Analysis of Accounts

Summary

The analysis of accounts involves understanding how financial data is used to assess a business's performance and financial health. It includes concepts like capital employed, ratio analysis, profitability ratios, and liquidity ratios, which are crucial for stakeholders to make informed decisions.

• Capital Employed — the total of owners’ equity and non-current liabilities used to obtain business assets.
  Example: If a business has $500,000 in equity and$200,000 in non-current liabilities, its capital employed is $700,000.
• Ratio Analysis — comparing financial figures to analyze business performance.
  Example: Using ratios like ROCE to compare profitability over time.
• Return on Capital Employed (ROCE) — measures profit made for each amount invested in the business.
  Example: A ROCE of 15% means $0.15 profit for every dollar invested.
• Gross Profit Margin (GPM) — indicates gross profit on each sale.
  Example: A GPM of 30% means $0.30 gross profit per dollar of sales.
• Net Profit Margin (NPM) — shows net profit on each sale after expenses.
  Example: A NPM of 10% means $0.10 net profit per dollar of sales.
• Current Ratio — assesses ability to pay short-term obligations with current assets.
  Example: A current ratio of 2 means $2 in assets for every$1 of liabilities.
• Acid-Test Ratio — similar to current ratio but excludes inventory.
  Example: An acid-test ratio of 1.5 indicates $1.50 in liquid assets for every$1 of liabilities.

Exam Tips

Key Definitions to Remember

• Capital Employed: Total of owners’ equity and non-current liabilities.
• Ratio Analysis: Comparing financial figures to assess performance.
• Return on Capital Employed (ROCE): Profit per amount invested.
• Gross Profit Margin (GPM): Gross profit per sales dollar.
• Net Profit Margin (NPM): Net profit per sales dollar.
• Current Ratio: Ability to cover short-term liabilities with assets.
• Acid-Test Ratio: Ability to cover liabilities excluding inventory.

Common Confusions

• Profit vs. Profitability: Profit is the total earnings, while profitability measures efficiency in generating profit.
• Current Ratio vs. Acid-Test Ratio: Both assess liquidity, but the acid-test excludes inventory.

Typical Exam Questions

• What is the importance of ROCE in business analysis? It helps assess how efficiently a company uses its capital to generate profits.
• How do liquidity ratios affect decision-making for creditors? They indicate the business's ability to meet short-term obligations, affecting credit decisions.
• Why might a high current ratio not always be positive? It could indicate inefficient use of assets or excessive inventory.

What Examiners Usually Test

• Understanding and calculating different profitability and liquidity ratios.
• Interpreting the implications of ratio results for business performance.
• Identifying limitations and uses of financial accounts for stakeholders.