5.5.3 Interpreting Performance
Instruction :
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Go through all instructions and course details thoroughly before starting each lesson or activity.
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Watch the attached video lessons attentively and take clear, organized notes in your notebook.
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Write all answers for the attached worksheets in your notebook. Make sure your work is neat and properly labeled.
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Revise your notes and completed worksheets after each lesson to reinforce understanding.
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If you face any difficulty or have questions, note them down and contact your instructor or course coordinator for guidance.
Click to download the Video Lecture Handout.
Good morning, class! Today we are going to explore analysis of accounts, which is all about examining a business’s financial statements using ratios to see how well it is performing. This includes both profitability—how efficiently a business earns profits—and liquidity, which shows whether it can pay its short-term debts. By the end of this lesson, you’ll understand how these ratios help owners, investors, and managers make smart decisions.
Let’s start with profitability ratios. These ratios tell us how good a business is at turning sales into profit. The first is the Gross Profit Margin, or GPM. It’s calculated by dividing gross profit by revenue and multiplying by 100. Gross profit is simply revenue minus the cost of sales, like raw materials or goods purchased. For example, if a bakery earns $100,000 in revenue and its cost of sales is $60,000, the gross profit is $40,000. So the GPM is 40%, meaning the business keeps 40 cents from every $1 of sales before paying other expenses. A higher GPM means the business is controlling its production costs well.
Next is the Net Profit Margin, also called Profit Margin. This shows how much profit is left after all expenses, such as wages, rent, and utilities, have been paid. Using our example, if the net profit is $15,000 on $100,000 revenue, the net profit margin is 15%. That tells us that for every $1 of sales, 15 cents is the final profit. A higher net profit margin indicates good cost control and financial efficiency.
Another important ratio is Return on Capital Employed, or ROCE. This measures how effectively the business is using its invested capital to generate profit. It’s calculated by dividing net profit by capital employed, which is total assets minus current liabilities, and multiplying by 100. For instance, if the net profit is $20,000 and the capital employed is $100,000, the ROCE is 20%. That means the business is earning a 20% return on the money invested in it.
Now let’s look at liquidity ratios, which focus on a business’s ability to pay short-term debts. The first is the Current Ratio, calculated by dividing current assets by current liabilities. A ratio of 2:1 is generally healthy, meaning the business has $2 in current assets for every $1 owed. For example, if a company has $40,000 in current assets and $20,000 in current liabilities, it has a strong position to pay off its debts.
The Acid Test Ratio, or Quick Ratio, is a stricter measure of liquidity. It subtracts inventory from current assets before dividing by current liabilities. This is because inventory may not be easily sold quickly. A ratio of 1:1 is generally acceptable. For example, if current assets are $40,000, inventory is $10,000, and liabilities are $30,000, the acid test ratio is 1:1. This shows that the business can meet its debts even without selling stock.
So, why are these ratios important? Profitability ratios tell us how efficiently a business earns profit and manages its costs. Liquidity ratios show whether it can meet short-term obligations and avoid financial problems. Together, they help business owners improve performance, investors decide whether to invest, banks assess loan applications, and managers identify weaknesses to fix.
In conclusion, interpreting these ratios is key to understanding a business’s financial health. Profitability ratios show how well it earns profits, and liquidity ratios show whether it can pay its bills. By learning to read and interpret these figures, you can understand the strengths and weaknesses of any business.
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