Accounting Chap 11

Question 1

Name two types of financial statement

Answer 1

Trading, Profit and Loss Account

Balance Sheet

Question 2

Explain the P and L account

Answer 2

The P&L A/C calculates the amount of profit (or loss) that the business makes in a year.
Two parts:
The Trading Account – calculates Gross Profit (before expenses)
The Profit and Loss Account – calculates Net Profit (after expenses)

Question 3

Explain sales

Answer 3

How much money the business sold its products for.

Question 4

Explain Cost of Sales

Answer 4

Shows how much the business spent making or buying the goods they sold.

Question 5

Explain Gross Profit

Answer 5

Shows the profit made by the business before they take into account any other expenses.

Question 6

What is the formula for gross profit?

Answer 6

Sales – Cost of Sales = Gross Profit

Question 7

Explain expenses

Answer 7

Shows the total of all the expenses of a business over that year e.g light and heat, rent, wages

Question 8

Explain Net profit

Answer 8

Shows the profit made by the business after all the expenses have been paid.

Question 9

What is the formula for Net Profit?

Answer 9

Net Profit = Gross Profit – Expenses

Question 10

Explain Balance Sheet

Answer 10

A balance sheet shows a business’s financial position (its wealth) at a certain period of time
It shows the company’s Assets and Liabilities and how the company is financed.

Question 11

Explain fixed assets

Answer 11

These are all the valuable items that a business owns that will last for longer than a year e.g buildings, vans, machinery

Question 12

Explain Current Assets

Answer 12

These are all the valuable items a business owns that will be kept for less than one year e.g cash at bank, stock, debtors

Question 13

Explain Current Liability

Answer 13

These are items that a business owes and must pay within one year e.g bank overdraft, creditors

Question 14

Explain working capital

Answer 14

This the cash left over in business for it to pay its bills.

Question 15

What is the formula for working capital?

Answer 15

Working Capital = Current Assets – Current Liabilities

Question 16

Explain Financed By

Answer 16

This shows the amount of money invested in the business e.g shares, long-term loans

Question 17

Explain Ordinary Share Capital (Equity Share Capital)

Answer 17

the amount of money paid into the business by shareholders

Question 18

Explain authorised share capital

Answer 18

The maximum value of shares that can be issued in the business by way of share capital

Question 19

Explain retained earnings (reserves)

Answer 19

shows the total amount of profit that has been reinvested into the business.

Question 20

Explain preference shares

Answer 20

Another type of investment in a company. Preference shares are guaranteed a dividend at the end of each year and come before other shareholders for payment

Question 21

Explain long-term loans

Answer 21

Money that the company has borrowed that are repaid over a number of years.

Question 22

What are the three main headings of ratio analysis

Answer 22

Profitability
Liquidity
Gearing or Debt/Equity Ratio

Question 23

What is the formula for gross profit percentage (gross profit margin)

Answer 23

Gross profit/sales x 100 = %

Question 24

What is the formula for net profit percentage (net profit margin)

Answer 24

Net profit/sales x 100 = %

Question 25

What is the formula for return on investment or return on capital employed

Answer 25

Net Profit/ Capital Employed x 100 = %

Question 26

What is the formula for capital employed

Answer 26

Capital employed=Ordinary Share Capital =Retained Earnings (reserves)+Long term loans + preference shares

Question 27

Who is interested in a business's profitability ratios?

Answer 27

``` Investors / Shareholders Employees Lenders / Banks Government Other Businesses-Competition ```

Question 28

Explain liquidity

Answer 28

Liquidity examines whether the business has enough cash available to pay its short term bills (current liabilities) e.g light & heat, rent, wages

Question 29

Name two liquidity ratios

Answer 29

Working Capital Ratio (Current Ratio) | Acid Test Ratio

Question 30

What is the formula for working capital (Current Ratio)

Answer 30

CA/CL = x:1

Question 31

What is the ideal current ratio for business

Answer 31

Ideal ratio 2:1 (business is said to be liquid) If ratio is below this business is illiquid and does not enough money to pay bills as they fall due If ratio is much higher business has excess cash and should invest it into other areas

Question 32

What is the purpose of the Acid test ratio?

Answer 32

Investigates if company has emergency cash to pay bills straight away

Question 33

What is acid test ratio formula?

Answer 33

CA- Closing stock/ CL = x:1

Question 34

What is ideal ratio for acid test ratio?

Answer 34

1:1

Question 35

Why is closing stock excluded for acid test ratio

Answer 35

It is the hardest asset to turn quickly into cash

Question 36

Who looks at a firm’s liquidity ratios?

Answer 36

Suppliers Employees Lenders / Banks Government

Question 37

Who looks at a firm’s Debt/Equity ratios

Answer 37

``` Investors / Shareholders Employees Lenders (Banks) Suppliers Government ```

Question 38

What are the limitations of ratios?

