Accounting for Business Flashcards
Purpose of ratio analysis
- Review performance over time
- To be compared with prior years, industry average, competitors
- Enables problems to be highlighted and corrective action then taken
Limitations of ratio analysis
- The analysis only looks back, and may not represent the future
- Some ratios only use financial position information which is only applicable at that date
- Figures in financial statements contain assumptions and estimates
- Only identify symptoms not causes of problems
Gross Profit margin
measures the profitability of sales before expenses
Operating profit margin
measures the profitability of sales after expenses
- retail may have a lower operating profit than heavy equipment manufacture, but will still sell more products
- small profit margin per loaf but will still sell a lot
Return on Total Capital employed
They key profitability ratio - measures the profit relative to the total capital of the business
EBIT
Earnings before interest/finance costs + tax
Long term debt
Is to represent the funding for the business provided by external parties
Liquidity ratios…
-Provide info on the ability of the company to pay its short term commitments if they fall due
- ‘Cash is king’ as a business could be profitable but have no cash to pay salaries, expenses and revenue
- Liquidity is crucial for business survival
Liquidity ratios significance
- Current ratio - measures the ability to meet short term debts - prudent ratio being 2:1
- Acid test - to see what would happen if a company were forced to settle their debts immediately - prudent ratio considered 1:1
Efficiency ratios…
- Measure how effective the business is in collecting its debts
- Expressed using days
- Calculate how many days credit the company is taking from suppliers
- Comparison between time taken to collect debts and to pay them
Efficiency ratios - inventory days
- Calculates how quickly the company is turning over its stocks during the year
- Efficiency of stock control policy
Gearing ratios
- Show the proportion of assets the company has been financed by lenders rather than shareholders
- the higher the proportion of debt the more vulnerable the company is perceived to be
- Debt/Equity ratio of 1:1 would be considered high for a quoted company
- The interest/finance cover ratio shows the ability of the company to cover the interest out of its profits
Considerations when deciding which business to invest in
- Type of Business and the economic outlook in that field
- Future sales contracts and orders in place for next year
- Past financial statements in order to look at the trajectory for each company and the plans for future growth
- Board structure and management in each company - review the corporate governance for each company
- The level of employment in the area of the company
- The company’s public image and attempts in ESG etc.
Rules applying to public listed companies when preparing accounts
- Accounting standards of accounting bodies
- Legal rules of the country and wider e.g. EU
- Stock exchange regulations when country listed on the stock exchange.
Variable cost
- Those costs that vary with number of units sold
Fixed costs
- Costs that don’t vary with number of units sold - such as machinery or wages
Contribution
- Represents the amount each unit sold contributes to the fixed costs
- Represented by the sales price less the variable cost
Breakeven cost
- Fixed costs / contribution per unit
- The number of units needed to be sold in order to cover costs
Margin of safety
- Represents the excess the business is expected to sell over the breakeven point
Sources of finance
- Venture capital
- Angle investors
-Govt. grants - Leasing
Venture capital + Angel investors
Adv
- Investment without interest costs
Disadvs
- Loss of control, voting rights + share of profits
Leasing
Adv
- No capital layout
- Tax deductible
Dis
- Don’t own asset
Breakeven
Fixed costs/contribution
