5.5 Analysis of accounts IGCSE Business Studies

Lesson Objectives: At the end of the lesson, students should be able to: 5.5.1demonstrate how to interpret financial statements by calculating and analysing accounting ratios: • Gross profit margin • Profit margin (‘profit margin’ was known as ‘net profit margin’ in the 2014 and previous syllabuses) • Return on Capital Employed • Current ratio • Acid test ratio 5.5.2 Liquidity: • The concept and importance of liquidity 5.5.3 Why and how accounts are used: • Needs of different users of accounts and ratio analysis • How users of accounts and ratio results might use information to help make decisions, e.g. whether to lend to or invest in the business. Class activity included to engage and assess students’ understanding.

A simple comparison of the change in revenue, costs, and profits, assets or liabilities of a business from one year to another can provide stakeholders with misleading information. Therefore, a business must check its performance regularly using the appropriate ratios. This will help it to Interpret its strength and weaknesses and make needed policy changes Know whether it is meeting its set objectives Interpret fut .

The profit and loss account: Shows how the net profit is calculated It begins with the gross profit calculated from the trading account All other expenses and overheads of the business are subtracted

Balance sheets. The balance sheet shows the value or worth of a business at a particular moment in time Assets: are items of value that are owned by the business Fixed assets – (Land, buildings, equipment and vehicles) they are usually kept by the business for more then a year. Most of the fixed assets depreciate over time Current assets – (cash, stocks and debtors) they are only held for a short period of time Liabilities: are the items owed by the business Long-term liabilities – they are long term borrowings (they do not have to be repaid within one year) Current liabilities – borrowings which must be repaid within one year

Explanation of Balance sheet terms: Working capital (or net current assets): It is used to pay short term debts Working capital = Current assets – Current liabilities Net assets = Fixed assets + Working capital These assets must be paid for by money put into the business in two ways : shareholders’ fund and long-term liabilities Shareholders’ founds is everything that is invested into the business by the owners of the company Share capital – is the money put into the business when the shareholders bought newly issued shares Profit and loss reserves are retained profits from current and previous years Capital employed = Shareholders’ founds + long term liabilities Capital employed = net assets

Analysis of published accounts: Liquidity: is the ability of a business to pay back it’s short term debts It is important to choose more than one figure from the accounts when trying to find how a business is performing. Comparing two features from one account is called ratio analysis.

Ratio analysis of accounts There are two main types of ratios : Performance ratios and, Liquidity ratios

Measuring business Performance: The three most common performance ratios are: Gross profit margin Profit margin Return on capital employed

1. Gross profit margin: This is calculated by the formula Gross profit margin (%) = Gross profit / Sales revenue * 100 An outcome of 25% for example, implies that for every $1 of sales revenue, $ 0.25 is earned as gross profit.

2. Profit margin: This is calculated by the formula Profit margin (%) = Profit before tax / Sales revenue *100 An outcome of 15% for example, implies that for every $1 of sales revenue, $ 0.15 is earned as profit.

3. Return on capital employed(ROCE): This is calculated by the formula ROCE(%) = Operating profit / Capital employed * 100 This is how much the business was able to get back from the capital it had employed. An outcome of 20% for example, implies that for every $1 of capital it had employed in the business, $ 0.20 is earned as operating profit.

Now, reflect on the lesson and formulas that you have learnt thus far Now, reflect on the lesson and formulas that you have learnt thus far. You would study the business data on next slide and apply the principles you have studied to calculate and interpret the business performance. After finishing your calculations, the answers would be shown to you.

Profit before interest and tax 63 70 2012 2013 $000 Revenue 420 500 Gross profit 189 240 Profit before interest and tax 63 70 Capital employed 120 Table 1 Extracts from the financial statement of Tang Toys Ltd Class Activity: Using the business data in table 1, calculate the following accounting ratios to analyse the business profitability: i. Gross profit margin, ii. Profit, iii. Return on capital employed. Compare the business performance in 2012 and 2013. Based on the results obtained, in which of the two years was the business more successful? Answers on next slide.

Answer to class activity. Year 2012: Gross profit margin (%) = (189/420)*100 = 45.5% This tells us that every $1 of sales revenue, earned $ 0.45 gross profit. Profit margin (%) = 63/420)*100 = 15% This tells us that every $1 of sales revenue, earned $ 0.15 of profit. ROCE(%) = 63/120*100 = 52.5% This tells us that every $1 of capital invested earned a return to the shareholders of $ 0.525.

Year 2013: Gross profit margin (%) = (240/500)*100 = 48% This tells us that every $1 of revenue earned $ 0.48 gross profit. Profit margin (%) = 70/500)*100 = 14% This tells us that every $1 of revenue earned $ 0.14 of profit. ROCE(%) = 70/120*100 = 58% This tells us that every $1 of capital invested earned a return to the shareholders of $ 0.58.

Liquidity ratios: These measure the ability of a business to pay back it’s short-term debts Two common liquidity ratios are: Current ratio and Acid test or liquid ratio

Current ratio: Current ratio Acid test or liquid ratio: This is calculated by the formula Current ratio = Current assets / Current liabilities Acid test or liquid ratio: Acid test or Liquid ratio = (Current assets – stocks) / Current liabilities

Class Activity: 2012 2013 $000 Current ssets 60 50 Current assests - inventories 20 30 Current liabilities 40 Table 2 Extracts from the financial statement of Tang Toys Ltd(TT) Class Activity: Using the business data in table 2 above, calculate the following accounting ratios to analyse the business profitability: i. Current ratio, ii. Acid test or Liquid ratio . Compare the business performance in 2012 and 2013. Based on the ratios obtained, in which of the two years was the business more liquid? Answers on next slide.

Example: Using data from figure 2 Current ratio (2012) = 60/40 = 1.5:1 [Note that the result is always in ratio] This means that for every $ 1 of current liabilities TT has $1.5 of current assets: that is it has access to more cash than it needs to meet its short term liabilities and has spare cash to pay for any unexpected expense Acid test or Liquid ratio (2012) = (60-20) / 40 = 1:1 An acid test of 1:1 is generally satisfactory. Below this there is the risks that the business not does have enough cash to pay its short term liabilities. If it is too high, cash is being tied up in unprofitable assets

Disadvantages of ratio analysis: Ratios are based on results collected on the past and therefore will not be able to show how a business might perform in the future Accounting results over time will be affected by inflation Different companies might use slightly different accounting methods