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Reporting on Accounts
This topic is known also as Assessing the Business and is only for the Higher Level students.
The final accounts are examined in detail to identify the strengths, weaknesses and trends of
the business using ratios (Calculations).
Summary of main points of information provided by the final accounts for a given year:
Turnover (Net Sales), Cost of sales, Gross Profit, Net profit or loss, Appropriation of net
profit, Dividends paid to shareholders.
The following are the main groups of people who would be interested in finding out
information about the performance of a firm. These groups of people will examine the
accounts and the ratios for their own reason:
1. Management
They are looking at the firms performance. They identify any
changes good or bad since last year e.g. sales, increased costs
2. Shareholders
Has the company made a big profit Will they receive a good
dividend? Should they sell their shares now?
3. Bank
Will loans be repaid? Is it safe to lend to this business?
4. Creditors
Will our money be repaid? If so, when? Should we give any
more credit?
5. Workers
Are their jobs secure? Is a pay rise possible? Is the business
expanding?
6. Potential Investors
Is this firm a worthwhile investment? E.g. A good return?
Limitations of the Final Accounts in Assessing a Business
The final accounts and balance sheet give a certain amount of information about the
performance of a company but this information is limited in that it does not take into account
certain factors
 Future changes in fashion, which may make the firm’s products unattractive
 A change in the exchange rates, which makes materials or goods more expensive
 Industrial relations problems in the firm, which may lead to a loss of production due
to strikes
 The figures for the fixed assets in the balance sheet may not be correct. They may be
over or under-valued
 Future changes in the economy, for example higher inflation or interest rates
 Some important staff members may leave the firm
Because the information from the final accounts and balance sheet is limited, it is necessary
to use ratios to analyse the information and compare the information with the accounts and
balance sheet of other years and other companies.
Ratios
Ratios are used to extract precise information from the final accounts to identify the
strengths, weaknesses and trends of the business.
In examining the accounts and calculating ratios, we will look at four main areas:
1. Profitability
2. Solvency
3. Activity
4. Liquidity
Profitability Ratio’s
The aim of profitability ratio is to see if the company is getting a good return on its sales and
investment. People get involved in business to make a profit. The following ratios are used to
examine the profitability of the business:
Gross Profit Margin (Gross profit percentage)
This shows the rate of profit made on sales before selling expenses are deducted. It should
normally be the same but may drop due to:
(a) Increases in cost of sales- goods stolen, damaged or destroyed
(b) Goods being sold off cheaply
Gross Profit
X
Sales
100
1
Example
Sales: €600,000
Gross Profit: €420,000
Calculate the gross margin.
Name of Ratio
Formula
Workings
Answer
Gross Margin
Gross Profit x 100%
€420,000 x 100%
70%
Sales
€600,000
The business made 70% gross profit (before expenses) on everything it sold.
Net Margin (Net profit percentage)
This shows the rate of profit made on sales after allowing for all the expenses and gains of a
company. The higher the percentage, the lower the net margin. Expenses may rise due to:
(a) Increased overtime
(b) Higher charges for electricity, telephone, advertising
Net Profit
X
Sales
100
1
Example
Sales: €600,000
Net Profit: €180,000
Calculate the net margin.
Name of Ratio
Net Margin
Formula
Net Profit x 100%
Sales
Workings
Answer
€180,000 x 100%
30%
€600,000
The business made 30% net profit on everything it sold i.e. after all expenses were paid
Return on Investment (Return on capital employed percentage)
The return on investment (ROI) shows the return obtained on the total amount of money
invested (shares, reserves and long term liabilities). It should be greater than the cost of the
long-term loan and greater than what a bank deposit account will give.
Net Profit
X
100
Capital employed
1
Example
Net Profit: €180,000
Capital Employed: €900,000
Calculate the Return on Investment.
Name of Ratio
Formula
Workings
Answer
Net Profit
Net Profit x 100%
€180,000 x 100%
20%
Capital Employed
€900,000
This ratio shows the business and the shareholders how much the business is making on the
investment. The answer can be compared with other investments e.g. bank interest rates to
see if it is making a worthwhile return.
Liquidity Ratio’s
Current Ratio
Current Assets: Current Liabilities
Example: €60,000 : €30,000 = 2:1
Ideal ratio is 2:1. If the ratio is too high – Might suggest that too much of its assets are tied up
in unproductive activities – too much stock, for example. Too low - risk of not being able to
pay your way.
Acid Test (Quick Ratio)
Current Assets-Closing Stock : Current Liabilities
The omission of closing stock gives an indication of the cash the firm has to pay its debts.
Example: €60,000-€15,000 (closing stock) : €30,000 = 1.5:1
Ideal Ratio is 1:1. A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as
it owes – very healthy. A ratio of 0.5:1 would suggest the firm has twice as many liabilities as
it has cash to pay for those liabilities. This might put the firm under pressure but is not in
itself the end of the world.
Solvency Ratio
A business is solvent if its total assets are greater than its external debt.
Example:
Fixed Assets =
€160,000
Current Liabilities =
Current Assets =
€60,000
Long-term loans =
Total Assets =
€220,000
External Debt =
€75,000
€100,000
€175,000
This business is solvent as its total assets are greater than its external liabilities by €45,000.
The opposite of being solvent is ‘insolvent’ when the business owes more than it can afford
to repay.
Activity Ratio’s
Stock Turnover
Example: Opening Stock: €12,000 Closing Stock: €18,000 Cost of Goods Sold: €120,000
Name of ratio
Formula
Workings
Stock Turnover
Cost of Goods Sold
Average Stock =
Average Stock
€12,000 + €18,000/2 = €15,000
(Opening +Closing /2) Stock Turnover =
€120,000/€15,000
Answer
8 times
This ratio shows the number of times a year that a business will sell its average stock. A high
stock turnover might mean increased efficiency? But this is dependent on the type of
business, i.e., supermarkets might have high stock turnover ratios whereas a shop selling high
value musical instruments might have low stock turnover ratio.
Creditors Payment (Creditor Days)
Example: Creditors = €13,000 Purchases = €120,000
Name of Ratio
Formula
Workings
Answer
Creditors Payment
Creditors x 365
€13,000 x 365
39.5 days
Purchases
€120,000
This ratio shows how long on average the business takes to pay its debts.
Debtors Payment (Debtor Days)
Example: Debtors = €20,000 Sales = €200,000
Name of Ratio
Formula
Workings
Answer
Debtors Payment
Debtors x 365
€20,000 x 365
36.5 days
Sales
€200,000
This ratio shows how long on average the firm takes to recover its debts. The business should
always be paid by its debtors quicker than the business has to pay its own creditors. This will
help to prevent cash shortages, i.e., liquidity problems.
Report
When an accountant is asked to assess a business, he/she examines the accounts, prepares
ratios and looks at all the financial dealings. Then he/she writes a report based on the results.
The report will highlight the information required by those for whom the report was written.
Students should revise the Business Letter chapter for the correct layout of a Report.