Flashcards in Unit 8 Deck (43):
What are balance sheets?
Balance sheets are a snapshot of a firms finances at a fixed point in time.
They show the value of all the business assets (the things that belong to the businesses including cash in the blank) and all its liabilities (the money invested in the business), and the source of that capital (eg loans shares or retained profits) so they show where the money's come from as well as what is being done with it.
The net assets value (the total fixed and current assets minus total current and non current (long term) liabilities) is always the same as the total equity value, the total of all the money that is been put into the business.
What are assets?
Assets (like machinery and stock) provide a financial benefit to the business, so they're given a monetary value on the balance sheet. Assets can be classified as non current assets (fixed assets) or current assets
Businesses can use capital to buy assets that will generate more revenue in the future, this is investment.
What are non current assets?
Non-current assets are assets that the business is likely to keep for more than a year like property, land, and production etc. The total non current assets value on the balance sheet is the combined value of all the business' non current assets.
Non current assets often lose value over time, so they over time, so they are worth less every year. This is depreciation. Businesses should factor in depreciation to give a realistic value of their non current assets on the balance sheets.
What are current assets?
Current assets are assets that the business is likely to exchange for cash within the accounting year, before the next balance sheet is made. All the current assets are added together to give the total current assets value on the balance sheet..
Current assets include receivables (money owed to the business by other companies and individuals) and inventories (or stock)
What are current liabilities?
Current liabilities are debts which need to be paid off within a year. Hit include overdrafts taxes due to be paid, payables (money owed to creditors) and dividends due to be paid to shareholders.
Total current liabilities are deducted from total fixed and current assets to give the value of assets employed.
What are non current liabilities?
Non current liabilities are debts that the business will pay off over several years.
What is working caPital?
Working capital is the amount of cash (and assets that can be easily turned into cash) that the business has available to pay its day to day debts. The more working capital a business has, the more liquid (able to pay its short term debts) it is.
Working capital is the same as net current assets on the balance sheet. The amount left over when you subtract current liabilities.
Businesses cant survive if they don't have enough working capital, as well as generating enough sales. The business must make sure it collects money quickly to get cash to pay back its liabilities.
Why do businesses need cash?
Businesses need just enough cash to pay off short term debts. They shouldn't have too much cash, because spare cash is great at paying debts, but lousy at earning money for the business.
Businesses with a long term cash flow cycle need more cash, as they have to wait for money to come in.
To make money, the business needs current assets that make sales possible like machinery.
Inflation increases the cost of wages and buying/holding stock so firms need more cash when inflation is high.
When a business expands, it needs more cash to avoid overtrading. Overtrading means producing so much that the business cant afford to pay its suppliers until it gets paid by customers.
What is Capital expenditure?
Capital expenditure (fixed capital) means money used to buy non current assets (fixed assets). These are things used over and over again to produce goods or services.
Businesses need to capital expenditure to start up, to grow and to replace worn out equipment. They must set aside enough money to stop non current assets from wearing out, and then they can decide how much money to invest in growth. This is called allocating capital expenditure.
How businesses can control Debtors (receivables)?
A business needs to control its debtors (people who owe money to the firm). It is important that businesses make sure that their debtors pay them on time.
A company might sell millions of pounds worth goods, but if it doesn't make sure that payment has been received, there will be no money coming in. That means that the business is no better off in terms of cash flow than if it had sold nothing at all.
The business has to still pay wages.
How businesses can control Stock (Inventories)?
A business needs to hold suitable volumes of stock (raw materials and unsold products) to allow and satisfy the demands of the market
A business holding too little stock will lose sales as it wont be able to supply enough goods to the market to meet demand.
A business with too much stock has money tied up stock instead of working for the company. It would be better to use the money to pay wages or debts or invest in new projects.
What is a realisable value?
Accounting conventions say that stock values must be realisible. The net realisible value is the amount the company could get by selling the stock right now in its current state (rather than after it's been used to make a finished product.
The realisible value might be lower than the cost value *(the amount the business paid for the stock). Or the net realisible value might be higher than its original cost price, if demand for the materials has increased since the business bought them which happens in businesses like jewellery manufacturers.
How do assets depreciate (lose value over time)?
Most assets lose value over time, the longer the businesses has them, the less they are worth.
Assets lose their value over three main reasons which are: wear, tear and they may break down or they become old fashioned when new inventions come onto the market
Although most assets depreciate sometimes it can work the other way around and assets can increase in value like property.
What do balance sheets show?
Balance sheets show how much a business is worth. Balance sheets show the short term financial status of the company.
Suppliers are particularly interested in working capital and liquidity. They can look at the balance sheet to see how liquid the firms assets are, as well as how much working capital the firm has. The more liquid the assets, the better the firm will be at paying bills.
It also shows sources of capital, ideally long term loans and mortgages are used to finance the purchase of fixed assets. A well managed business wouldn't borrow too much through short term overdrafts, because overdrafts are an expensive way of borrowing.
Benefits of comparing Balance sheets?
Comparing this years balance sheet to last years accounts let you pick out trends in company finances and evaluate the financial performance of the company.
