Analysis of accounts | IGCSE Class 10 Business Studies Notes

This note covers profitability and liquidity as measures of business performance, how to calculate and interpret gross profit margin, profit margin and return on capital employed, how to calculate and interpret the current ratio and the acid test ratio, the advantages and limitations of ratio analysis, and why different users of accounts analyse ratio results before lending to or investing in a business.

What is meant by profitability and why does it matter?

What profitability measures

Profitability is the ability of a business to earn a profit from its trading activities, usually measured by comparing profit figures with the revenue or capital that produced them.

A business can be growing in size and still be unprofitable if its costs rise faster than its revenue, so owners, managers and lenders all watch profitability closely.

Because profit figures on their own give no sense of scale, two businesses with the same amount of profit may have very different levels of profitability if one earned that profit from a much smaller amount of revenue or capital than the other.

Why profitability matters to the business

Profitability matters because profit is the reward for the risk taken by owners, the source of funds for reinvestment and dividends, and a signal to outside parties of how well the business is managed.

A firm with falling profitability may still be able to pay its bills in the short term, but a sustained fall warns that the business model, pricing or cost control needs attention.

Comparing profitability ratios over several years, or against similar firms, shows whether performance is improving or worsening and helps explain why profit has changed.

Profitability analysis also helps a business identify which areas of its operations are working well and which are not, so that management effort and resources can be directed towards the problem areas rather than spread evenly across the whole business.

What is meant by liquidity and why does it matter?

What liquidity measures

Liquidity is the ability of a business to meet its short-term obligations, that is, to pay the amounts it owes as they fall due, using cash and assets that can quickly be turned into cash. It is a short-term measure, unlike profitability, which can be assessed over any period.

A business can be profitable on paper yet run out of cash if too much money is tied up in inventory or trade receivables (amounts owed by customers) and too little is held as cash to pay suppliers, wages and short-term loans.

When this comes from expanding too fast without enough working capital it is called overtrading, and it can force an otherwise successful business to close. Liquidity ratios compare current assets (cash and items expected to turn into cash within a year) with current liabilities (debts due within a year) to check whether the business has enough short-term resources to survive.

Liquidity compared with profitability

Liquidity and profitability are not the same thing and do not always move in the same direction. A business tightening its credit terms and selling off slow-moving inventory may improve its liquidity in the short term even though this has no direct effect on the profit it reports for the year.

Because liquidity concerns the very near future, it is of particular concern to trade suppliers and short-term lenders, who need confidence that amounts owed to them will be paid on time, rather than merely that the business is profitable in the long run.

How is the gross profit margin calculated and interpreted?

Formula and definitions

The gross profit margin compares gross profit, which is revenue less the direct cost of the goods sold, with revenue itself, expressed as a percentage.

Gross Profit Margin = (Gross profit ÷ Revenue) × 100

Here, Gross profit = Revenue − Cost of sales, and Revenue is the total value of sales made in the period.

Interpreting the margin

A higher gross profit margin is generally a good sign, since it shows the business keeps more of each sale after covering the direct cost of goods sold.

A fall in the ratio may be caused by a change in selling price, a rise in the cost of goods sold, or a combination of both, so the margin on its own does not explain the cause; it only flags that something has changed and needs investigating.

The gross profit margin is particularly useful for comparing a business with itself over several years, or against other businesses in the same trade, since it shows how effectively the business buys and prices its goods before any other running costs are taken into account.

Worked example 1. Zeta Retail had revenue of $200,000 and a cost of sales of $120,000 for the year.

Answer: Gross profit = $200,000 − $120,000 = $80,000. Gross profit margin = ($80,000 ÷ $200,000) × 100 = 40%.

Since 40 cents of every dollar of revenue is kept as gross profit before other expenses, the owners should keep the current pricing and buying policy rather than cut prices to chase more sales.

How is the profit margin calculated and interpreted?

Formula and definitions

The profit margin (also called the net profit margin) compares profit for the year, after all operating expenses, interest and tax have been deducted, with revenue.

Profit Margin = (Profit for the year ÷ Revenue) × 100

Here, Profit for the year = Gross profit − Operating expenses − Interest − Tax, so this ratio is broader than the gross profit margin because it takes in every type of expense, not only the direct cost of the goods sold.

What the margin reveals

It reflects the overall efficiency of the business and is significant to investors, since it is the margin left after wages, rent, marketing, interest and all other running costs have been paid.

