Section F (BUSINESS FINANCE)

Question 1

What is a statement of a comprehensive income?

Answer 1

It calculates whether the firm has made a profit or a loss by deducting all expenses from sales revenue.
It shows the trading position of the business which is used to calculate gross profit. It then takes into account all other expenses to calculate the profit or loss of the year.

Question 2

What is a statement of financial position?

Answer 2

It calculates the net worth of a business by balancing what the business owns against what it owes.
A snapshot of a business net worth at a particular moment in time, normally the end of a financial year.

Question 3

What do you need to know for the calculation of gross profit?

Answer 3

• Sales Revenue
• Costs of Goods Sold

Question 4

What is SALES REVENUE?

Answer 4

It is the money coming into the business from providing a trade, e.g. selling goods, manufacturing goods or providing a service.
CALCULATION FOR SALES TURNOVER:
Quantity Sold X Selling Price

Question 5

What is COSTS OF GOODS SOLD?

Answer 5

It includes the costs directly linked to providing that trade, e.g. the cost of buying in the goods or the raw materials used to produce the goods. To workout the costs of goods sold, a simple calculation is done to ensure that the figure recorded for costs of goods sold can be directly linked to the goods actually sold and not just all the materials purchased.
The actual value of inventory used to generate sales.
CALCULATION FOR COSTS OF GOODS SOLD:
Opening Inventories + Purchases - Closing Inventories

Question 6

What is GROSS PROFIT?

Answer 6

It is the amount of money left or the surplus after the cost of goods has been deducted from the sales turnover. This is not however, the business’ final profit as there are still other expenses to deduct in the next part of the account.
CALCULATION:
Sales Turnover - Costs of Goods Sold

Question 7

Explanation of PROFIT

Answer 7

Profit is the money after all other expenses have been deducted from gross profit and any other revenue income has been added. Revenue income is non-capital income that is received by the business from sources other than sales, e.g. discounts received and interest on positive bank balances.

Question 8

Explanation of DEPRECIATION

Answer 8

Depreciation appears as an expense in the statement of comprehensive income, as this is a way that accountants can spread the cost of a fixed asset over its lifetime. Depreciation will be explained in more detail under the fixed asset heading when you look at a balance sheet.

Question 9

What is the calculation for PROFIT for the year?

Answer 9

• Gross Profit - Expenses + Other Revenue Income
• Gross Profit = Sales Revenue - Costs of Goods Sold
• Cost of Goods Sold = Opening Inventory + Purchases - Closing Inventory
• Profit or Loss for the year = Gross Profit - Expenses + Other Income

Question 10

What is a ‘transfer of profit to a statement of comrehensive income’?

Answer 10

Tax is to be deducted from the profit: this is a percentage of the profit that is to be paid to HM Revenue & Cutoms (HMRC). This then gives profits after tax.
The business then has to decide how to use this profit. In the case of a company, a proprtion of it may be issued to shareholders in the form of dividends. For a sole trader or partnership, it could be taken out of the business as drawings. Either some or all of it is likely, however, to be plouged back into the business - this is called retained profit. Retained profits are transferred from the statement of comprehensive income to the statement of financial position.

Question 11

What are ‘adjustments for depreciation (straight-line & reducing balance)?

Answer 11

Depreciation is an accounting concept used to spread the cost of an asset over its useful life. It is important that when fixed assets are shown in the statement of financial position, they are given a realistic value. For this reason, they are depreciated on an anual basis. The annual amount by which the assets are depreciated is therefore included as an example in the statement of comprehensive income. If, for example, a business bought a delivery van for £30,000 and three years later still showed its value as £30,000, this would be unrealistic and inaccurate accounting. The statement of financial position should therefore show the historic cost of an asset, the amount by which it has depreciated over its life and then a current value for the asset. The final figure is called the netbook value and this represents what the asset is thought to be worth at that moment in time.

Question 12

What are the 2 types of depreciation?

