Chapter 17 Flashcards
1 Explain the difference between analysing and interpreting financial information.
In accounting terms, analysing involves examining the reports in great detail to identify changes or differences in performance; interpreting involves examining the relationships between the items in the reports in order to explain the cause and effect of those changes or differences.
2 Define the following terms:
- profitability
- liquidity
- efficiency
- stability
- profitability – the ability of the business to earn a profit, as compared against a base such as sales, assets or owner’s equity
- liquidity – the ability of the business to meet its short-term debts as they fall due
- efficiency – the ability of the business to manage its assets and liabilities
- stability – the ability of the business to meet its debts and continue its operations in the long term.
3 Explain how the following measures can be used in an assessment of performance:
- trends
- variances .
- trends – trends can be useful in identifying changes in areas of business performance over a number of periods that form a pattern. They can indicate improvement or decline in business performance over a number of periods
- variances – a variance is identified by comparing the actual figures against the budgeted or expected figures to identify areas in which performance has been below –or hopefully above – expectations. Any unfavourable variances can be corrected by taking remedial action.
4 List three benchmarks which can be used to assess business performance.
- Comparing current performance against performance in a previous period
- Comparing current performance against budgeted performance
- Comparing a firm’s performance against performance of a similar business or industry averages
5 Explain how financial indicators can be used to assess business performance.
A financial indicator is a measure that expresses business performance in terms of the relationship between two different elements of that performance.
6 List the indicators which can be used to assess profitability.
• Return on Owner’s Investment (ROI) • Return on Assets (ROA) • Asset Turnover (ATO) • Net Profit Margin (NPM) • Gross Profit Margin (GPM)
7 List the indicators which can be used to assess liquidity.
- Working Capital Ratio (WCR)
* Quick Asset Ratio (QAR)
8 Explain how turnover indicators affect liquidity.
The turnover indicators (Stock Turnover, Debtors Turnover and Creditor Turnover) affect liquidity by determining the speed at which cash is generated.
1 State the two basic factors on which the ability to earn a profit is dependent.
1 State the two basic factors on which the ability to earn a profit is dependent.
2 Explain why an evaluation of business performance assesses profitability rather than just profit
Profitability is more than just assessing profit; it is about assessing the firm’s capacity or ability to earn profit, assuming all other factors (such as size of business, size of investment of owner and the level of sales when comparing to another business) are equal. Expressing profit relative to another measure therefore allows for comparisons between different firms and different periods.
1 State what is measured by Return on Owner’s Investment (ROI).
Return on Owner’s Investment assesses how effectively a business has used the owner’s capital to earn profit.
2 Show the formula to calculate Return on Owner’s Investment.
Return on Owner’s Investment = Net Profit/Average Capital x 100
3 List three benchmarks that could be used to assess the adequacy of the Return on Owner’s Investment
• Previous period’s Return on Owner’s Investment
• Budgeted Return on Owner’s Investment
• Return on Owner’s Investment of similar firms/industry averages
• Rate of return on alternative investments
1 Explain the significance of the return on similar investments as a benchmark for assessing the Return on Owner’s Investment.
When assessing Return on Owner’s Investment, it is important to remember that the owner has given up the opportunity to invest their money elsewhere, and therefore forgone the return that might be earned by investing in property, shares, financial products or other valuables. Thus, the return achievable from these alternative investments is crucial in assessing the Return on Owner’s Investment.
5 State what is measured by the Debt Ratio.
The Debt Ratio is a stability indicator that assesses the extent to which the business relies on borrowed funds to finance the purchase of its assets.
6 Explain how the Debt Ratio can affect the Return on Owner’s Investment.
An increase in the Debt Ratio (business is more reliant on borrowed funds) will increase the Return on Owner’s Investment because the business has borrowed more funds to purchase assets that, in turn, produce more profit. The owner still receives all the profit, but the business is using someone else’s funds in order to achieve this.
1 State what is measured by Return on Assets (ROA).
Return on Assets is a profitability indicator that assesses how effectively a business has used its assets to earn profit.
2 Show the formula to calculate Return on Assets.
Return on Assets (ROA) = Net Profit/Average Total Assets x 100
3 List three benchmarks that could be used to assess the adequacy of the Return on Assets.
- Return on Assets from previous periods
- Budgeted Return on Assets
- Return on Assets of a similar firm/industry average.
4 Explain why a firm’s Return on Owner’s Investment will always be higher than its Return on Assets.
Return on Owner’s Investment will always be higher because the total assets of a business will always be higher than its owner’s equity due to its liabilities.
5 Explain how Return on Assets is affected by the Asset Turnover and Net Profit Margin
Assuming assets do not change, a change in Return on Assets will be solely the result of a change in profit, which may itself be the result of a change in the firm’s ability to earn revenue, or control its expenses (or both). As a result, the Return on Assets will depend heavily on the firm’s ability to earn revenue (as measured by the Asset Turnover) and control its expenses (as measured by the Net Profit Margin).