A falling profit margin alongside a steady gross profit margin usually points to rising overhead expenses rather than a pricing or purchasing problem.

Because the profit margin takes account of every expense a business incurs, it is also described as being based on an "all inclusive concept of profit".

A business comparing its profit margin across several years can separate out whether a change in overall performance is coming from its day-to-day trading, as shown by the gross profit margin, or from the size of its overhead expenses, which only the profit margin reveals.

Worked example 2. Using the figures from Worked example 1, Zeta Retail's operating expenses, interest and tax for the year came to $65,000, leaving a profit for the year of $15,000.

Answer: Profit margin = ($15,000 ÷ $200,000) × 100 = 7.5%. Because the gross margin of 40% fell to only 7.5% after expenses, management should review overhead costs such as rent, wages and marketing rather than only looking at buying and selling prices.

How is the return on capital employed calculated and interpreted?

Formula and definitions

Return on Capital Employed, usually abbreviated to ROCE, measures the profit the business generates for every dollar of long-term capital invested in it, where capital employed means the long-term funds used in the business, namely shareholders' funds plus long-term borrowings.

ROCE = (Profit before interest and tax ÷ Capital employed) × 100

Capital Employed = Shareholders' funds + Long-term borrowings

Here, Profit before interest and tax is the profit earned before any interest on borrowings and tax are deducted, and Shareholders' funds means the share capital and reserves belonging to the owners.

Why ROCE matters to owners and lenders

ROCE is used to judge whether the business is earning a higher return on the funds invested in it than the rate of interest it would pay to borrow, or the return an investor could earn elsewhere, such as in a bank savings account.

A business earning a ROCE below the cost of its borrowing is, in effect, losing money on every dollar it has borrowed, which is a serious warning sign for owners and lenders alike.

ROCE is also considered a good measure of profitability for comparing one firm with another, because it relates profit to the whole pool of long-term funds a business has used, whether those funds came from owners or from long-term lenders, rather than only to revenue.

A business with a rising ROCE over several years is generally judged to be using its long-term capital more efficiently, whereas a falling ROCE, even alongside steady profit margins, suggests that new capital is being invested without yet generating a matching rise in returns.

Worked example 3. A small manufacturing business has profit before interest and tax of $40,000 and capital employed of $200,000. A bank is offering a savings account paying 5% a year.

Answer: ROCE = ($40,000 ÷ $200,000) × 100 = 20%. Since 20% is well above the 5% the owner could earn by simply saving the money, the owner should keep the capital invested in the business rather than withdraw and save it.

How is the current ratio calculated and interpreted?

Formula and definitions

The current ratio is the proportion of current assets to current liabilities, and it is the main measure of short-term liquidity.

Current Ratio = Current assets ÷ Current liabilities

Here, Current assets are cash and items expected to turn into cash within a year, and Current liabilities are debts due within a year.

The ratio is expressed as a number of times, for example 2:1, meaning the business has $2 of current assets for every $1 of current liabilities due.

Interpreting the ratio

It is often considered safe to have this ratio within a range of about 2:1, since a very high ratio can mean money is lying idle in unsold inventory or uncollected debts instead of being put to productive use, while a low ratio puts the business at risk of being unable to pay its short-term debts on time, which can damage its reputation with suppliers and lenders.

The current ratio provides a measure of the safety margin available against uncertainty in collecting current assets and in the timing of cash flows, so a business with a comfortable margin above its liabilities has more room to absorb a late payment from a customer or a delay in selling inventory without missing a payment of its own.

If this problem of a low current ratio persists over several accounting periods, it can affect the firm's reputation for creditworthiness, making suppliers less willing to offer credit terms and lenders more cautious about extending further loans.

How is the acid test ratio calculated and interpreted?

Formula and definitions

The acid test ratio, also called the quick ratio, is a stricter test of liquidity than the current ratio because it excludes inventory, the least liquid current asset, from the calculation.

Acid Test Ratio = (Current assets − Inventory) ÷ Current liabilities

Quick Assets = Current assets − Inventory

Here, Quick assets are the current assets expected to convert into cash most quickly, mainly cash and trade receivables, because inventory is excluded. Inventory is excluded because it usually takes longer to convert into cash than cash itself, trade receivables or other near-cash assets.

Interpreting the ratio

It is often considered safe to have a ratio of around 1:1, since an unnecessarily low ratio is risky, while an unnecessarily high ratio suggests resources are sitting idle rather than being used productively elsewhere in the business.

