Analysis and evaluation of financial information

Welcome to the World of Financial Analysis!

Ever looked at a business's final accounts and thought, "Okay, they made $50,000 profit... but is that actually good?". You're not alone! A giant company making $50,000 is doing poorly, but a small local shop making $50,000 is doing amazing.
In this chapter, we learn how to use ratios to look behind the numbers. Ratios are like a business's "health check-up"—they help us compare performance over time and against other businesses, no matter their size. Don't worry if you find the formulas a bit scary at first; once you see the logic behind them, they become much easier to remember!

1. Profitability Ratios: How Good Are We at Making Money?

Profitability ratios measure how efficiently a business is turning its sales into profit. It's not just about the total amount of money, but the percentage of profit made from every dollar earned.

Gross Profit Margin % and Markup %

These two are often confused, but they look at the same thing from different angles.

• Gross Profit Margin: Compares profit to Sales (Revenue). Think: For every $1 customers pay me, how much is left after paying the supplier?
• Markup: Compares profit to the Cost of Sales. Think: How much did I "mark up" the price from what I originally paid?

The Formulas:
\( \text{Gross Profit Margin \%} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \)
\( \text{Markup \%} = \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100 \)

Profit in Relation to Revenue % (Net Profit Margin)

This looks at the Profit for the Year (the bottom line) compared to Revenue. It tells us how well the business controls its expenses (like rent and electricity).

The Formula:
\( \text{Profit in relation to revenue \%} = \frac{\text{Profit for the Year}}{\text{Revenue}} \times 100 \)

Return on Capital Employed (ROCE) %

This is often called the "primary ratio." It shows how much profit is generated from the total money invested in the business.
Analogy: If you put $100 in a savings account and get $5 interest, your "return" is 5%. ROCE tells owners if their business is a better "investment" than just keeping money in a bank.

The Formula:
\( \text{ROCE \%} = \frac{\text{Profit from Operations}}{\text{Capital Employed}} \times 100 \)
(Note: Capital Employed = Equity + Non-Current Liabilities)

Quick Review: Profitability

If the Net Profit Margin is falling while the Gross Profit Margin stays the same, it means the business is losing control of its overhead expenses (like wages or rent).

2. Liquidity Ratios: Can We Pay the Bills?

Liquidity isn't about profit; it's about Cash Flow. A business can be profitable but still go bankrupt if it can't pay its suppliers tomorrow.

Current Ratio

This compares all Current Assets to all Current Liabilities. It asks: "Do we have enough short-term assets to cover our short-term debts?" A result of 2:1 is often seen as "ideal," though it depends on the industry.

The Formula:
\( \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \)

Liquid Capital Ratio (Acid Test)

This is a "tougher" version of the current ratio. It removes inventory (stock) from the assets. Why? Because you can't always sell your inventory instantly to get cash.
Analogy: If you need to pay for lunch right now, cash in your pocket is a "liquid asset," but a bicycle you’re trying to sell is "inventory"—it's worth money, but you can't spend it today!

The Formula:
\( \text{Liquid Capital Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \)

Key Takeaway:

A ratio below 1:1 in the Acid Test suggests the business might struggle to pay immediate debts if they were all due at once.

3. Efficiency Ratios: How Well Are We Working?

Efficiency ratios (also called "activity ratios") show how well the business manages its daily resources.

Inventory Turnover

This measures how quickly a business sells its stock. A high turnover is usually good because it means goods aren't sitting on shelves getting old.

• In Times: \( \frac{\text{Cost of Sales}}{\text{Average Inventory}} \) (How many times we emptied the warehouse)
• In Days: \( \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365 \) (How many days stock sits around)

Trade Receivable and Payable Days

These tell us about the "credit relationship" with customers and suppliers.

• Receivable Days: How long it takes customers to pay us. (We want this to be low!)
  \( \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \)
• Payable Days: How long we take to pay our suppliers. (We usually want this to be higher than receivable days, but not so high that suppliers get angry!)
  \( \frac{\text{Trade Payables}}{\text{Credit Purchases}} \times 365 \)

Did you know? If your Receivable Days are 60 but your Payable Days are 30, you are paying your suppliers twice as fast as your customers are paying you. This will cause a massive cash flow problem!

4. Capital Structure: Gearing

Capital Gearing looks at how a business is financed. Does it use the owners' money (Equity) or borrowed money (Long-term loans/Debentures)?

• High Gearing: The business has a lot of debt compared to its equity. This is risky because interest must be paid even if profits are low.
• Low Gearing: The business is funded mostly by the owners. It is "safer" but might mean the business isn't growing as fast as it could by using loans.

The Formula:
\( \text{Capital Gearing \%} = \frac{\text{Non-Current Liabilities}}{\text{Capital Employed}} \times 100 \)

5. The Golden Rule: Profit is NOT Cash

One of the biggest traps in accounting is thinking that Profit = Cash in the bank. They are very different!

Why they differ:

• Credit Sales: You record the "Profit" as soon as you sell the item, but you don't get the "Cash" until the customer pays 30 days later.
• Buying Assets: If you buy a $10,000 delivery van, $10,000 "Cash" leaves your bank immediately, but your "Profit" is only reduced by the depreciation (e.g., $2,000) for that year.
• Inventory: Buying stock uses cash, but doesn't affect profit until the stock is actually sold.

Quick Summary: A business can be profitable (selling for more than it costs) but illiquid (having no cash to pay the electricity bill because customers haven't paid yet).

6. Limitations of Ratio Analysis

Ratios are useful, but they aren't perfect. Don't rely on them 100% without considering other factors!

Financial Limitations:

• Historical Data: Ratios use past figures. They tell you where the business was, not necessarily where it is going.
• Window Dressing: Businesses can manipulate figures at the end of the year to make ratios look better (e.g., delaying a purchase to keep cash high).
• Inflation: Prices change over time, making it hard to compare this year's ratios with ratios from 10 years ago.

Non-Financial (Qualitative) Factors:

Ratios can't measure things like:

• Staff Morale: If workers are unhappy, future profits might drop.
• Reputation: A business might have great ratios but a terrible environmental record that will hurt it later.
• Competition: A new competitor opening next door won't show up in last year's ratios!

Common Mistakes to Avoid

1. Mixing up the denominator: For Gross Profit Margin, divide by Revenue. For Markup, divide by Cost of Sales.
2. Forgetting the "x 100": Most profitability ratios are percentages. Don't forget to multiply by 100 to get the final answer!
3. Over-generalizing: A current ratio of 1.5:1 might be "bad" for a jewelry shop but "excellent" for a supermarket like Walmart (which gets cash instantly from customers).

Final Encouragement: Ratio analysis is all about telling a story. When you look at a ratio, always ask yourself "Why?". Why did the inventory turnover slow down? Why did the bank loan increase? If you start asking "Why," you're already thinking like a great accountant!