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
Write the formula for stock turnover that you are familiar with.
STOCK TURNOVER (days)
= Average stock/cost of goods sold x 365 days
STOCK TURNOVER (number of times per year)
= Cost of goods sold/Average stock
c. In the formula for stock turnover, 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. The average stock figure can be taken as the average of _________ stock and __________ stock, but where the only information on stock is in the balance sheet opening stock will not normally be quoted; it may, therefore, be necessary to use the simpler method of taking closing stock instead of average stock. This could be a little misleading if stock levels _____________________________________ during the year, but, as with other ratios, consistency is essential.
Ans: opening, closing, have changed substantially
a. Debtor collection period is the period of time which …
debtors take to pay
Write the formula for debtor collection period that you are familiar with.
Average trade debtors/credit sales x 365 days
The level of credit sales may also be _______, because published accounts will only show total turnover, without separating cash sales from credit sales. This will reduce the value of the figures produced, giving the impression that debtors pay more ______ than they really do because some payments are made in cash. Again consistency in the method of calculation will remove the most serious distortions.
D. unknown, quickly
a. Creditor payment period is the period of time which …
your business takes to pay your creditors
b. When you pay your suppliers at a later date, you are essentially taking credit. Write the formula for creditor payment period that you are familiar with.
CREDITOR PAYMENT PERIOD, or CREDIT TAKEN (DAYS)
= Average trade creditors/credit purchases x 365 days
c. The same kinds of consideration that apply to the calculation of debtor collection period also apply to the calculation of the period of credit which the business itself is able to take from creditors. What are these considerations?
The best approach is to use average trade creditors for the year since credit purchases 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 only have the end-of-year accounts available, so an end-of-year figure may need to be used to achieve consistency.
Credit purchases may not be shown, and it may not always be possible to calculate the figure.
What’s quasi capital?
form of loan finance provided by the directors or owners which is intended to be kept fairly permanently in the business.
The long-term debt will normally appear in the balance sheet as long-term liabilities, but banks might also want to consider whether any of their short-term lending, for example
of an overdraft, should really be considered long-term because it never gets repaid (forming a hard-core of permanent lending).
Name another long term debt
Hire purchase is a system by which one pays for a thing (eg: machinery, car) in regular instalments while having the use of it. A hire purchase contract is usually for a period of longer than 1 year.
ratios concerned with the long-term strength of the business are
proprietorship ratio, and the interest cover.
Equation for proprietorship
PROPRIETORSHIP RATIO
= Shareholders’ stake/total sources of finance
The proprietorship ratio gives an indication of how well the business is cushioned against losses, before there is any risk to creditors.
What does the proprietorship ratio show?
indication of how well the business is cushioned against losses, before there is any risk to creditors.
What does the interest cover equation show
looks at how well the company is able to cover its commitment to meet interest payments. A high figure indicates that there is little likelihood of any problem, but if the interest payments are only covered once or twice by profit, the risk to lenders if profits decline is much greater. Yes
Equation for interest cover
Net profit before interest and tax/interest charged
For long-term loans the interest can be a larger commitment than the capital repayments, so lenders need to pay attention to interest cover.
What’s the better version of interest cover ratio?
DEBT SERVICE COVERAGE RATIO which takes into account the repayments as well as the interest charge
DEBT SERVICE COVERAGE RATIO =
Earnings before interest, tax and write-downs (depreciation of fixed assets and write-off of goodwill etc)/annual debt repayment plus interest.
A key implication of using Debt Service Coverage Ratio is that….
that any change to the proposed period of the lending can be taken into account; spreading a loan over 15 years rather than 5 years will improve DSCR considerably
What’s gearing/leverage?
Borrowed capital is described as providing gearing (or leverage), because the shareholders are able to increase the rate of return they get (provided the company is successful) by using borrowed funds.