The acid test ratio is particularly useful as a supplementary check alongside the current ratio, since a business can appear safe on the current ratio while still being at risk if most of its current assets are made up of slow-moving inventory rather than cash or amounts that will soon be received from customers.

Comparing the two ratios together, by looking at the size of the gap between them, shows how much of a business's short-term cover depends on selling inventory rather than on cash and receivables already close to being collected.

Worked example 4. A bank is deciding whether to extend a short-term loan to a wholesaler with current assets of $50,000, inventory of $20,000 and current liabilities of $25,000.

Answer: Current ratio = $50,000 ÷ $25,000 = 2:1. Acid test ratio = ($50,000 − $20,000) ÷ $25,000 = $30,000 ÷ $25,000 = 1.2:1. As both ratios are at or above the commonly used benchmarks, the bank should approve the short-term loan.

What are the advantages and limitations of ratio analysis?

Advantages

Ratio analysis simplifies complex accounting figures and turns them into relationships that are easier to understand and compare.

It helps users understand whether the operating, investing and financing decisions taken by a business have been the right ones, and it helps identify both problem areas needing attention and bright areas that are working well.

Ratios also allow comparison over several accounting periods for the same firm, with other firms in the same industry, and against standards set for that industry.

Ratios can also help a business carry out its own SWOT analysis (Strengths, Weaknesses, Opportunities and Threats), since a change revealed by a ratio often explains why a current threat or opportunity has arisen and what part of the business it affects.

Limitations

Ratios are derived from the figures in the financial statements, so any weakness or error in those statements, such as judgements made when valuing inventory or calculating depreciation, carries through into the ratio and can mislead the user.

Ratios also ignore price-level changes and non-monetary factors such as staff morale or customer satisfaction, and there is no single universally accepted ideal level for most ratios, since a level that is fine for one industry may be poor for another.

Ratios are a means of pointing to a problem rather than solving it; they act as a whistle blower, not a cure.

Different businesses may also follow different accounting practices, for example in valuing inventory or calculating depreciation, so a ratio calculated for one firm is not always safely comparable with the same ratio calculated for another firm using different accounting policies.

Who are the users of accounts and how do they use ratio analysis to make decisions?

Owners, managers and lenders

Different users of accounts need different information from ratio analysis because their interest in the business differs.

Owners and managers use profitability and liquidity ratios together to judge overall performance and to decide where to cut costs, raise prices or invest further.

Lenders, such as banks, pay particular attention to liquidity ratios, including the current ratio and acid test ratio, because they need to know whether the business can repay short-term loans and meet interest payments on long-term debt, and they also look at ROCE to compare the return the business earns with the rate of interest being charged.

Investors, suppliers and government bodies

Investors who are deciding whether to buy shares in, or lend money to, a business concentrate on profitability ratios such as the profit margin and ROCE, since these show the return they might expect on their investment and how that return compares with other uses of their money.

Trade suppliers who are deciding whether to offer credit are mainly interested in liquidity, since they need reassurance that the business can pay its bills within the agreed credit period.

Government bodies and tax authorities use published accounts to check that the right amount of tax is paid and to judge whether a business is likely to grow and create jobs. Employees and trade unions look at profitability and liquidity to judge job security and whether a pay rise is affordable.

In every case, a single ratio in isolation is less useful than comparing it with previous years, with similar businesses, or with an industry benchmark, before a lending, investing or trading decision is made.

Going beyond the syllabus

Businesses and analysts also use further ratios not listed here, such as the inventory turnover ratio (how many times inventory is sold and replaced in a period) and the trade receivables turnover ratio (how quickly customers pay what they owe).

These sit alongside profitability and liquidity ratios to give a fuller picture of efficiency, but they go beyond what this unit requires.

A bar chart with years on the horizontal axis and a ratio value on the vertical axis, with two bars per year, one for the current ratio and one for the acid test ratio, showing whether the gap between the two bars (representing the value of inventory held) is widening or narrowing over time.

A line graph with years on the horizontal axis and percentage on the vertical axis, with two lines, one for gross profit margin and one for profit margin, where a widening gap between the two lines shows rising overhead expenses.

How do profitability and liquidity ratios combine to give a full picture?

