Analysis of Accounts

Chapter Summary

• Ratio analysis pulls information out of financial accounts to judge how well a business is performing — profitability, growth, efficiency, and risk.
• Profit margins (gross profit margin & operating profit margin) show what percentage of revenue turns into profit.
• Mark-up shows profit made per item, based on cost — used to help set prices.
• Return on Capital Employed (RoCE) shows how efficiently a business uses the money invested in it to generate profit.
• Liquidity is a business's ability to pay short-term debts — measured with the current ratio and the acid test ratio.
• Ratios are only useful when compared — against previous years, competitors, or industry norms.
• Financial documents (statement of comprehensive income, statement of financial position, cash flow forecasts) are used by different stakeholders — managers, employees, owners, suppliers, lenders — to make decisions.

1. What Is Ratio Analysis, and Why Bother?

Imagine two ice cream shops both make $100,000 in sales this year. Shop A sounds impressive... until you learn Shop B only spent $40,000 to make that same $100,000, while Shop A spent $90,000. Suddenly Shop B looks like the much smarter business — even though the revenue figure alone told you nothing about that.

That's exactly the problem ratio analysis solves. It takes raw numbers buried in financial accounts (revenue, costs, profit, assets, liabilities) and turns them into percentages or ratios that can be fairly compared — between years, between competitors, or against what "good" looks like in an industry.

Ratio analysis helps answer questions like:

• Why is one business more profitable than a rival in the same industry?
• Is the business actually growing?
• How effectively is it using its assets and the capital invested in it?
• What return on investment should an investor expect?
• How risky is the business's financial structure — could it run into trouble paying debts?

2. Profit Margins

Profit margins measure how effectively a business turns its revenue into profit. Two businesses can have identical revenue but wildly different margins, depending on how well they control costs. Higher and rising margins are always the goal — it means more of every dollar of sales is actually being kept as profit rather than eaten up by costs.

AGross Profit Margin

This shows the proportion of revenue that survives after subtracting only the direct costs of making the product (the cost of goods sold) — things like raw materials and direct labour. It does not yet account for overheads like rent, marketing, or admin salaries.

B