Balance Sheet

Question 1

What is a Balance Sheet?

Answer 1

• The Balance Sheet provides a summary of the assets and liabilities of a business. It is snapshot of those assets at a particular.
• It is Snapshot of the business’ assets (what it owns or owes’) and its liabilities (what it owes) on a particular day - usually the last day of a financial period.

Question 2

How does the Balance Sheet ‘balance’?

Answer 2

• EVERY financial transaction results in an equal change in assets or liabilities.

Question 3

How do you calculate working capital?

Answer 3

current assets - current liabilities = working capital (net current assets)

Question 4

What is working capital?

Answer 4

the capital of a business which is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities

Question 5

What is Return on Capital?

Answer 5

• Return on Capital is return of an investment.
• the best way to look at the return on an investment is to calculate return on capital
• capital is the amount invested in a business.
• return on capital is the percentage return on that investment
  RETURN ON CAPITAL = NET PROFIT (BEFORE TAX) / CAPITAL INVESTED X 100

Question 6

What does return on capital measure?

Answer 6

• measure of the profitability and value-creating potential of companies after taking into account the amount of initial capital invested.
• a measure of the returns made from investing in the business
• how good the business is at converting money invested into profit
• provides a means of comparison with other investment opportunities.

Question 7

What is return on capital employed (ROCE)?

Answer 7

• ROCE is sometimes referred to as the primary ratio.

- it tells us what returns (profits) the business has made on the resources available to it

Question 8

How is ROCE calculated?

Answer 8

ROCE (%) = Operating profit / Capital employed X 100

Question 9

What is capital employed?

Answer 9

share capital + retained earnings + long term borrowings

Question 10

How can a business improve ROCE?

Answer 10

• improve the top line (increase operating profit) without a corresponding increase in capital employed
• maintain operating profit but reduce the value of capital employed.

Question 11

How do you evaluate ROCE (%)?

Answer 11

• Higher (%) is better
• watch for trend over time
• watch out for low quality profit which boosts ROCE
• leased equipment will not be included in capital employed

Question 12

What is accounting rate of return? ‘ARR’

Answer 12

• The accounting rate of return (ARR) method looks at the total accounting return for a project to see if it meets the target return.
• Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital.
• the average rate of return method of investment appraisal looks at the total accounting return for a project to see if it meets the target return (often referred to as a Hurdle rate)

Question 13

How do you calculate Accounting rate of return (ARR)?

Answer 13

• ARR (%) = (total net profit / no. years) / initial cost X 100

Question 14

What are the advantages of ARR?

Answer 14

• ARR provides a percentage return which can be compared with a target return
• ARR looks at the whole profitability of the project
• Focuses on profitability - a key issue for shareholders

Question 15

What are the disadvantages of ARR?

Answer 15

• Does not take into account cash flows; only profit (they may not be the same thing)
• takes no account of the time value of money
• treats profits arising late in the project in the same way as those which might arise early.

Question 16

What is the acid test ratio?

Answer 16

• Is another important and widely used liquidity ratio, particularly in industries where it is traditional to carry a large value of stocks (inventories) in working capital.
• Not all assets can be turned into cash quickly or easily.
• some - notably raw materials and other stocks - must first be turned into final product, then sold and the cash collected from debtors.
• The acid test ratio (also called quick ratio) therefore adjusts the current ratio to eliminate certain current assets that are not already in cash (or near cash) form.
• The tradition is to remove inventories from the current assets total, since inventories are assumed to be the most illiquid part of current assets - it is harder to turn them into cash quickly.

Question 17

How to interpret acid test ratio results?

Answer 17

• 1.5 - 2 is a good ratio, efficient management of wokring capital
• high ratio means too much capital is in inventories or debtors
• below 1 = liquidity problems

Question 18

How do you work out acid test ratio?

Answer 18

current assets / current liabilities = current ratio.

Question 19

What are the advantages of ratio analysis?

Answer 19

• encourages a systematic approach to analysing performance
• used by venture capitalists and bankers regularly to support their analysis when they consider investing in or loaning to banks.

Question 20

disadvantages of ratio analysis?

Answer 20

• ratios deal mainly in numbers- they don’t address issues like product quality, customer service, employee morale and so on
• ratios largely look at the past, not the future. However, investment analysts will make assumptions about future performance using ratios
• ratios are most useful when they are used to compare performance over a long period of time or against comparable businesses and an industry - this transformation is not always available
• financial information can be ‘massaged’ in several ways to make figures used for ratios more attractive. e.g. many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.

Question 21

What is gearing ratio?

Answer 21

• Gearing focuses on the capital structure of the business- that means the proportion of finance that is provided by debt relative to the finance provided by equity (or shareholders).
• The gearing ratio is also concerned with liquidity, however it focuses on the long term financial stability of a business.
• gearing measures the proportion of assets invested in a business that financed by long term borrowing

Question 22

How can a business reduce gearing?

Answer 22

• focus on profit improvement
• repay long term loans
• retain profits rather than pay dividends
• issue more shares
• convert loans into equity

Question 23

How can a business increase gearing?

Answer 23

• focus on growth- invest in revenue growth rather than profit
• convert short term debt into long term loans
• buy back ordinary shares
• pay increased dividends out of retained earnings
• issue preference shares or debentures