Why the two types of ratio are read together

A single ratio read on its own can be misleading, so profitability and liquidity ratios are normally examined side by side before any lending or investing decision is made. A business can show a strong gross profit margin and profit margin, yet still be at risk if its current ratio or acid test ratio reveals that it does not have enough cash and near-cash assets to pay its short-term debts on time.

Equally, a business with a comfortable current ratio and acid test ratio is not necessarily a good investment if its profit margin and ROCE are weak, since this suggests the business is not using its resources to generate an adequate return. Reading the two groups of ratio together shows whether good short-term survival is being matched by good long-term earning power, or whether one is masking a weakness in the other.

Interpreting the two groups over time

Comparing both groups of ratio across several years, rather than for one year in isolation, shows whether an improvement in profitability has been achieved at the cost of liquidity, for example by holding less cash and more inventory, or whether both profitability and liquidity are improving together, which is the sign of a business that is both well managed and financially secure.

Glossary

• Profitability: the ability of a business to earn profit from its trading activities, usually measured against revenue or capital.
• Liquidity: the ability of a business to pay its short-term debts as they fall due using cash and near-cash assets.
• Gross profit margin: gross profit expressed as a percentage of revenue, showing the margin kept after the direct cost of goods sold.
• Profit margin: profit for the year expressed as a percentage of revenue, after all expenses, interest and tax.
• Return on capital employed: profit before interest and tax expressed as a percentage of the long-term capital invested in the business.
• Capital employed: the long-term funds used in a business, made up of shareholders' funds plus long-term borrowings.
• Current ratio: current assets divided by current liabilities, the main measure of short-term liquidity.
• Acid test ratio: current assets minus inventory, divided by current liabilities; a stricter liquidity test than the current ratio.
• Current assets: cash and items expected to be turned into cash within one year, such as inventory and trade receivables.
• Current liabilities: debts and obligations that a business must pay within one year.
• Inventory: goods held by a business for resale or for use in production, often the least liquid current asset.
• Trade receivables: amounts owed to a business by customers who have bought goods or services on credit.
• Ratio analysis: the technique of calculating and interpreting relationships between accounting figures to assess performance.
• Overtrading: a situation where a growing business runs short of cash because too much money is tied up in inventory or receivables.

Common errors and misconceptions

• Misconception: a profitable business can never run out of cash. Correct: profit and cash are different; a profitable business can still fail if too much cash is tied up in inventory or receivables.
• Misconception: a higher current ratio is always better. Correct: a very high current ratio can mean resources are lying idle in unsold inventory rather than being used productively.
• Misconception: the acid test ratio and the current ratio measure the same thing. Correct: the acid test ratio excludes inventory, giving a stricter and faster test of liquidity.
• Misconception: gross profit margin and profit margin always move together. Correct: gross profit margin can stay steady while profit margin falls if overhead expenses rise.
• Misconception: ROCE only matters to the owners of a business. Correct: lenders also use ROCE to judge whether a business earns more than it would pay in interest.
• Misconception: a single ratio for one year is enough to judge a business. Correct: ratios are most useful when compared across years, with other firms, or against an industry benchmark.
• Misconception: ratio analysis solves business problems. Correct: ratios only point to problem areas; they do not explain the cause or provide the solution.

Exam-style questions with model answers

Q1. State two users of accounts who might use ratio analysis before deciding whether to lend to a business. [2 marks]

1. A bank, which might use liquidity ratios before approving a loan, and a trade supplier, who might use liquidity ratios before agreeing to offer credit terms.

Q2. Define the term "liquidity". [2 marks]

1. Liquidity is the ability of a business to meet its short-term obligations, that is, to pay the amounts it owes as they fall due, using cash and assets that can quickly be turned into cash.

Q3. A business has current assets of $60,000 and current liabilities of $30,000. Calculate the current ratio and state whether this suggests the business has good liquidity. [4 marks]

1. Current ratio = current assets ÷ current liabilities = $60,000 ÷ $30,000 = 2:1.
2. A ratio of 2:1 is within the range often considered safe for liquidity.
3. It shows the business has $2 of current assets for every $1 of current liabilities due.
4. This suggests the business should comfortably be able to meet its short-term debts as they fall due.

Q4. Explain two reasons why a business might want to improve its gross profit margin. [4 marks]

1. A higher gross profit margin means more of each sale is kept after covering the direct cost of goods sold.
2. This leaves more money available to cover operating expenses, interest and tax, which supports a higher profit margin.
3. A higher margin also gives the business more room to cope with a rise in the cost of goods sold without raising prices.
4. It can also make the business more attractive to investors, since a strong gross margin signals effective buying and pricing decisions.

