3.7.2 Analysing the existing internal position of a business to asses strengths and weaknesses: financial ratio analysis

Question 1

What is a balance sheet?

Answer 1

this shows the assets (what a business owns) and liabilities (what a business owes) at a particular time throughout the financial year

Question 2

Why should assets and liabilities equal each other?

Answer 2

Assets and liabilities must equal each other else the balance sheet won’t balance. If a firm owes more than what it owns, then this will limit their growth potential and they may have to consider retrenching (selling off stock)

Question 3

What are fixed assets?

Answer 3

anything the firm owns as long as it is useful to operating the firm (must last longer than a year)

Question 4

What are current assets?

Answer 4

these represent the working capital and are directly linked to what is sold to the customers (lasts less than 12 months)

Question 5

What are current liabilities?

Answer 5

things that a firm will need to pay out for within 12 months

Question 6

What is Working Capital (Net Current Assets)?

Answer 6

this shows the liquidity of the business – so if liabilities acceded assets, they the firm would go into liquidation
= current assets – current liabilities

Question 7

Explain the influences on the amount of working capital and why.

Answer 7

• The volume of sales – rising sales indicate that costs will rise as well to pay for the resources that create the goods and services
• The amount of trade credit offered by a business – a long pay back time requires more working capital
• Growth of the business – over trading can occur if the business grows too fast without arranging the needed working capital
• Length of the operating cycle – the time between paying for materials and receiving payments for goods and services (the longer the period, the greater the need for working capital)
• The rate of inflation – when prizes rise, greater working capital is needed

Question 8

What is depreciation?

Answer 8

• when the value if a non-current asset decreases
• Assets will eventually become worthless over time without continuous investment

Question 9

What is an income statement?

Answer 9

this describes the income and expenditure of a business over a given period of time (usually a year) – it shows the profits and losses of a firm

Question 10

What is Gross Profit?

Answer 10

Gross Profit = revenue – cost of sales

Question 11

What is Operating Profit?

Answer 11

Operating Profit = gross profit – expenses

Question 12

What is Profit Before Tax?

Answer 12

Profit Before Tax = operating profit – finance costs + finance income

Question 13

What is Profit for the Year?

Answer 13

Profit for the Year = profit before tax – tax expenses

Question 14

State the different purposes of an income statement?

Answer 14

Legal requirement
Review progress
Allows shareholders to access if investment is needed
Comparisons can be made
Used to show potential investors

Question 15

What is capital expenditure?

Answer 15

when spending money on items that will be used in the long run (e.g. property, machinery, vehicles, and office equipment)

Question 16

What is revenue expenditure?

Answer 16

spending on day to day items (e.g. raw materials, wages, and power)

Question 17

What is the order of an income statement?

Answer 17

• Revenue
• Cost of sales
• Gross profit
• Expenses
• Operating (net) profit
• Finance costs
• Profit before tax
• Taxation
• Profit for the year (retained)

Question 18

What is ratio analysis?

Answer 18

ratios assess the financial information by comparing two sets of linked data

Question 19

What are the three types of ratios?

Answer 19

• Profitability
• Liquidity
• Financial Efficiency

Question 20

What are the profitability ratios?

Answer 20

Question 21

What is the liquidity ratio?

Answer 21

And gearing ratio

Question 22

What are the financial efficiency ratios?

Answer 22

Question 23

What is the process of ratio analysis?

Answer 23

Question 24

List the stakeholders who are interested in financial ratios:

Answer 24

• Shareholders
• Customers
• Employees
• Government
• Competitors
• Manager
• Banks
• Suppliers

Question 25

What do Liquidity and Gearing Ratios allow managers to do?

Answer 25

These allow managers to control the business’ cash flow and ensure they have sufficient working capital

Question 26

Explain what the current ratio is, how to calculate it and what the figures mean

Answer 26

this is used the keep track of the working capital within a business and make sure it can pay off the debts
= current assets / current liabilities
The ratio should be between 1:1 and 3:1
If the figure is below 1, the business doesn’t have sufficient short term assets and many need to raise additional finance
If the figure is above 3, then they may have to much cash and aren’t using it effectively
Ideal current ratio is 1.5:1

Question 27

Explain what the gearing ratio is, how to calculate it and what the figures mean

Answer 27

this is used to show whether a firm’s structure is likely to be able to co tune to meet interest payments and to repay long term borrowing
= long term liabilities / capital employed x 100 (capital employed = long term liabilities + total equity (total capital and reserves))
The figure should be between 25% and 50%
If > 50%, then the business is highly geared
If < 25%, then the business is low geared
Between 25% and 50% is considered normal for a well established business

Question 28

What are profit ratios used for?

Answer 28

These allow managers to measure the performance if the business in generating profit compared to the costs involved

Question 29

Explain what profit margins are, how to calculate it and what the figures mean

Answer 29

this is an indication of a business’ ability to control costs
= ‘X’ profit / sales revenue x 100
Profit includes gross, operating, net, and retained
The higher the percentage the better as they are receiving more profit for the money they are investing in to the business and its products
The percentage reduces as further costs are subtracted
Profit margins depend upon the product life cycle and the placing of the product on the Boston matrix

Question 30

Explain what Return on Capital Employed is, how to calculate it and what the figures mean

Answer 30

this shows what returns (profits) the business has made on the resources available to it
= operating profit / capital employed x 100
The higher the figure the better as the firm will be getting more profit back for the resources and money it has used
The figures can be compared with previous figures as other competitors to gain an idea of where they stand in the market

Question 31

What are efficiency ratios used for?

Answer 31

These allow managers to measure how well the business is managing its stock and working capital

Question 32

Explain what payable days are, how to calculate it and what the figures mean

Answer 32

this estimates the average time it takes a business to settle its debts with the trade suppliers
= trade payables / cost of sales x 365
In general, a firm that wants to maximise its cash flow should take as long as possible to pay its bills
However a high figure could illustrate liquidity problems which could cause legal claims
Thus figure should be higher than the debtor days

Question 33

Explain what receivable days are, how to calculate it and what the figures mean

Answer 33

this is the time is takes for trade debtors to settle its bills
= trade debtors / sales revenue x 365
A high figure could suggest a general problem with debt collection or the financial position of major customers
This should be lower than the payables

Question 34

Explain what inventory turnover is, how to calculate it and what the figures mean

Answer 34

this helps firms to answer questions like ‘how much money do we have tied up in stock?’
= cost of sales / average stock held
The quicker a firm turns over its inventories, the better
But, it is also important to do that profitable rather than sell inventory at a low gross profit margin or worse a loss
A high inventory turnover figure could indicate poor stock management

Question 35

Explain who are the internal users who need to know the business’s financial position and why:

Answer 35

Managers – whether the firm is reaching objectives and using resources efficiently
Employees – whether the firm is stable and secure and if they are receiving the right amount of pay for the job they are doing
Shareholders – how does the return on investment compare with other investors

Question 36

Explain who are the external users who need to know the business’s financial position and why:

Answer 36

Creditors – how much cash a firm had and if it will be able to pay its bills
Government – the tax liability
Competitors – how the business is performing in relation to others in the industry