Unit 3 - Finance and accounts

To be used for the May 2024 exams. Subject: IB Business Management SL

final accounts

the published annual financial statements that all limited liability companies are legally obliged to report, namely the balance sheet and the P&L account

profit and loss (P&L) account

reports the revenues and expenses of a business at the end of a specified accounting period

balance sheet

reports the value of assets and liabilities of a business at a particular point in time (usually the last day of a financial year)

Why are final accounts important for different stakeholders?

• Shareholders analyze the accounts to check management’s performance and efficiencies

• Employees look for job security and the likelihood of pay increments

• Managers judge the operational efficiency of their organization’s target setting

• Competitors want to compare financial performance with other firms

• Government checks accounts for tax purposes

• Financiers assess the credibility of debt repayment

• Suppliers check whether trade credit should be approved

• Potential investors look at figures before investing to check likely return and make decisions

• Customers want to be sure of a reliable supply of goods and services

trading account

reveals the gross profit (difference between sales revenue and the direct costs of the goods sold)

gross profit

Gross Profit = Revenue - Cost of Goods Sold (COGS)

cost of goods sold (COGS)

the cost of producing or purchasing the products sold during that trading period

COGS = Opening stock + Purchases - Closing stock

net profit

Net Profit = Total Revenue - Total Expenses

expenses

the indirect of fixed costs of production (e.g. marketing costs, rent, local taxes, etc.)

appropriation account

records how the net profit is distributed (or appropriated). There are two parts to this account: dividends and retained profit.

dividends

the shareholders receive a share of the profits determined by the board of directors. It’s usual for dividends to be paid bi-annually

retained profit

what remains after tax and dividends are paid; used to fund future expansion. For non-profit organizations, it’s called retained surplus

Formatting the P&L account (the way IB wants it)

Here's an example of a formatted P&L account table:

Profit & Loss account for Florists-R-Us, for the year ended 31 December 2020

| Sales revenue | 460,000 |

| Cost of Sales | (230,000) |

| Gross profit | 230,000 |

| Expenses: | (165,000) |

| Profit before interest and tax | 65,000 |

| Interest | (10,000) |

| Profit before tax | 55,000 |

| Tax (10%) | (5,500) |

| Profit after interest and tax | 49,500 |

| Dividends (30%) | (14,850) |

| Retained profit (70%) | 34,650 |

ratio analysis

A quantitative management tool that compares different financial figures to examine and judge the financial performance of a business

• historical comparisons—involve comparing the same ratio in 2 time periods for the same firm

• inter-firm comparisons—involve comparing the ratios of businesses in the same industry

profitability ratios

examine profit in relation to other figures, comprised of the gross profit margin (GPM), profit margin (PM), and return on capital employed (ROCE) ratios

Gross-profit margin (GPM)

A profitability ratio that shows the value of a firm’s gross profit expressed as a percentage of its sales revenue.

GPM = (gross profit / sales revenue) x 100

higher GPM = more gross profit to go towards paying for its expenses

Profit margin (PM)

A profitability ratio that shows the percentage of sales revenue that turns into profit (i.e. the proportion of sales revenue left over after all direct and indirect costs have been paid).

PM = (profit BI&T / sales revenue) x 100

higher PM = more profit to go towards dividends and retaining profit

Return on capital employed (ROCE)

A profitability ratio that measures the financial performance of a firm based on the amount of capital invested (i.e. sources of funds).

ROCE = (profit BI&T / capital employed) x 100

higher ROCE = firm as been more efficient at generating profit from available funds

liquidity ratios

look at the ability of a firm to pay its short-term (current) liabilities, comprised of the current ratio and the acid test (quick) ratio

current ratio

A short-term liquidity ratio that calculates the ability of a business to meet its debts within the next 12 months.

current ratio = current assets / current liabilities

ideal benchmark: 1.5 to 2 : 1; “for every $1 of current liabilities, a firm has $1.50 to $2.00 of current assets to pay for it”

quick (acid test) ratio

A liquidity ratio that measures a firm’s ability to meet its short-term debts. It ignores stock because not all inventories can be easily turned into cash in a short time frame.

quick ratio = (current assets - stock) / current liabilities

ideal benchmark: 1:1; “for every $1 of current liabilities, a firm has $1 of cash or debtors to pay for it”

efficiency (debt and equity) ratios (HL)

enables a business to calculate the value of a firm’s liabilities and debts against its equity; measure of financial stability

stock turnover

measures the number of times a firm sells its stock within a time period, usually one year; indicates the speed at which a firm sells and replenishes all its stock (two ways to calculate)

• unit: times

• the more times, the better

• unit: days

• the fewer days, the better

debtor days

measures the average number of days it takes a business to collect money from its debtors (customers who purchased products on trade credit and owe money to the business)

• unit: days

• the fewer days, the better

• benchmark: 30-60 days

creditor days

used to measure the number of days it takes, on average, for a business to pay its trade creditors

• unit: days

• the fewer days, the better

• benchmark: 30-60 days

gearing ratio

used to assess a firm’s long-term liquidity position; done by examining the firm’s capital employed that’s financed by non-current liabilities (e.g. mortgages and debentures)

• unit: %

• highly geared if gearing ratio is 50% or above

• the lower, the better

insolvency

occurs when firms are unable to settle their debts when they’re due because of the lack of funds or cash in their bank accounts

bankruptcy

the formal and legal declaration of a firm’s inability to settle its debts

• Last resort when all attempts to tackle insolvency have failed

• Severely damages the owners’ credit rating, which hinders their ability to borrow money in the future

cash

a current asset and represents the actual money a business has. It can exist in the form of cash in hand (cash held in the business) or cash at bank (cash held in a bank account).

cash flow

the transfer or movement of money into and out of an organization

cash flow forecast

a financial tool used to show the expected movement of cash into and out of a business for a given period of time

cash flow statement

the financial document that records the actual cash inflows and cash outflows of a business during a specified trading period, usually 12 months

cash inflows

the cash that comes into a business during a given time period, usually from sales revenue when customers pay for the products that they have purchased

cash outflows

the cash that leaves a business during a given time period, such as when invoices or bills have to be paid

closing balance

the amount of cash left in a business at the end of each trading period, as shown in its cash flow forecast or statement

closing balance = opening balance + net cash flow

credit control

the process of monitoring and managing debtors, such as ensuring only suitable customers are permitted trade credit and that customers do not exceed the agreed credit period

net cash flow

the difference between a firm’s cash inflows and cash outflows for a given time period, usually per month

opening balance

the value of cash in a business at the beginning of a trading period, as shown in its cash flow forecast or statement

opening balance = closing balance from previous month

profit

the positive difference between a firm’s total sales revenue and its total costs of production for a given time period

working capital cycle

the time between cash outflows for production costs and cash inflows from customers who pay upon receipt of their finished goods and services