A quick increase in non current assets indicates that the company has invested in property or machinery. This means that the company is investing in a growth strategy, which may increase its profit over the medium term.
increases in revenue also suggest an increase in profit.
Looking at several balance sheets also shows trends in how the business has raised its capital. It is risky to suddenly start borrowing a lot in case interest rates rise.
What do income statements show?
The income statement (also known as a profit and loss account) shows how much money has been coming into the company (revenue) and how much goes out (expenses).
Revenue is sales income from selling goods and services. This includes cash payments and sales on credit. Expenses include the cost of raw materials, production costs, marketing costs, wages etc.
These figure can be used in assessing financial performance.
What is gross profit?
Gross profit is revenue minus the cost of sales.
This shows the money being made being made from actually making and selling goods. If gross profit is low, managers need to look at ways of reducing the cost of making the product, or increasing the selling price.
What is operating profit?
Operating profit is revenue minus the cost of sales minus operating expenses.
This shows the money made from normal business operations. If operating profit is significantly lower than gross profit then, it could show that the company's operating expenses are a weak area. Managers should take steps to reduce these expenses.
What is profit b4 tax?
Profit before tax takes into account any profit or loss from one off events and other expenses such as finance costs.
Comparing profit before tax to operating profit shows in income or expenses are coming from other activities (like buying/selling buildings) rather than normal activities (like making and selling goods)
What is profit after tax?
(Also called profit for the year) is what's left after corporation tax has been paid.
Profit tax tells you if a company is profitable or not, shareholders and potential investors will look at this figure to assess investments.
What is retained profit?
Retained profit is what is left from profit after tax, once share dividends have been paid to shareholders.
This shows how much internal finance the company has available to invest, which shows how strong its growth potential is.
What can a business do with its profit?
They can pay dividends to shareholders. Shareholders usually want companies to pay high dividends so that they get a good return on their investment. If companies don't pay dividends, or pay very low dividends, existing shareholders might sell their shares.
They can also keep the profit (retained profit). By retaining profit it allows the business to spend on things that are likely to increase their profits in the future. This allows a business to increase production, which could lead to increased revenue and profits in the future.
How useful is financial analysis?
Analysis of the balance sheet and income statement can be really useful for comparing a business's current performance to its competitors performance, and to its own performance in the past to identify trends business ' financial performance is.
The analysis can help managers to make decisions based on the company's financial strengths and weaknesses.
Potential investors and lenders can use the analysis to decide if they want to invest in or lend to the business.
Disadvantages of Financial analysis?
Financial analysis only takes into account financial data. This is useful for potential investors, but it ignores a lot of qualitative (non numerical) data that potential investors should also consider.
Internal factors that don't appear in the analysis include the quality of staff and products, the company's market share, future sales targets, productivity levels the firms impact on the environment and customer satisfaction
External factors like economic or market environment aren't reflected in the analysis either. It doesn't tell you anything about what a competitor might do next, or what legislation the government might pass. The development of technology doesn't show either.
Disadvantages of Balance sheets?
The balance sheet is a statement about one point in the past, which may not help predict the future.
The balance sheet doesn't give any clues about the market or the economy that the business is trading in.
Balance sheets value some intangible assets, but they don't value intangible assets like staff skill, staff motivation or management experience
If bad debts are included in the balance sheet as an asset, the analysis will be misleading.
Disadvantages of Income sheets?
It doesn't include information about external factors such as market demand, which would be useful in forecasting future revenue and profit.
It doesn't include any information about internal factors such as staff morale, which would be useful in determining productivity and profitability
In times of inflation, the income statement isn't useful because inflationary rises in price distort the true value of revenue.
The income statement can be deliberately distorted, by bringing forward sales from the next trading period and including them as part of this trading period.
What is liquidity ratios?
Liquidity ratios show how much money is available to pay the bills. A firm without working capital has poor liquidity. It cant use its assets to pay for things when it needs them.
The liquidity of an asset is how easily it can be turned into cash and used to buy things. Cash is very liquid, non current assets like factories are not liquid, and stocks and money owed by debtors are in between.
A business that doesn't have enough current assets to pay its liabilities when they are due in insolvent. It either as to quickly find the money to pay them, give up and cease trading or go into liquidation.
Liquidity can be improved by decreasing the stock levels, speeding up collection of debts owed to the business or slowing down payments to creditors.
Liquidity rations shows how solvent a business (how able it is to pay its debts) the main liquidity ratio you need to know is current ratio.
What is current ratio?
The current ratio compares current ratio to current liabilities.
current assets / current liabilities
What is return on capital employed?
It is the most important profitability ratio. The ROCE tells you how much money has been put into the business. The higher the ROCE the better.
It is important to compare the ROCE with the BOE interest rate at the time as this tells investors whether they'd be better of putting their money into a bank. ROCE can be improved by paying off debt to reduce non current liabilities, or by making the business more efficient to increase operating profit.
operating profit / (total equity + non current liabilities)
What is efficiency or performance ratios?
