limitations of using accounts and ratio analysis

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Topic 5.5 – Users of Accounts, Purpose, Limitations and Ratio Analysis

1. Users of Accounts (Syllabus 5.5.4)

Different users need different information from the accounts to help them make decisions. The table below lists the main internal and external users, the key information they look for and the typical decisions they may take.

User Information required from the accounts Typical decisions
Owners / Shareholders Profitability, return on investment, dividend‑paying capacity Retain earnings, invest further, sell shares
Board of Directors (internal) Overall performance, capital structure, risk exposure Strategic direction, dividend policy, capital‑raising
Managers Cost control, revenue trends, cash flow, asset utilisation Planning, budgeting, performance monitoring, pricing
Employees Profitability, cash‑flow position, ability to meet wage obligations Negotiating wages, assessing job security, deciding on training
Creditors (banks, trade lenders, suppliers) Liquidity, solvency, repayment capacity, credit history Granting or withdrawing credit, setting interest rates, deciding credit terms
Suppliers Current assets, payment history, credit terms Offering credit and on what terms
Customers Long‑term viability, ability to honour warranties or after‑sales service Choosing a reliable supplier, assessing risk of disruption
Government / Tax authorities Taxable profit, VAT, customs duties, statutory compliance Assessing tax liability, enforcing regulations, granting licences
Potential investors Overall profitability, growth trends, risk profile Comparing alternative businesses before investing
Financial analysts & media (external) Key performance indicators, trend data, comparative ratios Preparing reports, giving investment recommendations, influencing public perception

2. Purpose of Preparing Accounts (Syllabus 5.5.3)

  • Measure past performance – e.g., profit for the year. Used by: owners, shareholders, board of directors, analysts.
  • Assess current financial position – e.g., current ratio, net assets. Used by: creditors, banks, suppliers, management.
  • Inform future decisions – e.g., budgeting, investment appraisal, strategic planning. Used by: managers, board of directors, potential investors.
  • Meet statutory / legal requirements – Companies Act, tax legislation, regulatory filing. Used by: government, tax authorities, auditors.

3. Limitations of Using Accounts (Syllabus 5.5.3)

  • Historical nature – accounts record events that have already happened; they do not show current market conditions.
  • Subjectivity and estimates – depreciation methods, bad‑debt provisions and inventory valuation involve judgement, which can vary between firms.
  • Non‑financial information omitted – brand reputation, staff morale, technological change and market trends are not reflected in the numbers.
  • Different accounting policies affect comparability – FIFO vs. LIFO, straight‑line vs. reducing‑balance depreciation, etc., can give different profit figures.
  • Inflation and changes in price levels – historical cost accounting does not adjust for inflation, making comparison over time misleading.
  • Different accounting frameworks – IFRS, local GAAP, or other standards may produce different results for the same transactions.
  • Time lag – annual accounts are produced after the reporting period, so the data may be out‑of‑date when decisions are required.
  • Potential for manipulation – management can influence reported profit through selective disclosure, re‑classification of expenses or timing of transactions.

4. Ratio Analysis (Syllabus 5.5.5)

Ratios are calculated from figures in the income statement and balance sheet to give insight into profitability, efficiency, liquidity and solvency. Each ratio is shown with its formula, what it measures and an illustrative benchmark (benchmarks are industry‑specific and therefore only indicative).

Ratio Formula What it measures Illustrative benchmark*
Gross Profit Margin \(\displaystyle \frac{\text{Gross Profit}}{\text{Sales}} \times 100\%\) Percentage of sales left after covering cost of goods sold Retail ≈ 30‑40 %; manufacturing ≈ 20‑30 %
Net Profit Margin \(\displaystyle \frac{\text{Net Profit}}{\text{Sales}} \times 100\%\) Overall profitability after all expenses Varies widely – compare with industry average
Return on Assets (ROA) \(\displaystyle \frac{\text{Operating Profit}}{\text{Total Assets}} \times 100\%\) Efficiency of using total assets to generate profit > 5 % is often considered satisfactory for many sectors
Return on Capital Employed (ROCE) \(\displaystyle \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100\%\) Efficiency of capital (equity + long‑term debt) in generating profit Higher than the cost of capital indicates good performance
Current Ratio \(\displaystyle \frac{\text{Current Assets}}{\text{Current Liabilities}}\) Short‑term liquidity – ability to meet current debts 1.5 – 2.0 is generally acceptable
Acid‑test (Quick) Ratio \(\displaystyle \frac{\text{Cash} + \text{Marketable Securities} + \text{Receivables}}{\text{Current Liabilities}}\) Liquidity without relying on inventory ≥ 1.0 is usually considered safe
Inventory Turnover \(\displaystyle \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}\) How many times inventory is sold and replaced in a period Higher numbers indicate efficient stock management
Receivables Turnover \(\displaystyle \frac{\text{Credit Sales}}{\text{Average Trade Receivables}}\) Speed of collecting money owed by customers Higher numbers show effective credit control
Debt‑to‑Equity Ratio \(\displaystyle \frac{\text{Total Debt}}{\text{Equity}}\) Proportion of financing that comes from creditors vs. owners Typically < 1.0 for low‑risk firms; higher for capital‑intensive sectors

*Benchmarks are illustrative only; students must always compare with the relevant industry average or the company’s own historical data.

5. Limitations of Ratio Analysis (Syllabus 5.5.5)

  • Reliance on historical data – ratios are based on past figures and may not predict future performance.
  • Different accounting methods – variations in depreciation, inventory valuation or revenue recognition can distort ratios and hinder comparison.
  • Industry differences – a “good” ratio in one sector may be poor in another; benchmarks must be sector‑specific.
  • Quantitative focus only – ratios ignore qualitative factors such as management quality, brand strength, or market conditions.
  • One‑period snapshot – a single ratio gives no trend information; analysing several periods is essential.
  • Potential for distortion – extraordinary items, seasonal peaks or one‑off transactions can inflate or depress ratios.
  • Inflation effect – price level changes can make balance‑sheet‑based ratios (e.g., debt‑to‑equity) misleading over time.
  • Different accounting frameworks – IFRS vs. local GAAP may lead to different numerator or denominator values, affecting comparability.

6. Key Takeaway

Accounts and ratio analysis are powerful tools for the many users listed in the syllabus, but they provide an incomplete picture when used in isolation. Recognising their limitations—historical bias, subjectivity, policy differences, inflation, lack of qualitative data and the need for industry‑specific benchmarks—enables students to combine quantitative analysis with sound judgement, leading to more balanced and realistic business decisions.

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