users of accounts and ratio analysis: external, e.g. suppliers, government, lenders/banks
5.5.3 Users of Accounts
Who Looks at the Numbers?
Accounts are like a company’s report card. Just as teachers, parents and students check the grades, different people outside the company check the financial statements to see how well the business is doing. The main external users are:
- Suppliers – they want to know if the company can pay its bills on time.
- Government – they need to see if taxes are being paid and if the company follows regulations.
- Lenders & Banks – they want to know if the company can repay loans and interest.
Why Ratios Matter to Them
Ratios are short‑cuts that turn big numbers into quick insights. Think of them as cheat‑codes that tell you if the company is healthy, risky or strong. External users use these ratios to decide:
- Can the company pay its suppliers? (Liquidity ratios)
- Will the company pay its taxes on time? (Profitability ratios)
- Is it safe to lend money? (Solvency ratios)
Key Ratios & What They Reveal
| Ratio | What It Means | Why External Users Care | Quick Example |
|---|---|---|---|
| Current Ratio = Current Assets ÷ Current Liabilities | Shows if the company can cover short‑term debts. | Suppliers want a ratio > 1 to feel safe that invoices will be paid. | $1,200,000 ÷ $800,000 = 1.5 |
| Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities | A stricter test of liquidity. | Banks use it to judge loan safety. | $900,000 ÷ $800,000 = 1.125 |
| Debt to Equity Ratio = Total Debt ÷ Total Equity | Shows how much of the business is financed by debt. | Lenders look for a lower ratio to reduce risk. | $1,000,000 ÷ $2,000,000 = 0.5 |
| Interest Coverage Ratio = EBIT ÷ Interest Expense | Shows how many times earnings cover interest. | Banks want a ratio > 3 to feel comfortable. | $600,000 ÷ $150,000 = 4 |
| Return on Equity (ROE) = Net Income ÷ Shareholder Equity | Shows how well the company uses shareholders’ money. | Government and investors care about profitability. | $200,000 ÷ $2,000,000 = 0.10 or 10% |
Analogy: The Company’s Health Check
Imagine a company as a person going to the doctor. The current ratio is like checking the person’s blood pressure – it tells you if they’re stable right now. The debt to equity ratio is like checking the person’s cholesterol – high levels mean more risk. The interest coverage ratio is similar to measuring how many times the person can afford to pay their monthly medication costs with their income. If the numbers look good, the doctor (suppliers, banks, government) will give a green light. If they’re bad, the doctor will recommend treatment (e.g., better cash flow management, debt restructuring).
Quick Tips for Students
- Always check the trend of a ratio over several periods – a single year can be misleading.
- Compare ratios with industry averages; a 1.5 current ratio might be great in retail but low in manufacturing.
- Remember that ratios are tools, not the whole story. Look at the context and other financial statements.
- Use emojis to remember: 📈 for growth, 💰 for cash, ⚖️ for balance.
Practice Question
A company has the following figures (in £):
- Current Assets: £1,500,000
- Current Liabilities: £900,000
- Cash: £200,000
- Accounts Receivable: £400,000
- Total Debt: £1,200,000
- Total Equity: £1,800,000
- EBIT: £300,000
- Interest Expense: £75,000
- Net Income: £120,000
Calculate the Current Ratio, Quick Ratio, Debt to Equity Ratio, Interest Coverage Ratio, and Return on Equity. Which external user would be most concerned with each ratio? Write a short sentence for each.
Answer: Students should calculate and write their own answers here.
Revision
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