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Unit 6 - Analysis interpretations 

 

Profitability ratios - measure the performance of the business by comparing the profit to other figures in the same set of financial statements.

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Profitability ratios

  • Return on capital employed

    • To find the ratio/percentage in how much value has been spent in the business to get profit.

    • (Profit of the year b4 interest x 100) / Capital employed 

  • Gross margin

    • To calculate the ratio of gross profit.

    • Improvement: Increasing selling prices, obtaining cheaper supplies

    • Effects: Increasing the rate of trade discount, selling goods at cheaper prices.

    • (Gross profit x 100) / Sales

  • Profit margin

    • To calculate the ratio of profit.

    • Improvement: Controlling expenses, increasing other income.

    • Effects: Spent a lot in expenses, less money received.

    • (Net profit x 100) / Sales

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Liquidity ratios - measure the ability of the business to turn assets into cash.

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Liquidity ratios

  • Current ratio

    • The ability of a business to meet its current liabilities when they fall due.

    • Improvement: invest more money into business, obtain long-term loans/non-current liabilities

    • Effects: Cannot meet payment on time, experience difficulties in obtaining further supplies 

    • Current ratio : current liabilities

  • Liquid (acid test) ratio

    • Compares the assets which are in the form of money, or which will convert into money quickly, with the liabilities which are due for repayment.

    • (Current assets - inventory) : Current liabilities

  • Rate of inventory turnover

    • Calculates the number of times a business sells and replaces its inventory in a year.

    • Improvement: Increase sales by offering discounts, change marketing strategies.

    • Effects: Lower sales, inventory over-purchased

    • Cost of sales / Average inventory

  • Trade receivable turnover

    • Average time the credit customers take to pay their accounts.

    • Improvement: Improving credit control policy (sending regular statements of account, ‘chasing’ overdue accounts and so on), offering cash discount.

    • Effects: no credit control policy, no cash discount.

    • [Trade receivable x 365 (days)] / Sales 

  • Trade payable turnover

    • Average time taken to pay the accounts of credit suppliers.

    • Improvements: business in good financial position, pays on time.

    • Effects: suppliers refusing credit, supplier refusing further supplies, business in bad financial position 

    • [Trade payable x 365 (days)] / Purchases

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6.4 Interested parties

 

Users of accounting statements

  • Owners - check performance of business

  • Manager - to gather information about the company’s financials to report to owner and plan for decision making.

  • Employees - wants to know that the company is able to continue operating, maintain jobs and pay wages.

  • Lenders / trade payables - interested in the security available, the repayment of the loan when due and the payment of interest when due.

  • Government - want to know how much tax they can charge to the company 

  • Investors

  • Club members 

  • Banks

 

6.5 Limitations of accounting statements

 

Limitations of accounting statements

  • Historic cost - the value placed on an asset in the statement of financial position based on the original cost at which the asset was acquired.

  • Difficulties of definition - accounting policies, principles & concepts used worldwide can differ from country to country. (Tax, currency) 

  • Time factor - A user of financial statements can gain an incorrect view of the financial results or cash flows of a business by only looking at one reporting period.

  • Non-monetary items - skill of a workforce can’t be recorded.

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