Chapter 11: Accounting Flashcards
Explain three limitations of ratios.
Historical figures-show what happened in the past. Not true indicators or what will happen in future. E.g. Investment may be developing a five year plan and will not show return till then.
Difference in calculation of accounting figures-Change it’s method and comparing ratios may not be accurate.
Limited picture-only show financial information of one business. E.g. Whole market could be collapsing
Why are investors/shareholders interested in profitability ratios?
-Improving them more likely to receive dividends and so more likely to invest in business. Can compare ROI with returns available from other investments.
Why are lenders/bankers interested in profitability ratios?
An improving business is more likely to be able to repay interest on loan.
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 last 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 is making relatively less gross profit than last year. Selling price business gets for products decreased 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 last 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 the business is making relatively less net profit than last year. Business expenses must have increased. Business can make cuts to expenses by asking employees 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. Manager improved their performance over the 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. Net profit didn’t increase in line with capital invested. Owners should consider replacing directors for people better able to manage resources and generate profit. Need to reduce capital employed or increase net profit with cost cutting measures.
The ROI isn’t much higher than risk free investments in the bank at 2% and so isn’t worth the risk for investors.
Define liquidity. With three examples of short term spending.
Liquidity is whether the business has enough cash available to pay its short term bills when they fall due. E.g. light & heat, rent, wages
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 the trend if the Current Ratio is at the ideal 2:1.
Good trend as business has enough cash available to pay its bills when they fall due. Business has twice the amount that it owes and should have no problem paying for short term bills when they fall due.
Discuss the trend of a business is highly geared.
High gearing means more risk. Higher amount of loans leads to high interest payments. Loans also need to be secured against assets and if not paid back the bank takes the assets which could bankrupt the business.
Discuss the trend if a business is low geared.
Low gearing means lower risk but maybe the business is not fulfilling its potential by borrowing to improve and expand the business. Other businesses who borrow more will have more resources available.
What is the formula for the break-even point?
Break Even Point=Fixed Costs/Selling Price-Variable Costs
Explain the debt/equity ratio.
The debt/equity ratio compares the long term debt (loans + preference shares) of a business to the equity (ordinary shares + retained profits)
Discuss the trend if the current ratio is below the ideal 2:1.
Bad trend as business may not have enough cash available to pay its bills when they fall due. This could leads to lawsuits and bankruptcy.
What is the formula for the current ratio and the acid test ratio?
Current Ratio=(Current Assets : Current Liabilities)
Acid Test Ratio=(Current Assets-Closing Stock : Current Liabilities)
What is the formula for gross profit margin, net profit margin and Return on Investment (ROI)?
Gross Profit Margin = Gross Profit / Sales x 100
Net Profit Margin = Net Profit / Sales x 100
Return on Investment = Net Profit / Capital Employed x 100
Why are employees interested in liquidity ratios?
Improving liquidity ratios means they will definitely be paid and their jobs are secure. A lack of credit will force the business to make redundancies.
Explain why investors/shareholders, lenders/banks and employees are interested in debt/equity ratios.
Investors / Shareholders : High gearing means high interest payments paid out of profits and less dividends for shareholders.
Lenders/Banks: High gearing means high interest and less likely to be able to pay it back in time and in full.
Employees: High gearing means increased risk. Risk of bankruptcy as business could lose secured assets. Employees job security lessens.
Give three examples of tax credits.
Single Person Tax Credit
Dependent Relative Tax Credit
Rent Tax Credit
Define working capital.
The level of cash available for the day to day running of a business.
