To measure the growth and performance of a particular business, we may compare the calculated ratios of the present year and the previous years. Also, we can specify the drifts in profitability, liquidity, and other ratios. Moreover, it is of most significance to compare the ratios of different businesses but the same category.
Example:
Trader A runs a business for years, whereas Trader B has just started a related business two years back in another city. The financial year for both the business will at the end of December. Trader B permits Trader A to access his financial record for years, as mentioned below:
(a). For each business calculate the following ratios:
i. Return on capital employed
ii. Gross profit as a percentage of sales
iii. Net profit as a percentage of sales
iv. Current Ratio
v. Quick ratio
vi. Rate of inventory turnover
vii. The collection period for trade receivables
viii. Payment period for trade payables
(b) Using the ratios calculated in (a), compare the performance of the two businesses.
SOLUTION: (a)
SOLUTION: (b)
Comparing the ratios of both businesses
Profitability
Trader A is employing more capital and has a greater return on capital employed than Trader B. For every hundred dollars of capital employed, Trader A had a return of $10.49, whereas Trader B only achieved $9.13. This may indicate that Trader B is not employing the capital in its most effective way.
Both the businesses have earned the same amount of gross profit, but Trader B achieved a higher gross profit as a percentage of sales. It may be that Trader A has failed to pass on increased costs or sold goods at lower prices in order to achieve more significant sales. Trader B may have been selling the goods at increased rates or buying goods at a low cost than Trader A.
Despite both businesses earning the same amount of gross profit, Trader A has achieved a higher net profit by sustaining and limiting his expenses. Trader A ‘s expenses as a percentage of sales were 8.50% compared with 13.50% of Trader B. Hence Trader A has higher net profit as a percentage of sales.
Liquidity
Trader A current ratio of 2.5:1 is entirely satisfactory as his current assets are two and a half times the current liabilities. Trader B’s current ratio of 1.43:1 can be indicated as low because her current assets are only 1.43 times greater than its current liabilities. Trader B may find it challenging to meet its current liabilities whenever they are due and hence will not be able to take benefit of cash discounts or business opportunities whenever they ascend.
The introduction of additional capital or a long-term loan to replace part of the bank overdraft would most probably increase their working capital position. Trader A quick ratio is also satisfactory. Trader B's quick ratio is reasonable as his liquid assets and current liabilities or almost equal. However, their only liquid asset is trade receivables, which is why he is dependent on debtors to pay his accounts before he pays his current liabilities. Trader B has achieved a quicker rate of inventory turnover than trader A, which indicates that trader B is more efficient. Trader A should reduce his inventory levels and likely increase his rate of sales. Trader A credit sales are a bit greater than trader B. the amount of trade receivables of each business is almost equal. Trader A debtors are going to pay their accounts in around 35 days: whereas debtors of trader B are taking around 40 days to pay their accounts. It may be that trader B’s credit control policy is not efficient, or maybe he is not offering cash discounts.
The Amount of Trader A’s credit purchases was much more significant than that of Trader B. The total of Trader A’s trade payables is much higher than that owed by Trader B. Trader A’s creditors are being paid in an average of 48 days: Trader B takes an average of 37 days to pay her creditors. This may be linked to the fact that Trader B is relying on a bank overdraft for short-term finance, and her trade payables much less than Trader A’s.
Problems of Inter-Firm Comparison
Businesses can gain valuable information if they compare their accounting ratio with another business. However, they must know the limitations of comparison. Each business is different, having different requirements and accounting policies. The comparison is only meaningful if it is done between two businesses of the same category. The problems of comparison include:
• Businesses may apply different accounting policies.
• They may apply different operating policies such as renting or purchasing premises
• Gaining long term finance from capital only or using capital and long-term loans. These policies impact both the profit for the year and balance sheet
• Non-monetary items such as workforce skill goodwill of business and others do not appear in the accounting records; however, they are significant in the successful business.
• It is not always possible to find each and every information of another business to make an accurate comparison.
• The information relating to other businesses might also be for only one financial year hence making it impossible to calculate business strength.
• Financial years may even end on different dates, which makes the comparison difficult.
• Accounts are based on historical cost and do not represent the impact of inflation.
Users of Accounting Statement
Other than the owners, numerous people are interested in analyzing and interpreting the financial statements of the business. These users consist of two categories, mainly; internal users and external users.
Internal Users
1. Owner
Owners of the business, for instance, partners or sole traders, are interested in all aspects of the business hence assessing the performance and progress. Other potential partners may be interested in the profitability of the business.
2. Manager
Owners manage small businesses. In other cases, an employee may even carry out the management. Just like the owner’s managers are also interested in every aspect of the business. Ratios are used to access previous performance, future plans, and take any action whenever necessary.
External Users
Bank manager
Bank Manager requires financial statements whenever a business requests a bank loan/ overdraft facility. He also needs to know the adequate security to cope up with the loan amount or overdraft, whether it can be repaid when due, and whether interest can be paid when due.
Other Lenders
Those who have made a loan to a business will be interested in the security available, the repayment of the loan whenever it is due, and the payment of interest when it is due.
Creditors
Those who have supplied a business with goods on credit terms are usually interested in the liquidity position and the payment period for trade payables. These factors are considered when determining the credit limit and the length of credit allowed.
Potential buyers of business
Those who are interested in purchasing the business or making a take over bid will be interested in the profitability of the businesses and the market value of the assets of the business.
Customers
They are interested in ensuring the supplies are continuous
Employees and trade unions
They are interested in knowing that the company wants to operate and hence maintain jobs and pay sufficient wages.
Government Departments
It is for purposes like compiling statistics and checking that taxes are paid adequately.
