Capital employed: is shareholders' equity plus non-current liabilities and the total long-term and permanent capital invested in the business
What is analysis of accounts?
Using the data contained in the accounts to make some useful observations about performance and financial strength of the business and tell:
Performing better this year than last year
Performing better than other businesses
Liquidity: is the ability of a business to pay back its short-term debts
Profitability: is the measurement of the profit made relative to either the value of sales achieved or the capital invested in the business
Measurement of the profit made relative to either:
The value of sales achieved
The capital invested into the business
It is important to:
Investors: deciding which business to invest in
Directors and managers: assess if the business is becoming more or less successful over time
These ratios are used to measure and compare profitability ( performance ) and liquidity of the business
Profitability ratios:
Return on capital employed ( ROCE )
formula: net profit / capital employed x 100
If the ROCE has fallen: this mean the business is not successful at earning profit from capital used in the business.
if capital employed increase: managers have invested more hoping for higher profit in the future -> shareholder's fund is increased or non-current liabilities are increased
if net profit has fallen: this could mean that expenses ( overhead) has increased or gross profit has reduced
If the ROCE has increased: this mean the business is successful at earning profit from capital used in the business.
if net profit has increase: this mean gross profit has increase or expenses are reduced
if capital employed decrease: the business has pay off its long term debt ( non-current liabilities)
2. Gross profit margin
formula: gross profit / revenue x 100
If the gross profit margin has fallen: this meant that either:
Sales revenue might have fallen: lower sale or lower price charge for the product
Higher cost of goods sold: Higher cost of raw materials/ ingredients/ direct cost
If the gross profit margin has increased: this mean that the business is successful at converting sales into profit
Sale revenue has increased: price of each product increase or number of goods sole increase
Cost of good sold has fallen:
3. Net profit margin
formula: net profit ( before tax ) / revenue x 100
If the net profit margin has fallen: this mean that the business is less successful at converting sales into net profit .
The overhead ( expenses) / fixed costs must have increase significantly during the year -> reduce the business's net profit compare to revenue
Overhead (expenses) have increased: electricity/ salaries/ advertising/ loans/ interest have increase significantly
Fixed cost have increased: the managers just bought a new assets ( ex.building) for expansion
If the net profit margin has increased: this mean that the business is more successful at making net profit from sales.
Increase in sale revenue: by increasing sale of products -> using promotion method to attract more customers
Reduce cost of good sold and expenses: reduce the cost of raw material and expenses like advertising, electricity, loans, etc
Liquidity ratios
Current ratio
Formula: Current assets / Current liabilities
Result over 2 : this could mean that too much working capital is tied up in unprofitable current assets
Result between 1.5 and 2 : this could be because the business has bought and used many more supplies, but not yet pay for them or used cash to pay for fixed assets
Result at 1.25 : the business could only just pay off all of its short-term debts from current asset
Result below 1: it would mean that the business could have some real cash flow problems. It could not pay off its short term debts from current assets
Working capital: is the capital available to a business in the short term to pay for day-to-day expenses
working capital = current assets - current liabilities
2. Acid ratio test
formula: Current assets - Inventories / Current liabilities
Result at 0.75 : this mean that might be too low, the business might be at risk of not be able to pay its short-term debts from its liquid assets - cash and accounts receivable ( debtors )
Result at 1 : would mean that the company could just pay off its short-term debts from its most liquid assets -> acceptable results
Why and how accounts are used
Managers: they will use the accounts to help them keep control over the performance of each product or each division since they can see which products are profitably performing and which are not.
This will allow them to take better decisions
Ratios can be compared with other firms in the industry/competitors and also with previous years to see how they’re doing. Businesses will definitely want to perform better than their rivals to attract shareholders to invest in their business and to stay competitive in the market. Businesses will also try to improve their profitability and liquidity positions each year.
Shareholders: since they are the owners of a limited company, it is a legal requirement that they be presented with the financial accounts of the company. From the income statements and the profitability ratios, especially the ROCE, existing shareholders and potential investors can see whether they should invest in the business by buying shares. A higher profitability, the higher the chance of getting dividends. They will also compare the ratios with other companies and with previous years to take the most profitable decision. The balance sheet will tell shareholders whether the business was worth more at the end of the year than at the beginning of the year, and the liquidity ratios will be used to ascertain how risky it will be to invest in the company- they won’t want to invest in businesses with serious liquidity problems.
Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position and debts of the business. They will only be ready to supply to the business if they will be able to pay them. If there are liquidity problems, they won’t supply the business as it is risky for them.
Banks: Similar to how suppliers use accounts, they will look at how risky it is to lend to the business. They will only lend to profitable and liquid firms.
Government: the government and tax officials will look at the profits of the company to fix a tax rate and to see if the business is profitable and liquid enough to continue operations and thus if the worker’s jobs will be protected.
Workers and trade unions: they will want to see if the business’ future is secure or not. If the business is continuously running a loss and is in risk of insolvency (not being liquid), it may shut down operations and workers will lose their jobs!
Other businesses: managers of competing companies may want to compare their performance too or may want to take over the business and wants to see if the takeover will be beneficial.
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