section 4 topic 4 and 5

What is a balance sheet (statement of financial position)?

A snapshot showing what a business owns (assets) and owes (liabilities) at a specific point in time.

What is a statement of comprehensive income (profit and loss account)?

A record of revenues and costs over a period of time (usually one year), showing financial performance.

What is the difference between a balance sheet and a P&L account?

Balance sheet = position at one point in time; P&L = performance over a period of time.

What are non-current (fixed) assets?

Assets used over a long period, e.g. land, buildings, machinery, vehicles. Their value declines through depreciation.

What are current assets?

Assets easily turned into cash: inventory (stock), trade receivables (debtors), and cash/bank.

What are current liabilities?

Debts due within 12 months: trade payables (creditors), bank overdraft, unpaid tax, unpaid dividends.

What is working capital (net current assets)?

Current assets minus current liabilities; it shows whether a business can meet its short-term debts.

What is the prudence concept?

Financial documents must not mislead; asset values should err on the cautious side and never be overvalued.

What is the matching rule (accruals concept)?

Revenues and expenses must be matched to the period they relate to, regardless of when cash is actually paid or received.

What is depreciation?

The reduction in the value of a fixed asset due to wear and tear or age, included to give a fair value.

What is straight-line depreciation?

Depreciating an asset by an equal amount each year. Formula: Cost ÷ Expected life (years).

Example: Machine costs £250,000 with a 5-year life. What is annual depreciation?

£50,000 per year. After 2 years its book value is £150,000 (£250,000 − £100,000 depreciation).

What are net assets?

Total assets (fixed + current) minus total liabilities (current + long-term). It equals shareholders’ funds.

What are shareholders’ funds?

Share capital plus reserves (retained profits); it shows how the net assets were financed by the owners.

What is capital employed?

Shareholders’ funds plus long-term liabilities (or simply total shareholders’ funds).

What does the trading account show?

Revenue minus Cost of sales = Gross profit.

What is the formula for cost of sales?

Opening inventory + Purchases/Raw materials − Closing inventory (+ Direct labour for manufacturers).

What is gross profit?

Revenue minus cost of sales.

What does the profit and loss account show?

Gross profit minus operating expenses = Operating profit; then minus interest and tax = Profit for the year (net profit).

What is operating profit?

Profit after all operating expenses (admin, distribution, power, salaries, depreciation) but before interest and tax are deducted.

What is the appropriation section?

The part of the accounts showing how profit for the year is used: dividends to shareholders + retained profit kept in the business.

What is an auditor?

An independent person who examines business records to ensure they give a “true and fair view” of financial information.

Why must a balance sheet always have a date?

Because figures such as inventory, debtors and cash change on a daily basis.

Name 4 groups interested in a business’s accounts.

Shareholders, directors/managers, employees/unions, suppliers, banks, government, investment analysts, local community.

What do profitability ratios measure?

The ability of the business to make satisfactory profits compared to its sales and capital.

Q: What do liquidity ratios measure?

The ability of the business to convert assets into cash to pay short-term debts as they fall due.

What is the gross profit margin formula?

(Gross profit ÷ Revenue) × 100%.

What does gross profit margin show?

How much gross profit is made on every £1 of sales after the cost of sales has been deducted.

What is the operating profit margin formula?

(Operating profit ÷ Revenue) × 100%.

What does operating profit margin show?

How much operating profit is made on every £1 of sales after all operating expenses; it indicates efficiency in controlling overheads.

What is the ROCE formula?

(Operating profit ÷ Capital employed) × 100%.

Why is ROCE important?

It shows the return owners get on their investment; it should be well above safer investments like savings accounts.

What is the mark-up formula?

(Profit per item ÷ Cost per item) × 100%.

Example: An item costs £2 and sells for £8. What is the mark-up?

300% [(£6 profit ÷ £2 cost) × 100].

What is the current ratio formula?

Current assets ÷ Current liabilities (expressed as X : 1).

What is the ideal current ratio?

Between 1.5 : 1 and 2 : 1. Below 1.4 : 1 is risky because inventory may not sell quickly.

What is the acid test ratio formula?

(Current assets − Inventory) ÷ Current liabilities (expressed as X : 1).

What is the ideal acid test ratio?

It should not fall below 1 : 1. It is stricter than the current ratio because it excludes inventory.

Cardboard Box Co: GP £420k, Revenue £840k. What is the gross profit margin?

50%.

Cardboard Box Co: OP £168k, Revenue £840k. What is the operating profit margin?

20%.

Cardboard Box Co: OP £168k, Capital employed £1344k. What is ROCE?

12.5%.

Jones Mouldings 2016: Current assets £325k, Current liabilities £120k. Current ratio?

2.7 : 1 (very healthy).

Jones Mouldings 2016: Current assets £325k, Inventory £100k, Current liabilities £120k. Acid test?

1.87 : 1 (very healthy).

Jones Mouldings 2016: Revenue £950k, GP £600k, OP £260k, Capital employed £1055k. Calculate GP%, OP% and ROCE.

GP% = 63.2%; OP% = 27.4%; ROCE = 26.6%.

Did Jones Mouldings perform better in 2015 or 2016?

2016. All profitability and liquidity ratios improved compared to 2015.

Why should ratio results be compared with previous years and competitors?

To identify trends, judge relative performance, and improve business decision-making.

Why might a very high current ratio be bad?

Too much cash may be tied up in inventory or debtors; the money could be used more efficiently elsewhere.

What is liquidity?

The ability of a business to meet its short-term debts by having sufficient working capital.

What is the difference between gross profit margin and operating profit margin?

GP margin shows profit after cost of sales; OP margin shows profit after all operating expenses (overheads) are also deducted.

What does a fall in gross profit margin indicate?

Selling prices have been cut and/or the cost of sales has increased (e.g. more expensive raw materials).

If gross profit margin falls by 2% but operating profit margin only falls by 1%, what does this suggest?

The business has become more efficient at controlling its overheads/expenses.