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Edexcel IGCSE Business Your notes

Analysis of Accounts
Contents
Accounting Ratios
Liquidity
Using Financial Documents

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Accounting Ratios
Your notes
An Introduction to Ratio Analysis
Ratio analysis involves extracting information from financial accounts to assess business
performance

It helps managers to answer key questions including

Why is one business more profitable than another one in the same industry?
Is a business growing?
How effectively is a business using assets and capital invested?
What return on investment is expected?
How risky is the financial structure of the business?
Ratios can be compared over time and between businesses or functions to determine how well
financial objectives are being met

Examiner Tips and Tricks

Formulas to calculate profit margins, mark up, RoCE and liquidity are provided on page 2 of your
exam paper.

Profit Margins
Profit margins measure of how effectively a business converts revenue into profit
Profit margins can be compared to previous years' to better understand business performance
Higher and increasing profit margins are preferable, as it means that more revenue is being
converted to profit

The Gross Profit Margin

This calculation shows the proportion of revenue that is turned into gross profit
It is calculated using the following formula and is expressed as a percentage

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Gross Profit
Gross Profit Margin = × 100
Revenue
Your notes

Worked Example
Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its gross profit was $105,731
Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022 [2 marks]

Step 1: Substitute the values into the formula

Gross profit
Gross profit = × 100
Revenue

$ 105, 731 [1 mark]

=
$ 124, 653

= 0. 8482

Step 2: Multiply the outcome by 100 to find the percentage

= 0. 8482 × 100
[1 mark]
= 84. 82 %

84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2022

Improving the Gross Profit Margin

The gross profit margin can be improved in two ways
The business can increase its sales revenue
The business can reduce its direct costs

Ways to Increase the Gross Profit Margin

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Method Explanation
Your notes
Increase Increase the value of sales
revenue
Raise prices
If costs remain the same, this will improve profitability as the difference
between the selling price and costs is now greater
Sell premium products
If customers are willing to spend money on these goods, the business could
earn more profit per item sold

Increase the volume of sales

Price tactics
Use price tactics to encourage higher quantity or more frequent purchases

Increase marketing activities

Engage in more marketing activities to increase sales volume

Reduce direct Purchase cheaper/alternative resources

costs
Negotiate with suppliers or find new suppliers
However businesses must ensure that reducing variable costs will not
have an adverse effect on the quality or desirability of products
Buy stock in greater quantities
Purchase in bulk amounts less frequently
Investment in increased storage space may be needed, which will reduce
the impact of cost savings made
Reduce wastage of raw materials and components

The Operating Profit Margin

This calculation shows the proportion of revenue that is turned into operating profit
It is calculated using the formula below and the outcome is expressed as a percentage

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Operating Profit
Operating Profit Margin = × 100
Revenue
Your notes

Worked Example
Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its operating profit was $65,864
Calculate Head to Toe Wellbeing Ltd’s Operating Profit Margin in 2022
[2 marks]
Step 1: Substitute the values into the formula

Operating Profit
Operating Profit Margin = × 100
Revenue

$ 65, 864 [1 mark]

=
$ 124, 653

= 0. 5284
Step 2: Multiply the outcome by 100 to find the percentage

= 0. 5284 × 100
[1 mark]
= 52. 84 %

In 2022, 52.84% of Head to Toe Wellbeing’s revenue was converted into operating profit

Improving the Operating Profit Margin

The profit margin can be improved in two ways
Increase the gross profit margin (see above)
Reduce expenses by cutting staffing levels, relocating to cheaper premises or changing utility
companies
Reducing staffing levels may affect staff morale and negatively affect productivity

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Relocation costs may outweigh some of the benefits of moving to a cheaper location
Replacing inefficient or outdated equipment may require staff training Your notes
Mark-up
The mark-up is a measure of profit made on each item sold

Some businesses calculate the markup in order to determine the price at which they should sell their
products
This methods ensures that all costs are covered and that a profit will be made on every item they
sell
Mark-up is expressed as a percentage and calculated using the formula

