IGCSE Business Studies Ch 26: Analysis of Accounts

Cambridge IGCSE Business Studies

Chapter 26: Analysis of Accounts

This chapter explains how students use financial statements and ratio analysis to judge business performance, profitability, liquidity and financial strength. The key skill is not only calculating ratios, but interpreting what they mean and comparing them with previous years or similar businesses.

Account analysisRatio analysisProfitabilityLiquidityUsers of accountsLimitations

Infographic showing how financial statements are converted into useful judgements through ratio analysis and comparison

Topic 1: Why accounts are analysed

Account figures become useful when they help users explain business performance and make comparisons.

1. Analysis of accounts

Analysis of accounts means using information from a business's financial statements to make useful observations about its financial performance, profitability, liquidity and financial strength.

Simply knowing that one business made a higher profit than another is not enough. The larger business may also have much more capital invested, so students need to compare figures in a meaningful way.

Why ratio analysis is useful

Ratio analysis compares two figures from the accounts to provide more useful information about business performance.

It helps compare the same business over different years.
It helps compare one business with similar businesses.
It helps users judge whether performance has improved or worsened.

Important exam point: A single ratio by itself tells us very little. It should normally be compared with previous years, competitors or similar businesses.

2. Profit vs profitability

Profit

The amount remaining after costs have been deducted from revenue.

Profitability

Measures the profit made in relation to sales or capital invested. It is usually expressed as a percentage.

Example: Business A makes a profit of $300,000 and Business B makes $30,000. This does not automatically mean A is more profitable. If A needed $900,000 of capital and B needed only $60,000, Business B may use its capital more efficiently.

The five main ratios

Visual summary of the three profitability ratios and two liquidity ratios

Type	Ratios students need	Main purpose
Profitability ratios	Gross profit margin, net profit margin, ROCE	Measure profit in relation to sales or capital invested.
Liquidity ratios	Current ratio, acid test ratio	Measure the ability to pay short-term debts.

Topic 2: Profitability ratios

These ratios show how effectively the business earns profit from sales and from capital employed.

3. Return on Capital Employed — ROCE

ROCE measures how effectively the business uses the capital invested in it to generate profit.

ROCE = Net Profit ÷ Capital Employed × 100Capital employed = Shareholders' Equity + Non-current Liabilities

Example: Net profit = $280 million. Capital employed = $1,065 million. ROCE = 26.3%. This means the business earned a return of 26.3% on the capital employed.

Interpreting ROCE

A higher ROCE generally means the business is making more effective use of its capital.
If ROCE falls, possible reasons include lower net profit or higher capital employed.
An increase in capital employed is not automatically bad because the business may have invested now to earn higher profits in the future.

4. Gross profit margin

The gross profit margin measures gross profit as a percentage of revenue.

Gross Profit Margin = Gross Profit ÷ Revenue × 100

Example: Gross profit = $400 million. Revenue = $1,300 million. Gross profit margin = 30.8%. This means the business makes about 30.8 cents gross profit from every $1 of revenue before other expenses are deducted.

What can increase the gross profit margin?

Selling prices rise

Prices may have increased by more than the cost of sales.

Cost of sales falls

The business may have found a cheaper supplier or negotiated lower purchasing costs.

5. Net profit margin

The net profit margin, also called the profit margin, measures net profit as a percentage of revenue.

Net Profit Margin = Net Profit ÷ Revenue × 100

Example: Net profit = $280 million. Revenue = $1,300 million. Net profit margin = 21.5%. This means approximately 21.5 cents of net profit is earned from every $1 of sales.

Interpreting gross and net profit margins together

Ratio	2017	2018	Possible interpretation
Gross profit margin	20%	24%	Improved: the business earns more gross profit from sales.
Net profit margin	14%	12%	Fallen: overhead expenses may have increased significantly.

Exam skill: Do not just write “net profit margin decreased.” Explain what it means: the business is earning less net profit from each $1 of revenue, possibly because overhead expenses increased.

Topic 3: Liquidity ratios

Liquidity is about whether the business can pay short-term debts when they are due.

6. Liquidity

Liquidity is the ability of a business to pay its short-term debts.

A business may be profitable but still experience serious liquidity problems. If it cannot pay suppliers, overdrafts and other short-term debts, creditors may eventually force it to stop trading.

Important: Profitability and liquidity are different. A profitable business can still have cash-flow or short-term debt problems.

7. Current ratio

The current ratio compares current assets with current liabilities. The textbook interprets this as a ratio, such as 1.25, rather than a percentage.

