IGCSE Business Studies - 5.5.3 Users of Accounts and Ratio Analysis

Limitations of Using Accounts

While financial accounts provide valuable information about a business's performance and financial position, it's crucial to understand their limitations. These limitations can affect the reliability and usefulness of the information for different users.

Time Lags

Accounts are prepared at specific intervals (e.g., monthly, quarterly, annually). This means the information presented may not reflect the most current financial situation of the business. Events that have occurred since the last reporting period will not be included.

Subjectivity and Estimates

Preparing accounts involves making estimates and judgments. For example, depreciation, allowance for doubtful debts, and the valuation of inventory often rely on assumptions. These subjective elements can introduce bias and affect the accuracy of the figures.

Historical Cost

Many assets are recorded at their historical cost, which may not reflect their current market value. This can lead to an inaccurate picture of the business's true financial position.

Limited Information

Financial accounts primarily focus on monetary transactions. They may not provide information about non-financial aspects of the business, such as employee morale, customer satisfaction, or brand reputation, which are also important for overall success.

Potential for Manipulation

Although regulations exist, there is a potential for businesses to manipulate their accounts to present a more favorable financial picture. This can involve techniques like delaying the recognition of expenses or accelerating the recognition of revenue.

Ratio Analysis

Ratio analysis is a method of interpreting financial information by calculating and comparing different ratios. These ratios provide insights into a business's profitability, liquidity, solvency, and efficiency.

Types of Ratios

There are four main categories of financial ratios:

• Profitability Ratios: Measure how well a business generates profit.
• Liquidity Ratios: Measure a business's ability to meet its short-term financial obligations.
• Solvency Ratios: Measure a business's ability to meet its long-term financial obligations.
• Efficiency Ratios: Measure how effectively a business uses its assets.

Calculating and Interpreting Ratios

Ratios are calculated using information from the financial statements, such as the income statement and the balance sheet. The formula for a ratio is typically: Ratio = (Numerator) / (Denominator)

To interpret a ratio, it's often compared to:

• Previous periods' performance: Comparing current ratios to past ratios can show trends.
• Industry averages: Comparing ratios to those of similar businesses in the same industry provides a benchmark.
• Budgeted figures: Comparing actual ratios to budgeted ratios helps assess performance against targets.

Example Ratios

Here are some examples of common financial ratios:

Ratio	Formula	What it measures
Profit Margin	$$ \frac{Net\, Profit}{Revenue} $$	The percentage of revenue that remains as profit.
Gross Profit Margin	$$ \frac{Gross\, Profit}{Revenue} $$	The percentage of revenue remaining after deducting the cost of goods sold.
Current Ratio	$$ \frac{Current\, Assets}{Current\, Liabilities} $$	A business's ability to pay off its short-term debts.
Debt-to-Equity Ratio	$$ \frac{Total\, Debt}{Total\, Equity} $$	The proportion of debt and equity used to finance the business.
Inventory Turnover Ratio	$$ \frac{Cost\, of\, Goods\, Sold}{Average\, Inventory} $$	How many times a business sells and replaces its inventory during a period.

By analyzing these ratios, users of accounts can gain valuable insights into the financial health and performance of a business.

Users of Accounts

Various stakeholders rely on financial accounts for different purposes:

• Investors: Use accounts to assess the profitability and potential return on investment.
• Creditors (e.g., banks): Use accounts to evaluate the business's ability to repay loans.
• Management: Use accounts to monitor performance, make decisions, and plan for the future.
• Employees: May use accounts to assess the financial stability of the employer.
• Customers: May consider the financial stability of a supplier.
• Suppliers: May assess the creditworthiness of a customer.
• Government Agencies: Use accounts for tax purposes and regulatory oversight.