7.2 analysing internal position: financial ratio analysis

Question 1

2 examples of financial statements

Answer 1

• balance sheets

- income statements

Question 2

what is a balance sheet

Answer 2

financial statement recording assets and liabilities of a business on a particular day at the end of an accounting period, only a ‘snapshot’ in time

Question 3

The short term of a balance sheet

Answer 3

known as current liabilities/assets, within the next 12 months, balance between current assets and current liabilities is known as working capital

Question 4

the long term of the balance sheet

Answer 4

• movement of non-current assets, sudden increase can lead to rapid growth, means that financial performance may improve over medium term
• reserves indicate the profits made by a business, so a rapid increase likely to correlate to a healthy position
• overall value of the business

Question 5

what is working capital

Answer 5

the measure of the amount of money available to a business to pay day-to-day expenses

Question 6

what is depreciation

Answer 6

reduction of the value of an asset over a period of time

Question 7

why do things depreciate

Answer 7

• lose value due to wear and tear
• availability of more modern equipment, making current equipment less desirable
• poor or inadequate maintenance may mean expensive repairs are required

Question 8

what is gross profit

Answer 8

form of profit calculated by deducting direct costs from sales revenue, gives a broad indication of the financial performance of the business without taking into account other costs such as overheads
Gross profit = revenue - cost of goods sold

Question 9

what is net profit

Answer 9

gives a better indication of the performance of a business over a period of time as it takes into account all costs of a business
Net profit = total revenue - total costs

Question 10

what is window dressing

Answer 10

improve the look of a balance sheet

Question 11

examples of window dressing

Answer 11

• borrow money to improve cash flow before the date of the balance sheet
• maintain the value of intangible assets on the balance sheet

Question 12

4 types of ratios

Answer 12

• profitability ratio- assess the amount of profit made by a business in relation to the capital available to it or to other figures such as revenue
• liquidity ratio- measures the ability for business to settle debts in the short term
• gearing ratio- relationship between internal and external sources of finance
• efficiency ratio- measures effectiveness with which an enterprise uses the resources available to it

Question 13

examples profitability ratio

Answer 13

• gross profit margin = revenue - cost of goods sold/revenue x 100
• operating profit margin = gross profit - operating expenses/revenue x 100
• profit for the year margin = profit for the year/revenue x 100
• ROCE = operating profit x 100/total equity + non-current liabilities(capital employed), comparing the operating earned and the amount of capital employed the business

Question 14

liquidity ratios

Answer 14

current ratio = current assets / current liabilities
current ratio is expressed in the form of a ratio eg 2:1
typical figure is 1.6:1 because of new systems of production like JIT

Question 15

Gearing ratio

Answer 15

gearing = non-current liabilities x 100 / total equity + non-current liabilities
measures long-term liquidity of as business
highly geared business = more than 50% of its capital from loans
low geared business = less than 50% borrowing capital
recommended is between is between 25% and 50%

Question 16

efficiency ratio

Answer 16

• inventory turnover ratio = cost of goods sold / average inventories held, measures a companies success in converting inventories into sales
• inventory turnover ratio (average number of days taken to sell the business’s inventory) = inventoriesx365/cost of sales
• receivable days = receivablesx365/revenue, calculate the typical time by a business to collect the money it is owed
• payable days = payablesx365/cost of sales, typical time for a business to pay money it owes