Efficiency ratios show managers and shareholders how well the business is using its resources.
There are three important efficiency ratios you need to know: inventory turnover ratio (stock turnover ratio), payables days ratio (creditor days ratio) and receivable days ratio (debtor days ratio). They show how efficiently the business is using its assets and how well managers are controlling stock, creditors and debtors.`
What is inventory turnover ratio?
The inventory turnover ratio (stock turnover ratio) compares the cost of all the sales a business makes over a year to the cost of average stock held.
You need to know the cost price of everything the business has sold. Stock is valued at cost price, so you need sales at cost price too. You'll find the cost of sales on the income statement and stock held on the balance sheet.
(cost of sales) / (cost of average stock held)
What is payables days ratio?
The payables days ratio (creditors days ratio) compares the amount the business owes to its creditors to the cost of all the sales a business makes over the year.
This is the number of days the firm takes to pay for goods it buys on credit from suppliers.
You can establish a trend over a period of time and use this trend to analyse the efficiency of the firm.
( (payables) / (cost of sales) ) x 365
What is receivable days?
The receivable days ratio (debtor days ratio) compares the amount owed to a business by its debtors to the total sales revenue over the year.
Receivable days is the number of days that the business has to wait to be paid for goods its supplies on credit.
It is best to have low receivable days, because it helps with cash flow and working capital. The type of business affects the receivable days. A retailer tend to get straight away unless they offer credit on items like TVs. Medium sized businesses usually take 70 - 90 days to get invoices paid.
(receivables / sales revenue) x 365
What is gearing?
Gearing shows potential investors where a business' finances has come from i.e what proportion of its finance comes from non current liabilities rather than share capital or reserves.
A gearing above 50% shows that more than half of a business' finance come from long term debt then the business is high geared. A gearing between 25% - 50% is fairly standard. A gearing below 25% show its low geared.
Gearing shows us how vulnerable a business is top changes in interest rates
non current liabilities / total equity + non current liabilities
What are the benefits of gearing?
One benefit is borrowing money for the business is extra funds for expansion. Ideally, the loan is invested in projects or technology which increase profits by more than enough to pay off the loan repayments. High gearing can be attractive during the growth phase. A firm that is trying to become the market leader, and has growing profits along with a strong product portfolio, may decide to borrow heavily in order to fund expansion and gain a competitive advantage.
When interest rates are very low, high gearing is less risky because interest payments are lower.
What are the disadvantages of gearing?
The risk to the business of borrowing money is that it might not be able to afford the repayments, it might not make enough profit to pay back the loan and interest.
Taking out loans can be risky even when interest rates are low, because they might go up later and the business will be committed to make repayments.
What are the rewards for investors?
The reward (of investing money in the business) for the leader or shareholder is interest for lenders or a share dividend for shareholders (often paid out twice a year). Shareholders can also sell their shares at a profit if the share price goes up. Since high gearing can lead to high profits for businesses, shareholders might expect to see large dividends and a big increase in the share price compared to a low geared company.
What is the risk for investors?
The risk to the shareholder of high gearing is that the business may fail if it cant afford to keep up with loan repayments. When a business goes into liquidation, lenders will probably get the money they are owned, but the shareholders could lose most or all of the money they have invested.
What are the benefits of ratio analysis?
Ratios are a really good way of looking at a business's performance over a period of time, they can be used to spot trends, and to identify the financial strengths and the weaknesses of the business.
However these trends need to take account of variable factors, things which change over time, like inflation, accounting procedures, the business activities of the firm and the market environment.
Managers can use ratio analysis to help with decision making
Potential investors can use the ratios to help them decide if they want to invest in the business, they may choose not to invest in high geared business if they think it is too risky.
What are the limitations for Ratio analysis?
Ratios don't take account of any non numerical factors, so they don't provide an absolute means of assessing a company's financial health.
Internal strengths such as quality of staff, don't appear in the figures, so they won't come up in ratios.
External factors, like economic or market environment, aren't reflected in the figures. When the market's very competitive, or the economy's in a downturn.
Future changes like technological advances or changes in interest rates can't be predicted by the figures, so the won't show up in the ratios.
Why do businesses compare their data to other businesses?
Businesses can compare their data from similar businesses, this allows the,m to compare their performance with that of their competitors, and see where they need to improve (or what they are doing better than their rivals)
Making comparisons puts a business's data in context.
one way of making comparisons is by benchmarking. Benchmarking means looking at successful businesses and identifying what do well, then trying to apply their strengths to your businesses. It can by looking at data or by looking at the processes they use.
Why does businesses can look at their data over time?
Data analysis needs to be repeated at regular intervals to allow a business to see how things are changing.
Analysis pf both financial and non financial data can be helpful to show trends in performance. A trend is a general pattern in the data values over period of time.
Analysing data over time allows the business to assess its log term performance, as well as its short term performance, it needs to consider whether the data shows that there is a permanent trend, or just a temporary change. The business will need to take this into account when developing its strategy.
A business should try to predict future trends by extrapolating the data. This will help the business to see how likely it is that it will meet its objectives.