Answer 12

• Straight-line Depreciation = An asset is depreciated by a set amount each year
• Reducing Balance Depreciation = An asset is depreciated by a set percentage of its remaining value each year

Question 13

What is the straight-line method

Answer 13

It involves reducing the value of an asset, from the price paid, i.e. its historic cost, by a fixed amount each year. To calculate the amount, the accountant must, first of all, make 2 decisions:
- how long the asset is expected to be useful to the business, i.e. its EXPECTED LIFE
- at the end of its useful life, how much it might be worth if sold on or sold for scrap, i.e. its RESIDUAL VALUE

Once the decision is made, this formula is applied:
(Historic Value - Residual Value) / Expected Life

EXAMPLE:
Van costs £16,000. It’s expected life is 4 years. It’s resale value is £4,000.
Calculation for depreciation:
(£16,000 - £4,000) / 4 years
= 12,000 / 4
= £3,000 per year
It is seen as an expense on the statement of comprehensive income.

Question 14

Adjustments for REPAYMENTS, ACCRUALS

Answer 14

It is important that the financial records are true and fair records of the business’ activities. For this reason, adjustments will be made to a statement of comprehensive income so that the expenditure shown matches the period in which the good or service is used. E.G. if rent is paid quaterly in advance, the expense may be incurred in one financial year but the premises are actually used in the next financial year. To take account of such timing differences, two types of adjustments are made:

• Prepayments:
  A prepayment is when an expense is made in advance of the periods of which it relates.
  The expense is therefore taken out of expenses in the statement of comprehensive income and shown as a current asset in the statement of financial position.
  An example would be rental on a phone line paid quarterly in advance.
• Accruals:
  An accrual is when an expense is paid after the periods to which it relates.
  The expense is therefore added as an expense in the statement of comprehensive income and shown as a cuurent liability in the statement of financial position.
  An example would be electricity paid quarterly in arrears.
  (Arrears = money that is owed and should have been paid earlier)

Question 15

Interpretation, Analysis and Evaluation of statements in regards to profitability

Answer 15

Once produced, the statement of comprehensive income can be used internally by management to help measure the perfomance of the business and inform future decision making. It can also be used externally by potential investors and creditors. A creditor, for example, might look at the business’ statement of comprehensive income when deciding whether or not to offer trade credit.
The statement of comprehensive income may be analysised in a number of ways including making:
- Comparisons between figures within the statement of comprehensive income, e.g. profit as a percentage of sales revenue
- Comparisons between years, i.e. gross profit this year compared with gross profit for last year
- Intrafirm comparisons to see how different aspects of the business are performing, e.g. revenue for one product or branch compared with another profit or branch
- Interfirm comparisons to see how the business is performing in relation to its competitors

When interpreting and analysing a statement of comprehensive income, it is also useful to consider profitability. Profit quality is how sustainable the profit is. If profits have increased, but this is because of a one-off event, such as selling an asset, then this cannot be repeated the following year and profit quality may therefore be seen as poor. However, if the increase in profit is as a result of increased sales or lower costs, then this may be seen as achievable in future years and therefore profit quality is seen as good.
Profit quality can be used to evaluate the statement of comprehensive income. Anyone looking at the accounts may also want to consider the accuracy of the information. Accounts must be accurate to meet legal requirements but it is possible to manipulate data to make it look more favourable. This is called window dressing.

Question 16

What is the purpose and use of a ‘statement of financial position’?

Answer 16

A statement of financial position is a snapshot of a business’ net worth at a particular moment in time, normally the end of a financial year. It is a summary of everything that the business owns (its assets) and owes (its liabilities). A statement of financial position therefore states the value of a business.

Question 17

Statement of financial positions

Answer 17

Statement of financial position can be shown in a vertical or horizontal format, vertical being the most common, and therefore the style of presentation you will use in this unit. A vertically presented balance sheet is presented as:
- Non-current assets
- Intangible assets (bullet point)
- Tangible assets (bullet point)
- Current assets (+)
- Current liabilities (-)
- Non-current assets / liabilities (=)
- Non-current liabilities (-)
- Net assets (=)

This is the first half of the balance sheet that calculates the net assets, that is, the worth of the business. Imagine if the business were to close today and you sold all of its assets, then paid off all of its liabilities. This is the amount you would be left with.

