Chapter 11 - Accounting Flashcards
What is the gross profit and the net profit
The ‘Gross Profit’ is the profit from ‘sales’ minus the ‘cost of sales’. [Gross Profit = Sales – Cost of Sales]
The ‘Net Profit’ is the money made by the business after all the expenses have been paid.
[Net Profit = Gross Profit – Expenses]
What is the priapism of a balance sheet ad what does it show
The purpose of the Balance Sheet is to show the business’s financial position.
It shows what the business owns (i.e. assets) and all the money it owes (i.e. liabilities).
Fixed Assets – the valuable items owned and used by the business for more than a year, e.g. buildings, vehicles.
Current Assets – valuable items owned and used in less than a year, e.g. stock, cash, debtors, bank account.
Current Liabilities – money the business owes that has to be repaid in less than a year, e.g. bank overdraft, creditors.
Working Capital – the cash left over to pay bills that come in.
Working Capital = Current Assets – Current Liabilities
Financed By – the amount of money invested in the business by the investors, including shares and loans.
Why is the balance sheet important to managers
- The value of the fixed assets determines the amount of collateral (security) the business can offer a bank when applying for a loan.
- The working capital figure shows whether the business has enough cash available to pay any bills that may come in. This is called ‘liquidity’.
- The ‘Financed By’ section, and the amount of borrowing, determines whether the business can get another loan.
What are profitability ratios and what are the three types of ratios
These ratios examine whether the profit made is good or bad for the size of the business.
The results can be compared to:
• The business’s results from previous years
• Other business’s results (especially in the same line of business)
• The industry average.
There are THREE ratios to measure Profitability:
1. Gross Profit Margin
2. Net Profit Margin
3. Return on Investment (ROI)
What is risk analysis
An entrepreneur must examine the business to make sure that it is in a healthy position.
A firm is monitored under three headings:
1. Profitability: examines the firm’s ability to make a
healthy profit.
2. Liquidity: the firms ability to pay its short-term bills as they fall due.
3. Gearing or Debt/Equity Ratio: examines how the firm is financed.
What is gross profit margin
Gross Profit x 100
——————
Sales
For example, a 30% Gross Profit means that for every €100 of products sold, that 30% of this amount, i.e. €30, is the business’s gross profit.
If the gross profit is up on last year then that’s good, and means the selling price is up or the cost of raw materials are down.
If the gross profit is down on last year then that’s bad, and means the selling price is down or the cost of raw materials are up.
What is net profit margin
Net Profit x 100
—————
Sales
For example, a 12% Net Profit means that for every €100 of products sold, that 12% of this amount, i.e. €12, is the business’s net profit.
If the net profit is up on last year then that’s good, and means the Gross Profit is up or the business expenses (e.g. wages, insurance) are down.
If the net profit is down on last year then that’s bad, and means the Gross Profit is down or the business expenses are up. Steps can be taken to cut expenses.
What is return on investment and what does a good ROI mean
Net Profit x 100
—————
Capital Employed
Capital Employed is the total amount of money invested in the business:
Capital Employed = Ordinary Share Capital + Retained Earnings (Reserves) + Long Term Loans + Preference Shares.
A good ROI means:
• Better returns than secure investments, e.g. bonds
• A good return will result in happy enthusiastic investors
• If greater than loan interest, then it may be time to borrow
• A good performance by the business’s managers.
What are liquidity ratios and what two ratios measure liquidity
Liquidity examines whether the business has enough cash available to pay its short-term bills when they are due to be paid.
There are TWO ratios to measure Liquidity:
- Working Capital Ratio (Current Ratio)
- Acid Test Ratio
Working capital ratio
Current Assets divided Current Liabilities
The ideal ratio is 2:1.
This means the business should have twice the current
assets (owns) than the size of current liabilities (owes).
The Working Capital (Current) ratio is important because:
• If the ratio is lower than 2:1 then this is an issue which could effect paying bills and obtaining credit. Cash can be raised by selling investments.
• If the ratio is a lot higher than 2:1 then the business should consider investing the excess cash.
What is the acid test ratio
Acid Test Ratio
Current Assets – Closing Stock divided by Current Liabilities
The ideal ratio is 1:1.
Closing stock is excluded because it’s needed in the
business, and can’t be turned into cash quickly.
The Acid Test Ratio measures the business’s ability to pay its debts immediately. Has the business enough current assets minus closing stock to pay its current liabilities?
If the ratio is less than 1:1 then the business is illiquid.
Why is the acid test ratio important
It lets the business know its liquidity position in an emergency situation. If the ratio is less than 1:1 then the business is illiquid, and its credit rating could be badly effected. Steps can be taken now to raise cash by selling stock (e.g. a sale) or fixed assets.
• A ratio greater than 1:1 indicates that the business is successfully managing its cash flow, and does not have liquidity issues.
What is the debt/equity ratio
The Debt/Equity ratio examines the capital structure of the business (i.e. how it is financed).
Long Term Debt + Preference Shares divided by Ordinary Shares + Reserves
It shows how much of the capital has come from long- term loans (borrowings) and how much has come from the shareholders through issued share capital and retained earnings (reserves).
The Debt/Equity ratio indicates the level of long-term debt the business is carrying, and whether this might be too much.
Why is the debt/equity ratio important
It lets management know if the business is in danger of going bankrupt. If the business is ‘high geared’ and the business cannot afford the repayments then the business might be taken to court by the lenders (creditors), and the court might decide to wind up the business and sell its assets.
• The debt/equity ratio lets management know if the business is able to take out more loans or not.
How can be high geared and low geared
- Its just starting off and needs initial start-up money.
- The owners prefer to borrow rather than sell shares.
- The firm could earn more with the money from the long-term loan than it cost to borrow.
• More of the profits made are available for use in the
business.
• The business will find it easier to borrow and to meet
repayments.