1 State what is measured by Asset Turnover (ATO).
Asset Turnover is an efficiency/profitability indicator that assesses how productively a business has used its assets to earn revenue.
2 Show the formula to calculate Asset Turnover.
Asset Turnover (ATO) = Sales/Average Total Assets
3 List three benchmarks that could be used to assess the adequacy of a firm’s Asset Turnover
- Asset Turnover from previous periods
- Budgeted Asset Turnover
- Asset Turnover of a similar firm/industry average
4 Explain the relationship between Asset Turnover and Return on Assets
Both the Return on Assets and Asset Turnover assess the firm’s ability to use its assets; the only difference being that the Return on Assets measures profit, whereas Asset Turnover measures only revenue. Theoretically, a higher Asset Turnover should mean a higher Return on Assets; however, revenue does not always translate into profit – expense control is also required.
1 Define the term ‘expense control’.
Expense control is the firm’s ability to manage its expenses so that they either decrease or, in the case of variable expenses, increase no faster than sales revenue
2 State two reasons why some expenses must increase in the pursuit of profit.
- Expenses such as Cost of Sales and Wages must increase as sales revenue increases.
- Expenses such as Advertising may, in fact, have to increase in order to generate greater sales.
3 State what is measured by the Net Profit Margin (NPM).
The Net Profit Margin is a profitability indicator that assesses expense control by calculating the percentage of sales revenue that is retained as Net Profit.
4 Show the formula to calculate the Net Profit Margin
Net Profit Margin (NPM) = Net Profit/Sales x 100
5 Explain the relationship between Asset Turnover, Net Profit Margin, and Return on Assets
The Return on Assets will be a function of the Asset Turnover and the Net Profit Margin (NPM): if these indicators change, then so too will the Return on Assets. This is because the Asset Turnover measures the firm’s ability to use its assets to generate sales revenue, while the NPM measures the firm’s expense control. Therefore, if the firm’s revenue earning capacity improves (Asset Turnover) and expense control is maintained or improved (NPM), then the Return on Assets should also improve. However, a business may improve its Asset Turnover, meaning revenue earning capacity has improved, but if it has been unable to control its expenses (as seen in a decrease in NPM), then the Return on Assets may actually worsen/decrease and indicate that while the firm was able to use its assets effectively to generate revenue, it was unable to use them effectively to generate profit due to poor expense control.
1 State what is measured by the Gross Profit Margin (GPM).
The Gross Profit Margin assesses the average mark-up by calculating the percentage of sales revenue that is retained as Gross Profit
2 Show the formula to calculate the Gross Profit Margin.
Gross Profit Margin (GPM) = Gross Profi/Sales Revenue x 100
3 Explain two ways a business could increase its average mark-up
- Increase the selling price.
* Decrease the cost price by finding a cheaper supplier.
4 Explain how an increase in mark-up could actually lead to a decrease in Gross Profit
By increasing the selling price, the mark-up will also increase; however, it runs the risk of lowering demand, and thus reducing the volume of sales. If the drop in demand outweighs the increase in the selling price, then Gross Profit in dollar terms will actually fall.
1 Explain what is shown in a vertical analysis of the Income Statement.
Vertical analysis is a report that expresses every item as a percentage of a base figure (in this case, sales revenue).
2 Explain one benefit of preparing a vertical analysis as a pie chart.
Given that not all business owners are accountants, presenting a vertical analysis in a pie chart is one way of ensuring Understandability in the accounting reports, making it easier for the reader to comprehend its meaning.
1 Define the term ‘liquidity’
Liquidity assesses the firm’s ability to meet its short-term debts as they fall due
2 Explain the role of the Cash Budget in evaluating liquidity.
The Cash Budget predicts cash inflows and cash outflows for the coming year, allowing the owner to assess exactly whether the business will have enough liquid funds to meet its short-term debts.
3 Suggest four strategies the owner may implement to address a predicted cash deficit
- Defer the purchase of non-current assets, or use credit facilities or a loan for their purchase.
- Defer loan repayments.
- Reduce cash drawings.
- Make a cash capital contribution.
- Organise (or extend) an overdraft facility
4 Suggest two strategies the owner may implement to use a predicted cash surplus.
- Purchase more/newer non-current assets.
- Increase loan repayments.
- Increase cash drawings.
- Expand trading activities by increasing advertising, employing more staff, etc.
1 State what is measured by the Working Capital Ratio (WCR
The Working Capital Ratio assesses the firm’s ability to meet its short-term debts as they fall due by measuring the ratio of current assets to current liabilities.
2 Show the formula to calculate the Working Capital Ratio.
Working Capital Ratio (WCR) = Current assets/ Current liabilities
3 Explain why the Working Capital Ratio should be at least 1:1.
A Working Capital Ratio of 1:1 or more indicates that the business has sufficient current assets to cover current liabilities and is therefore able to meet its short-term debts as they fall due. If the ratio is less than 1:1 (for example 0.8:1), this indicates that for every $1 of current liabilities, the business only has 80 cents of current assets, indicating they will have difficulty meeting short-term debts as they fall due.