Question 18

Non-current assets

Answer 18

Non-current assets are those items of value that are owned by the business and likely to stay within the business for more than one year. These can be:
- Tangible assets: i.e. they can be touched, e.g. a machine or premises.
- Intangible assets: i.e. they cannot be touched, e.g. a trademarker or recognised name.

Question 19

Tangible Assets

Answer 19

These include premises, fixtures and fittings, equipement and vehicles. It is important that when these are shown in the statement of financial position, they are given a realistic value. For this reason, they are depreciated on an annual basis. As you have already learned, if a business buys a delivery van for £30,000 and 3 years later still shows as £30,000, this is unrealistic and inaccurate accounting. The statement of financial position should therefore show the historic cost of an asset, the amount by which it has depreciated over its life and then a current value for the asset. The final figure is called the net book value and this represents what the asset is thought to be worth at that moment in time.

You have already looked at how to calculate depreciation using the straight-line method. The van that cost £16,000, with a residual value of £4,000, was to be depreciated by £3,000 per year.
In the balance sheet, the netbook value (the cost of an asset - depreciation) would be shown as:
Year = 1 - Cost = £16,000 - Accumulated Depreciation = £3,000 - Net Book Value = £13,000
Year = 2 - Cost = £16,000 - Accumulated Depreciation = £6,000 - Net Book Value = £10,000
Year = 3 - Cost = £16,000 - Accumulated Depreciation = £9,000 - Net Book Value = £7,000
Year = 4 - Cost = £16,000 - Accumulated Depreciation = £12,000 - Net Book Value = £4,000
Net Book Value = Cost - Accumulated Depreciation

Question 20

Intangible Assets

Answer 20

This is something that adds value to the business but does not have a physical presence. One example of this that you might see on a balance sheet is ‘goodwill’. This means when someone buys an already-established business, they are also buying the goodwill that the business has built up, such as brand recognition or a loyal customer base.
The value of an intangible assets can change over time. If a decision is made to decrease the value of an intangible asset, a principle similar to depreciation is applied. This is called ‘amortisation’ where a one-off change is made to the value of the intangible asset. This will be shown in the statement of financial position to record the cost, amortisation and net book value of the intangible asset.

Question 21

Current Assets

Answer 21

Current assets are those items of value owned by a business whose value is likely to fluctuate on a regukar basis. Every time a business makes a transaction, the value of its current assets will fluctuate. Current assets include:
- Inventories
- Trade Receivables
- Prepayments
- Cash in the bank
- Cash in hand

Question 22

What is INVENTORY?

Answer 22

Inventory is the value of stock held at that moment in time. Depending upon the nature of the business, it can take 3 different forms:
- Raw materials
- Work in progress
- Finished goods
A business must be careful to give stock a realistic value and not over value stock, e.g. inventory which they are unlikely to sell because it has gone out of fashion or is damaged.

Question 23

What are TRADE RECEIVABLE?

Answer 23

They are people who owe the business money. Although the business does not yet physically have the money, it is, in effect, owned by the business. Trade receivables are customers who have not yet paid for the good or service provided by the business and must be monitored to ensure that they do make the payment by the due date.

Question 24

What are PREPAYMENTS?

Answer 24

These are when an expense is made in an advance of the period to which it relates. Therefore it is classed as an asset and transferred from the statement of comprehensive income.

Question 25

Current Assets

Answer 25

Current assets are listed in order of how easy it is to turn them into cash quickly. E.G. if a business has liquidity problems, it may find it difficult to turn inventory into cash quickly. In addition, in trying to do so, it may not receive its true value. In contrast, cash in hand is just that - cash!

