working capital.

Ratio	Formula	Unit
Rate of inventory turnover	Cost of sales ÷ average inventory	times per year
Inventory turnover (days, if requested)	Average inventory ÷ cost of sales × 365	days
Trade receivables turnover	Average trade receivables ÷ credit sales × 365	days
Trade payables turnover	Average trade payables ÷ credit purchases × 365	days

$Average balance = (Opening balance + Closing balance) / 2$

Cost of sales $0.40m and average inventory$ 0.13m: turnover = 3.08 times (or 118.6 days). Receivables $1.4m and credit sales$ 5m: days = $1.4m ÷$ 5m × 365 = 102.2 days.

Higher inventory times/lower days usually releases cash but can mean stockouts; lower receivable days speeds cash but may reflect restrictive credit; higher payable days retains cash but can damage supplier terms. Compare actual credit flows and average balances; if only closing/all-sales/purchases data exist, state the approximation.

Inventory turnover uses cost of sales, not revenue, and 'rate' answer is times—not money, percent or days. Match receivables to credit sales and payables to credit purchases wherever data permit.

Gearing measures the proportion of long-term capital employed financed by non-current liabilities/debt. It matters because interest/repayment are fixed claims: debt can fund growth without ownership dilution and amplify shareholder return when operating return exceeds debt cost, but increases cash, covenant, refinancing and failure risk.

Interpret with interest rates/coverage, cash stability, asset collateral, industry cyclicality, lender covenants, maturity/currency, growth opportunity and owner control—not a universal high/low cut-off. A capital-intensive utility can sustain a different level from a volatile start-up.

Reduce gearing method	Mechanism	Trade-off
Retain profit and repay debt	Debt falls/equity reserves rise	Less dividend/cash and slower growth
Issue shares/new equity	Capital employed equity rises and cash can repay debt	Dilution, issue cost and owner control
Sell non-core assets to repay debt	Debt and fixed claims fall	Lost capacity/income and sale timing/value
Refinance/restructure	Longer term/lower cost may reduce immediate risk	May not reduce ratio; fees/interest/covenants
Improve operating cash/profit	Supports repayment and resilience	Takes time and does not directly change ratio until retained/repaid

Low gearing is not automatically optimal: unused debt capacity can forgo profitable investment. Equity also has opportunity/control costs even without compulsory interest.

$Gearing ratio = Non-current liabilities / Capital employed × 100$

$Capital employed = Issued share capital + Reserves + Non-current liabilities$

Non-current liabilities $10m and capital employed$ 16m give gearing = $10m ÷$ 16m × 100 = 62.5%. State 62.5%, not 0.625 or $62.5.

A rise means a larger share of long-term capital carries debt claims, usually increasing sensitivity to interest/cash downturn and potentially shareholder leverage. Diagnose whether debt rose, equity/reserves fell or both; compare trend, sector, maturity/rates and use of funds. Profitable debt-funded expansion can raise both risk and return.

Use the syllabus denominator, not debt ÷ equity or assets. The percentage alone does not reveal repayment dates, interest affordability, cash volatility or asset quality.

Shareholder return comes from cash dividends and changes in share value, supported by sustainable earnings/cash, risk and growth expectations. Dividend yield measures cash return relative to market price; cover measures dividend sustainability; P/E reflects price paid per unit of earnings and market expectations/risk.

Judge trends and alternatives: dividend/yield/cover/P-E, profit/margins/ROCE, cash/liquidity/gearing, share-price movement, risk, inflation/interest, business objective/life cycle and shareholder preference. A low current dividend may be acceptable if retained funds create credible higher future return.

Method	Possible return mechanism	Risk/trade-off
Raise sustainable profit/cash through strategy/efficiency	More dividend capacity and future valuation	Execution risk/time/investment
Increase dividend / regular policy	Higher immediate cash return and confidence	Lower cover/reinvestment/cash and possible borrowing
Retain and invest in positive-return projects	Future earnings/share value	No guarantee, delay and agency risk
Reduce risk/gearing, improve disclosure/governance	Lower required return/more confidence	Debt repayment/opportunity/implementation cost
Share buyback if appropriate	Fewer shares and possible EPS/price support	Uses cash, timing/valuation and may mask weak investment

A higher dividend is not automatically better if it weakens cover, liquidity or valuable investment. Market price—and therefore yield/P-E—can change because expectations and external markets change without current operating action.

Ratio	Formula	Unit/meaning
Dividend yield	Dividend per share ÷ market price per share × 100	% cash return at market price
Dividend cover	Profit for year ÷ total annual dividends (or EPS ÷ dividend per share on consistent basis)	times earnings cover dividend
Price/earnings (P/E)	Market price per share ÷ earnings per share	times price relative to current earnings

Dividend per share $0.03 and market price$ 0.40: yield = 7.5%. Profit for year $4m and dividends$ 1m: cover = 4 times. Price $4.00 and EPS$ 0.60: P/E = 6.67 times.

Higher result can indicate	But may also indicate
Yield: more cash return	Falling share price/risk or unsustainable dividend
Cover: safer dividend/reinvestment capacity	Low payout despite shareholder income needs
P/E: strong growth/quality expectations	Overvaluation; low P/E may reflect risk or undervaluation

When comparing yield, calculate each year using that year's dividend and price. A move from 7.5% to 5.7% is −1.8 percentage points; relative change is −1.8 ÷ 7.5 × 100 = −24%. Do not call these the same measure.

Do not mix total profit with per-share dividend or EPS with total dividend. Ratios need trend, competitor/market, accounting policy, cash, risk and growth evidence; investor return includes capital gain/loss not captured by dividend yield alone.

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—10.3 Investment appraisalRead

10.2 Analysis of published accounts

Learning objectives

Liquidity is the ability to meet short-term obligations when cash is due

Current and acid-test ratios compare liquid resources with short-term claims

Profitability measures sustainable profit from sales and capital

Profitability ratios isolate gross, operating and capital performance

Financial efficiency manages cash tied in inventory, receivables and payables

Efficiency ratios match average balances to their operating flows

Gearing balances leverage benefits against fixed financial claims

The gearing ratio compares non-current liabilities with capital employed

Investor return combines cash dividends, retained growth and market expectations

Investment ratios separate cash yield, dividend cover and earnings expectations

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