Chapter 23 - Analysis of Accounts
Learning Objective: To evaluate on profitability and liquidity ratios
You are a pro at profitability and liquidity ratios now - you know:
- Profitability Ratios:
Gross Profit Margin
Profit Margin
Return on Capital Employed
- Liquidity Ratios:
Current Ratio
Acid-Test Ratio
Liquidity is good: ability to pay short-term debts;
Too much liquidity is not good: the money could be invested in more profitable ways.
There should be a balance between profitability and liquidity:
'Spare' liquidity can be invested in profitable non-current assets;
Non-current assets, however, do not increase liquidity;
Current assets increase liquidity - but does not increase profitability.
Activity 23.6
Different stakeholders look at profitability and liquidity numbers for different reasons:
Owners and Shareholders: interested on the return on their investment - how profitable and liquid the business is directly impacts shareholders' returns;
Potential Investors: assessment of future returns;
Managers: assessment of the possibility of investments;
Employees: job security and wages;
Trade Unions: opportunities to request for better wages/conditions;
Suppliers: ability to pay trade payables (liquidity) and assessment of business growth opportunities;
Lenders: liquidity and profitability impact on the payment of debts;
Government: tax revenues, job creation, grants and government assistance;
Customers: business continuity and investment in quality.
Activity 23.8
Evaluation on Financial Statements and Accounting Ratios:
Although useful to compare ratios and identify trends it does not provide information on the future, which is more important (than information of the past);
It's useful to compare with businesses in the same industry but it doesn't consider qualitative factors or even external factors: verdict of a business performance may be inaccurate;
Ratios make it easier to visualize profitability and liquidity numbers. On the other hand, different companies have different templates for their Financial Statements (not standardized).
To-Do-List:
Exam Practice Question #2 (p. 294)
Chapter 23 - Analysis of Accounts
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