Question 26

Current Liabilities

Answer 26

A current liability is something owed by a company that should be paid back in under one year. Examples include:
- Overdrafts = The ability to withdraw money from a current account that you do not have
- Accruals = This is when an expense is paid after the period to which it relates
- Trade Payables = These are people or businesses the business owes money to because it has received a good or service but has not yet paid for it

Question 27

Net Current Assets / Liabilities

Answer 27

Net current assets / liabilities is a very important figure for a business; it represents the business’ ability to meet short-term debts. A business with insufficient net current assets, also called working capital, does not have enough current assets to meet its current liabilities. This is potentially disastrous because, if the liabilities have to be paid for now, and the business cannot meet these demands from its current assets, then it will have to find the cash elsewhere. This could mean being forced to sell a fixed asset without which the business cannot operate. Net current assets / liabilities is calculated as:
Current Assets - Current Liabilities

• Current assets are GREATER than current liabilities = net current assets
• Current assets are LESS than current liabilities = net current liabilities

Question 28

Non-current Liabilities

Answer 28

A liability is something that the business owes. If it is classed as non-current, this means the business will pay it back in more than one year. Examples of non-current liabilities include bank loans and mortgages. These are likely to be used to buy fixed assets or to set up the business initially.

Question 29

Capital

Answer 29

The second half of the statement of financial position then asks how this has been financed. This shows the ‘capital employed’ and is presented as:
- Owner’s or Shareholder’s capital
- + Retained profit
- - Drawings
- = Capital employed

Capital employed = The total amount of capital tied up in a business at a point in time. Calculated as:
Owner’s or Shareholder’s capital + Retained profit - Drawings

Question 30

Opening Capital

Answer 30

It is the capital in the business at the start of trading. This is the money invested in the business from the owners. Owners may be a sole trader, partners or shareholders.

Question 31

Retained Profit

Answer 31

It is the profits kept from the previous year + the net profit from the current year. This will be transferred from the statement of financial position.

Question 32

Drawings

Answer 32

These are withdrawals made by owners from the business. For a statement of financial position to balance, net assets must be equal to capital employed.

Question 33

Adjustments

Answer 33

These will be made between the statement of comprehensive income and the statement of financial position to ensure that both records are showing a true and fair picture of the business’ activity. These adjustments are outlined below:
- Depreciation, straight line or reducing balance:
Annual depreciation Is shown as an expense on the statement of comprehensive income.
Each year depreciation is deducted from the net book value of an asset to show the value of the asset at the end of the year; this is the value of the asset recorded in the statement of financial position.
- Prepayments:
A prepayment is when an expense is made in advance of the periods to which it relates.
The expense is therefore taken out of expenses in the statement of comprehensive income and shown as a current asset in the statement of financial position.
If, for example, broadband is paid for 12 months in advance, and the accounts are produced half way through this 12 month period, half of the total payments would be recorded as a prepayment under the current asset heading on the statement of financial position.
- Accruals:
An accrual is when an expense is paid after the periods to which it relates.
This expense is therefore added as an expense in the statement of comprehensive income and shown as a current liability in the statement of financial position.
An example would be electricity paid for quarterly in arrears; a figure would be shown in the statement of financial position to account for the value of electricity already consumed.
- Interpretation, analysis & evaluation of statements:
Once produced, the statement of financial position can be used internally by management to help measure the financial health of the business and inform future decision making. It can also be used externally by potential investors and creditors. An investor, for example, might look at the business’ statement of financial position when deciding whether or not to offer capital to the business.

Question 34

Interpretation, Analysis and Evaluation of statements in regards to working capital

Answer 34

The statement of comprehensive income may be analysised in a number of ways including making:
- Comparisons between figures within the statement of comprehensive income, e.g. profit as a percentage of sales revenue
- Comparisons between years, i.e. gross profit this year compared with gross profit for last year
- Intrafirm comparisons to see how different aspects of the business are performing, e.g. revenue for one product or branch compared with another profit or branch
- Interfirm comparisons to see how the business is performing in relation to its competitors

When interpreting and analysing a statement of comprehensive income, it is also useful to consider working capital because this is a measure of the firm’s ability to meet day-to-day expenses. The statement of financial position is a useful indicator of how effectively management are running the business.
Both statements of financial position and comprehensive income are interpreted with the use of ratio.

