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CIE IGCSE Business Your notes

5.5 Analysing the Accounts

Contents
Profitability & Liquidity
Using Profitability Ratios to Analyse Performance
Using Liquidity Ratios to Analyse Performance
How Stakeholders use the Accounts

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Profitability & Liquidity

Your notes
The Importance of Profitability
Profit is what a firm earns once the total costs have been deducted from the total sales
revenue
Profitability is a measure of how successful a business is
Profitability can be defined in two ways
A measure of how effectively a business converts sales revenue into profit - effectively,
what percentage of sales revenue is profit
A measure of how well capital resources invested in the business generates profit

Profitability is expressed in percentage form, which allows comparison of business

performance over time and also comparisons with other businesses

Several stakeholders are interested in profitability

Investors look carefully at profitability when deciding which business to invest in
The higher the level of profitability, the higher their rewards are likely to be
Directors and managers consider profitability when assessing business success and
determining future objectives and strategy
Employees may consider profitability as justification for requesting higher wages or better
working conditions

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The Importance of Liquidity

Liquidity is defined as the ability of a business to pay back its short-term debts, e.g. its Your notes
suppliers

A businesses that cannot pay its debts is considered illiquid

If a business cannot pay its suppliers, raw materials or components may not be delivered and
production will be delayed
If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will
suffer
Creditors may force it to stop trading and sell its assets so that the debts owed to them are
repaid

Stakeholders interested in liquidity include

Suppliers want to be reassured that a business is likely to be able to pay for them
Financial providers such as banks want evidence that a business is likely to be able to repay
loans or overdrafts
Customers want to be sure that a supplier will be able to produce and deliver goods it orders

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Using Profitability Ratios to Analyse Performance

Your notes
The Gross Profit Margin
This calculation shows the proportion of revenue that is turned into gross profit
It is calculated using the following formula and is expressed as a percentage
Gross Profit
Gross Profit Margin = × 100
Sales Revenue
Improving the gross profit margin
The gross profit margin can be improved in two ways
The business can increase its sales revenue
The business can reduce its direct costs

How to Increase the Gross Profit Margin

Method Explanation

Increase the sales 1. Increase the value of sales

revenue
Raise prices
If costs remain the same, this will improve profitability as the
difference between the selling price and costs is now greater
Sell premium products
If customers are willing to spend money on these goods, the
business could earn more profit per item sold

2. Increase the volume of sales

Price tactics
Use price tactics to encourage higher quantity or more frequent
purchases
E.g. 'Buy one get one half price' doubles the number of items
a customer purchases, increasing revenue
Increase marketing activities
Engage in more marketing activities to increase sales volume

Reduce the direct Reduce variable costs

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costs This may involve purchasing cheaper/alternative resources,

negotiating with suppliers or purchasing in bulk
Businesses must ensure that reducing variable costs will not have an Your notes
adverse effect on the quality or desirability of products
Buying stock in greater quantities may require investment in
increased storage space which will reduce the impact of the cost
savings made

Businesses may also be able to reduce wastage of raw materials and

components

Worked example
Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its gross profit was $105,731
Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022 [2 marks]

Step 1: Substitute the values into the formula

Gross profit
Gross profit = × 100
Sales revenue

$ 105, 731 [1 mark]

=
$ 124, 653

= 0. 8482

Step 2: Multiply the outcome by 100 to find the percentage

= 0. 8482 × 100
[1 mark]
= 84. 82 %

84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during
2022

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The Net Profit Margin

The Net Profit Margin shows the proportion of revenue that is turned into profit before interest Your notes
and tax
It is calculated using the formula below and the outcome is expressed as a percentage

Profit Before Interest and Tax

Net Profit Margin = × 100
Sales Revenue
Improving the net profit margin
The profit margin can be improved in two ways
Increasing the gross profit margin (see above)
Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or
changing utility companies
Reducing staffing levels may affect staff morale and negatively affect productivity
Relocation costs can outweigh some of the benefits of moving to a cheaper location
Replacing inefficient or outdated equipment may require staff training

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Worked example
Your notes
Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its profit before interest and tax
was $65,864
Calculate Head to Toe Wellbeing Ltd’s Profit Margin in 2022
[2 marks]

Step 1: Substitute the values into the formula

Profit Before Interest and Tax

Net Profit Margin = × 100
Sales Revenue

$ 65, 864 [1 mark]

=
$ 124, 653

= 0. 5284

Step 2: Multiply the outcome by 100 to find the percentage

= 0. 5284 × 100
[1 mark]
= 52. 84 %

In 2022, 52.84% of Head to Toe Wellbeing’s revenue was converted into profit before
interest and tax

