Accounts and finance

Table of Contents

1. Topic pack - Accounts and finance - introduction
2. 3.1 Sources of finance - notes
3. 3.1 Sources of finance - questions
4. 3.2 Investment appraisal - notes
5. Investment appraisal
6. 3.2 Investment appraisal - questions
7. 3.3 Working capital - notes
8. 3.3 Working capital - questions
9. 3.4 Budgeting - notes (HL only)
10. 3.4 Budgeting - questions
11. 3.5 Final accounts - notes
12. 3.5 Final accounts - questions
13. 3.5 Final accounts - simulations and activities
14. 3.6 Ratio analysis - notes
    1. Ratio analysis
    2. Profitability ratios
    3. Interpretation of profitability ratios
    4. Profitability - examples
    5. Liquidity ratios - introduction
    6. Current ratio
    7. Acid test ratio
    8. Efficiency ratios
    9. Efficiency ratios - ROCE
    10. Efficiency ratios - asset turnover ratio
    11. Efficiency ratios - stock turnover ratio
    12. Debtor days
    13. Creditor days
    14. Efficiency ratios - use and calculation
    15. Financial efficiency ratios - examples
    16. Shareholders' ratios
    17. Factors affecting share prices
    18. Gearing
    19. Ratio analysis - A summary
15. 3.6 Ratio analysis - questions
16. 3.6 Ratio analysis - simulations and activities
17. Printable version

Ratio analysis

We have examined the purpose, layout and content of the balance sheet and profit and loss account. We have said that these documents contain a story of the business bit that this story is sometimes difficult to reveal. We need to find some way of bringing this information to life and to provide answers to stakeholders on a whole series of questions about the performance, efficiency and liquidity of the business. We can do this through the use of financial ratios. A ratio is simply a mathematical relationship between one figure and another. Financial ratios are relationships between quantities taken from the accounts.

Single balance sheets and profit and loss accounts tell us very little. If we are told that sales this year were $20m and profit rose to $5m, this information has limited meaning expressed as it is in absolute terms. What we want is some way to provide a relative comparison. Financial ratios offer a tool to do this, but are only of significant use when they are compared to other ratios. In practice, comparison will be between different years and between the firm and its competitors or industry averages (inter-firm comparisons). However, it is important that any comparison is between similar organisations. Comparing ratios of the local grocer's shop with multinational supermarkets will have little practical use.

What we are hoping to reveal are trends in performance or contrasts with similar organisations that may require further analysis. Ratios should help decision-makers and provide the information to set future policy

To help us understand more about the firms we are studying, we will be examining specific groups of ratios, namely:

• Profitability ratios examine profit in relation to other figures
• Liquidity ratios identify the ability of a firm to pay its current liabilities
• Financial efficiency ratios provide information on how effectively resource are used in the business
• The gearing ratio shows the long-term liquidity position of the business
• Shareholders ratios measure the returns to shareholders

In the following sections we will also examine the limitations of ratio analysis