Outcome F Flashcards
What are the 2 documents that are used to assess and monitor financial performance
Statement of comprehensive income (profit & loss)
Statement of financial position ( balance sheet )
What is a statement of comprehensive income
Provides a business with an accurate account of its profit and loss
It records sales, costs, gross and net profit over a period of time usually a year
Why is a statement of comprehensive income used
Vital for understanding the business’ position financially
If they’re making a profit or a loss.
However if they can identify that they are making a loss then they can assess they profit n loss account to see why and where the business is losing money
Sales revenue
Is the money a company earns from selling its goods and services to customers. It is income the company earns exclusively from the sales of goods or services. It does not include sources of income that derive from anything other than sales
Costs of goods sold (COGS)
Includes all of the costs and expenses used for the production of goods. It excluded indirect costs such as overhead and sales & marketing. Costs of goods sold is deducted from revenue (sales) in order to calculate gross profit and gross margin. Higher COGS results in lower margins
Inventory
The goods available for sale and raw material used to produce goods available for sale. Investors represents one of the most important assets of a business because the turnover of inventory represents one of the primary sources of revenue generation.
Gross profit
Is the profit a company makes after deducting the costs associated with making and selling its products. Gross profit will appear on a company’s income statement and can be calculated by subtracting the cost of goods sold from revenue
Net profit
Is the measurement of a company’s profit once operating costs interest and depreciating have all been subtracted from its total revenues. The term is often referred to as a company’s ‘bottom line’ and may also be described as ‘net earnings’ or ‘net income’
Expenses
Is the costs of operations that a company incurs to generate revenue
Common expenses include payments to suppliers, employee wages, leases and equipment depreciation
Depreciation
Is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectant. Depreciation represents how much of an asset’s value has been used up.
Profit
The amount of money you still have once all expenses have been deducted your gross profit and any other revenue income has been added
Loss
Where all expenses have been deducted and the business has made less money that it has earned in sales revenue. Meaning the business has lost money that year
Sales formula
Quantity sold times selling price
Gross profit formula
Sales turnover minus costs of goods sold
Net profit formula
Gross profit minus expenses plus other revenue income
What are the two way of calculating how much an asset has depreciated
Straight line method
Reducing balance method
Historic value
The cost of an asset when it was first purchased e.g a MacBook at £1400
Expected life
How long the asset is expected to be used within the business e,g 3 years
Residual value
The value of the asset at the end of it expected life. How much the asset is worth once it is disposed of. After 3 years the Macbook may be valued at £500
Macbook historic value £1400 - Residual value £500 = £900
£900 divide by expected life 3 years = £300 a year
Depreciation of £300 a year on a statement of comprehensive income
Straight line depreciation
Historic value - residual value
divided by expected life
Reducing balance depreciation formula
Historic value x percentage of depreciation
Take the historic value and reduce the price by 20% a year
Historic value = 30000
Year 1 - 30000 x 0.8 = 24,000
Year 2 - 24000 x 0.8 = 19,200
Year 3 - 19200 x 0.8 = 15,360
Value after 3 years - £15,360
Depreciation after 3 Years £14,640
Adjustments for prepayments, accruals
What are prepayments
These are when an expense is made in advance of the period where it is used. It is a pre payment
Accruals
This is the opposite and is when an expense is paid after the period where it was incurred. An example could be utility bills
Statement of comprehensive income
What can it be used for?
Compare figures such as gross and net profit. It will allow you to look at how expenses have impacted the difference between the two.
Compare years. Have sales improved from one year to the next? Had net & gross profit improved? Have expenses increased or decreased?
Compare different departments and products within the business.
Compare how the business is performing in relation to its competitors
Purpose and use of a statement of financial position
Shows a business’s net worth at a particular point in time and is usually produced at the end of the financial year.
