Why analyse accounts?
Financial statements list figures, but the figures only become useful when they are compared. Ratio analysis turns raw numbers from the income statement and the statement of financial position into percentages and ratios that stakeholders can interpret. Owners, banks, suppliers, employees and investors each look at the accounts for different reasons, so a business is judged on both profitability and liquidity.
Profitability ratios
These measure how good a business is at turning sales into profit.
Key idea
Gross profit margin = (gross profit / revenue) x 100. Net profit margin = (profit / revenue) x 100. Return on capital employed (ROCE) = (profit before interest and tax / capital employed) x 100.
A rising gross profit margin means the firm controls its cost of sales well. If the gross margin holds steady but the net profit margin falls, then overheads or expenses have grown. ROCE shows how efficiently the money invested in the business is generating profit, so investors watch it closely.
Liquidity ratios
Liquidity is the ability to convert assets into cash to pay short-term debts. A profitable firm can still fail if it runs out of cash.
| Current ratio | current assets / current liabilities |
| Acid test | (current assets - inventory) / current liabilities |
A current ratio of about 1.5 to 2 is usually seen as healthy. The acid test is stricter because it removes inventory, which can be hard to sell quickly.
Remember
- Compare ratios over time and against similar firms.
- Ratios ignore qualitative factors such as staff morale and reputation.
- High profit does not guarantee good liquidity.