Question 35

Measuring Profitability

Answer 35

Ratio analysis allows for a more meaningful interpretation of published accounts by comparing one figure with another. Ratio analysis also allows for both ‘interfirm’ and ‘intrafirm’ comparisons.
Ratios will be used by internal ‘stakeholders’ such as managers and employees, as well as external stakeholders such as investors and creditors.
Profitability is a measure of the profit of a firm in relation to another factor. It allows for a more comprehensive assessment of the performance of a firm by comparing one figure to another. Imagine that there are 2 firms, A & B, both with a profit of £75,000 per year - how would you be able to tell which one was performing better? If, however, you were told that firm A has sales revenue of £1.5 million and firm B has sales revenue of £3 million, then it is generating the same amount of profit from a lower level of sales. This indicates it is more efficient and better at controlling its costs.
There are 4 profitability ratios to look at:
- Gross Profit Margin
- Mark-up
- Net Profit Margin
- Return On Capital Employed (ROCE)

‘Interfirm’ = Between different firms, e.g. comparing the performance of 2 different house builders

‘Intrafirm’ = Within the firm, e.g. comparing this years results with last years, or the performance of the York branch with the Leicester branch of a retail store

‘Stakeholder’ = Anyone with an interest in the activities of a business, whether directly or indirectly involved

Question 36

GROSS PROFIT MARGIN

Answer 36

FORMULA:
(Gross Profit / Revenue) X 100

This ratio looks at gross profit as a percentage of sales turnover. It shows us, for every £1 made in sales, how much is left as gross profit after the costs of goods sold has been deducted. A gross profit of 88% therefore means that, for every £1 of sales made, 88p is left as gross profit.
If gross profit margin falls from one year to the next or is thought to be too low, a firm may try to reduce the cost of its purchases. This may involve looking for a cheaper supplier, but the firm must try to ensure that this does not affect the quality of the product. Alternatively, it may try to increase sales without increasing the costs of goods sold.

Question 37

MARK-UP

Answer 37

FORMULA:
(Gross Profit / Cost of Sales) X 100

This ratio looks at profit as a percentage of cost of sales. It shows what percentage of cost of sales added to reach selling price. E.G. A mark-up of 25% would mean that if the cost of raw materials used to produce a good were £1, it has been sold for £1.25.

Question 38

NET PROFIT MARGIN

Answer 38

FORMULA:
(Net Profit / Revenue) X 100

This ratio looks at net profit as a percentage of sales turnover. It shows, for every £1 made in sales, how much of it is left as net profit after all expenses have been deducted. A net profit of 31% therefore means that, for every £1 of sales made, 31p is left as profit.
If net profit margins falls from 1 year to the next or is thought to be too low, a firm may look to reduce its expenses, e.g. moving to cheaper premises or cutting staff costs. Before taking any action however, the accountant must try to identify the cause of a falling figure - whether it is related to sales, cost of goods sold or expenses - as all of these factors will impact upon the net profit margin.

Question 39

RETURN ON CAPITAL EMPLOYED (ROCE)

Answer 39

FORMULA:
(Net Profit before interest tax / Capital Employed) X 100

This ratio shows the percentage return a business is achieving from the capital (or money) being used to generate that return. It shows, for every £1 invested in the business in owner’s capital or retained profits, what percentage is being generated in profit. A ROCE of 5% means that, for every £1 tied up in the business, 5p is being generated in net profit.
Investors will often compare ROCE to the interest rate being offered in a bank or building society to see if their investment is working effectively for them in generating a return.

