Accounting Chap 11 Flashcards
Name two types of financial statement
Trading, Profit and Loss Account
Balance Sheet
Explain the P and L account
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)
Explain sales
How much money the business sold its products for.
Explain Cost of Sales
Shows how much the business spent making or buying the goods they sold.
Explain Gross Profit
Shows the profit made by the business before they take into account any other expenses.
What is the formula for gross profit?
Sales – Cost of Sales = Gross Profit
Explain expenses
Shows the total of all the expenses of a business over that year e.g light and heat, rent, wages
Explain Net profit
Shows the profit made by the business after all the expenses have been paid.
What is the formula for Net Profit?
Net Profit = Gross Profit – Expenses
Explain Balance Sheet
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.
Explain fixed assets
These are all the valuable items that a business owns that will last for longer than a year e.g buildings, vans, machinery
Explain Current Assets
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
Explain Current Liability
These are items that a business owes and must pay within one year e.g bank overdraft, creditors
Explain working capital
This the cash left over in business for it to pay its bills.
What is the formula for working capital?
Working Capital = Current Assets – Current Liabilities
Explain Financed By
This shows the amount of money invested in the business e.g shares, long-term loans
Explain Ordinary Share Capital (Equity Share Capital)
the amount of money paid into the business by shareholders
Explain authorised share capital
The maximum value of shares that can be issued in the business by way of share capital
Explain retained earnings (reserves)
shows the total amount of profit that has been reinvested into the business.
Explain preference shares
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
Explain long-term loans
Money that the company has borrowed that are repaid over a number of years.
What are the three main headings of ratio analysis
Profitability
Liquidity
Gearing or Debt/Equity Ratio
What is the formula for gross profit percentage (gross profit margin)
Gross profit/sales x 100 = %
What is the formula for net profit percentage (net profit margin)
Net profit/sales x 100 = %
What is the formula for return on investment or return on capital employed
Net Profit/ Capital Employed x 100 = %
What is the formula for capital employed
Capital employed=Ordinary Share Capital =Retained Earnings (reserves)+Long term loans + preference shares
Who is interested in a business’s profitability ratios?
Investors / Shareholders Employees Lenders / Banks Government Other Businesses-Competition
Explain liquidity
Liquidity examines whether the business has enough cash available to pay its short term bills (current liabilities) e.g light & heat, rent, wages
Name two liquidity ratios
Working Capital Ratio (Current Ratio)
Acid Test Ratio
What is the formula for working capital (Current Ratio)
CA/CL = x:1
What is the ideal current ratio for business
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
What is the purpose of the Acid test ratio?
Investigates if company has emergency cash to pay bills straight away
What is acid test ratio formula?
CA- Closing stock/ CL = x:1
What is ideal ratio for acid test ratio?
1:1
Why is closing stock excluded for acid test ratio
It is the hardest asset to turn quickly into cash
Who looks at a firm’s liquidity ratios?
Suppliers
Employees
Lenders / Banks
Government
Who looks at a firm’s Debt/Equity ratios
Investors / Shareholders Employees Lenders (Banks) Suppliers Government
What are the limitations of ratios?
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
What is the debt/equity ratio formula
(Long-term debt (loans) + Pref Shares) / (Ordinary hare capital + retained earnings(reserves)) = X:1
What is the gearing of a firm if they have less debt capital than equity capital
low gearing
What is the gearing of a firm if they have more debt capital than equity capital
high gearing
What is the gearing of a firm if they have equal debt capital to equity capital
neutral gearing
If firm is low gearing with ratio answer be greater than or less than one
less than
If firm is high gearing with ratio answer be greater than or less than one
greater than
Discuss the trend if the gross profit percentage increases from one year to the next
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
Discuss the trend if the gross profit percentage decreases from one year to the next
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
Discuss the trend if the net profit percentage increases from one year to the next
This is a good trend as business is making relatively more net profit than least year.
Business expenses decreased
Discuss the trend if the net profit percentage decreases from one year to the next
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
Discuss the trend if the Return on investment increases from one year to the next
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
Discuss the trend if the Return on investment decreases from one year to the next
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
Why are investors/shareholders interested in profitability ratios
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
Why are lenders/bank interested in profitability ratios
improving then business sis more likely to be able to repay interest on loan
Discuss trend if current ratio decreases from one year to next
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
Discuss trend if current ratio increases from one year to next
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
Discuss trend if acid test ratio increases from one year to the next
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
Discuss trend if acid test ratio decreases from one year to the next
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
Explain why Lenders/Banks and Suppliers are interested in a business’s liquidity ratios
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
Discuss trend if debt/equity ratio decreases from one year to the next
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
Discuss trend if debt/equity ratio increases from one year to the next
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
Why are investors/shareholders interested in debt/equity ratio
Increasing- more profits being used to pay interest and means fewer dividends for investors. Investors will be less likely to buy shares
Why are lenders/banks interested in debt/equity ratio
decreasing then business is likely to be able to repay loan and interest on time and in full
