Key terms in financial analysis

Financial analysis involves examining a business's accounts to assess its performance and financial health.

Key financial terms:

• Capital employed - The total long-term and permanent capital invested in a business, calculated as shareholders' equity plus non-current liabilities.
• Liquidity - The ability of a business to meet its short-term debts.
• Profitability - A measure of the profit generated in relation to either the sales revenue achieved or the capital invested in the business.
• Illiquid - Describes assets that cannot be easily converted into cash.

Financial ratios are tools used in this analysis, divided into two main categories: profitability ratios and liquidity ratios.

Users of business accounts and their purposes

Business accounts provide essential information for various stakeholders. Analysis of these accounts allows stakeholders to draw conclusions about a business's overall performance or financial stability.

Stakeholders who use business accounts:

• Shareholders, creditors, and governments - To check company performance.
• Lenders - To make lending decisions.
• Managers - For decision-making and operational control.
• Competitors - For performance comparison.

Through ratio analysis, these users can identify trends, such as a business having higher absolute profit than a rival but lower profitability ratios.

Profitability ratios

Profitability ratios measure how effectively a business generates profit from its sales or invested capital.

Gross profit margin

$\text{Gross profit margin}=\frac{\text{gross profit}}{\text{revenue}}\times 100$

An increasing gross profit margin suggests the business is achieving higher selling prices or lower costs of goods sold. It is useful for year-on-year comparisons within the business or against industry rivals. However, gross profit margin can decrease while net profit margin increases if overhead costs are substantially reduced.

Net profit margin

$\text{Net profit margin}=\frac{\text{net profit}}{\text{revenue}}\times 100$

A rising net profit margin indicates improved gross profit or reduced expenses. This ratio is valuable for tracking changes over time or benchmarking against competitors.

Return on capital employed

$\text{Return on capital employed}=\frac{\text{net profit}}{\text{capital employed}}\times 100$

This ratio evaluates the efficiency of the business in generating profit from its invested capital. It is used to monitor efficiency trends and for competitive analysis.

Worked example - Calculating profitability ratios

A business has revenue of £300,000, gross profit of £120,000, net profit of £45,000, and capital employed of £250,000. Calculate the gross profit margin, net profit margin, and return on capital employed.

Step 1: Identify the values

• Revenue = £300,000
• Gross profit = £120,000
• Net profit = £45,000
• Capital employed = £250,000

Step 2: Calculate gross profit margin

$\text{Gross profit margin}=\frac{\pounds \mathrm{120,000}}{\pounds \mathrm{300,000}}\times 100=40\%$

Step 3: Calculate net profit margin

$\text{Net profit margin}=\frac{\pounds \mathrm{45,000}}{\pounds \mathrm{300,000}}\times 100=15\%$

Step 4: Calculate return on capital employed

$\text{Return on capital employed}=\frac{\pounds \mathrm{45,000}}{\pounds \mathrm{250,000}}\times 100=18\%$

Liquidity ratios

Liquidity ratios assess whether a business has enough short-term assets to cover its immediate liabilities.

Current ratio

$\text{Current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$

A ratio above 1 indicates sufficient assets to cover short-term debts, while below 1 suggests illiquidity and potential struggles to pay debts. A value above 2 may mean excess working capital.

Acid test ratio

$\text{Acid test ratio}=\frac{\text{current assets}-\text{inventories}}{\text{current liabilities}}$

This is a stricter measure than the current ratio, excluding inventories. It can be slightly below 1 and still allow liabilities to be met, but a value below 1 signals potential liquidity problems, even if the current ratio is adequate.

Worked example - Calculating liquidity ratios

A business has current assets of £180,000, inventories of £60,000, and current liabilities of £90,000. Calculate the current ratio and acid test ratio.

Step 1: Identify the values

• Current assets = £180,000
• Inventories = £60,000
• Current liabilities = £90,000

Step 2: Calculate current ratio

$\text{Current ratio}=\frac{\pounds \mathrm{180,000}}{\pounds \mathrm{90,000}}=2.00$

Step 3: Calculate acid test ratio

$\text{Acid test ratio}=\frac{\pounds \mathrm{180,000}-\pounds \mathrm{60,000}}{\pounds \mathrm{90,000}}=\frac{\pounds \mathrm{120,000}}{\pounds \mathrm{90,000}}=1.33$

Limitations of ratio analysis

While ratio analysis provides valuable insights, it has several drawbacks that can affect its reliability.

Key limitations of using ratios:

• Incomplete information - External users may lack full details.
• Historical data - Ratios are based on past information.
• Impact of inflation - Rising prices can distort comparisons over time.
• Variations in accounting methods - Different companies may use diverse approaches.