unit 7.2 - financial ratio analysis

Question 1

what is the balance sheet

Answer 1

-document describing the financial position of a company at a particular point in time
-historical data
- measures liquidity ( ability to pay bills on time)
- shows source of capital invested & in what form that capital is in

Question 2

what is the income statement

Answer 2

• describes income or expenditure of a business over a period of time
• also known as the profit and loss account ( shows profit /loss business has made over a year)
• helps assess profitability ( how effectively the business coverts its sales revenue into profit & how well it controls costs)

Question 3

non current assets

Answer 3

what the business owns with a lifespan of more than one year
- used repeatedly in the production process and allow a business to operate
- should not be sold
- machinery, land, vehicles, premises,
-lose their value through use ( depreciation)

Question 4

current assets

Answer 4

• assets owned by a business that are likely to be turned into cash within a year
  -constantly change form
• used to pay for current liabilities
  1. cash
  2. receivables - money owed from customers from purchases on credit, may become bad debt if they are unlikely to be able to pay back and so it is written off. - can use debt factoring
  3. inventories - stock, work in progress, finished goods. - value may reduce if it goes out of fashion or is damaged - stock control methods ( slowest to convert to cash)

Question 5

non current liabilities

Answer 5

debts due for repayment after more than a year
-e.g. mortgages, loans w fixed interest + long repayment date

Question 6

current liabilities

Answer 6

debts due for repayment within a year (short term debt)
- e.g. payables (owed to suppliers), overdrafts
- ideally business has £2 in CA to be able to pay every £1 in CL but this depends on whether they operate JIT & B2B

Question 7

working capital

Answer 7

-also known as net current assets + / net current liabilities -
formula : Current Assets - Current Liabilities
- money left over to be used for day 2 day operations
- gives an idea of a businesses liquidity

Question 8

net assets

Answer 8

• also known as net worth
• total assets ( NCA + CA) - total liabilities (NCL + CL)
• should be the same as the total equity

Question 9

total equity

Answer 9

• also known as shareholder’s funds ( funds provided by shareholders to set up business, fund expansions etc)
• total equity = retained profits + share capital
• capital & reserves shows how the business has been financed

Question 10

capital employed

Answer 10

CE = total equity + non current liabilities
- the amount of capital investment a business uses to operate & indicates how it is using its money

Question 11

liquidity

Answer 11

the ability to pay short term debts on time e.g. operating costs

Question 12

reserves + retained profit

Answer 12

• profit reinvested into the business that hasn’t been paid as dividends

Question 13

purposes x users of company accounts

Answer 13

• stakeholders
• shows value x size of business
• indication of firms liquidity
• helps bank identify collateral for loan requests
• shows current borrowing levels

Question 14

liquidity ratios

Answer 14

• measure whether a business can pay its short-term liabilities + how easily they can do this (how solvent they r)
  1. current ratio
  = CA / CL –> between 1.5 to 2:1 desirable ratio ~ between bcos firms can use JIT & suppliers to hold stock meaning they can operate at lower level

2. Gearing ratio - shows how reliant a firm is on borrowing & what proportion of capital invested is borrowed ( firm’s long-term liquidity)
   = NCL / ( TE + NCL) ~ aka capital employed –> above 50% highly geared & 25% lowly geared

Question 15

profitability ratios

Answer 15

• compares profits made with the size of the business ( show a firms efficiency at producing profit)
  1. gross profit margin, operating profit margin etc
  2. return on capital employed ( ROCE)

Question 16

efficiency ratios

Question 17

current ratio

Answer 17

• dependant on size of firm x industry
• firms w higher ratio may not be investing enough cash in NCA to expand business to generate profit or may be holding too much stock
• sources of finance e.g. sale x leaseback & long term borrowing used to improve cash level and therefore C ratio
• experience poor liquidity when growing due to extra costs so need healthy C ratio before expansion

Question 18

Gearing ratio

Question 19

-gross profit margin
- operating profit margin
- profit for the year margin