Unit 4

Monitoring the Business

Why We Prepare Financial Accounts

Profitable Liquid

Taxes are paid Loans/Grants

Financial Accounts Prepared Are..

Profit and loss account

Balance sheet

Cash flow forecast

Profit and Loss Account
Importance of Profit and Loss Account
• Shows Sales – how much the business has sold it’s products for
• Shows Cost of Sales – cost of buying/making products
• Shows Gross Profit (Sales - Cost of Sales) – profit made before expenses
paid
• Shows Expenses – bills paid by business
• Shows Net Profit (Gross Profit - Expenses) – actual profit made after all
bills been paid – this profit can be paid out in dividends/reinvested
Importance of Profit and Loss Account
• A Low Gross Profit
- tells managers may need to raise prices to cover costs & increase profits
- materials too expensive so may need to source cheaper supplier
• A Low Net Profit
- tells managers expenses are too high so they need to make cutbacks to
increase profits
- business can’t afford to pay dividends/retained earnings & identifies if the
business may need to borrow for future expansion
Balance Sheet
Fixed Assets xxx
Current Assets xxx
Less Current Liabilities - xxx
Working Capital xxx +xxx
Net Assets xxx

Financed By
Ordinary Share Capital xxx
Preference Shares xxx
Retained Earnings/Reserves xxx
Long Term Loans +xxx
Capital Employed xxx
Importance of Balance Sheet
• Shows Fixed Assets – assets/items that business owns that last a number of years eg.
buildings, equipment

• Shows Current Assets – Items business owns that will keep for less than 1 year eg.
debtors, stock

• Shows Current Liabilities – money owed by business that has to be repaid within 1 year
eg. creditors, bank overdraft

• Shows Working Capital – difference between Current Assets & Current Liabilities –
shows cash left over to pay incoming bills
Importance of Balance Sheet
• Shows Financed By – amount invested by investors (shares & loans)

• Shows Ordinary Share Capital/Equity Capital – money shareholders invested – 1 share = 1 vote at
meetings & entitles shareholders dividends

• Shows Preference Shares – money shareholders invested with guaranteed payment of dividends
before other shareholders – no vote at meetings

• Shows Retained Earnings/Reserves – amount of reinvested profits

• Shows Long Term Loans – money borrowed that bus has more than 1 year to repay
Importance of Balance Sheet
Shows Fixed Assets
•NB because: → tells managers if business has security/collateral to apply for loans

Shows Working Capital

•NB because:→ tells managers if business can pay their debts as they fall due – if
not the business will be illiquid
Shows Financed By
•NB because:→ tells managers if difficult to borrow more money
Interpreting Accounts Using Ratios
Ratio analysis is a technique used to compare the financial
performances of a business relative to previous years and to its
competitors.
Businesses are assessed using
ratios under three headings:

Profitability Liquidity Gearing

 Ratio Formula
Profitability Gross Profit Percentage/ Gross profit X 100
Gross Profit Margin Sales
Profitability Net Profit Percentage/ Net Net Profit X 100
Profit Margin Sales
Profitability Return on Investment/ Net Profit X 100
Return on Capital Employed Capital Employed
Liquidity Current Ratio/ Working Current Assets : Current Liabilities
Capital Ratio
Liquidity Acid Test Ratio Current Assets less Closing Stock :
Current Liabilities
Gearing Debt Equity Ratio Long Term Loans + Preference Shares :
Equity (Ordinary) Shares + Retained
Earnings (Reserves)
1. Profitability Ratios
→ shows if profit is good/bad for the size of the bus

→ businesses know if the profit is good/bad by comparing answer to:

- other businesses
- previous years or
- industry average
(a) Gross Profit Percentage = Gross Profit X 100
Sales

- Answer is written as %
- What it means: If Gross Profit Percentage = 20%, it means that 20% of the
money from customer sales is business’s profit – but this is profit level
before bills have been paid
Analysis of Gross Profit Percentage
• State whether the percentage is increasing /decreasing & results of percentage
calculations

If Gross Profit Percentage is Decreasing:

• What it Means: Shows Selling Price decreased/Cost Price increasing
• How to Improve: Must increase Selling Price/ shop around for cheaper supplier
• User: Employees → to see if business can afford pay rise for staff

If Gross Profit Percentage is Increasing:

• What it Means: Shows selling price increased or cost price decreasing or both
(b) Net Profit Percentage = Net Profit X 100
Sales

- Answer is written as %
- What it means: If Net Profit Percentage = 20%, it means that 20% of the
money from customer sales is actual business’s profit – this is the real
profit level because it’s after bills have been paid
Analysis of Net Profit Percentage
• State whether the percentage is increasing /decreasing & results of percentage calculations

If Net Profit Percentage is Decreasing:

• What it Means: Shows expenses are increasing
• How to Improve: Must make cutbacks to expenses – no overtime, cheaper electricity &
telephone suppliers
• User: Employees → to see if business can afford pay rise
• User: Shareholders → to see dividends is available

If Net Profit Percentage is Decreasing:

• What it Means: Shows expenses are decreasing
(c) Return on Investment = Net Profit X 100
Capital Employed

- Answer is written as %
- What it means: If Return on Investment = 10%, it means that the
business made 10 cent profit on every €1 invested
- Capital Employed = Equity (Ordinary) Share Capital + Retained
Earnings (Reserves) + Long Term Loans + Preference Shares
Analysis of Return on Investment
• State whether the percentage is increasing /decreasing & results of percentage
calculations