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Return on Capital Employed

The Return on Capital Employed (RoCE) measures how how effectively a business uses the Your notes
capital invested in the business to generate profit
It is calculated using the formula below and is expressed as a percentage

Profit Before Interest and Tax

Return on Capital Employed = × 100
Capital Employed

RoCE be compared over time and with competitors

It can also be compared with other potential capital investments, such as savings rates

The Capital Employed figure is usually provided for you

If required, it is calculated using the formula

Capital Employed = Non− current Liabilities + Equity

Improving RoCE
When analysing the RoCE, the higher the rate the better, as it indicates that the business is
profitable and using its capital efficiently
Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk
growth is being achieved
A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial
position

To increase the RoCE, a business can

Increase the level of profit generated without introducing new capital into the business
Maintain the level of profit generated whilst reducing the amount of capital in the business

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Worked example
Your notes
The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities €1.5 million

Revenue €7 million
Equity €15.4 million
Profit before Interest & Tax €2.2 million

Calculate Keals Cosmetics' Return on Capital Employed.

[3 marks]

Step 1: Calculate the capital employed

Capital employed = Non− current liabilities + Equity

Capital employed = € 1.5 m + € 15.4 m [1 mark]

Capital employed = € 16.9 m

Step 2: Divide Operating Profit by Capital Employed

Profit Before Interest and Tax

RoCE = × 100
Capital Employed

€ 2.2 m
= × 100 [1 mark]
€ 16.9 m

= 0. 13

Step 3: Multiply the result by 100 and express the outcome as a percentage

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= 0. 13 × 100 [1 mark] Your notes

= 13 %
The capital employed in Keals Cosmetics has generated a return of 13%

Using RoCE to make decisions

RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to
determine the most profitable option given the level of capital employed

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Worked example
Your notes
Faced with increasing costs, Kent & Medway Properties Ltd is looking to close one of its three
high street estate agency branches.
The table below shows some key data for each of the branches.

Capital Profit Before

Branch
Employed Interest & Tax
Sevenoaks £2.4m £0.37m
Whitstable £3.1m £0.57m
Rochester £2.9m £0.51m

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch,
on profitability terms, should close
[5 marks]

Step 1: Apply the formula to calculate the RoCE for each branch

Profit Before Interest and Tax

RoCE = × 100
Capital Employed

£ 0. 37m
RoCE Sevenoaks = × 100 = 15. 42 % [1 mark ]
£ 2.4m

£ 0. 57m
RoCE Whitstable = × 100 = 18. 39 % [1 mark ]
£ 3.1m

£ 0. 51m
RoCE Rochester = × 100 = 17. 59 % [1 mark ]
£ 2.9m

Step 2: Identify the least profitable branch for closure

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Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch
selected for closure [2 marks]
Your notes

Exam Tip
When calculating financial ratios check that you are using the correct units.
In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases, you will
be working in thousands (£000) or millions (£m).
Ensure that you convert correctly, e.g. £0.39 million is equal to £390,000 and £34.9 (000) is
equal to £34,900
Make sure the decimal place is in the correct place
Calculate to two decimal places unless stated otherwise

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Using Liquidity Ratios to Analyse Performance

Your notes
The Current Ratio
Liquidity refers to the cash and other current assets businesses have available to quickly pay bills
and meet short-term financial obligations

The liquidity of a business can be measured using two ratios

Current ratio
Acid test ratio
The current ratio
The Current Ratio is a quick way to measure liquidity
The outcome is expressed as a ratio
All types of current asset are included in calculating this ratio
The result indicates how many £s (or other currency units) of current assets are available to
cover each £1 (or other currency unit) of short-term debt
It is calculated using the formula
Current Assets
Current ratio =
Current Liabilities

= ? :1

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Worked example
Your notes
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory
(stock) figure of $8,250.
Calculate Packer Sports Ltd.’s current ratio. [2]

Step 1: Substitute the values into the equation

$ 15, 545 ÷ $ 5, 060

[1 mark]
= 3. 07

Step 2: Express the outcome as a ratio

= 3. 07 : 1 [1 mark]

In this example, Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term
debt

The acid test ratio

The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses
that hold large amounts of stock
It is expressed as a ratio
It is also known as the liquid capital ratio
The least liquid form of current assets (stock) is deducted so the acid test ratio provides a
more realistic measure of the businesses ability to meet short-term debts quickly
It often takes time to sell stock so it is excluded

The Acid Test is calculated using the formula

Current Assets − Stock

Acid Test Ratio =
Current Liabilities

= ? : 1

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Worked example
Your notes
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and a stock figure of
$8,250.
Calculate Packer Sports Ltd’s acid test ratio. [3]

