Financial analysis: budgets and variance analysis, the balance sheet and income statement, and ratio analysis of profitability, liquidity and efficiency.

What this dot point is asking

WJEC Unit 3 deepens the financial work from Unit 2 into full financial analysis: budgets and variances, reading the balance sheet and income statement, and ratio analysis of profitability, liquidity and efficiency. The marks reward accurate calculation, correct interpretation of each ratio, and a realistic view of what ratios can and cannot tell you.

The answer

Budgets and variance analysis

Variances flag where the firm is off-plan so managers can investigate and act. Realistic budgets also motivate staff and clarify responsibility; unrealistic ones demotivate.

The financial statements

Two statements underpin the analysis:

• The income statement (profit and loss account) shows performance over a period: revenue minus cost of sales gives gross profit, minus expenses gives operating/net profit.
• The balance sheet (statement of financial position) shows the firm at a point in time: its assets (what it owns - non-current such as premises, current such as stock, debtors and cash), its liabilities (what it owes - current and non-current) and the capital invested. Assets must equal liabilities plus capital.

Ratio analysis

Profitability ratios:

• Gross profit margin = (gross profit / revenue) x 100.
• Net profit margin = (net profit / revenue) x 100.
• Return on capital employed (ROCE) = (operating profit / capital employed) x 100 - the return generated on the money invested, a key measure for investors.

Liquidity ratios:

• Current ratio = current assets / current liabilities - around 1.5 to 2 is usually healthy; too low risks insolvency, too high may mean idle resources.
• Acid-test (quick) ratio = (current assets - stock) / current liabilities - a stricter test that excludes stock, which may be hard to turn into cash quickly.

Efficiency measures such as stock turnover and debtor days show how well the firm manages its resources and collects what it is owed.

Strengths and limits

Ratios are most powerful as comparisons - over time and against rivals - and as early-warning signs of trouble. But they use historic data, can be distorted by one-off events or different accounting policies, and ignore qualitative factors such as staff quality and market conditions, so they must always be interpreted in context.

Examples in context

Example 1. A liquidity warning. A retailer's current ratio falls from 1.8 to 0.9 over two years, with an acid-test of just 0.4. The ratios warn that the firm may struggle to pay short-term debts, prompting action to raise cash (chase debtors, reduce stock, arrange finance) before a crisis. The example shows liquidity ratios as an early-warning system that triggers a response.

Example 2. Comparing ROCE for investment. An investor comparing two firms uses ROCE: Firm A returns 18% on capital employed, Firm B only 7%. All else equal, Firm A uses its capital more productively, making it the more attractive investment. The example illustrates ROCE as the headline profitability ratio for judging how well a business turns invested capital into profit, and why comparison is essential.

Try this

Q1. Define the term current ratio. [2 marks]

• Cue. A measure of liquidity calculated as current assets divided by current liabilities, showing a firm's ability to meet its short-term debts.

Q2. A firm has operating profit of £60,000 and capital employed of £400,000. Calculate its ROCE. [2 marks]

• Cue. ROCE = (operating profit / capital employed) x 100 = (60,000 / 400,000) x 100 = 15%.