BUSINESS STUDIES A2 1 - ACCOUNTS TOPICS

Reasons for financial accounts

• financial institutions require it - shows ability to meet interest payments and if it is able to secure investment

• investors - will facilitate their decisions with respect to acquiring an interest in the firm

• owners will want access to detailed financial information regarding the financial position of the firm

Usefulness of Income Statement

• enables management to make decisions - able to see the profit made which may influence decision son future expenditure

• investors can see if they should invest their money in the business - if profitable attracts future investors

• management can use it to monitor the progress of the business and allows comparisons to be made between financial years

• employees can see how much profit was made - is the business in a strong position to increase wages - increased job security

Difference between cash and profit

cash is the flow of money both into and out of a business

profit is the money left over after all expenses have been paid

Evaluation of company accounts

Benefits

• showcase good performance and ability to meet interest payments on prospective loans

• attract potential investors to the business

• compare performance against set targets - assist with forward planning and future decisions

Drawbacks

• concentrates on quantitative issues affecting business and, therefore, may be limited in evaluating overall performance

• general not available until months after the end of the accounting year - lacking in relevancy - fast-changing nature of the business environment

• difficult to compare performance of firm with competitors as they may have different accounting policies

Return On Capital Employed

net profit before interest ——————————— x100 Total assets - total liabilities

Compares the operating profit to the capital invested acting as a benchmark of returns on investment

IMPROVED BY:

• increasing operating profit without raising further capital

• reducing the amount of capital employed - repaying some long term debt

e.g. 28% = 28p for every £1

Gross profit margin

Gross Profit ————— x100 Sales

Indicates the profitability of trading operations. Represents funds available to meet operating expenses of the business

IMPROVED BY:

• reducing cost of sales - cheaper supplier or economies of scale

• Increase selling price

• Raising sales revenue - keep cost of sales the same

• Reduce price in an elastic market Raise the price in an Inelastic market

e.g 67% - for every £1 67p remains after all direct costs have been deducted

Net Profit margin

Net Profit before interest ——————————— x100 sales

indicates profitability and how successful the business is in managing costs and keeping them under control

IMPROVED BY:

• higher selling price

• higher control of costs particularly indirect costs

e.g. 17% for every £1 17p remains after all direct and indirect costs have been paid

Current ratio

Current assets ——————— = X:1 Current liabilities

measures the ability of the firm to meet its short-term debt requirements.

TOO HIGH: too many resources tied up in unproductive assets which could be invested more productively

TOO LOW: may not be able to pay back its debts

IMPROVED BY:

Bring in more cash by:

• sell underutilised non-current assets

• raising more share capital

• increasing long-term borrowings

• postponing planned investment

Gearing

Non current liabilities —————————— x100 ordinary shareholder funds - non current liabilities

examines the extent to which the business is dependent on borrowed money - concerned with long term financial position of the company

IMPROVED BY:

RAISING -

• buy back more ordinary shares

• issue more preference shares

• issue more debentures

• obtain more loans

REDUCING -

• issuing more ordinary shares

• redeeming debentures

• retain more profits

• repay loans

High Gearing ratio

Borrowed a lot of money in relation to total capital

Benefits:

• relatively few shareholders - easier to hold control of firm

• benefit from cheap source of finance when interest rates are low

• time of high profit - interest repayments = much lower than shareholder dividend requirements - firm can obtain much more profit for future expansion

Low Gearing ratio

Raised most of its capital from shareholders - share capital and retained profits

Benefits:

• Permanent share capital therefore lower risk of creditors forcing the business onto liquidation

• avoid difficulties paying increased interest rates on borrowed capital when interest rates are high

Earnings per share

Profit after tax ——————— = X Pence Number of ordinary shares

indicates the profitability of the company in the first instance.

compare to previous years to have better insight into profit movements experienced over time on a per share basis

Return on equity

Profit before tax - preference dividend ————————————————— x100 Ordinary share capital + reserves

used to measure return on funds contributed by shareholders as represented by equity in the business.

should be compared to other measures of return or previous accounting periods

Ratios as a method of analysis

Benefits:

• assist user to identify areas of potential strength/weakness - facilitate decision making

• predict potential earnings

• financial comparisons to be undertaken over time or with separated entities to evaluate performance

• used to identify and explain trends in relation to specific areas of performance

Drawbacks:

• not representative of entire performance over time - only a snap shot

• comparison with other companies may be different due to different accounting policies

• ignores qualitative factors e.g. economic climate, industrial relations

• impact of inflation is not properly reflected - may impact analysis

Factors affecting ratios

• inflation

• performance

• competitors performance

• yearly comparisons

• management changes

• reputation

• product quality

• human relations - customer service

Payback

Length of time that it takes for an investment to pay for itself from the net returns provided by that particular method

Benefits:

• easily understood - straightforward

• takes into account of all cash flows

• good for screening projects

• emphasising speed of return - popular in rapidly changing markets

Drawbacks

• ignores revenue or costs that occur after payback has been reached - don’t consider overall net return from project. May ignore most profitable option

• doesn’t consider current value of cash - time value - not taken into account

• values future costs and revenues at same value as current costs and revenue

• encourage short termism

AO4: useful if aim is survival, money in quickly, useful in poor economic conditions

Net Present Value

The net return on an investment when all revenues and costs have been converted to their current worth.

Benefits:

• calculations should be straightforward

• takes into account all cash flows

• only method that considers the time value of money

• gives a precise answer- +ve should be taken

Drawbacks:

• difficult to determine discount rate - interest rates can change

• difficult to accurately forecast annual cash flows throughout project life span - depends on quality of market research

• time-consuming and more difficult to calculate

• more difficult to understand than other approaches - management could distrust conclusions

Cash Flow Forecast

Benefits:

• enables management or owner to plan expenditure

• shows amount required and when it is needed any business wishing to borrow money can see how much needs to be borrowed and how long.

• inspires confidence by setting targets

Drawbacks:

• inexperience

• unexpected costs

• inaccurate assumptions

Qualitative Factors

• Economic- funding may not be available from capital providers or possible recessionary conditions - save money in short term

• Personnel - machinery - level of training needed, safety of the machine - redundancies - low morale and poor motivation

• Technical- invest in up to date equipment - improve productivity therefore increasing staff redundancy.

• Environmental- environmental concerns may disrupt projects, protests from pressure groups and community.

• Legal- breach of legislation, consumer protection laws, health and safety

• Image- consider influence of project on public image and relations, ethical is not a legal requirement

Decision tree analysis

Advantages:

• encourage a quantitative approach - may improve results and process can be computerised

• useful when similar scenarios have occurred before so realistic estimates of probabilities and financial returns can be made

• set out a problem clearly encouraging a logical approach to decision-making

• encourage a careful consideration all alternatives

Disadvantages:

• difficult to get accurate and realistic data in order to estimate probabilities

• ignores constantly changing nature of business environment

• quite easy for management bias to influence estimates of probabilities and financial returns - manipulate data

• may lead to managers taking less account of important qualitative decisions