Profit per item

Markup = x 100
Cost per item

Worked Example
Evolve Boards' bestselling penny skateboard costs $12.13 to produce. Each board is sold for $20.
Calculate the percentage markup on each penny skateboard sold [2 marks]
Step 1: Calculate the profit per item

= $ 20 − $ 12. 13
[1 mark]
= $ 7. 87

Step 2: Divide profit per item by cost per item

= $ 7. 87 ÷ $ 12. 13

= 0. 6488

Step 3: Multiply the outcome by 100

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= 0. 6488 × 100
[1 mark]
Your notes
= 64. 88 %

Return on Capital Employed

The Return on Capital Employed (RoCE) measures how how effectively a business uses the capital
invested in the business to generate profit
It is calculated using the formula below and is expressed as a percentage

Operating Profit
Return on Capital Employed = × 100
Capital Employed

RoCE can be compared over time and with competitors

It can also be compared with other potential capital investments, such as savings rates
The Capital Employed figure is usually provided for you
If required, it is calculated using the formula

Capital Employed = Non− current Liabilities + Equity

Worked Example
The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities €1.5 million

Revenue €7 million

Equity €15.4 million

Operating Profit €2.2 million

Calculate Keals Cosmetics' Return on Capital Employed.

[3 marks]

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Step 1: Calculate the capital employed

Your notes
Capital employed = Non− current liabilities + Equity

Capital employed = € 1.5 m + € 15.4 m [1 mark]

Capital employed = € 16.9 m

Step 2: Divide Operating Profit by Capital Employed

Operating Profit
=
Capital Employed

€ 2.2 m
= [1 mark]
€ 16.9 m

= 0. 13

Step 3: Multiply the result by 100 and express the outcome as a percentage

= 0. 13 × 100 [1 mark]
= 13 %
The capital employed in Keals Cosmetics has generated a return of 13%

Improving RoCE
When analysing the RoCE, the higher the rate the better, as it indicates that the business is profitable
and using its capital efficiently
Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth
is being achieved
To increase the RoCE, a business can
Increase the level of profit generated without introducing new capital into the business

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Maintain the level of profit generated whilst reducing the amount of capital in the business

Your notes
Using RoCE to make decisions
RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to
determine the most profitable option given the level of capital employed

Worked Example
Faced with increasing costs, Kent & Medway Properties Ltd is looking to close one of its three high
street real estate branches.
The table below shows some key data for each of the branches.

Branch Capital Employed Operating Profit

Sevenoaks £2.4m £0.37m

Whitstable £3.1m £0.57m

Rochester £2.9m £0.51m

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on
profitability terms, should close
[5 marks]

Step 1: Apply the formula to calculate the RoCE for each branch

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Operating Profit
RoCE = × 100
Capital Employed Your notes

£ 0. 37m
RoCE Sevenoaks = × 100 = 15. 42 % [1 mark]
£ 2.4m

£ 0. 57m
RoCE Whitstable = × 100 = 18. 39 % [1 mark]
£ 3.1m

£ 0. 51m
RoCE Rochester = × 100 = 17. 59 % [1 mark]
£ 2.9m

Step 2: Identify the least profitable branch for closure

Sevenoaks [1 mark] is the least profitable branch with a RoCE of 15.42% [1 mark] and should be the
branch selected for closure

Examiner Tips and Tricks

When calculating financial ratios, check that you are using the correct units.
In some cases financial data is presented as raw figures (e.g. $14,520), but in most cases, you will be
working in thousands ($000) or millions ($m).
Ensure that you convert correctly; e.g. $0.39 million is equal to $390,000 and $34.9 (000) is
equal to $34,900
Make sure the decimal place is in the correct place
Calculate to two decimal places unless stated otherwise

