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5.5. Analysis of accounts

Syllabus
0264–2027–2028
Topic
5.5
Level
—

Learning objectives

5.5.1Profitability• concept of profitability• calculate and interpret the following profitability ratios:• gross profit margin• profit margin• return on capital employed (ROCE)5.5.2Liquidity• concept of liquidity• calculate and interpret the following liquidity ratios:• current ratio• acid test ratio5.5.3Users of accounts• users of accounts and ratio analysis: internal, e.g. owners (sole traders, partnerships, shareholders), managers, employees• users of accounts and ratio analysis: external, e.g. suppliers, government, lenders/banks• how users of accounts may use financial information to help make decisions, e.g. whether to lend to or invest in a business• limitations of using accounts and ratio analysis

Measure and interpret profitability

Profitability measures how effectively a business turns revenue or invested capital into profit. Ratios make comparison across years or businesses more meaningful than profit alone.

gross profit margin=gross profitrevenue×100,profit margin=profitrevenue×100,ROCE=profitcapital employed×100gross\ profit\ margin=\frac{gross\ profit}{revenue}\times100,\quad profit\ margin=\frac{profit}{revenue}\times100,\quad ROCE=\frac{profit}{capital\ employed}\times100

Ratio change Possible interpretation
gross profit margin falls selling prices weakened or cost of sales rose
profit margin falls while gross margin is stable operating expenses rose
ROCE rises more profit is generated for each unit of long-term finance

A higher ratio is usually favourable, but not conclusive. Check the cause, time period, accounting policies, business type and any trade-off such as lower prices used to build market share.

Measure and interpret liquidity

Liquidity is the ability to meet short-term debts when they fall due. It depends on the quality and timing of current assets, not simply their total value.

current ratio=current assetscurrent liabilities,acid ⁣− ⁣test ratio=current assets−inventorycurrent liabilitiescurrent\ ratio=\frac{current\ assets}{current\ liabilities},\qquad acid\! -\! test\ ratio=\frac{current\ assets-inventory}{current\ liabilities}

The acid-test ratio removes inventory because it may be slow to sell or lose value. Ratios that are too low can signal payment difficulty; very high ratios can signal idle cash, excessive receivables or inventory. Compare with prior years and the needs of the industry.

A current ratio above 1 does not guarantee bills can be paid: receivables may arrive late and inventory is not cash. A retailer can also operate safely with a lower acid-test ratio than a business that holds little inventory.

Use accounts for decisions—without overclaiming

User Internal or external Example decision
sole trader, partners or shareholders internal owners invest, withdraw profit or change strategy
managers internal control costs, pricing and finance
employees internal assess job security or support a pay claim
suppliers external offer trade credit
lenders or banks external approve a loan and set terms
government external assess tax or compliance

Identify the user’s decision, select relevant profit, liquidity or position figures, calculate consistently, compare with a useful benchmark, and explain what the result implies for that user.

Accounts are historical and may use different accounting policies. Inflation, seasonality, one-off events and window dressing can distort comparisons. Ratios omit qualitative information such as product quality, employee skills, market change and future cash flows; published accounts may also be too aggregated or out of date.

One ratio cannot prove that a business is safe, profitable or worth financing. Use several linked measures plus context and non-financial evidence.