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A-Level Business Studies (WJEC) > Component 2.2 > Flashcards

Component 2.2 Flashcards

Balance sheets Income statement Profitability liquidity Gearing Comparing financial accounts Non-financial measures of performance

1
Q

Why are financial accounts required?

A

To analyse financial performance and include balance sheets and trading, profit and loss accounts (income statement).

Once business has produced their financial accounts they will use ratio analysis to evaluate their financial performance.

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2
Q

What is a Balance sheet?

A

Snapshot 📸 of business assets (what it owns/owned) and its liabilities (what it owes) on particular day (last day of financial year).

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3
Q

What would you find on a balance sheet?

A
  • Assets (resources, which business owns and uses) i.e. monetary value, land ⛰
  • Liabilities (debts of business i.e what it owes).
  • Capital Employed (sum of company’s share capital, reserves (retained profit) and long term liabilities.
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4
Q

How do you find the worth of a business?

A

Assets - Liabilities

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5
Q

What is a fixed/non current asset?

A

resources that the business owns for MORE than 1 year, may include land 🏔, machinery📽, buildings🏗.

  • they are used to produce the output of the business and so generate profit.
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6
Q

What is CURRENT ASSETS?

A

Resources owned for LESS than 1 year, and short term use, include:

> Stock (inventory) (owned by business & change daily)

> Debtors (trade receivables): customers that have purchased and received goods on credit and yet to pay

> Cash & bank (tills, petty cash, cash reserved held in bank.

> money 💰 in bank 🏦

> more liquid i.e. can be converted into cash quickly.

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7
Q

What is CURRENT LIABILITIES?

A

debts of business which must be paid back WITHIN 1 year.

  • can include: trade creditors/ payables, overdraft. = both are short term finances and commonly and long term liabilities used by businesses.
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8
Q

What are LONG TERM LIABILITIES?

A

long term debts of business, what business owes and must pay back over period of longer than a year. They are a source of long term finance.

e.g. Long term loan, mortgage, bank loan (3-5 years).

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9
Q

What is NET ASSETS?

A

shows financial worth of business.

Calculated by adding Fixed and Current Assets and then deducting Current and Long Term Liabilities.

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10
Q

NET CURRENT ASSETS / WORKING CAPITAL

A

difference between current assets and current liabilities.

  • money needed to pay day to day expenses of business i.e. paying wages and buying stock, pay overdraft and creditors.
  • shows financial strength .
  • positive working capital means business can afford their daily expenses.
  • if negative working capital then occurs when current liabilities greater than current assets (would be minus number).
  • Insufficient working capital could result in:

> suppliers and banks may be reluctant to give business credit.

> Business may not be able to pay their suppliers who already given credit = poor reputation

> too little working capital = firm will struggle to finance increased production.

> if working capital too high, business may be wasting resources, just holding money in bank instead of investing it. - too much money = opportunity cost.

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11
Q

Capital Employed

A

referred to as long term capital employed.

  • sum of companies share capital, reserves (retained profit) and long term liabilities.
  • it shows capital and funds that have been invested into business.
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12
Q

Shareholders’ funds/ capital

A

money thats been invetsed into business by owners through sales of shares,

  • included retained profit/reserves which has been kept within business rather than being given to shareholders in dividends.
  • owners/directors may keep profit in business to finance future growth.
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13
Q

What is DEPRECIATION

A

fall in value of fixed asset over time.

i.e. machine will not be worth same after 5 years as it was when bought. This is due to:

> wear and tear - get worn out (level of performance deteriorates and so does value.

> Asset can become obsolete

> outdated.

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14
Q

Annual depreciation

A

Historic Cost - Residual Value / expected lifespan.

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15
Q

Obsolete

A

not used anymore or not sold anymore

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16
Q

Limitations of Balance sheets

A
  • snap shot of business’s performance @ end of financial year so might not be representative of performance throughout the year.
  • high degree of subjectivity in some elements of balance sheet e.g. valuation of assets i.e. brand name.
  • window dressing (dressing up accounts to make them look flattering) - can be misleading to users of published accounts i.e. banks.
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17
Q

Strength of Balance sheets

A

+ provides valuation of all assets, capital and liabilities.

+ business can analyse structure and see how much of assets are financed by liabilities.

+ assess ability to pay short term debts through working capital.

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18
Q

Income Statement

A

trading profit or loss account measures business’s performance over given period of time usually 1 year.

compares income of business against costs of goods/services and expenses incurred in earning revenue.

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19
Q

What is the difference between Profit and Profitability

A

They are not the same

  • Profit is an absolute measure and expressed as monetary terms
  • Profitability is relative measure, shows profit as % of sales revenue or capital invested into the business.
    Measuring it indicates how efficient business is turning revenues into profit, if profit growing and how it compares to rest of industry.
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20
Q

What are the 3 measures of profitability?