Question 40

MEASURING LIQUIDITY

Answer 40

Liquidity ratios measure how solvent a business is - that is, how able it is to meet short-term debts. There are 2 liquidity ratios:
- Current Ratio
- Acid Test Ratio / Liquidity Ratio (Liquid Capital Ratio)

Question 41

CURRENT RATIO

Answer 41

FORMULA:
Current Assets / Current Liabilities

This ratio shows the amount of current assets in relation to current liabilities and is expressed as x:1. If a firm had a current ratio of 2:1, this would mean that, for every £2 it owned in current assets, it owed £1 in current liabilities, and this would generally be considered acceptable. If, however, a firm had a current ratio of 0.5:1, this would mean that for every £1 owed in current liabilities, 50p is owned in current assets. This means if the firm’s bank demanded that it repaid its overdraft immediately and creditors demanded payment, the firm would not be able to cover these demands from current assets. This is therefore a dangerous position to be in.

Question 42

LIQUID CAPITAL RATIO

Answer 42

FORMULA:
(Current Assets - Inventory) / Current Liabilities

The liquid capital ratio is thought to be a tougher measure of a firm’s liquidity. Like the current ratio, it shows the amount of current assets in relation to current liabilities, but it does not include inventory. This is because inventory is considered to be the hardest current asset to turn into cash quickly. The result is expressed as x:1.

Question 43

MEASURING EFFICIENCY

Answer 43

Efficiency ratios tend to be used to access how well management is controlling key aspects of the business, primarily stock and finances. There are 3 ratios:
- Trade Receivable Days
- Trade Payable Days
- Inventory Turnover

Question 44

TRADE RECEIVABLE DAYS

Answer 44

FORMULA:
(Trade Receivables / Credit Sales) X 365

If you do not know what percentage of sales were made on credit, then it is acceptable to use the sales figure as given in the statement of comprehensive income. The ratio measures, on average, how long it takes for debtors to pay; it is expressed as a number of days. E.G. if a business has a debtors payment period of 60 days, this means, on average, it takes debtors 2 months to pay for goods or services purchased on credit. A business with cash flow problems will try to reduce its debtors payment period.
Trade Receivable days will vary from firm to firm, depending on the nature and price of items sold and whether the business deals in ‘business-to-business’ or ‘business-to-customer’ sales. If it is business-to-business, longer payment terms may be given. One business may also give different payment terms to different customers depending on the the size and importance of a customer’s business, reliability of payment and discounts offered.

‘Business-to-business’ = Refers to when one business sells to another business, e.g. a stationary business selling to a firm of accountants
‘Business-to-customer’ = Refers to when one business sells to an individual, e.g. a stationary business selling wedding stationary to a bride and groom

Question 45

INVENTORY TURNOVER

Answer 45

FORMULA FOR INVENTORY TURNOVER:
(Average Inventory / Cost of Sales) X 365

FORMULA FOR AVERAGE INVENTORY:
(Opening Inventory + Closing Inventory) / 2

This ratio measures the average amount of time an item of stock is held by a business, and is expressed as a number of days. If a business has an inventory turnover of 7, this means that, on average, it holds each item of stock for one week. The rate of inventory turnover is very much dependent on the nature of the firm. E.G. you could expect a florist or fishmonger to have a much lower inventory turnover than a fashion store or car showroom. However, if the rate of inventory turnover appears high for the nature of the product, this might result in stock going out of date or out of fashion.

Question 46

LIMITATIONS OF RATIO

Answer 46

Although ratios are very useful, there are some limitations:
- They’re calculated on past data and therefore may not be a true reflection of the business’ current performance
- Financial records may have been manipulated and therefore the ratios will be based on potentially misleading data
- Ratios don’t consider qualitative factors
- A ratio can indicate that there’s a problem in a business but doesn’t directly identify the cause of the problem or the solution
- Interfirm comparisons can be difficult as not all firms report their performances in the same way or generate their accounts in the same way

Ratios only report on the financial performance at a set point in time; the statement of financial position is a snapshot of the business at a point in time. At other times of year the picture may be different.