users of accounts and ratio analysis: external, e.g. suppliers, government, lenders/banks

5.5.3 Users of Accounts and Ratio Analysis

Learning objective

Identify the external users of a business’s accounts and explain how they use ratio analysis to make decisions. You must be able to:

• name each external user and state why they need financial information,
• calculate the key ratios listed in the syllabus,
• interpret the ratios in the context of each user, and
• evaluate the reliability of the information (AO4).

Contents

1. External users of accounts
2. Why each external user needs financial information
3. Key ratios – definitions & formulas
4. Key ratios – primary users & typical interpretation
5. How each external user applies the ratios
6. Limitations of ratio analysis (AO4)
7. Ratio‑user mapping summary
8. Worked example – calculation & interpretation
9. Summary checklist for students (AO1‑AO4)

External users of accounts

External users are not involved in the day‑to‑day running of the business but have a financial or legal interest in its performance.

Why each external user needs financial information

• Suppliers / Trade creditors – need evidence of short‑term liquidity and payment history before granting trade credit.
• Government – must be assured that the firm can meet tax liabilities, national‑insurance contributions and any sector‑specific statutory requirements.
• Lenders / Banks – assess credit risk before issuing loans, overdrafts or guarantees; they look for the ability to service debt and generate cash.
• Shareholders / Investors – evaluate profitability, growth potential and dividend‑paying capacity; they compare returns with alternative investments.
• Credit‑rating agencies – produce ratings that affect borrowing costs; they need a holistic picture of solvency, liquidity and profitability.

Key ratios – definitions & formulas

Key ratios – primary external users & typical interpretation

How each external user applies the ratios

1. Suppliers / Trade creditors

• Current Ratio – checks short‑term liquidity.
• Quick Ratio – confirms cash‑equivalent assets are sufficient.
• DPO – shows whether the firm is stretching payments to preserve cash.
• Interest Coverage – a low figure warns of possible default on interest, affecting future credit.
• AO4 evaluation points
  • Reliability of inventory valuation (affects Quick Ratio).
  • Seasonal fluctuations in sales may distort Current Ratio.
  • One‑off large purchases can temporarily inflate Current Assets.

2. Government (tax & regulatory bodies)

• Current Ratio – ensures the ability to settle tax liabilities when due.
• Gross Profit Margin – provides a basis for estimating taxable profit.
• Debt‑to‑Equity – monitors financial stability in regulated sectors.
• Net Profit Margin – helps gauge corporation‑tax payable.
• AO4 evaluation points
  • Profit margins can be affected by accounting policy choices (e.g., depreciation methods).
  • Tax allowances or reliefs may cause a temporary rise in Net Profit Margin.

3. Lenders / Banks

• Interest Coverage – primary test of debt‑service capacity.
• Debt‑to‑Equity – assesses overall leverage and risk of over‑borrowing.
• Current & Quick Ratios – evaluate short‑term liquidity and cash‑flow risk.
• DSO & DPO – give insight into working‑capital management.
• ROCE – shows how efficiently borrowed capital is turned into earnings.
• AO4 evaluation points
  • EBIT may include non‑cash items; lenders often adjust for cash flow.
  • Seasonal businesses can show misleadingly high or low ratios at year‑end.
  • Window‑dressing of current assets (e.g., overstating receivables) can inflate liquidity ratios.

4. Shareholders / Investors

• Gross & Net Profit Margins – indicate profitability trends.
• ROE – measures return on the equity they have invested.
• ROCE – shows efficiency of using all capital (debt + equity).
• Debt‑to‑Equity – highlights financial risk that could affect dividends.
• AO4 evaluation points
  • Different accounting policies (e.g., inventory costing) affect profit margins.
  • One‑off gains or losses can distort ROE in a single period.
  • Share buy‑backs change Owner’s Equity, influencing ROE without operational improvement.

5. Credit‑rating agencies

• All liquidity, solvency and profitability ratios are combined to produce an overall credit rating.
• Ratios are compared with industry benchmarks and historical trends.
• AO4 evaluation points
  • Ratings rely on published figures; any manipulation of accounts reduces reliability.
  • Macro‑economic factors (inflation, interest‑rate changes) are not reflected in the ratios.
  • Ratings may lag behind rapid changes in a firm’s financial position.

Limitations of ratio analysis (AO4)

• Historical data – ratios are based on past accounts and may not reflect future conditions.
• Seasonality – businesses with strong seasonal swings can show extreme ratios at year‑end.
• Different accounting policies – e.g., inventory valuation (FIFO vs. LIFO) or depreciation methods can affect profitability and asset figures.
• Window‑dressing – firms may temporarily boost current assets or reduce liabilities to improve liquidity ratios.
• One‑off items – extraordinary gains or losses can distort profitability ratios.
• Industry differences – what is a “good” ratio in one sector may be poor in another; benchmarks are essential.
• Non‑financial factors – market position, management quality, legal environment etc. are not captured by ratios.

Ratio‑user mapping summary

Worked example – calculation & interpretation

Assume the following figures (all amounts in £ 000):

• Current Assets = 150
• Current Liabilities = 100
• Inventory = 40
• Total Assets = 550
• Total Liabilities = 200
• Owner’s Equity = 350
• EBIT = 80
• Interest Payable = 20
• Sales = 500
• Cost of Sales = 300
• Gross Profit = 200
• Net Profit = 60
• Average Accounts Payable = 30
• Average Debtors = 45

1. Current Ratio = 150 ÷ 100 = 1.5
2. Quick Ratio = (150 − 40) ÷ 100 = 1.1
3. Debt‑to‑Equity = 200 ÷ 350 = 0.57
4. Interest Coverage = 80 ÷ 20 = 4.0
5. Gross Profit Margin = (200 ÷ 500) × 100 = 40 %
6. Net Profit Margin = (60 ÷ 500) × 100 = 12 %
7. ROCE = 80 ÷ (550 − 100) × 100 = 80 ÷ 450 × 100 = 17.8 %
8. ROE = 60 ÷ 350 × 100 = 17.1 %
9. DPO = (30 ÷ 300) × 365 = 36.5 days
10. DSO = (45 ÷ 500) × 365 = 32.9 days

Interpretation for each external user

• Suppliers – Current Ratio 1.5 and Quick Ratio 1.1 show adequate short‑term liquidity; DPO ≈ 37 days indicates the firm is taking a moderate time to pay suppliers – acceptable but worth monitoring.
• Government – Gross Profit Margin 40 % signals a healthy taxable base; Current Ratio > 1 reassures that tax liabilities can be met when due.
• Lenders / Banks – Interest Coverage 4 shows comfortable ability to meet interest; Debt‑to‑Equity 0.57 reflects moderate leverage; DSO ≈ 33 days and DPO ≈ 37 days suggest balanced working‑capital management.
• Shareholders / Investors – ROE 17 % and ROCE 18 % are attractive returns; Net Profit Margin 12 % demonstrates solid overall profitability.
• Credit‑rating agencies – The combination of solid liquidity, moderate leverage and strong profitability would likely result in a favourable credit rating, reducing future borrowing costs.

Summary checklist for students (AO1‑AO4)

• List all external users of accounts and state why each needs financial information.
• Recall the formulae for the ten ratios required by the syllabus.
• Calculate each ratio accurately from any given data set.
• Interpret the numerical result in the context of the relevant external user.
• Evaluate the reliability of the information for each user (consider seasonality, accounting policies, one‑off items, window‑dressing, industry benchmarks).