Q5. A business has current assets of $50,000, inventory of $20,000 and current liabilities of $25,000. Calculate the acid test ratio. [3 marks]

1. Quick assets = current assets − inventory = $50,000 − $20,000 = $30,000.
2. Acid test ratio = quick assets ÷ current liabilities = $30,000 ÷ $25,000.
3. Acid test ratio = 1.2:1.

Q6. Explain the difference between profitability and liquidity. [4 marks]

1. Profitability measures the ability of a business to earn profit from its trading activities, usually compared with revenue or capital employed.
2. Liquidity measures the ability of a business to pay its short-term debts as they fall due, using cash and near-cash assets.
3. Profitability can be assessed over any period, while liquidity is specifically a short-term measure.
4. A business can be profitable yet have poor liquidity if too much cash is tied up in inventory or trade receivables, which shows the two concepts are not the same thing.

Q7. A business has profit before interest and tax of $40,000 and capital employed of $200,000. A bank savings account pays 5% interest a year. Calculate the return on capital employed and evaluate whether the owner should keep the money invested in the business rather than place it in the savings account. [6 marks]

1. Return on capital employed = profit before interest and tax ÷ capital employed × 100.
2. ROCE = ($40,000 ÷ $200,000) × 100 = 20%.
3. A ROCE of 20% is far higher than the 5% available from the savings account.
4. This means every $100 invested in the business earns $20 a year, compared with only $5 from the bank.
5. However, business profit is less certain than bank interest, since it can rise or fall with trading conditions.
6. On balance, because the return is so much higher than the safe alternative, the owner should keep the capital invested in the business rather than move it into the savings account.

Q8. Discuss how a bank manager and a shareholder might use ratio results differently when deciding whether to support a business. [6 marks]

1. A bank manager considering a loan is mainly concerned with whether the business can repay on time, so focuses on liquidity ratios such as the current ratio and acid test ratio.
2. The bank manager also checks the return on capital employed against the interest rate charged, to see if the business can comfortably cover interest payments.
3. A shareholder, by contrast, is mainly concerned with the return their investment will earn, so focuses on profitability ratios such as the profit margin and return on capital employed.
4. A shareholder may tolerate a lower current ratio than a bank would, if profitability and growth prospects are strong.
5. Both users benefit from comparing ratios over several years and against similar businesses rather than relying on one year's figures.
6. Overall, the bank manager prioritises short-term safety while the shareholder prioritises long-term return, so the same ratio results can lead them to different decisions.

Key takeaways

• Profitability measures how well a business earns profit; liquidity measures whether it can pay its short-term debts on time.
• Gross profit margin compares gross profit with revenue; a higher margin is generally a good sign.
• Profit margin compares profit for the year, after all expenses, with revenue, reflecting overall operating efficiency.
• Return on capital employed compares profit before interest and tax with capital employed, and should exceed the cost of borrowing.
• The current ratio compares all current assets with current liabilities and is often considered safe around 2:1.
• The acid test ratio excludes inventory and is often considered safe around 1:1, since inventory is the least liquid current asset.
• Ratio analysis simplifies accounting figures but is only as reliable as the financial statements it is calculated from.
• Different users of accounts, such as lenders, investors and suppliers, focus on different ratios depending on their decision.

Test yourself

What is the formula for the current ratio?

Current ratio equals current assets divided by current liabilities, usually expressed as a ratio such as 2:1.

Why is inventory excluded from the acid test ratio?

Inventory is usually the least liquid current asset, taking longer to convert into cash than cash itself or trade receivables.

What does a rising gross profit margin but falling profit margin usually suggest?

It usually suggests that overhead or operating expenses, rather than pricing or the cost of goods sold, are rising and need attention.

Which users of accounts are most interested in liquidity ratios?

Lenders such as banks and trade suppliers offering credit are most interested, since they need to know short-term debts can be paid on time.

What does return on capital employed compare the business's return against?

It is often compared against the rate of interest the business would pay to borrow, or the return available from an alternative investment.

Give one limitation of ratio analysis.

Ratios are only as reliable as the financial statements they are calculated from, so errors or judgements in the accounts carry through into the ratios.

Why might a very high current ratio not be a good sign?

It can mean money is lying idle in unsold inventory or uncollected debts rather than being used productively in the business.