Gearing ratio equation=
DEBT/EQUITY RATIO
= long-term debt/shareholders’ stake (or equity)
Ratios dealing with capital adequacy/long-term financial strength? PID
DEBT/EQUITY RATIO
INTEREST COVER
PROPRIETORSHIP RATIO
Other ratios examining profitability / overall performance and efficiency
NAGR NET PROFIT RATIO ASSET TURNOVER RATIO GROSS PROFIT RATIO ratio of expenses to sales
GROSS PROFIT RATIO=
Gross profit/sales x 100 %
ASSET TURNOVER RATIO=
Sales/total net assets (times)
NET PROFIT RATIO
Net profit after interest and tax/sales x 100 %
In general a business might expect to increase sales by investing in more assets, but the———- charged on fixed assets can make the figure for total net assets fall while sales are constant, and this would give the rather misleading impression of——–performance.
depreciation
improved
Gross profit arises from ….
difference between sales revenue and the cost of sales. An increased one means that selling prices have risen or costs of goods sold have fallen, though it cannot indicate which one of the two (or both).
The ratio of expenses to sales shows
shows any difference between the gross profit margin and the net profit margin
common alternative to R.O.C.E.?
Return on Equity (or Return on Shareholders’ Funds) which takes the shareholders’ perspective and relates the profit earned for shareholders (therefore after interest and tax, but before payment of any dividend) to the level of equity. It is important to appreciate that equity (the shareholders’ stake consisting of share capital and all reserves and retained profits) like capital employed, like capital employed, changes through the year as the business makes profits - do not make the mistake of thinking that the share capital alone is the equity.
RETURN ON EQUITY (or RETURN ON SHAREHOLDERS’ FUNDS)=
Net profit after tax and interest/shareholders’ stake x 100%
What is hire purchases?
hire purchase is often considered as long-term debt too. Hire purchase is a system by which one pays for a thing (eg: machinery, car) in regular instalments while having the use of it. A hire purchase contract is usually for a period of longer than 1 year.
- In general when carrying out an analysis of the accounting information provided about a business, the key starting point is to identify any particularly __________ figures and any ___________ in the figures from one year to the next.
D. large, significant changes
- Given a set of accounts / financial statements, basic areas to explore are the profitability of the business, the ¬¬¬¬¬_________ of the business, the _________ of the business and the cash flow generated by the business.
D. liquidity, capital adequacy / level of gearing
- Briefly explain a few of the differences between a private business and a listed company. Consider
a) Availability of accounts / financial statements to the public
b) Ways to raise capital / funds / money
a) A listed company is listed on a stock exchange and its shares are usually publicly available for trading. It usually has to make public its accounts / financial statements, whereas a private business does not have to do so.
b) Both a private company and a listed company can raise capital / funds / money from both shareholders and lenders. Compared to a private business though, a listed company is usually not just limited to borrowing from the bank, it can usually also borrow from the capital markets, ie by issuing bonds.
Gearing ratios take many forms, so it is preferable for you to stick to one standard approach. Give an example for this and write out the formula for it.
DEBT/EQUITY RATIO
= long-term debt/shareholders’ stake (or equity)
- The higher the level of borrowed capital the greater the level of ____________ which the company needs to cover before being able to “reward” its shareholders by paying dividends.
D. interest payments
What is horizontal analysis
When ratios of a company from previous years, adjusted for inflation if necessary, can be compared with current ratios to provide trends
Non-current assets?
these are not sold for profit but used to generate profits, such as buildings, land, equipment, patents
Current assets?
short-term sources of income such as inventory, receivables, cash
Current liabilities?
short-term debts such as trade payables, overdraft, proposed dividend, tax liability, lease rental obligation
Non-current liabilities?
loans, bonds, equity
Users of ratio analysis?
Investors - financial institutions and ordinary investors need to make decisions about buying or selling shares in a company
Managers - assess performance of different divisions and company as a whole against competitors and against previous years
Financial institutions – make decisions on, for example, lending cash to a company
What are Benchmarks?
Ratios must be compared with benchmarks
Target ratios (e.g. ROCE > 16%) can be compared with calculated ratios
Ratios of similar companies in the same business area can offer a comparison (but remember to ensure to ‘benchmark against the best’)
Average ratios for company’s business sector (industry norms) can show …..BENCHMARKS
how well or how badly a company is performing against competitors