4 Explain one problem associated with an excessive Working Capital Ratio.
A Working Capital Ratio that is too high may indicate that the business has current assets that are idle. For example:
• Excess cash in the bank account is likely to earn relatively little interest.
• Excess stock can create problems in terms of storage costs, stock loss and obsolescence.
• Excessive debtors balance may mean that debtors are not paying (on time or at all), and that debts are less likely to be collected.
5 State two actions the owner may be required to take if the Working Capital Ratio is:
- too low
- too high
• too low
i make a cash capital contribution
ii seek additional finance by entering into (or extending) an overdraft facility
iii take out a loan for the purchase of non-current assets
• too high
i employ cash to repay debt; expand the business (via non-current asset purchases, advertising, or hiring staff)
ii increase drawings
iii allow stock levels to run down before reordering
iv contact debtors to collect amounts outstanding.
1 State what is measured by the Quick Asset Ratio (QAR).
The Quick Asset Ratio assesses the firm’s ability to meet its immediate debts by measuring the ratio of quick assets to quick liabilities.
2 Show the formula to calculate the Quick Asset Ratio
Quick Asset Ratio (QAR) = Current assets (excluding stock and prepaid expenses)/Current liabilities (excluding bank overdraft)
3 Explain why the following items are excluded from the calculation of the Quick Asset Ratio:
- stock
- prepaid expenses
- bank overdraft
- stock – a business cannot assume that it will be able to liquidate all its stock just because the firm is facing liquidity problems, and there is virtually no chance of this happening
- prepaid expenses – may not be able to be liquidated at all, especially if the business has entered into a written contract with the supplier
- bank overdraft – it is unlikely that a bank overdraft will be called in (for repayment).
4 Explain what is indicated if the Working Capital Ratio is satisfactory, but the Quick Asset Ratio is unsatisfactory.
If this is the case, it is likely that while the business is able to meet its short-term debts in the next 12 months, they probably have an over-investment in stock, which, when removed in the Quick Asset Ratio calculation, makes it unsatisfactory to meet its immediate debts. Together, the indicators suggest that if the business can sell its stock, it will be able to meet its debts as they fall due; if not, liquidity problems may result.
1 Explain how a firm with a high turnover may avoid liquidity problems despite an unsatisfactory Working Capital Ratio.
A business can survive in spite of an unsatisfactory level of liquidity if the speed of their trading cycle is fast enough. That is, if a business can sell its stock – and collect the cash from its customers – before that cash is needed, it will survive even with a very low Working Capital Ratio. Businesses such as this can survive because their turnover (Stock Turnover/Debtors Turnover) is so fast.
2 State what is measured by Stock Turnover (STO).
Stock Turnover measures the average number of days it takes for a business to convert its stock into sales.
3 Show the formula to calculate Stock Turnover.
Stock Turnover (STO) = Average stock / Cost of Goods Sold x 365
4 State what is measured by Debtors Turnover (DTO).
Debtors Turnover measures the average number of days it takes for a business to collect cash from its customers.
5 Show the formula to calculate Debtors Turnover.
Debtors Turnover (DTO) = Average debtors/Credit sales x 365
6 State what is measured by Creditors Turnover (CTO).
Creditors Turnover measures the average number of days it takes for a business to pay its creditors
7 Show the formula to calculate Creditors Turnover.
Creditors Turnover (CTO) = Average creditors/Credit purchases x 365
8 Explain the importance of Stock and Debtors Turnover, and Creditors Turnover, for liquidity.
The firm’s ability to pay its creditors on time (Creditors Turnover) will rely heavily on its ability to sell its stock quickly (Stock Turnover), and then collect cash from its debtors promptly (Debtors Turnover).
9 Explain why it is advantageous for a trading firm to buy on credit, but sell on cash.
The best circumstance for a trading business is to sell stock for cash and to buy stock on credit. This approach provides time for the business to sell its stock before paying their creditors, and this should minimise liquidity problems.
1 State three limitations of relying solely on the financial statements and financial indicators to evaluate performance.
- The reports use historical data.
- Reports contain incomplete information.
- Firms use different accounting methods.
2 Define the term ‘non-financial information’
Non-financial information is any information that cannot be found in the financial statements, and is not expressed in dollars and cents, or reliant on dollars and cents for its calculation.
3 State two measures that could be used to assess:
- the firm’s relationship with its customers
- the suitability of stock
- the firm’s relationship with its employees
- the state of the economy
• the firm’s relationship with its customers i customer satisfaction surveys ii the number of repeat sales iii the number of sales returns iv the number of customer complaints
• the suitability of stock
i the number of sales returns
ii the number of purchase returns
iii the number of customer complaints
• the firm’s relationship with its employees
i performance appraisals
ii the number of days lost due to sick leave/industrial action
iii the staff turnover/average length of employment
• the state of the economy i examining interest rates ii examining the unemployment rate iii the level of inflation iv the number of competitors in the market.