Current Ratio = Current Assets ÷ Current Liabilities

Example: Current assets = $125 million. Current liabilities = $100 million. Current ratio = 1.25.

Interpreting the current ratio

Around 1.5–2.0 is considered a relatively safe current ratio.
Below 1 may indicate serious liquidity problems.
A very high ratio, such as above 2, may mean too much money is tied up in current assets.

A very high current ratio is not automatically good. The business may have excessive inventory or too much unused cash.

8. Acid test ratio

The current ratio includes inventory, but inventory may not always be easy to sell quickly. The acid test ratio removes inventory from current assets.

Acid Test Ratio = (Current Assets − Inventory) ÷ Current Liabilities

Example: Current assets = $125 million. Inventories = $50 million. Current liabilities = $100 million. Acid test ratio = 0.75.

A result of around 1 is generally considered acceptable because the business could then just cover its short-term debts using its more liquid current assets.

Current ratio	Acid test ratio
Includes inventory.	Excludes inventory.
Current assets ÷ current liabilities.	(Current assets − inventory) ÷ current liabilities.
Gives the general liquidity position.	Gives a stricter measure of liquidity.

Application: If current ratio = 1.75 but acid test = 0.5, the business may be holding a large amount of inventory. It may struggle to pay debts without first selling inventory.

Topic 4: The five ratios at a glance

Students must be able to calculate and interpret all five ratios accurately.

9. Summary table of ratios

Ratio	Formula	What it measures
Gross Profit Margin	Gross Profit ÷ Revenue × 100	Gross profit earned from sales.
Net Profit Margin	Net Profit ÷ Revenue × 100	Net profit earned from sales.
ROCE	Net Profit ÷ Capital Employed × 100	Return from capital invested.
Current Ratio	Current Assets ÷ Current Liabilities	Ability to cover short-term debts.
Acid Test Ratio	(Current Assets − Inventory) ÷ Current Liabilities	Ability to cover short-term debts without relying on inventory.

GPMNPMROCECurrent ratioAcid test

Topic 5: Users of accounts

Different stakeholders use the same accounts for different decisions.

10. Stakeholders who use accounts

Stakeholder infographic showing managers, investors, creditors, banks, government and workers using accounts

User	How they use accounts
Managers	Monitor performance, identify successful and unsuccessful products or divisions, make expansion decisions, consider changing prices and decide whether to close poorly performing activities.
Shareholders and potential investors	Assess profitability, whether profitability is improving, whether the business's value is increasing and whether serious liquidity problems exist.
Creditors / suppliers	Check whether the business is likely to pay on time. Poor liquidity may cause suppliers to refuse further trade credit.
Banks	Analyse accounts before deciding whether to lend more money.
Government	Check the amount of tax due and monitor businesses whose difficulties could result in job losses.
Workers and trade unions	Judge whether jobs are secure and whether the business can afford higher wages.

Topic 6: Comparisons, limitations and judgement

Good answers compare, explain and avoid relying on one number alone.

11. Why comparisons are essential

Four-step exam process for ratio analysis: calculate, interpret, compare and judge

One ratio by itself has limited usefulness. For example, if a business has improved its ROCE from 5.8% to 12%, this seems positive. However, if a competitor's ROCE is 20%, the business has improved but is still less profitable than its competitor.

Exam application: Always compare with previous years, competitors or similar businesses before making a final judgement.

12. Limitations of accounts and ratio analysis

Ratio analysis is useful, but it does not provide all the answers.

Limited information

Managers have detailed internal information, but outsiders mainly depend on published accounts.

Based on the past

Past performance does not guarantee future performance.

Inflation

Rising prices may make comparisons between different years misleading.

Accounting methods

Different methods of valuing assets can make company comparisons less reliable.

13. Key definitions

Term	Meaning
Analysis of accounts	Using accounting information to assess business performance and financial strength.
Ratio analysis	Comparing figures from financial statements using ratios.
Profitability	Profit measured relative to sales or capital invested.
Liquidity	Ability of a business to pay its short-term debts.
Capital employed	Shareholders' equity plus non-current liabilities.
Illiquid	Having assets that cannot easily be converted into cash.

14. What students must know for the examination

Distinguish between profit and profitability.
Explain the importance of liquidity.
Calculate and interpret gross profit margin, net profit margin, ROCE, current ratio and acid test ratio.
Compare ratios between different years and different businesses.
Explain possible reasons why ratios have improved or worsened.
Understand why one ratio by itself has limited usefulness.
Explain why managers, shareholders, creditors, banks, government and workers use accounts.
Explain important limitations of ratio analysis.
Use calculations to support a justified judgement about a business's financial performance.