0264 · 5.5.3Users of accounts

Accounts, ratios and user interests

0:00The same business accounts can help an owner decide whether to invest more and a bank decide whether to lend money. An employee might study those figures for a different reason, such as job security. Each user has something different at risk. By the end of this video, you will understand how financial information supports these decisions and why further evidence matters. Accounts are financial records and statements showing a business’s performance and financial position.

0:25The statement of profit or loss shows revenue, costs and profit over a period. Assets, liabilities and owners’ equity at a particular date appear in the statement of financial position. Together, these statements provide evidence about financial performance and the resources available to meet obligations. Revenue is the income a business receives from selling goods or services, while profit is total revenue minus total costs. Cash is the money a business holds as notes and coins and in its bank account.

0:53Profit helps users judge financial performance. Having cash available when payments fall due lets the business meet its obligations. Ratio analysis uses relationships between financial figures to assess business performance and financial position. Profitability is how well a business turns its revenue or the capital invested in it into profit, measured as a percentage. The ability of a business to pay its short-term debts when they are due is called liquidity.

1:19The videos on profitability and liquidity show the calculations, and this video uses their results to make decisions. People within the business, including its owners, managers and employees, are called internal users. External users are individuals or organisations outside the business that use its financial information. Suppliers, government, lenders and banks belong to this group. Each user has its own interest, and the accounts provide evidence that helps protect it.

Internal users of accounts

1:46A shareholder owns part of a limited company. Owners include sole traders, partners in a partnership, and shareholders. These owners have invested money, so they want evidence that the business earns an adequate profit. They compare profitability over time before deciding whether to invest more, keep their investment or sell their shares. Rowan Workshop provides bicycle maintenance. Its owner sees improving profitability and considers investing more money in equipment. The accounts help judge whether previous spending has produced worthwhile financial results.

2:18Future demand also matters, because new equipment brings benefits only when enough customers buy the service. Managers use financial information to make decisions, compare performance with targets and plan future activities. At Rowan Workshop, a manager could investigate expenses that exceed the planned amount. The accounts identify where spending needs attention. Information about daily operations then helps the manager choose a suitable response and improve future performance. Employees are interested in job security and whether pay rises are affordable.

2:48A profitable business with adequate liquidity has stronger financial evidence to support continued employment and higher wages. Employees can use the accounts when preparing a pay request. Managers still need to consider future costs and payment commitments before agreeing to an increase. Access to information differs between users. Managers can usually obtain detailed internal records, while employees and external users may receive only selected information or published accounts. Existing shareholders appear among owners in this classification.

External users and lending risks

3:19Someone considering buying shares can also use available accounts to judge whether becoming an owner is worthwhile. Trade credit allows a business to receive goods or services now and pay its supplier later. Suppliers examine liquidity before deciding whether to offer this arrangement. Wren Timber sells wood to furniture makers and needs its customers to pay on time. If a furniture maker shows weak liquidity, Wren Timber could demand immediate payment or set a smaller credit limit.

3:45Government uses financial information to check the tax due on profits. Accounts also help it assess whether businesses are growing and providing employment. Rising revenue and investment in assets can provide evidence of growth. A business that recruits more employees creates jobs, so unemployment in its area can fall. Lenders and banks want evidence that a business can repay borrowed money. Interest is the payment made for borrowing money. Before deciding whether to lend, they examine liquidity, existing debts and profitability.

4:16Profit helps pay the interest on a loan. Existing borrowing already needs repayments, so a new loan adds to those commitments.

Worked example: Oakridge Engineering

4:24Oakridge Engineering is a private limited company that makes hand tools and sells them to hardware shops every month. It aims to expand production and asks its bank for a loan of twenty thousand dollars. The business already has borrowing of forty thousand dollars. An existing shareholder is also deciding whether to invest more. Current assets are assets expected to be converted into cash or used up within twelve months.

4:47Cash and inventory both belong to this group. Inventory is the goods and materials a business holds, for use in production or for sale. Current liabilities, by contrast, are debts a business expects to pay within twelve months. In the previous year, revenue was one hundred and fifty thousand dollars and profit was twelve thousand dollars. The latest year shows revenue of two hundred thousand dollars and profit of twenty-four thousand dollars.

