Page 5: Ratio analysis
Businesses generate a huge amount of data. Management accountants can use a number of the company’s key accounting statements to extract greater meaning from this information.
Prospect plc - Balance sheet/statement of financial position as at 31 March 2012
The income statement sets out the total sales revenue and subtracts the costs of generating that revenue to give operating profit. This is the surplus earned by the normal operations of the company and tells us most about underlying business performance.
To continue to use the earlier illustrative example, Prospect plc is expanding rapidly as it builds a commercial property portfolio consisting mainly of shops and offices. The company receives rents and also benefits from any profits when it sells property and sites.
Prospect plc - Summarised income statement for year ending 31 March 2012 (against previous year for comparison)
The balance sheet (or statement of financial position) shows the wealth of a company at a particular date. It lists the company's assets (what it owns) followed by its liabilities (what it owes) – the difference being the net assets. Assets may be current, such as cash, or fixed, such as property or equipment. This value represents the shareholders' equity – the value in the company that the shareholders actually own.
This looks as if Prospect plc has expanded very fast indeed – but how strong is its performance? Accounting ratios allow different pieces of financial data to be compared. Analysing some key ratios helps to explore behind the figures and offer strong clues for the business to steer towards its objectives (previous year data in brackets):
The chart shows every sign of a firm that has expanded too quickly:
- sales have increased by an impressive 50% in one year
- however, profitability has halved
- liquidity has weakened while gearing is more risky at nearly 50%.
The result is a danger signal! Management accountants investigate this sort of data in order to alert managers to worrying trends, as well as to possible opportunities.