LEC1 Flashcards
- Profit figure looked at __________ does not mean very much. Profit therefore needs to be put into some context before it can be used to assess how well a business has performed. Comparing profit with the ______ of the business is one valuable starting point, and this can be done by calculating the return on capital employed (ROCE).
D. in isolation, size
- What are the two main sources of capital / finance / funds / money for a business?
i) Equity capital, ie money from the shareholders / owners
ii) Debt capital, ie money from lenders
- In return on capital employed (ROCE), what is capital employed?
The capital employed in a company is the total of resources being used by the company, and is measured by adding all of the shareholders’ stake in the business (share capital + all reserves + retained profits) to any long-term liabilities, which is the same as saying the total assets less any current liabilities.
- Write the formula for ROCE that you are familiar with. By now, you should be able to do this without looking it up!
RETURN ON CAPITAL EMPLOYED
= Net profit before interest and tax/capital employed x 100%
where capital employed = total asset – current liabilities or …
- The R.O.C.E. does present some problems, because you may sometimes be faced with accounts which do not identify clearly the net profit before interest payments and tax, and because the profit relates to ____________ while the balance sheet figure for capital employed is _______________. Alternative versions of R.O.C.E. therefore try to use a figure for ________ capital employed through the year; the simplest way to do this is by taking the opening capital employed plus the closing capital employed divided by two.
D. a whole year, at one point in time, average
- You may often come across R.O.C.E. calculations based on total assets (sometimes referred to as gross assets) rather than total assets less any current liabilities. Whatever approach you use (and this may depend on what ¬¬¬___________ is available), the most important principle is to be consistent, in calculating any ratios which you are going to compare.
D. information
- A common alternative to R.O.C.E. in looking at overall efficiency is the Return on Equity (or Return on ___________________) which takes the shareholders’ perspective and relates the profit earned for shareholders (therefore after interest and _____, but before payment of any ____________) to the level of equity.
C. Shareholders’ Funds, tax, dividend
- Equity, also known as shareholders’ stake or shareholders’ funds consists of.
C. share capital, all reserves and retained profit
- It is important to appreciate that equity (or the shareholder’s stake), like capital employed, changes through the year as the business makes profits. If comparative data on average shareholders’ stake is not available it is usual to use ___________ figures.
C. end-of-year
- Write the formula for return on equity (or return on shareholders’ funds) that you are familiar with. By now, you should be able to do this without looking it up!
RETURN ON EQUITY (or RETURN ON SHAREHOLDERS’ FUNDS)
= Net profit after tax and interest/shareholders’ stake x 100%
where shareholders’ stake = share capital + all reserves + retained profits
- Write the formula for gross profit ratio. By now, you should be able to do this without looking it up!
GROSS PROFIT RATIO
= Gross profit/sales x 100 %
where gross profit = sales (or turnover) - cost of sales
- Gross profit arises from the difference between sales revenue and the cost of sales. An increased gross profit margin means that selling prices have risen or costs of goods sold have fallen, though it cannot indicate which one of the two (or both).
I. Selling prices have risen
II. Cost of goods sold have fallen
- Net profit before interest and tax arises from the difference between
D. Gross profit and expenses
- Give examples of ‘Other expenses’. By now, you should be able to do this without looking it up!
Depreciation, Audit fee, Remuneration, Directors’ remuneration
- ratio of expenses to sales. The ratio simply shows any difference between the gross profit margin and the net (operating) profit margin. For example if gross profit consists of 25% of sales and net profit consists of 10% of sales, the expenses must amount to 15% of sales.
When you are looking at accounts where there seems to be a substantial increase in the proportion of sales revenue used up in expenses, what further investigation / analysis might you do?
It may make sense to try to analyse which elements of the expenses have increased most.
The cost of goods sold figure is used because
this treats sales at cost price, and the value of stock is normally at cost price
- Liquidity is concerned with the question of whether a business is in a position to
Ans: meet its debts when they fall due.
- One of the most basic measures of liquidity is the current ratio. Write the formula for current ratio. By now, you should be able to do so without looking it up!
CURRENT RATIO
= Current assets : current liabilities
- It is often argued that the current ratio should be at least ______ to give a good margin for delay in turning current assets into the cash needed to pay current liabilities. In practice businesses vary enormously in what current ratio they need.
B. 2:1
- Acid-test ratio is based on the concept of liquid assets rather than current assets. The main difference between the two is likely to be the …
D. stock (of all kinds including raw materials and work-in-progress)
- As with the current ratio there is no right level for the acid- test ratio, though if this is above ______ the business might be seen as being well capable of meeting any commitments as they fall due.
D. 1:1
DEBTOR COLLECTION PERIOD, or CREDIT GIVEN (DAYS) equation
Average trade debtors/credit sales x 365 days
The best approach to working out the period of time which debtors take to pay is, again, to use an average for the year since credit sales are spread throughout the year. However such information may not be available or it may only be available for certain years and in other years, you might
end-of-year figure may need to be used to achieve consistency.
why might the level of credit sales may also be unknown
because published accounts will only show total turnover, without separating cash sales from credit sales
What effect does an unknown credit sales have on the debtor
DEBTOR COLLECTION PERIOD, or CREDIT GIVEN (DAYS)
= Average trade debtors/credit sales x 365 days
This will reduce the value of the figures produced, giving the impression that debtors pay more quickly than they really do because some payments are made in cash. Again consistency in the method of calculation will remove the most serious distortions.
- For retail shops which buy goods on credit, but sell for cash, the acid-test ratio may show a ______ figure because of the lack of debtors to balance the creditors.
C. very low
- Note that the more resources the business keeps in liquid form the ______ it is able to earn a return from those assets. Very high liquidity can be just as much a problem as very low liquidity (though you will come across it much less often).
less
- In addition to calculating the two fundamental ratios for assessing liquidity, it is often useful to look at:
- the rate at which stock is being sold, because a slowdown in this rate may indicate problems, for example of unsaleable stock.
- the period of credit being given to debtors, because the longer debtors take to pay, the more likely the business is to become short of cash
- the period of credit being taken to pay creditors, because pressure from creditors may shorten this period, and make it harder for a business to maintain adequate liquidity
a. Stock turnover is the rate at which…
stock is being sold