5:11At the end of the latest year, current assets total eighty thousand dollars, including inventory of forty-five thousand dollars. Current liabilities stand at fifty thousand dollars. Profit margin is profit as a percentage of revenue, so it equals profit divided by revenue, times one hundred. Twelve thousand divided by one hundred and fifty thousand, times one hundred, gives eight per cent for the previous year. For the latest year, twenty-four thousand divided by two hundred thousand gives twelve per cent.

5:39A larger share of each sales dollar now remains as profit after all costs. Current ratio equals current assets divided by current liabilities. Eighty thousand divided by fifty thousand gives one point six to one. Oakridge Engineering has one dollar and sixty cents of current assets for each dollar of current liabilities. That covers its short-term debts, although some of those assets take time to become cash. Acid test ratio equals current assets minus inventory, divided by current liabilities.

6:09Inventory is left out because goods must be sold before they bring in money. Eighty thousand minus forty-five thousand gives thirty-five thousand dollars. Dividing that by fifty thousand gives zero point seven to one. Without selling inventory, the business has only seventy cents for each dollar of current liabilities. I recommend that the bank lends Oakridge Engineering the twenty thousand dollars. Profit has doubled from twelve thousand to twenty-four thousand dollars, so more profit is available to pay interest on both loans.

6:38Current assets exceed current liabilities by thirty thousand dollars, as the current ratio shows. The low acid test result matters less here, because hardware shops buy the finished hand tools every month. Refusing the loan is the weaker choice for this business. Rising profit and monthly sales show that money keeps coming in to meet repayments. A refusal would also delay the planned expansion, so revenue would grow more slowly.

7:02Lending therefore keeps a profitable customer that can repay its old and new loans. For the shareholder, I recommend investing more in Oakridge Engineering. The profit margin rose from eight per cent to twelve per cent, so more of each sales dollar now becomes profit. Selling shares is weaker, because the shareholder would give up part of a rising profit. Extra money from the owner also raises cash, so the low acid test ratio becomes less of a risk.

7:27The same figures therefore support two different decisions. Repayment is the bank’s main concern, so it gave most weight to liquidity and regular sales. For the shareholder, the rising profit margin mattered most because it points to a worthwhile return. Each user reads the accounts through its own risk.

Limitations and exam application

7:44Accounts describe the past, while lending and investment decisions concern the future. A strong trading period provides evidence of past success. Future sales depend on conditions such as customer demand and competition. Users should combine historical results with forecasts and current information before committing money. Comparisons need matching time periods and similar businesses. A full year of profit covers a different length of activity from six months. Businesses in different industries can also have different normal levels of inventory or payment arrangements.

8:16Comparing similar businesses over matching periods makes differences in performance easier to interpret fairly. Non-financial factors are information about a business that financial figures alone do not fully capture. Employee morale, reputation, environmental impact and product quality can affect future performance. Poor morale can reduce effort, while unreliable products can discourage repeat purchases. Users therefore need evidence about operations and relationships alongside the accounts. Outside influences also affect financial results.

8:47Inflation is a sustained rise in the general price level. Revenue can rise because prices increase, even when the quantity sold stays unchanged. The business cycle matters too, since customers spend less during a recession. Sales can then fall even in a well-managed business. A ratio reveals a financial relationship and its movement over time. Explaining the cause requires additional evidence. A rising profit margin could follow higher selling prices, lower costs or a different mix of products.

9:16Each cause has different implications for whether the improvement will continue. Keep three distinctions clear when using accounts. Profit measures the difference between revenue and costs, while liquidity concerns meeting short-term debts. A ratio provides evidence that must be interpreted in the business’s circumstances. Strong decisions combine several financial measures with information about future conditions and operational performance. In Paper One Short Answer and Data Response or Paper Two Case Study, you may use financial information from a business situation.

9:47An exam-style question could ask you to explain why a supplier uses a café’s liquidity ratios before offering trade credit. Explain means set out purposes or reasons, say why and how, supported with relevant evidence. Connect the financial evidence to the user’s risk and decision. The supplier uses liquidity ratios to assess the café’s ability to meet short-term debts. Selling ingredients on trade credit creates a risk that payment will arrive late.

10:13Evidence of weak liquidity could lead the supplier to require immediate payment. This protects the supplier’s ability to pay its own bills when they fall due. Owners, managers and employees use accounts for investment, planning, pay and job security decisions. External users need evidence about payment, taxation or lending risks. Ratio analysis uses relationships between financial figures to assess business performance and financial position. The strongest decisions connect that evidence to the user’s purpose, then consider its limitations and future conditions.