Unit 7a Analysing internal position: financial ratio analysis

Question 1

Businesses in the UK use a range of information to assist stakeholders in assessing their performance and to inform decision making.

What statements shall we consider?

Answer 1

• Balance sheets.
• Income statements.

Question 2

What is a balance sheet?

Answer 2

• A balance sheet is a financial statement recording the assets (possessions) and liabilities (debts) of a business on a particular day at the end of an accounting period.
• It is commonly described as a “snapshot” of the financial position of an organisation.
• The report gets its name from the fact that the two sides of the equation must balance!

Question 3

What are assets?

Answer 3

Assets are items owned by a business, such as cash in the bank, vehicles and property.

Question 4

What are liabilities?

Answer 4

Liabilities represent money owed by a business to individuals, suppliers, financial institutions and shareholders.

Question 5

What is a statement of financial position?

Answer 5

It is an alternative name for a balance sheet!

Question 6

What is a consolidated balance sheet?

Answer 6

The total balance sheet for the business, including all of its divisions!

Question 7

What may shareholders use balance sheets for?

Answer 7

Assess a businesses potential to generate good returns in the future.

• They may examine the extent and type of assets available to the business.
• A high proportion of assets, such as machinery and property, may signify a potential for profit, depending upon the type of business.

Question 8

What may suppliers use balance sheets for?

Answer 8

To investigate the short-term position of the company.

• They may consider cash and others liquid assets a business holds and make a judgement about whether the business is likely to pay its bills over the coming months.
• This may help the supplier reach the decision on whether or not to offer credit to the business in question.

Question 9

What may managers use balance sheets for ?

Answer 9

Use it as an indication of the performance of a business.

• They may extract information to help them reach a decision on how to raise further capital for future investment.
• The amount of existing loans may be one factor influencing the decision.

Question 10

What are the types of assets a business holds?

Answer 10

Non current assets

Current assets

Question 11

What are non-current assets and give some examples?

Answer 11

Assets owned by a business that it expects to retain for one year or more.

Examples include land, property, production equipment and vehicles.

Question 12

What are current assets & do you know some examples.?

Answer 12

• Assets held for less than a year.
• Likely to be converted into cash before the next balance sheet is drawn up.
• Therefore cash and inventories are examples of current assets as they are only retained by the business for a relatively short period of time.

Question 13

What are receivables?

What are they a type of?

Answer 13

Receivables= another category of current asset.

They are debts owed to the business in question due for payments within 12 months- and so will become cash within one year.

Question 14

What are liabilities?

Answer 14

A liability is a debt owed by the business to organisations or individuals.

Question 15

What are the different types of liabilities a business has?

Answer 15

Current liabilities.

Non-current liabilities.

Total equity.

Question 16

What are current liabilities?

Examples?

Answer 16

They represent debts owed by the business due for payment within one year or less.

• Examples of short-term debt are overdrafts & tax due for payment.
• Trade and other payables (money owed to suppliers and other organsations) are another category of payments that will be made within 12 months.

Question 17

What are non-current liabilities?

Examples?

Answer 17

• They are debts that a business does not expect to repay within the period of one year.
• Mortgages and bank loans repayable over several years are common examples of this type of liability.

Question 18

What is total equity & how is it a liability?

Answer 18

• It may seem strange that the money invested into a business by its owners (shareholders in the case of a company) is a liability.
• However- if the company ceases trading, shareholders would hope for the repayment of their investment. Therefore, these funds (called total equity or total shareholders equity) are liabilities.

Question 19

How do you calculate net assets of a business?

Answer 19

By totalling the businesses assets and subtracting the businesses total liabilities.

Net assets = (non-current assets + current assets)- (non-current liabilities + current liabilities)

Question 20

Why does a balance sheet always balance?

Answer 20

• Any transaction that is recorded on the balance sheet has two effects that cancel each other out, if a business borrows to purchase vehicles this is a liability, however the vehicles are assets.
• Alternatively a business might sell a non-current asset for cash, this means non current assets decrease but current assets increase
• Also the reserves mean that the balance sheet balances

Question 21

What are reserves?

Answer 21

Reserves are simply profit accumalated during previous years of trading and not paid out to the owners of the business.

Question 22

What are net current assets also known as?

Answer 22

Working capital

Question 23

What do net assets show on a balance sheet?

Answer 23

Show the worth of a business.