Step 1: Subtract stock from current assets

$ 15, 545 − $ 8, 250

[1 mark]
= $ 7, 295

Step 1: Substitute the values into the equation

Current Assets − Stock

Acid Test Ratio =
Current Liabilities

$ 7, 295 [1 mark]
=
$ 5, 060

= 1. 44

Step 2: Express the outcome as a ratio

= 1. 44 : 1 [1 mark]

In this example, Packer Sports Ltd has $1.44 of the most liquid current assets to cover each
$1 of short-term debt

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Improving Liquidity Ratios

The best way to improve liquidity is to manage the business better Your notes
Use cash flow forecasts to identify potential cash flow issues before they arise and take
appropriate action
Budget effectively and consider adopting z ero budgeting to carefully control spending
Set clear financial objectives and look for ways to reduce costs and increase income
wherever possible

Methods to Improve Liquidity

Method Explanation

Reduce the credit period Collecting money owed from customers more quickly will increase
offered to customers the level of current assets in the business
Customers may move to competing businesses that offer better
credit terms

Ask suppliers for an Current liabilities will not be reduced

extended repayment The business can use cash it would have paid to suppliers for other
period, e.g an extension purposes
from 60 to 90 days Suppliers may be unwilling to extend credit terms

Make use of Overdraft Current liabilities will increase

facilities or short-term The business can spend more money than it has in its bank
loans account
Banks may be reluctant to lend to businesses with cash-flow
problems

Sell off excess stock Less liquid current assets will be reduced and converted into
more liquid forms of current asset (e.g. cash)
Storage and security costs may also be reduced
Stock may need to be sold at a low price to attract sales

Sell assets and lease fixed Both current assets and current liabilities will increase
assets instead (e.g. sale

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and leaseback) The business will continue to have the use of assets but must make
regular payments to the leasing company
Your notes
Introduce new capital and
reduce drawings out of Current assets will be increased
the business New capital may be introduced by the owner or from additional
investors
This may result in the dilution of control of the business

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How Stakeholders use the Accounts

Your notes
Using Financial Accounts to make Decisions
The financial accounts of a limited liability business need to be submitted to Companies House
each year
Public Limited Companies need to have their accounts audited before they publish them

Different stakeholders use the business accounts for different purposes

Stakeholder Interactions with the Financial Accounts

Stakeholder How they use the Balance Sheet How they use the Income
Statement

Investors/Shareholders Used to identify the asset Interested in revenues, costs

structure of the business and and profits earned, business
how their investment has been growth and dividend payments
put to use
Shareholders may use ratio
Used to calculate the working analysis tools to identify profit
capital of the business and margins and returns on
determine its solvency investment

Used to determine the

rough value of a
business, which helps make a
judgement on whether their
investment is growing

Management Used to identify the financial Interested in key performance

position of the business at a data such as an improvement in
given point in time sales revenue and net profit
This data can aid in business
It is useful to assess decision-making
the working capital position of Financial data can provide
the business and determine if evidence to support the
there are enough liquid assets payment of bonuses

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to pay its bills

Provides information on Your notes

the capital structure of the
business which helps guide
decisions on whether to raise
further funds
through borrowing or via other
means (e.g. share issue)

Lenders/Creditors Look at the balance sheet to Consider profit generated, as

evaluate the company's this could indicate the stability
solvency of the business and level of risk
it presents
They are interested in the
company's ability to pay back
its debts

Suppliers Businesses with low levels of Interested in the continued

working capital may find it success of the company
difficult to pay short-term debts
and so suppliers may offer This information is also used by
trade credit, but with stricter suppliers to determine the level
terms of trade credit offered to
businesses

Employees Used to answer questions such Interested in profits earned,

as: the potential for wage
Is the business financially increases, and job stability
stable or are jobs at risk?
Has the businesses Employees may look at notes
performance improved or to the accounts that detail
worsened? levels of executive pay
What is the business
spending its money on?
How much are senior
executives paid?
How much tax is the
business paying?

Regulatory bodies/Tax Regulatory bodies use financial Tax authorities use financial
authorities statements to ensure a statements to check the

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business is complying with accuracy of tax returns and

accounting standards and assess how much tax a
regulations business is liable to pay Your notes

The Income Statement can

provide an insight into whether
the business will continue to
provide employment, place
orders with other businesses
and supply goods and services
to the public sector

Local community Interested in the stability of the Another interest is to see if the
business and what this may firm is generating enough profit
mean for jobs in the community to perhaps approach them for
local sponsorship

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