Answer 38

Historical figures- shows what happened in past. Not true indicators f what will happen in future Difference in calculation of accounting figures- change it's method and comparing ratios may not be accurate Limited picture- only show financial information

Question 39

What is the debt/equity ratio formula

Answer 39

(Long-term debt (loans) + Pref Shares) / (Ordinary hare capital + retained earnings(reserves)) = X:1

Question 40

What is the gearing of a firm if they have less debt capital than equity capital

Answer 40

low gearing

Question 41

What is the gearing of a firm if they have more debt capital than equity capital

Answer 41

high gearing

Question 42

What is the gearing of a firm if they have equal debt capital to equity capital

Answer 42

neutral gearing

Question 43

If firm is low gearing with ratio answer be greater than or less than one

Answer 43

less than

Question 44

If firm is high gearing with ratio answer be greater than or less than one

Answer 44

greater than

Question 45

Discuss the trend if the gross profit percentage increases from one year to the next

Answer 45

This is a good trend as business is making relatively more gross profit than least year. Either business increased selling price or now pays less to make/buy products

Question 46

Discuss the trend if the gross profit percentage decreases from one year to the next

Answer 46

This is a bad trend as business if making relatively less gross profit than last year. Cause- Selling price business gets for products decreased and/or cost they pay for them increased Business should shop for cheaper supplier so GP margin will increase next year

Question 47

Discuss the trend if the net profit percentage increases from one year to the next

Answer 47

This is a good trend as business is making relatively more net profit than least year. Business expenses decreased

Question 48

Discuss the trend if the net profit percentage decreases from one year to the next

Answer 48

This is a bad trend as business if making relatively less net profit than last year. Business expenses must have increased Business can make cuts to expenses immediately by asking worker to take voluntary pay cuts

Question 49

Discuss the trend if the Return on investment increases from one year to the next

Answer 49

Good trend as business is making better return than last year for shareholders Managers improved their performance over year They made more money from business's resources than last year

Question 50

Discuss the trend if the Return on investment decreases from one year to the next

Answer 50

Bad trend as business is making lower return for shareholders than last year Reason- net profit didn't increase in line with capital invested in business Owners should consider replacing directors - better able to manage resources and generate profit Need to reduce capital employed or increase net profit with cost cutting measures ex: voluntary pay cuts ROCE for both years higher than return on risk free investments? 1/2% approx

Question 51

Why are investors/shareholders interested in profitability ratios

Answer 51

Improving then more likely to receive dividends and so more likely to invest in business ROI- interest as will compare with returns available from other investment opportunities

Question 52

Why are lenders/bank interested in profitability ratios

Answer 52

improving then business sis more likely to be able to repay interest on loan

Question 53

Discuss trend if current ratio decreases from one year to next

Answer 53

Bad trend as business has relatively less cash available to pay it's bills than last year Compare to ideal ratio 2:1 both years. If below business does not have enough cash to pay bills- illiquid Cause- Business increased overdraft? and spent all the money Could lead to creditors cutting off business's credit Business could sell investments to raise cash and improve liquidity

Question 54

Discuss trend if current ratio increases from one year to next

Answer 54

Good trend as business has more cash than last year available to pay bills May have paid off some of it's bank overdraft Compare to ideal ratio 2:1 - if below business does not have enough cash to pay bills- illiquid Business should have twice amount that it owes

Question 55

Discuss trend if acid test ratio increases from one year to the next

Answer 55

Good trend as business has more cash available to pay bills than last year May have paid off some of it's bank overdraft Compare to 1:1- if below business does not have enough cash to pay bills- illiquid Cash is not tied up in stock

Question 56

Discuss trend if acid test ratio decreases from one year to the next

Answer 56

Bad trend as business has relatively less cash available to pay it's bills than last year Compare to ideal ratio 1:1 both years. If below business does not have enough cash to pay bills- illiquid Cause- Business stock levels increased? - cash tied up in stock Could lead to creditors cutting off business's credit Business could have sale to get rid of some stock and raise cash to bring ratio back to 1:1

Question 57

Explain why Lenders/Banks and Suppliers are interested in a business's liquidity ratios

Answer 57

Lender- Improving means business more likely to repay loan and interest on it in full on time Supplier- Improving business is more likely to pay invoice full and on time

Question 58

Discuss trend if debt/equity ratio decreases from one year to the next

Answer 58

Good trend as business has relatively less long-term debt outstanding than last year High/Low geared Business may have paid back some of loan or sold more shares in business Business should continue this strategy

Question 59

Discuss trend if debt/equity ratio increases from one year to the next

Answer 59

Bad trend as business has relatively more long-term debt outstanding than last year Business increased long-term loans and increased levels of borrowing mean more interest to repay. Higher chance of bankruptcy Business should reinvest more profit o sell more shares to get money and pay off loans

Question 60

Why are investors/shareholders interested in debt/equity ratio

Answer 60

Increasing- more profits being used to pay interest and means fewer dividends for investors. Investors will be less likely to buy shares

Question 61

Why are lenders/banks interested in debt/equity ratio

Answer 61

decreasing then business is likely to be able to repay loan and interest on time and in full