It shows everything that the business owns (assets) and everything the business owes (liabilities)
Statement of financial position (balance sheet)
A balance sheet is useful because it shows
Assets (things the business owns)
Liabilities (debts a business owes)
Capital employed (how the business is financed)
Tangible non current assets
Something that can be physically touched
Premises
Vehicles
Fixtures and fittings
Intangible non current assets
Something that cannot be touched
Patents
Goodwill
Branding
Copyrights
Current assets
Are all assets of a compartment that are expected to be sold or used as a result of standard business operations within the current year.
Current assets include:
Cash in hand
Cash in the bank
Inventories
Trade receivables (people that owe the business money)
Current liabilities
Are debts that the business owes the need repaying in under one year
Overdrafts
Accruals (an expenses paid after the period it was used)
Trade payables (people the business owes money to)
Working capital formula
Current assets - current liabilities
The higher the working capital….
The more it shows how easily the business can pay back it’s short term debts. If current liabilities are breather than current assets then this could indicate cash flow problems
Non current liabilities
Long term debts that need to be paid back in more than one years time.
Examples include:
Bank loan
Mortgages
Net asset formula
Non current assets + current assets - (current liabilities + non current liabilities)
Capital employed formula
Capital + retained profit
What can the statement of financial position be used for?
Compare figures such as the current asset and current liabilities. What is the difference between the two figures? And what can be done?
Compare years. Have assets increased or decreased? Has the business got more or less working capital? Has the business increased or decreased in value?
Compare how the business is performing in relation to its competitors
Ratio analysis
A form of financial statement analysis that is used to obtain a quick indication of a business’s financial performance in several key areas.
It uses the two financial documents:
Statement of comprehensive (profit n loss)
Statement of financial position (balance sheet)
Why is ratio analysis important
Helps businesses to see how it is performing now and how it compares to last year or the year before and against other competitors in the industry.
Ratio analysis provides concrete data that shows:
Profitability
Liquidity
Efficiency
Types of profitability ratio
There are several calculations a business can use to show them their profitability
Gross profit margin
Net profit margin
Mark up
Return on capital employed (ROCE)
Gross profit margin formula
Gross profit divided by revenue x 100
Remember:
Revenue can also be known as sales or turnover
Gross profit formula
Revenue - cost of sales
What does gross profit margin tell us
The profit a business makes on its sales minus the cost of goods sold.
It is the percentage of gross profit made on sales.
If a business had a gross profit margin of 70% that means for every £1 made in sales the business makes 70p in gross profit.
Gross profit is the profit earned before any expenses, usually it is a lot higher than net profit.
It can help a business decide whether it needs to raise prices or reduce the cost of goods sold.
Net profit margin formula
Net profit divided by sales revenue x 100
Net profit formula
Gross profit (sales revenue) - expenses
What does net profit margin tell us
Shows the percentage of net profit made on sales taking into account expenses.
If a business has a net profit margin of 35% then this means that for every £1 made in sales the business makes 35p in net profit.
If the net profit margin is too low then it will usually be because expenses are too high. The business will then look at reducing expenses to improve the net profit margin.
It could be due to too high wages, expensive rent or distribution costs
Net profit margin formula
Net provide divided by revenue X 100
Markup formula
Gross profit divided by costs of goods sold X 100
What does mark up tell us
Looks at profit as a percentage of cost of goods sold.
It shows what percentage is added to the cost of goods sold to reach the selling price.
For example, a mark up of 20% would mean that if the costs of raw materials used to produce a product were £1, then a product would be sold for £1.20 as it has been marked up by 20%
Return on capital employed (ROCE) formula
Net profit divided by capital employed X 100
What does ROCE tell us?
Shows if the managing director is doing their job properly. Tells the company the percentage return the business is making in relation to the capital invested.
The ROCE percentage is usually compared to the return fro, interest rates at a bank. if investors can put their money in a bank and can achieve a higher percentage than the ROCE it may not be worth the risk of investing it in the business.
Profitability ratios
Show how efficiently a company generates profit and value for shareholders. Higher ratio results are often more favourable, but ratios provide much more info when compared to results of similar companies.
These figures can be used to:
Compare figures such as gross and net profit. It will allow you to look at how expenses have impacted the difference between the two figures.
