Analysis of Accounts 2.pptx

WHY IS IT IMPORTANT TO ASSESS THE FINANCIAL PERFORMANCE OF A BUSINESS? Learning Objectives • Why do businesses need to analyse accounts? • What are profitability and liquidity ratios? • How do we interpret the financial performance of a business using: • Profitability ratios • Liquidity ratios • Ho...

WHY IS IT IMPORTANT TO ASSESS THE FINANCIAL PERFORMANCE OF A BUSINESS? Learning Objectives • Why do businesses need to analyse accounts? • What are profitability and liquidity ratios? • How do we interpret the financial performance of a business using: • Profitability ratios • Liquidity ratios • How do stakeholders us the ratio analysis information? • What are the limitations with ratio analysis? Learning Outcomes Students: Must be able to the explain why businesses use ratio analysis and the importance of business performance Should be able to undertake profitability and liquidity ratios and interpret the significance of the figure Could analyse and evaluate the use of the ratio analysis and understand the limitations with the ratio analysis WHY DO BUSINESSES NEED TO ANALYSE ACCOUNTS? • Accounts of private companies are only seen by the owners or investors. They are not accessible to the public. • Accounts of public limited companies such as Apple can be seen by anyone who has an interest in the performance of the business. • Accounts are analysed so businesses can assess their performance: • Year on year • Against other businesses • Comparing the the figures from the accounts is referred to as a ratio analysis. • Ratios can be calculated from the information in the income statements and statement of financial position. • The ratios can be used to measure and compare the profitability/performance and the liquidity of a business. WHAT ARE PROFITABILITY RATIOS? • Profit (noun) is the money that a business has remaining after all the costs and expenses have been paid. • The purpose of the business is to make a profit. (verb) • Profitability is the measure of the profit made relative to: • The value of sales achieved • The capital invested in the business WHAT ARE PROFITABILITY RATIOS? • Profitability is measured as a percentage. • It is a measure of efficiency • It can be used to compare the business’s performance over a number of years • It can be used to compare performance to other businesses Profitability ratios are used by: • Investors when deciding to invest • Directors and managers of the business to assess if the business is becoming more or less successful. GROSS PROFIT MARGIN • Information acquired from the Income statement. Gross Profit Revenue x100 What does the value mean? • For every £1 worth of goods sold, the business makes x amount of profit. • If the % increases in comparison to previous years it suggests that the prices have increased more by more than the cost of sales • Or the costs of sales have reduced However, this ratio is limited as the other expenses have not been deducted and this is not the final profit company. OPERATING PROFIT MARGIN Information is obtained from the Income Statement. Operating Profit Revenue x100 What does the value mean? • This figure will be lower than the GPM as all other expenses including interest have been deducted. • The higher this % the more successful the managers are making net profit from the sales. • It is compared to previous years. STUDENT TASK 1 • CALCULATE THE PROFITABILITY MARGINS RETURN ON CAPITAL EMPLOYED Information acquired from the statement of financial position and income statement. Net profit Capital employed x 100 What does the value mean? • This shows how well businesses make profit from the capital employed in the business. (Capital employed is a reference to the money that is borrowed/invested in the business). • A high figure means that the managers are efficient and making higher profits. • Year on year businesses want this figure to increase. WHAT ARE LIQUIDITY RATIOS? • Liquidity is a reference to how quickly a business is able to buy and sell and raise cash. • It is the ability of a business to pay back its short term debts. • If a business cannot pay its suppliers, or repay an overdraft it is said to be illiquid. • The current ratio is one of two main liquidity ratios which are used to help assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due. CURRENT RATIO Information is obtained from the statement of financial position. The current ratio is one of two main liquidity ratios which are used to help assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due. Current assets Current liabilities x100 What does the value mean? • A current ratio of between 1.0-3.0 is positive. It suggests that the business has enough cash to be able to pay its debts, but not too much finance tied up in current assets which could be reinvested or distributed to shareholders. • A low current ratio of less than 1.0 might suggest that the business is unable to pay its debts. It might be required to raise extra finance or extend the time it takes to pay creditors. • However, this very much depends on the nature of the business. When evaluating the current ratio, it is important to compare with key competitors and industry averages for a better perspective on the strength or weakness of the number. • Perhaps more significant would be a sharp decline in the current ratio from one period to the next, which may indicate liquidity issues. ACID TEST RATIO The Acid Test Ratio therefore adjusts the Current Ratio to eliminate certain current assets that are not already in cash (or "near-cash") form. The tradition is to remove inventories from the current assets total, since inventories are assumed to be the most illiquid part of current assets – it is harder to turn them into cash quickly. Current assets – inventories Current liabilities x100 What does the value mean? • A ratio below 1 is bad. • The value of inventories a business needs to hold will vary from industry to industry. • An acid test ratio for Bravo or Vanguard would indicate a very low figure after taking off the value of inventories but leaving in the very high amounts owed to suppliers (trade creditors). However, there is no suggestion that either of these two businesses has a problem being able to pay its debts! • Managers • Shareholders HOW DO STAKEHOLDERS USE THE RATIO ANALYSIS INFORMATION? • Creditors • Banks • Government • Employees and trade unions • Other businesses – competitors WHAT ARE THE LIMITATIONS WITH RATIO ANALYSIS? • Managers have access to all accounts but external users will only be able to use the published accounts • Ratios are based on past accounting data • Accounting data does not take into account external factors such as inflation • Different companies use different accounting methods in valuing fixed assets.