5.5 Analysis of accounts

Question 1

What does profitability measure?

Answer 1

It measures how efficiently a business is making a profit

Question 2

How do you calculate gross profit margin?

Answer 2

Gross Profit Margin = Gross Profit ÷ Revenue

x 100

Calculates how much profit is made for every $1 of revenue.

Gross Profit = Revenue – Cost of Sales

Question 3

How do you calculate profit margin?

Answer 3

Profit Margin = Profit ÷ Revenue

x 100

Calculates how much profit is made for every $1 of revenue.

Profit = Revenue – Total costs

Question 4

How can profitability ratios be improved?

Answer 4

Increase price. This means that the business will make more gross profit for every $ of sales revenue.

Evaluation: If the price increase leads to significantly lower sales this will have a negative impact on business profits

Decrease in cost of sales
If the business can reduce the cost of materials but keep their selling price the same they will earn more gross profit for every $ of revenue.

Evaluation: if a business reduces their cost of materials this may impact the quality of their products and lead to a decrease in sales.

Question 5

How do you improve profit margin?

Answer 5

Decrease expenses. If the business can reduce the expenses they will earn more profit for every $ of revenue

Evaluation: if a business decreases expenses this may reduce sales. For example, if the advertising budget is reduced this could lead to less people finding out about the product and reducing sales as a result.

Question 6

How do you calculate Return on Capital Employed (ROCE)?

Answer 6

Capital Employed = Profit ÷ Capital Employed x 100

Measures how efficiently a business makes profit compared to the capital invested in the business.

Question 7

How do you increase ROCE?

Answer 7

Increasing profit or reducing capital employed.

Question 8

Define liquidity.

Answer 8

the ability of a business to pay its short term debts

Question 9

What happens if a business has low cash flow?

Answer 9

it can’t pay it’s short term debts and it will become illiquid, insolvent and stop operating.

Question 10

What happens if a business has high cash flow?

Answer 10

there is an opportunity cost. If that cash is not needed to pay short term debts it means that it could be used more effectively elsewhere and re-invested in the business.

Question 11

How do you calculate current ratio?

Answer 11

Current Assets ÷ Current Liabilities

Question 12

How do you calculate acid test ratio?

Answer 12

Current Assets – Inventory ÷ Current Liabilities

Question 13

What is the best current ratio result?

Answer 13

best current ratio result is somewhere between 1.5 and 2.0. Below 1.5 there is a danger that the business will not have enough cash to be able to pay its short term debts.

Question 14

What is the optimum figure for Acid Test Ratio?

Answer 14

1.0

Question 15

What does it mean if the ATR is lower than the optimum figure?

Answer 15

the business may have difficulty paying short term debts and is at risk of not having enough cash flow for the business to continue operating.

Question 16

Why do we subtract inventory to calculate ATR?

Answer 16

The reason we subtract inventory from current assets to calculate the acid test ratio is that inventory is the most difficult current asset to convert to cash

Question 17

Why are manager interested in income statements?

Answer 17

They are interested in the income statement and profitability ratios, so they can see how the performance of the company compares against previous years and against competitors. They also use financial information to make decisions for the business going forward.

For example, if the income statement shows a particular market or product has a higher profit margin, this could be the focus for their marketing strategy in the future.

It’s worth noting managers success (and bonuses) will often be measured against the profitability of the business.

Question 18

Why are managers interested in liquidity ratios?

Answer 18

so they can analyse the businesses ability to pay its short term debts. If working capital is low they can look at ways of improving cash flow to ensure the business can continue to operate.

Question 19

Why would investors look at the income statement and profitability ratios?

Answer 19

If the business is improving it’s profitability it will mean more dividends for shareholders. If profit margins are low investors may decide to move their money elsewhere.

Question 20

Why do investors look at the statement of financial position?

Answer 20

it shows the total value of a business. If the net worth of the business is increasing year on year, it means the value of the investors shares is likely to increase.

Question 21

Why are banks and creditors interested in the statement of financial position?

Answer 21

they need to make sure a business can pay its debts.

If a business has a high level of debt banks may be unwilling to loan capital as there is a risk the business will not be able to repay.

If a business has low liquidity a supplier may decide not to sell on credit, as they may not receive payment from the business.

Question 22

Why are competitors interested in financial accounts and ratios?

Answer 22

Competitors will compare their profitability to companies in the same industry to assess their performance. Toyota may compare its results with Ford, Tesla and other car manufacturers.

Question 23

Why are governments interested in financial accounts?

Answer 23

because of tax. If a business is profitable it will pay more tax so the government will want it’s share.

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Question 39

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