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Liquidity
Your notes
The Importance of Liquidity
Liquidity is defined as the ability of a business to pay back its short-term debts, e.g. its suppliers
A businesses that cannot pay its debts is considered insolvent
If a business cannot pay its suppliers, raw materials or components may not be delivered and
production will be delayed
If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will
suffer
Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid
Stakeholders interested in liquidity include
Suppliers want to be reassured that a business is likely to be able to pay for them
Financial providers such as banks want evidence that a business is likely to be able to repay loans
or overdrafts
Customers want to be sure that a supplier will be able to produce and deliver goods it orders

Liquidity Ratios
The liquidity of a business can be measured using two ratios
Current ratio
Acid test ratio

The Current Ratio

The Current Ratio is a quick way to measure liquidity
The outcome is expressed as a ratio
All types of current asset are included in calculating this ratio
The result indicates how many £s (or other currency units) of current assets are available to cover
each £1 (or other currency unit) of short-term debt
It is calculated using the formula

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Current Assets
Current ratio =
Current Liabilities Your notes

= ? :1

Worked Example
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory figure
of $8,250.
Calculate Packer Sports Ltd.’s current ratio. [2]

Step 1: Substitute the values into the equation

$ 15, 545 ÷ $ 5, 060

[1 mark]
= 3. 07

Step 2: Express the outcome as a ratio

= 3. 07 : 1 [1 mark]

In this example, Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term
debt

The Acid Test Ratio

The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that
hold large amounts of inventory
It is expressed as a ratio
It is also known as the liquid capital ratio
The least liquid form of current assets (inventory) is deducted so the acid test ratio provides a
more realistic measure of the businesses ability to meet short-term debts quickly
It often takes time to sell inventory so it is excluded
The Acid Test is calculated using the formula

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Current Assets − Inventory

Acid Test Ratio =
Current Liabilities Your notes

= ? : 1

Worked Example
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory figure
of $8,250.
Calculate Packer Sports Ltd’s acid test ratio. [3]

Step 1: Subtract inventory from current assets

$ 15, 545 − $ 8, 250

[1 mark]
= $ 7, 295

Step 1: Substitute the values into the equation

Current Assets − Inventory

Acid Test Ratio =
Current Liabilities

$ 7, 295 [1 mark]
=
$ 5, 060

= 1. 44

Step 2: Express the outcome as a ratio

= 1. 44 : 1 [1 mark]

In this example, Packer Sports Ltd has $1.44 of the most liquid current assets to cover each $1 of
short-term debt

Analysing Liquidity
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Comparing Liquidity
Businesses compare and monitor liquidity over time Your notes

A business may be able to identify a pattern of periods of good and poor liquidity
For some businesses poor liquidity can be seasonal
E.g. Low sales often follow major public holidays such as Christmas
Steps can be taken to improve the liquidity position at these times
E.g. Short-term finance such as overdrafts can be arranged

The impact on liquidity of spending decisions can be determined

Budgets that ensure a healthy liquidity position can be set
Capital expenditure could be delayed to avoid liquidity problems

Comparing liquidity between different businesses is problematic

Some businesses can survive on very low ratios
Businesses that have a high level of inventory turnover and sell for cash can have very low liquidity
ratios
In 2023 Tesco Plc, the UK's largest supermarket, had a current ratio was just 0.71:1
Businesses that sell small volumes of expensive products, often on credit, require much higher
liquidity ratios
In 2023 LVMH Group, owner of brands including Louis Vuitton and Acqua di Parma, had a
current ration of 4.34:1

Improving Liquidity
A business will often need to take quick, decisive steps to improve their liquidity

Diagram: Ways to Improve Liquidity

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Your notes

Liquidity can be improved in a number of ways

Methods to Improve Liquidity

Method Explanation

Manage the business better Use cash flow forecasts to identify potential cash
flow issues before they arise and take appropriate
action
Budget effectively and consider adopting zero
budgeting to carefully control spending
Set clear financial objectives and look for ways to
reduce costs and increase income wherever
possible

