<5.5 ANALYSIS OF ACCOUNTS>

--"RISK vs RETURN?"--

• Which company should you invest in? Are you focused on profitability or are you focused on safety? Often it is hard to find both! Thankfully, rather than scroll through multiple income statements and balance sheets we can quickly convert a firm's profitability and liquidity data into easily comparable ratios.

 "For each $ invested what % of net profit is generated?" 

• Firm's issue shares and borrow money for a reason right?!!! So they can use it ('EMPLOY it') to grow and create a RETURN/PROFIT. we can use the ROCE (Return on Capital Employed) to show... 

• "How well the Firm/Mgt. is using its share capital and non-current liabilities (Loans) to generate profits"

• The formula is for calculated the ROCE is...

• ROCE = NET PROFIT / CAPITAL EMPLOYED 

• "What does a HIGH ROCE necessarily mean?"

• There are TWO reasons why the ROCE would INCREASE, namely, a combination of HIGHER NET PROFITS (Greater profitability) or LOWER CAPITAL EMPLOYED (Greater efficiency in using capital). 

  • • • • • HIGHER NET PROFITS implies; increased sales revenue, improved cost control, or better operational efficiency.

          • LOWER CAPITAL EMPLOYED implies; – Reducing unnecessary assets, improving inventory turnover, or repaying debt decreases capital employed, enhancing ROCE.

 "For each $ revenue what % was gross profit?" 

GROSS PROFIT (SALES REVENUE - COGS), as we know, only deducts COGS and not EXPENSES/OVERHEADS/FIXED COSTS.

The formula for calculated the GROSS PROFIT MARGIN is...

GPM = GROSS PROFIT / SALES REVENUE

"Why is it useful?"

Clearly a firm that has a higher GPM, has MORE AVAILABLE FUNDS FOR EXPANSION,

 "For each $ revenue what % was net profit?" 

• Of course NET PROFIT (= GROSS PROFIT – EXPENSES) is a better measure of profitability as we have also deducted expenses, so this figure gives us a more realistic value. 

• Remember the more NET PROFIT AFTER TAX remaining the greater the RETAINED EARNINGS that can be used to grow the firm.

• NPM = NET PROFIT / SALES REVENUE

• Copy the statement below then make TWO MORE comparative statements about this data:

• "We can see that the gross profit margin of Firm A has increased between 2022 and 2023 from 28% to 30%, this could imply that the COGS have fallen due to finding a cheaper supplier or that total revenue has increased due to higher prices or indeed lower prices and greater sales , whereas in the case of firm B the opposite may have occured as their GPM ahs fallen"

 "Can we get quick cash to cover our immediate debts?" 

• The CURRENT RATIO measures the ratio (of CURRENT ASSETS (the $-value of the assets it can quickly turn into cash (Including; cash itself, debtors and stock that it holds) to CURRENT LIABILITIES (the $-value of liabilites/debts that must be repaid very soon.) 

• In other words current assets are HOW MUCH TIMES MORE THE SIZE of current liabilities? 

 CURRENT RATIO  = CURRENT ASSETS / CURRENT LIABILITIES

• "What is the ideal ratio?"

• ⚠️LESS THAN ONE TIMES?, Nah! If its current assets are lower than its current liabilities (negative working capital), then the business may have problems paying back trade creditors and suppliers. In the worst-case scenario, negative working capital can lead a firm to go bankrupt. 

• ⚠️GREATER THAN TWO TIMES? Nah! If a firm has a current ratio greater than 2 it would imply a combination of the following: 

  • • • • • • i) There is too much cash in the business, which could be better spent to generate more trade. 

            • ii) There are too many debtors, which increases the likelihood of bad debts or customers defaulting on the money they owe.

            • iii) There is too much stock, which increases storage and insurance costs.

• ☑️BETWEEN 1.5 TO 2.0 TIMES? Yes! This seems about right as it means they have enough to cover their immediate liabilities and that they are using a good amount of their assets to invest and grow.

• Q. The above ratio assumes all CURRENT ASSETS can be turned into cash in a relatively short period of time. Do you think that's realistic? Explain.

"Did you get it?, that's right Stock isn't easy to turn to cash"

 "So, if we can't sell our stock, can we get enough quick cash to cover our immediate debts?" 

• This is why we use the ACID RATIO which, is very similar to the current ratio except it measures the ratio of CURRENT ASSETS not including STOCK to CURRENT LIABILITIES 

 ACID TEST RATIO  = CURRENT ASSETS - STOCKS / CURRENT LIABILITIES

• Copy the statement below then make TWO MORE comparative statements about this data:

• "We can see that the current ratio of firm A has fallen between 2022 and 2023 from 1.8 to 1.5, this is 'not a bad thing' as the firm's current assets still cover their current liabilities. This is possibly due to a fall in current assets if the company holds less cash, or stocks which could mean they are using them to buy fixed assests and grow the business. OR it could imply they are taking on more current liabilities by having more payments receivables.

I think Elton should be pleased in most part by the financial performance of his business because firstly...

Revenue has increased from $24,000 to $25,000

Gross profit margin has improved from 70% to 72%, however profit margin has decreased 

• "Do we need to reduce COGS to increase Gross profit?", 

• "Do we need to reduce expenses as our net profit margin is too low?", 

• "Do we have better margins than our competitors?"

• "Are we still an attractive investment proposition?" 

• "Should I buy a share in this company?"

• "Is it profitble enough to earn us dividends?"

• "Is it safer to put the money in the bank?"

• "Does it look like it will have liquidity issues?"

• "Should I supply or give trade credit to this firm?"

• "Do they always pay their debts on time?"

• "Should we lend money to this firm?"

• "Does it have enough current assets to pay its current liabilities so they don;t go bankrupt?"

• "Does he earn enough net profit to pay back any loans we give?"

"Is the firm able to pay its taxes as well as stay healthy so workers don't lose their jobs?"

• "Is the firm stable, so our jobs are safe?"

• "Is the firm doing well enough for us to bargain for a raise in salary?"

• "Are our competitors performing better or worse than us, should we be worried?"

•  "Are they vulnerable for a takeover?"

• RATIOS are BASED ON PAST ACCOUNTING DATA and WILL NOT INDICATE HOW THE BUSINESS WILL PERFORM IN THE FUTURE.

• Managers will have all accounts, but the external users will only have those published accounts that contain only the data required by law- they may not get the ‘full-picture’ about the business’ performance.

• Comparing accounting data over the years can lead to misleading assumptions since the data will be affected by inflation (rising prices)

• Different companies may use different accounting methods and so will have different ratio results, making comparisons between companies unreliable.