3.7.2 Flashcards
what 2 financial info used to support stakeholders in decision making
income statement and balance sheet
what is the income statement
An income statement at its most basic will communicate the revenue generated by a business and then its profit at various levels following a series of expenses and exceptional incomes.
cost of goods sold
The direct costs associated
with the production and sale of the product or service.
administration/rent/salaries
Operating costs (overheads) are then deducted from gross profit
operating profit
The profit left after other
indirect operating costs
(overheads) have been deducted.
what is net profit
The bottom line - what a
business has left to reinvest or return to shareholders/owners after tax has been deducted.
an income statement can be used to calculate
profitability ratios such as gross profit margin, operating profit margin and return on capital employed (ROCE).
what is gross profit
The profit after direct costs have been deducted. Gives a broad indication of the success. of a business’s trading activity.
what is exceptional expenses and income
These could be expenses or incomes not associated with the direct activity of the business.
They may be one-off items. They are kept separate in order to give an indication of the quality of profit.
what can you find out from an income statement
- Changes in sales revenue
- Changes in the direct costs of sales
- How well a business is managing its operating costs
- The profitability of a business
- Identify unusual incomes/expenses during the year
what is the balance sheet
A balance sheet is a financial document that records the assets and liabilities of a business. A balance sheet gives a snapshot of the value and financial strength of a business.
non current assets
Also known as fixed
assets
Non-current assets are used to operate the business and include land and machinery (tangible or fixed assets) and brands and patents (intangible).
current assets
Assets that the business
expects to use or sell within the year. These can be
converted into cash to pay off liabilities
net current assets
current assets - current liabilities = working capital a business has available
net assets =
total assets - total liabilities = the value of a business
total equity
Will always balance with net assets - it represents how a business has been financed.
non-current liabilities
Debts that a business does not expect to pay within a year.
current liabilities
Payments due within 1 year
A balance sheet can be used to calculate
financial ratios such as liquidity ratios, gearing ratios and efficiency ratios.
what can we find out from a balance sheet
the value of a business (equity)
the current assets a business holds
short-term liabilities the business will need to pay within the year
the liquidity of a business
the long-term debts of a business
how a business has been financed
profitability ratio
provides a key measure of success for a business comparing profit to revenue and investment
efficiency ratio
provides an indication of how well an aspect of a business has been managed
gearing ratio
assesses the extent to which a business is based on borrowed finance
liquidity ratio
assesses the ability of a business to pay its debts
what do profit margin ratios do
compare a type of profit to the revenue that it was generated from over a trading period.
gross profit margin
gross profit/revenue x100
profit for the year margin
net profit/revenue x100
operating profit margin
operating profit/revenue x100
why is profitability a key measure
Profitability is a key measure of success for most businesses and these ratios allow managers to compare performance over time. It is also useful to compare these ratios, as doing this will give an indication of the quality of profit and how well the business is managing various aspects of the business such as its direct and indirect costs.
what does ROCE ratio compare
operating profit earned with the amount of capital employed by the business.
capital employed =
total equity + non-current liabilities
ROCE ratio
operating profit/capital employed
what does ROCE show
how effectively the business was able to generate a profit from the investment placed within the business. It can be compared to previous years and the general rate of interest.
how can a business improve ROCE
A business can improve its ROCE by increasing operating profit or by reducing capital employed.
what is the current ratio
The current ratio is a key liquidity ratio. It compares current assets with current liabilities. In doing so it assesses whether a business has sufficient working capital to pay its short-term debts.
current ratio equation
current assets/current liabilities
interpreting current ratio
This suggests that the business has $2 of current assets for every £1 of current liabilities.
If the ratio is less than 1, such as 0.5:1, then the business might struggle to pay its short-term debts.
what is the gearing ratio
Gearing analyses how a business has raised its long-term finance. The ratio represents the proportion of a firm’s equity that is borrowed.
gearing ratio formula
Non-current liabilities/
Total equity + non-current liabilities X 100
interpreting gearing ratio
A highly geared business has more than 50% of its capital in the form of loans. A highly geared business is vulnerable to increases in interest rates.
A low-geared business may have the opportunity to borrow funds in order to expand. Businesses with secure cash flow or considerable assets may be able to borrow more for this purpose.
using financial ratios
Performance as a trend - financial information in isolation often holds little value. Low profitability might be acceptable if it is improving gradually.
Benchmarks and industry average - manufacturers typically have lower operating profit margins than service businesses.
Understanding the industry norm is important.
The economic environment - poor performance might be less significant if the business is operating in a tough economic climate.
inventory turnover
This ratio measures a company’s success at
converting inventories into revenue. It compares the value of inventories (at cost - cost of goods sold) with the sales achieved. The faster
a business sells its inventories the faster it
generates profit.
inventory turnover formula
Cost of goods sold/
Average inventories held
interpreting inventory turnover
The lower the number, the more efficient the business is. This ratio is only really relevant for manufacturers. The turnover rate will be
determined by the nature of the product.
Perishable goods such as food will have a much
faster turnover than manufactured goods
To determine average number of days an
Cost of goods sold
Average inventories held
inventory is held, the number needs to be divided into 365.
what is receivables days ratio
This ratio calculates the time it takes for a business to collect debts that it is owed. The shorter the period, the faster cash is flowing into the business.
receivables days formula
Receivables/Revenues X 365
interpreting receivables days ratio
The shorter the period the easier the firm will find it to meet its short-term cash needs. However, businesses that offer trade credit to customers will experience long payment periods.
Businesses can use a range of techniques to reduce the length of time debtors take to pay.
what can trade credit mean
mean a business will wait quite some time before payment is received and this can cause cash flow problems.
payables days ratio
This ratio calculates the time it takes for a business to pay its creditors. The longer the period, the longer the business is retaining cash within the business.
payables formula
Payables/Cost of sales X 365
interpreting payables days ratio
The longer the period the easier the firm will find it to meet its short-term cash needs. However, businesses that delay payments to suppliers or creditors may damage the business relationship and this may cause problems when making future deals.
how are financial accounts used
Managers - to assess the performance of the business and whether resources are being used efficiently
Shareholders - to assess the return they may receive on their investment
Potential investors and
lenders - to assess the security and liquidity of the
business
Government - to calculate the tax liability of the business
advantages of ratio analysis
Allows a business to calculate and compare trends over time.
Shows greater insight than financial accounts on their own.
Information can be used against benchmark data - such as an industry average.
Can be used to assess the performance of other functional areas of the business operations and human resources.
disadvantages of ratio analysis
Does not take into account qualitative issues such as brand image or customer service performance.
Does not take into account the impact of long-term decisions, such as investments today may lower profitability but boost it in the long term.
Economic climate - ratios do not take into account economic conditions or the performance of other businesses.
what is window dressing
involves a business manipulating its financial accounts to make them look more favourable to stakeholders. Window dressing can limit the value and validity of information interpreted from financial
accounts.