A
  1. Gross Profit Margin: shows GP as % of revenue
  2. NPM: shows NP as % of revenue
  3. Return on capital employed: Show NP as % of capital invested.
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21
Q

What is the equation for Gross Profit

A

Revenue - Cost of sales

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22
Q

Profitability

A

relative measure, shows profit as % of sales revenue or capital invested into the business.

Measuring it indicates how efficient business is turning revenues into profit, if profit growing and how it compares to rest of industry.

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23
Q

Explain what is GP

A

indicator of how efficient business is at marketing and selling its products, however figure on its own doesn’t help judge level of efficiency.

24
Q

What is GPM

A

an accounting ratio and the better the performance the higher the GPM % will be.

25
Q

What is the equation for GPM

A

Gross profit / Sales Revenue x 100

  • it shows as a % how much out of each $1 of revenue is GP.
26
Q

GPM interpretation

A
  • higher the GP the better but can’t state whether good or bas without considering type of business involved.
  • If its raising year on year then business making more GP for every $1 of SR.
- Fall in GP most likely due to:
> fewer units sold
> Increasing cost of raw materials.
> Price discounting/ other reasons for decrease in selling price
> Stock damage
27
Q

GPM interpretation

A
  • higher the GP the better but can’t state whether good or bas without considering type of business involved.
  • If its raising year on year then business making more GP for every $1 of SR.
- Fall in GP most likely due to:
> fewer units sold
> Increasing cost of raw materials.
> Price discounting/ other reasons for decrease in selling price
> Stock damage

GPM will vary by both industry and size of business as some businesses can operate on low GPM due to them s replying on selling large volume of units of products with relatively low contribution per unit. e.g. supermarket can trade with lower GPM as it can spread risk. Other low GPM are manufactures or mass production goos and food manufacturers.

  • High GPM businesses are service businesses with lower cost per unit and high contribution per unit i.e. restaurants and retailers of upmarket goods.

Improving ration is always positive and higher the ration the better.
The trend over a number of years has to be considered.

28
Q

Net profit

A

How profitable the business is overall: die to business’s revenues and expenses in its calculation are included.

  • doesn’t help to judge level of efficiency - large business likely to have higher NP than small business, however small business can manage expenses more efficiently.
29
Q

NPM

A

accounting ration to judge efficiency of business

30
Q

Equation for NP

A

GP - expenses

31
Q

Equation for NPM

A

Net profit before tac & interest / SR x 100

Shows as a % how much of each $1 of revenue is NP.

32
Q

NPM interpretation

A
  • higher the NPM the better
  • business with high GPM has proportionately higher expenses whilst low GPM lower expenses.
  • low NPM when business relatively new as first year trading will have high expenses to establish itself.
  • if difference between GPM and NPM low then overheads are low
  • NPM shows whether firm is efficiently controlling their expenses.
33
Q

What are the benchmarks for NPM

A

NPM >18% = Good: indicates effective business management of cost and expenses

NPM 10-17%: Satisfactory: cost or expense management can be improved.

NPM<10% = Poor: real opportunities for improving cost and expense management.

Walmart has NPM<10%

34
Q

What are the ways to improve Profit margins

A 
Increase sales by:
> advertising 
> change selling price
> offers
> New markets
Decrease expenses by:
> reduce wages
> find cheaper suppliers
> reduce marketing costs
> find cheaper business premises
> administration cost (little expenses and paperwork).
35
Q

What is meant by Return on Capital Employed

A

is the % return on capital invested in business

measures how effective business is at using capital invested to create profit

It’s of particular interest to shareholders.

36
Q

What is the equation for ROCE

A

NP before tax and interest / Long term capital employed (Shareholder funds + long term liabilities) x100

37
Q

What is the equation for Long term capital employed

A

Shareholder funds + long term liabilities

38
Q

ROCE interpretation

A
  • for every $1 of capital invested _ is net profit
  • Shareholders want ROCE to be high as possible if increasing then pleasing
  • To judge whether ROCE is good need to compare to previous years to see trend and internal targets.
  • no ideal ratio for ROCE - just need to be high as possible.
  • Should always be higher than bank interest rate due to shareholders receiving higher % return and higher risk involved in investing in business.
  • ROCE can be improved by Increasing profit generated by same level of capital invested or maintaining profit generated but decreasing amount of capital employed to do so.
  • get interest for saving money.
39
Q

What is the difference between GPM and NPM

A

difference lies in overhead expenses, it’s possible for GMP to be too high but NPM disappointingly low because business not efficiently controlling its expenses.

