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Analysing accountsAnalysing accounts


Analysing accounts is...

Using an organization’s accounts (balance sheet and income statement – see financial accounting) to evaluate its performance in four areas:


1. Profitability 

Is it making enough profit?

Profit is increased by:

  • increasing sales revenue (or turnover – goods sold x their price) and/or


2. Liquidity (or solvency) 

Does it have enough cash to pay off its bills?

See also cash flow management.


3. Capital structure

How does it raise capital e.g. loans and shares?

Is it overly dependent on loans?

The level of its borrowing is called gearing (or leverage in America).


4. Investment 

Is it making enough money for its owners or shareholders?


The main problem is balancing liquidity and profitability - Why?


Liquidity comes from...

Current assets that are either cash or can be easily turned into cash.


Profitability requires

Fixed assets like property and equipment that are held in the organization for a longer period of time:


1. If you spend too much on fixed assets for profitability, you won’t have enough cash.

2. If you have too much cash, you won’t be investing enough in fixed assets and new profitable business opportunities.


Sales (and so profits) aren’t always the same thing as cash, because...

Some customers may delay payment by buying on credit (called debtors, or accounts receivable).



How to analyse a company’s accounts


You must do four things:


1. Find out sales, profit, assets and liabilities

From the company’s Annual Report and Accounts find out

a)sales and profit (from the company's income statement)

b)assets and liabilities (from its balance sheet) –

  • current and fixed assets (see above)
  • long-term liabilities (loans and shares)
  • current liabilities (short-term debts).



2. Calculate key performance indicators

These are financial ratios that measure the company’s profitability, liquidity, capital structure and investment (see below).

If the company sells abroad ,the profitability of different countries or continents should be analysed.



3. Compare these key performance indicators with those of competitors

This is called inter-firm comparison.



4. Analyse changes in the company’s key indicators in the last five years

Use the five year summary of the company’s financial results in its Annual Report and Accounts.

Analysing accounts

We will now look at the key financial performance indicators for a public limited company  that can raise money by selling its shares to the public (usually big institutional investors like pension funds).

We shall use the British supermarket, Tesco as an example.


Key profitability indicators


1. Percentage changes in turnover (or sales revenue)


Annual percentage increase/decrease in turnover (or sales revenue – goods sold x their price) – the bigger increases the better!Analysing accounts

For 2010-14 Tesco had lower percentage increases (average 4.5% p.a.) than its competitor, J. Sainsbury (average 5.0%) - sales include VAT:

  2010 2011
 2012 2013 2014 
 Tesco  5.2   8.1
 7.4  1.3  0.3
 Sainsbury  5.1   7.1  5.6  4.5  2.8

Tesco's sales growth has fallen badly since 2012 due to tougher competition.



2. Profit margin

Operating profit x100%




Operating profit is the company’s profit (sales less expenditures) before the deduction of tax and loan interest.

The expected profit margin will vary from industry to industry – for example, because of its high sales volume, Tesco (a big supermarket) will have a smaller margin than a small grocery store.

Tesco had a higher profit margin (average 5.1%) than Sainsbury (average 3.8%) from 2010-14 (sales include VAT):

   2010  2011
 2012  2013 2014 
 Tesco  5.5  5.6
 6.5  3.7  4.1
 Sainsbury   3.3   3.7  3.9  3.8  4.2

  Tesco's profit margin has fallen badly since 2012 due to tougher competition.



3. Return on capital employed (ROCE)

Operating profit  x100%

Capital employed (total assets, current and fixed, less current liabilities) 


This should be increasing because this shows that the company is making more profit from its assets. For 2010-14 Tesco had a higher ROCE (average 9.0%) but Sainsbury (average 8.3%) did better in 2013 and 2014:

   2010  2011
 2012  2013  2014
 Tesco  11.5  12.9
 9.4  5.4  5.9
 Sainsbury  8.8  10.1  7.8  7.7  7.1


Tesco's ROCE has fallen badly since 2012 due to tougher competition.



4. Sales/profit per employee

Sales (or operating profit)

Number of employees


This indicates employee performance – obviously the higher the better! For 2010-14 sales per employee (£) for Tesco and Sainsbury were:

   2010  2011  2012  2013  2014
 Tesco  132,467  137,349
 138,748  139,511  138,887
 Sainsbury  220,154  231,047  240,540  244,686  246,290


Operating profit per employee was:

   2010  2011  2012  2013  2014
 Tesco  6,718  8,021
 8,127  4,700  5,154
 Sainsbury  7,297   8,570  8,577  8,400  9,430

 Sainsbury's has done better in both!


Key liquidity indicators


1. Current ratio

Current assets

Current liabilities



For most companies this should be between 1.5 and 2.