If ROI is Decreasing:
• What it Means: Shows managers inefficient at turning resources into profit
• How to Improve: Must make cutbacks/ hire more efficient managers/ reduce expenses/
use resources more efficiently
• User: Investors → to see ROI, if business is good investment

If ROI is Increasing:
• What it Means: Shows managers efficient at turning resources into profit
2. Liquidity Ratios
Liquidity
→ shows if the business has enough cash to pay its short term bills

(a) Current Ratio/Working Capital Ratio = Current Assets : Current Liabilities

• Answer is written as __ : 1
• What it means: identifies how much money business has for every €1 it owes →
shows if the business has enough cash to pay its day-to-day bills
• Ideal ratio is 2:1 → if less than this the business is illiquid
Analysis of Working Capital Ratio
• State whether the ratio is increasing /decreasing & results of ratio calculations

If Working Capital Ratio is Increasing

• Good – means the business has more cash than previous year
• Might be because the business paid off its bank overdraft, or paid off creditors

If Working Capital Ratio is Decreasing

• Bad – means the business has less cash than the previous year
• Might be because the business increased its bank overdraft, or bought more from
creditors
If Working Capital Ratio is less than 2:1:
• What it Means: Business hasn’t enough money coming in, can’t pay bills as they fall due,
will loose discounts from suppliers for early payment
• How to Improve: must sell shares to raise money

If Working Capital Ratio is more than 2:1:

• What it Means: Business has too much spare cash
• How to Improve: must invest extra cash to make profit on it
• User: Lenders & Suppliers/Creditors → to see if the business can repay loans & pay debts
(b) Acid Test = (Current Assets less Closing Stock) : Current Liabilities

• Answer written as __ : 1
• What it means: Shows how much real cash business has → current
stock in factory left out because it may not be turned into cash
quickly in emergency situation
• Ideal ratio is 1:1 → if less than this the business is illiquid
Analysis of Acid Test Ratio
• State whether the ratio is increasing /decreasing & results of ratio calculations

If Acid Test Ratio is Increasing:

• Good – means the business has more cash than previous year
• Might be because the business paid off its bank overdraft, or paid off creditors

If Acid Test Ratio is Decreasing:

• Bad – means the business has less cash than the previous year
• Might be because the business increased its bank overdraft, or bought too much stock
which is unsold
If Acid Test Ratio is less than 1:1:
• What it Means: The business is illiquid, can’t pay bills as they fall due, can’t pay creditors
immediately, may lose credit rating & difficult to get credit in the future
• How to Improve: must sell shares to raise finance, have sale on stock
• User: Lenders & Suppliers → to see if the business can repay loans & pay debts

If Acid Test Ratio is 1:1/Greater:

• What it Means: The business is liquid, can pay bills as they fall due, can pay creditors
immediately, good at managing cash flow
Overcoming Liquidity Problems

Credit control

Stock control

Raise finance

Financial planning
3. Gearing
Debt Equity Ratio =
Long Term Debt + : Equity (Ordinary) Shares
Preference Shares + Retained Earnings (Reserves)

• What it means: Shows how the business is financed ie. how much was
borrowed and how much was invested
• No ideal ratio → __: 1
• Business can be High Gearing, Low Gearing or Neutral Gearing
Analysis of Debt Equity Ratio
• State whether the ratio is increasing /decreasing & results of ratio calculations
• State the 3 levels of gearing and which gearing applies to each year

If Debt Equity Ratio is Increasing:

• Bad – means the business has more long term loans than previous year
• Might be because the business took out another long term loan
• The business should try to sell more shares

If Debt Equity Ratio is Decreasing:

• Good – means the business has less long term loans than previous year
• Might be because the business repaid long term loan/ sold more shares
High Gearing
• Debt Capital > Equity Capital
• Answer > 1:1
• What it Means: the business borrowed more than shareholders invested
• Consequence: the business will have high interest repayments, less profits to pay
dividends, increased chance of business going bankrupt, harder to get loans, less
profit available to pay dividends so less investment, increased pressure on
managers to produce profit
• How to Improve: the business must reinvest more profits, sell shares, sell
investments to repay long-term loans
Low Gearing
• Debt Capital < Equity Capital
• Answer < 1:1
• What it Means: the business borrowed less than shareholders invested
• Benefit: the business will have low interest repayments, more profits to pay
dividends so increased investment, reduced chance of business going bankrupt,
may find it easier to get loans, reduced pressure on managers to produce profit
• Consequence: risk losing control
• How to Improve: the business must reinvest more profits
Neutral Gearing
• Debt Capital = Equity Capital
• Answer = 1:1
• What it Means: borrowing and investment by shareholders is the same

User: Employees → to see likelihood of bankruptcy and safety of jobs

User: Lender → to see if the business is worthy of further loans
User: Lender → to see if the business is capable of paying ROI
Who Uses Financial Information?
Investors Investors
Management
(banks) (shareholders)

Suppliers
Employees Competitors
(creditors)

Government
 Limitations of Ratio Analysis
• Ratios do not show if there are poor industrial relations
Industrial relations
in a firm.

Accounting policies • Different accounting policies distort comparisons.

• Ratios do not show if the business is acting sustainably

Ethical behaviour
or ethically.

Non-financial • This can be excluded from financial analysis e.g. staff

information morale.

Past performance • Ratios do not indicate what the future holds.