Purpose: To show the firm’s financial position.
Contents: Assets (items owned by the firm) and Liabilities (items owed by the firm): capital expenditure.
Accountants also produce cash flow statements which analyze the movements in the cash and bank balances and summarize the firm’s liquidity that is its ability to meet its debts as they fall due.
Accounting ratios are used to analyze financial information. Two major profitability ratios are:
ROCE (return on capital employed) = Net Profit x 100 / Capital Employed
This shows the rate of return on capital, and can be compared with the rate an investor could receive elsewhere, for example by investing in a safer fixed-interest source such as a building society account.
Net Profit Margin = Net Profit x 100 / Sales
This shows how many pence in each ₤’s worth of sales is represented by net profit. This gives information on whether the selling price could be dropped (by cutting this margin) in an attempt to increase sales.
The main liquidity ratio is the Current Ratio:
Current Ratio = Current Assets / Current Liabilities
A ratio of 2:1 tells us that there is £2 cash or “near-cash” available to pay short-term debts. The difference between the current assets (stock, debtors and cash) and current liabilities (creditors and bank overdraft) is called Working Capital. In practice, many large firms, especially in the retail sector, have a negative working capital, a ratio less than 1:1, but still survive financially.
Accountants also remove stock from the Current Assets total to calculate the Liquid Assets (also known as the Acid Test) ratio. This informs them whether the firm’s cash and debtor resources are sufficient to meet its own short-term debts, without having to sell any stock.
Efficiency ratios are also used by accountants. These include “debtor days” and “creditor days” which show how many days’ credit the firm allows and takes respectively. This is important information for credit control purposes.
Debtor Days = Debtors x 365 / Sales
Creditor Days = Creditors x 365 / Purchases
Another efficiency ratio is the Rate of Stock Turnover (“Stockturn”) which calculates the number of times the firm’s average stock is sold or “turned over” during the period.
Rate of Stock Turnover = Cost of Sales / Average Stock