But a supermarket like Tesco will have a much lower figure, because it buys good on credit (shown as creditors, a current liability in the accounts) and sells in cash (so it has virtually no credit customers, or debtors, an important current asset for other companies).

Tesco's and Sainsbury's current ratios were

   2010  2011 2012  2013  2014
 Tesco  0.73  0.67  0.64  0.67  0.65
 Sainsbury  0.66  0.58  0.65  0.61  0.64

Tesco's average was 0.67 and Sainsbury's was 0.63 - both highly satisfactory liquidity positions for a supermarket business. 




2. Acid test (or quick) ratio

Current assets less stocks

Current liabilities


This should be around one for most companies. But again Tesco will be able to operate with a much lower figure, because of its low debtors, high creditors (unpaid suppliers) and high levels of cash.

Tesco's and Sainsbury's acid ratios were:

   2010  2011 2012  2013  2014
 Tesco  0.56  0.49  0.46  0.47  0.47
 Sainsbury  0.41  0.31  0.35  0.29  0.5

Tesco's average was 0.49 and Sainsbury's was 0.37 - both satisfactory liquidity positions.



3. Stock turnover

Stocks   x 365 days



This shows how long it takes for a company to sell and replace its stocks of goods (the goods Tesco has in its stores and depots).

This figure will be high for a high volume business like Tesco – in 2014 its stock turnover was only 18 days.


4. Debt collection period (or debtor turnover)

Debtors  x 365 days



Debtors are included in trade and other receivables in the balance sheet


 This shows how quickly debtors (credit customers) pay their bills.

This doesn’t apply to Tesco or Sainsbury whose customers pay by cash.



5. Interest cover

Operating profit

Interest paid on loans (called finance costs in the income statement)


 This indicates the company’s ability to pay off loan interest from its profits. If this gets very low, it will be difficult to pay interest, particularly if there is an increase in interest rates.

For 2010-14 both Tesco (average 6.7) and Sainsbury (average 6.1) had enough profit to pay its loan interest:

   2010  2011  2012 2013  2014 
 Tesco   6.0  7.9
 10.2  4.6  4.7
 Sainsbury  4.8   7.3  6.3  5.8  6.3



Key capital structure indicator


Gearing ratio (or debt-to-equity ratio)

Total borrowings (short- and long-term)   x 100%

Capital employed (total assets less current liabilities)



 If this gets very high (e.g. above 50%), the company is said to be highly geared (or leveraged) and paying interest on its loans will be more difficult.


   2010  2011 2012  2013 2014
 Tesco   44.2  37.6
 37.3  34.8  40.0
 Sainsbury  8.8  23.7  24.6  24.2  19.7

Tesco is more highly geared with a sharp increase in borrowing in 2014.


Key investment indicators


1. Earnings per share (or EPS)

Profit (after deducting tax and loan interest) less
dividends paid to preference shareholders

Number of ordinary shares issued

Shareholders will get a higher return (from a higher dividend, the shareholders’ share of the profits, and share price) if the EPS is high.



2. Price/earnings ratio (or P/E ratio)

Market price per share

   Earnings per share


A high P/E ratio indicates that a company’s shares are over-priced and may fall.

Earnings are the company's dividends and how much profit it’s reinvesting back into the business.



Key quotes explained


Analysing accounts

Profit is not a cause. It is the result of the performance in marketing, innovation and productivity.

- Peter Drucker (in his 1954 book, The Practice of Management, pictured right).

Profit comes from customer satisfaction and innovative and productive employees. So these should be a company’s main objectives, not profit.

 Analysing accounts


Increase the value of the whole pie, not merely the size of each person’s slice.

- Richard Brearley, pictured right above, and Stewart Myers, pictured right below, (in their textbook, Principles of Corporate Finance).Analysing accounts

 Increase the profit of the whole organization (through customer satisfaction) and then there will be a bigger cake and bigger slices for employees and shareholders.



Analysing accounts


The investor of today does not profit from yesterday’s growth.

- Warren Buffett (American share investor, pictured right)

An organization’s success depends on its future, not its past. Buffett says that profit margins and return on capital are the best indicators of success.



Best books

Analysing accounts


Kenneth Andrews (pictured right), The Concept of Corporate Strategy (1971)

Financial analysis of company accounts may encourage short-term thinking (e.g. cost cutting) at the expense of long-term strategy (e.g. creating lasting relationships with customers and employees).

 Analysing accounts


Robert Kaplan (pictured right above) and David Norton (pictured right below), The Balanced Scorecard (1996)

Analysing accounts
The Balanced Scorecard emphasizes the importance of non-financial objectives like customer satisfaction, employee motivation and learning (see balanced scorecard).

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