Compare years. Have sales improved one year to the next?
Compare different departments and products within the business (intrafirm comparison)
Compare how then business is performing in relation to its competitors (intrafirm comparison)
Why is liquidity important
Liquidity ratios are used to determine whether the business has enough current assets to pay off any debts that may need repaying.
Current liabilities are analysed in relation to liquid assets. By doing this the business is evaluating whether they have enough capital to cover short term debt obligations.
Businesses need to control and conserve their cash and assets as well as making a profit.
Liquidity is of particular interest to those who may be providing short term credit to the company
Liquidity ratios
There are two calculations that you need to know to be able to analyse the liquidity of a business, these are:
Current ratio
Liquid capital ratio
Both of these are worked out by using figures on a statement of financial position
Current ratio formula
Current assets divided by current liabilities
The answer to this calculation is given as a ratio
What does the current ratio show
The general concept of the current ratio is examining the relationships between assets and liabilities. If the current assets are greater than the liabilities, then the business is in healthier shape than if it were the other way around.
Liquid capital ratio formula
Current assets - inventory
Divided by current liabilities
The liquid capital ratio calculation answer is also expressed as a ratio to one. It shows the number of current assets the business has (excluding inventory) to the number of current liabilities
What does the liquid capital ratio tell us
It works out current assets in comparison to current liabilities, however this time it excludes inventory from current assets as it is seem as least liquid of the current assets.
It is important to measure a business’s liquidity without the inclusion of inventory as inventory is the least liquid as it takes time to sell
Measuring efficiency
Efficiency ratios are used to help management determine how key areas of the business are performing, mainly in terms of cash flow and inventory
The ratios used to determine efficiency are
Trade receivable days
Trade payable days
Inventory turnover
Trade receivable days formula
Trade receivables X 365
Divided by credit sales
How long it takes debtors to pay for goods they have purchased on credit.
The answer is displayed in data and is why the answer is multiplied by 365 as this represents the days in a year.
Important: if you can not find the amount of sales that were made on credit then it is acceptable to use the overall sales figure on a statement of comprehensive income
What does trade receivables show
This ratio measures the average amount of days it takes for debtors to pay for a product or service.
It expresses the figure as the amount of days it takes for something to be paid for that is bought on credit.
It is very important to know in terms of cash flow as you want to receive the money owed as quickly as possible.
Depending on the industry/sector the acceptable amount of days to receive payment is different
Trade payable days formula
Trade payable X 365
Divided by credit purchases
This measures how long it takes a business to pay for the goods or services bought on credit
Important: if you don’t know the amount of purchases that were made on credit then it is acceptable to use the purchases figure on a statement of comprehensive income
What does trade payable days show
This ratio measure the average amount of days it takes for the business to pay creditors for the goods or services it has received.
the answer is expressed as a number of days as this shows the average amount of days it takes the business to pay.
This figure is usually compared with trade receivable days and the business will want to receive the money it is owed quicker than paying the money it owes. This will positively impact cash flow
Inventory turnover formula
Average inventory X 365
Divided by costs of goods sold
This measures the average amount of time an item is held by the business before it’s sold
If a business has an inventory turnover of 10 days then that means the business holds each item for an average of 10 days until it is sold
Average inventory formula
Opening inventory + closing inventory
Divided by 2
What does inventory turnover show
The average number of days stock is held within the business before it is sold.
If the average number of days is high then the item could go out of date or out of trend.
Positives of using ratio analysis
Ratios help compare current performance with previous records.
Ratios help compare a firm’s performance with similar competitors.
Ratios help monitor and identify issues that can be highlighted and resolved
Limitations of ratio analysis
The data is historic, meaning that it is calculated using past data which may not reflect current performance.
Ratio analysis does not take into account external factors such as a worldwide recession
Ratio analysis does not measure qualitative impacts such as workplace culture
Financial records are easy to manipulate which can lead the ratios to be misleading or false
Interfirm comparison can be difficult with large companies that report their accounts using different formats