Reduce the credit period offered to Collecting money owed from customers more quickly
customers will increase the level of current assets in the
business
Customers may move to competing businesses that
offer better credit terms

Ask suppliers for an extended repayment Current liabilities will not be reduced
period, e.g an extension from 60 to 90
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days The business can use cash it would have paid to

suppliers for other purposes
Your notes
Suppliers may be unwilling to extend credit terms

Make use of overdraft facilities or short- Current liabilities will increase

term loans
The business can spend more money than it has in its
bank account
Banks may be reluctant to lend to businesses with
cash-flow problems

Sell off excess inventory Less liquid current assets will be reduced and
converted into more liquid forms of current asset
(e.g. cash)
Storage and security costs may also be reduced
Inventory may need to be sold at a low price to
attract sales

Sell assets and lease fixed assets instead Both current assets and current liabilities will
(e.g. sale & leaseback) increase
The business will continue to have the use of assets
but must make regular payments to the leasing
company

Introduce new capital and reduce

drawings out of the business
Current assets will be increased
New capital may be introduced by the owner or from
additional investors
This may result in the dilution of control of the
business

Examiner Tips and Tricks

In the exam, you could be asked to compare two ways to improve liquidity and make a
recommendation. You may consider factors such as how quickly cash is needed, how much cash is

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needed, and how the methods may affect the business's ability to continue to operate effectively.
For example, selling assets may raise a large amount of finance, but it is unlikely to be a quick Your notes
solution, and the business may be unable to operate effectively without key equipment or buildings.

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Using Financial Documents

Your notes
How Financial Documents are used
Stakeholders use financial documents to assess business performance and inform decision-making
How Stakeholders use Financial Documents

Stakeholder Use of Financial Documents

Managers Financial documents help managers track performance and identify areas
for improvement
This helps them make informed decisions to achieve business objectives

Employees Employees use financial accounts to assess the stability of their employer
This helps them determine their job security or support salary negotiations

Owners Owners and shareholders can assess the profitability and growth potential
of a business
This helps them determine its ability to provide them with returns on their
investment

Suppliers Suppliers will want to assess the financial stability of key customers
Financial documents can show whether customers can pay what they owe
on time

Banks & other Financial statements can help to determine whether a business is
lenders creditworthy
Lenders can assess the risk of lending money to the business and set
appropriate credit terms

Owners and managers use the quantitative data in financial documents to make a range of informed
decisions

Diagram: Decisions Using Financial Documents

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Your notes

Managers and owners use financial documents to inform decisions about investments, financing,
improving profit and managing assets
Investments
The statement of comprehensive income can show whether a business can afford to purchase new
non-current assets such as machinery, property or vehicles
The impact of spending on research and development or overseas growth on costs and revenues can
be determined

Financing
The impact on the statement of financial position of taking out loans or other credit can be determined
The statement of financial position also identifies the value of share capital and retained profit

Improving Profit
Ratio analysis can identify the impact of different types of cost on the businesses ability to generate
profit
The impact of increased prices on sales revenue can be identified in the statement of comprehensive
income

Managing Assets
The impact of leasing assets rather than owning them can be seen in both key financial documents

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Investment in non-current assets can be compared to investment in human resources to determine

whether capital-intensive or labour-intensive production is most suitable
Your notes
Deciding whether to continue to maintain equipment or dispose of it can be determined by
considering costs and revenues in the financial documents

Examiner Tips and Tricks

In the exam you may be asked to explain how a stakeholder uses a particular financial statement,
such as a cash flow forecast or a statement of financial position. A good way to structure your 3-
mark response is to consider, first, what the particular document shows. This can then be used to
develop a strong response.
Example
Managers use cash flow forecasts to understand the predicted cash inflows and cash outflows over
a period of time [1]. This allows them to plan for cash shortfalls [1] by making arrangements for short-
term finance, such as overdrafts, to ensure they are able to meet their financial obligations [1].

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