Analysis of Accounts

Analysis of Accounts

Understanding Financial Statements

  • A crucial part of business operations is understanding and analysing financial statements.
  • Financial statements demonstrate the financial health of a business.
  • They include the balance sheet, the income statement, and the cash flow statement.

Balance Sheet

  • The balance sheet displays a snapshot of a business’s assets, liabilities, and equity at a specific point in time.
  • Assets include both current and non-current items owned by the business such as cash, receivables, inventory and property.
  • Liabilities include both current and non-current debts or obligations of the business such as loans, taxes, and payables.
  • Equity (also called net assets or capital) is what’s left when liabilities are subtracted from assets.

Income Statement

  • The income statement (often known as the profit and loss account), displays a business’s revenues, costs, and profits or losses over a period of time.
  • It typically includes sections for sales revenue, cost of sales (direct costs), gross profit, operating expenses, and net profit.

Cash Flow Statement

  • The cash flow statement details the inflow and outflow of cash in a business over a period of time.
  • It is categorized into three sections: operating activities, investing activities, and financing activities.

Key Ratios for Analysis

  • Financial ratios are widely used to analyse the accounts of businesses.
  • Ratios such as the current ratio, quick ratio, return on capital employed (ROCE), and gross profit margin are used to study liquidity, profitability, efficiency, and solvency.

Current Ratio

  • The current ratio compares current assets to current liabilities to assess the liquidity of a business. A high current ratio usually suggests sound liquidity.

Quick ratio (Acid-Test ratio)

  • Like the current ratio, the quick ratio is another measurement of liquidity; however, it excludes inventory from current assets since it may not be readily convertible to cash.

Return on Capital Employed (ROCE)

  • ROCE measures the profitability of a business in relation to the capital that has been invested. Higher ROCE suggests that the business is using its capital efficiently.

Gross Profit Margin

  • The gross profit margin ratio analyses the relationship between gross profit and sales revenue. A high gross profit margin indicates the business is able to make a reasonable profit after deducting the cost of goods sold (COGS).