Chapter 26: Analysis of Accounts

Profitability Ratios
● examines profits against revenue

1) Gross Profit Margin

● shows gross profits as a percentage of revenue
● tells how much gross profit is earned per $1 of per revenue
● the higher the figure, the better - it means business is successful at
converting sales into profit

how to increase GPM

● increase revenue
- marketing
- pricing
- add value
- new revenue stream

● decrease cost of production (variable costs)

- automation
- cheap supplies

2) Net Profit Margin

● shows profits as a percentage of revenue
● tells how much profit is earned per $1 of per revenue
● the higher the figure, the better - it means business is successful at
converting sales into net profit

how to increase NPM

● increase revenue
- marketing
- pricing
- add value
- new revenue stream

● decrease expenses (fixed costs)

- negotiate rent
- reduce wages
- less fringe benefits

3) Return on Capital Employed

● shows profits before tax as a percentage of capital employed
● tells how much profit is earned per $1 invested in business
 ● ideal ratio is 20%, if higher than no growth potential
- if percentage falls due to rise in capital employed, business could
be planning for expansion
- if percentage falls due to decrease in net profit, there may be an
increase in investment

Liquidity Ratios
● firms ability to pay its short terms debts

1) Current Ratio
● ideal ratio is between 1.5 - 2
● if it’s more than 2
- business has too much chas tied up in unprofitable assets . To
overcome, decrease liabilities
● if it’s less than 1.5
- business has a risk of running out of cash. To overcome, increase
assets

2) Acid Test Ratio

● ideal ratio is >= 1
● if it’s less than 1
- business cannot pay its debts. To overcome, reduce inventories
Why And How Accounts Are Used

● owners/ shareholders
- know how well the business is performing
- compare with previous years and similar businesses

● potential investors
- know the return they expect to receive from their investments

● managers
- know whether the financial objectives have been achieved
- check level of retained profit

● employees
- interested in profitability - job security
- support claim for higher wages

● supplier
- ensure business has enough cash to pay for supplier

● lender
- ensure business has enough to pay for interest