40
Q

Liquidity

A

How quickly an asset can be converted into cash.

Liquidity ratios assess whether business has sufficient cash/equivalent current assets to pay short term debts as they fall due.

Current ratio and acid test used to measure liquidity of business.

41
Q

Current Ratio

A

Shows current assets as proportion of current liabilities.

  • ideal is 1.5:1 - 2:1
42
Q

What is the calculation for Current Ratio

A

Current assets / current liabilities.

43
Q

Current Ratio interpretation

A

Within the ideal:
- business in good liquidity position with sufficient current assets to finance current liabilities as they fall due.

Above the ideal:

  • business in strong liquidity position as they can finance short term debts as they fall due.
  • business could pay creditors on time = beneficial for reputation
  • However, business with high current ratio should consider reinvesting cash to generate more profit.

Below the ideal:

  • if below 1:1 then worry of liquidity position as business doesn’t have sufficient assets to finance their current liabilities.
  • result in delaying payment = poor reputation, less credit being made available by banks and suppliers.
  • suppliers may stop supplying.
  • if ration above 1.5:1 then even though they can technically finance their short term debts they may struggle if debtors don’t pay back or if stock fails to sell.
44
Q

What should be considered when interpreting current ration

A
  • size of business, if business places large, valuable orders with suppliers then they will have high bargaining power - means able to delay payment (supermarkets operate on low liquidity)
  • if business has high stock turnover they will be able to operate on low current ratio because they will have cash so will be able to repay suppliers.
  • to fully judge liquidity, business need to compare ratios to industry average, low current ratios are common in some industries.
  • useful to compare ratios with previous years to see if pattern e.g. strengthening or weakening.
45
Q

Acid Test

A

Stock is least liquid of all current assets so acid test deducts stock to give stricter test of liquidity.

  • measure of whether business can meet short term debts without selling stock.
46
Q

Equation for acid test

A

Current Assets - stock / current liabilities.

47
Q

Acid test interpretation

A

ideal is 1:1

Above the deal:
- strong liquidity position as business can meet their short term debts without selling their stock.

Below the ideal:
- if current ratio above 1:1 and acid ratio is below, it means that business is reliant on selling stock to finance their short term debts. Could be issue when difficult trading conditions i.e. recession.

48
Q

What should be considered when interpreting acid test

A
  • not all businesses deal in large quantities of stock, True is service business don’t sell tangible goods. Current ration and acid test ratio would be very similar. Acid test not always relevant.
  • some retail business hold large quantities of stock but have predictable sales and high stock turnover, agian acid test may hold less relevance.
49
Q

Gearing

A

tell us what proportion of long term finance comes from loans and what proportion came form shareholders funds.

  • good indication of how exposed firm is to financial risk.
  • if firm have high level of debt than the firm likely to face high interest charges.
50
Q

Equation for gearing

A

Long term liabilities / capital employed (shareholder funds + LTL) x 100.

For every _ of long term investment, _ is debt - means business is financed more by shareholder funds.

51
Q

What is the ideal ratio for gearing

A

There is no ideal ratio for gearing but

Low gearing below 25%:

  • financed more by shareholder funds than debt
  • business is not highly exposed to risk of interest rates increasing
  • can be beneficial in times of difficult trading such as recession as ales may fall making it difficult to meet loan commitments.
  • if low gearing then should look at increasing borrowings to grow and create more profit long term.

Normal Gearing 25-50%:

  • business not financed more then debt than they are shareholder funds
  • acceptable level of gearing.
  • if close to 50% business may be in danger of becoming highly geared if they were to borrow money in future.

Highly geared over 50%:

  • business financed more by debts than shareholder funds
  • business exposed to financial risk i.e. interest rates may rise which could affect business depending on terms of loan agreement. If trading conditions difficult the business may struggle to meet loan repayment. these factors could deter potential investors.
  • high levels of debt means profit is reduced by high interest rate payments.
52
Q

What should be considered when interpreting gearing

A
  • business with strong predictable sales can afford to have higher levels of gearing
  • high gearing not really bad if sales and profit is increasing
  • business may be investing in growth to take advantage of rising demand, may require loans to purchase more resources.
  • if business highly geared it is worth assessing whether there is an increasing or decreasing demand.
  • business low geared may not be taking advantage of investment opportunities.
53
Q

Equation for Payback month

A

Amount outstanding at start of year / net cash flow in following year x 12

54
Q

What is the equation for Average Rate of Return

A

Total net profit/ no. of years / initial investment x 100

55
Q

Equation for present Value

A

Net cash flow x Discount factor

A-Level Business Studies (WJEC) (10 decks)

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