Question 24

What are tangible assets?

Answer 24

They are assets that have a physical existence and have been traditionally included on a balance sheet.

• Include land & property which are frequently the most valuable assets owned by a business.
• Machinery and equipment- a tangible asset that is likely to be of importance to manufacturing industries.

Question 25

What are intangible assets and some examples?

Answer 25

They are assets that do not take a physical form.

• Include patents & other rights.
• Goodwill. This is the value of established custom and a good name to a business.
• Brands.

Question 26

What is working capital?

Answer 26

The amount of money a business has available for day to day operations- e.g. payment of wages & purchase of inventories.

The balance between current assets and current liabilities.

Question 27

What would be the result if a business has more current assets than current liabilities?

Answer 27

It has a positive figure for working capital and should be able to pay its debts in the short term.

Question 28

How can a businesses balance sheet be examined for the long term?

Answer 28

• Movement of non-current assets- sudden increase in non-current assets may indicate a rapidly growing company- which may mean that the companys financial performance might improve over the medium term.
• Considering how a business has raised its capital = valuable. It is risky for a company to borrow too much. A company raising more through borrowing (non-current liabilities) than through share capital and reserves might be vulnerable to rises in interest rates.
• Reserves provide an identification of the profits earned by a business. A rapid increase in reserves is likely to reflect a healthy position with regard to profits.
• The overall value of the business. May be a good sign if the businesses value measured in e.g. net assets has increased. If the business has achieved this without borrowing heavily, it may be regarded as positive development.

Question 29

What is working capital?

Answer 29

Working capital measures the amount of money available to a business to pay its day-to-day expenses, such as bills for fuel and raw materials, wages and business rates.

Working capital = current assets- current liabilities.

Question 30

On a Balance sheet- how may working capital be labelled?

Answer 30

Net Current Assets

Question 31

What are debentures?

Answer 31

Are loans with fixed interest rates which are long term and may not even have a repayment date.

Question 32

What different factors can influence how much working capital a firm holds and why?

Answer 32

• Volume of sales
• The amount of trade credit offered by the business.
• Whether or not the firm is growing.
• The length of the operating cycle.
• The rate of inflation.

Question 33

Different factors that influence the amount of working capital a firm needs to hold.

The volume of sales?

Answer 33

A firm with a high level of sales will need to purchase more raw materials, pay a greater amount of wages etc. Therefore its need for working capital will be correspondingly higher.

Question 34

What different financial ratios we need to know?

Answer 34

Liquidity

Profitability

Gearing

Efficiency- payables days/ receivables days/ inventory turnover

Question 35

What are payables days & how is it calculated?

Answer 35

The ratio calculates the average number of days a business takes to pay its bills.

Payables days= (payables/ cost of sales) x 365

Question 36

Payables days

What may a business aim to achieve with the number of days & why?

Answer 36

A figure that is higher than receivables days- so money comes into the business before its paid out- although this is not always possible.

A business might look to improve its own liquidity position by increasing the payables days figure- however it could damage the relationship with suppliers & lead to higher payments.

Question 37

What are reveivables days & how is this calculated?

Answer 37

This ratio shows the number of days it takes to convert receivables into cash.

Receivables days = (receivables/ revenue) x 365

Question 38

What does receivables days show?

Answer 38

The number of days it takes to collect payments, the lower the number the better.

This is important as allowing customers lengthy credit periods can lead to cash-flow problems.

Question 39

Inventory turnover ratio- what does this calculate & what is the calculation?

Answer 39

Calculates the number of times per period a business sells & replaces its entire stock of inventories.

Inventory turnover= cost of goods sold/ average number of inventories held.

Question 40

What does a high inventory turnover figure indicate?

Answer 40

Generally efficient operations- however it needs to be compared with the industry average when analysed!

Question 41

What does liquidity measure?

Answer 41

Measures the extent to which a business can meet its immediate short term financial obligations.

Question 42

How much working capital should a business aim to have?

Answer 42

If it has too little- it may struggle to make payments & run into cash flow problems.

If a business has too much working capital- its an inefficient use of resources. E.g. cash sitting in the bank isnt earning the business anything.

Question 43

What is capital employed?

Answer 43

The value of total equity + non-current liabilities, and is the total amount of money invested into the business.

Question 44

What is profit quality?

Answer 44

The degree to which profit is likely to continue into the future- the sustainability of profit.