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Unit 4 – Managing 2. Accounting – Monitoring the Business. Objectives. The following topics from Unit 4 of the syllabus are covered in this chapter Why monitor the business? Who is interested in the financial position of an enterprise? How important is financial information to a business?
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Unit 4 – Managing 2 Accounting – Monitoring the Business
Objectives The following topics from Unit 4 of the syllabus are covered in this chapter • Why monitor the business? • Who is interested in the financial position of an enterprise? • How important is financial information to a business? • The final accounts • Ratio analysis • Accounting ratios
Monitoring a business How do we judge the success of a business? • Profit? • Sales? • Reputation? • Size of company? • Number of employees? • History? • Potential?
Financial Controls • The financial controller in a business is responsible for ensuring that proper financial controls and procedures are in place.
Final Accounts • The financial controller also prepares the final accounts and balance sheet of the business.
Trading Account • Purpose of the trading account is to find the gross profit or gross loss over a period. Trading Account for year end 31-12-11 Sales 600,000 Less cost of sales Opening Stock 20,000 Purchases 150,000 Cost of goods available for sale: 170,000 Less closing stock (30,000) Cost of Sales (140,000) Gross Profit 460,000
Profit and Loss Account • This shows the net profit or net loss made by the business in the trading period. P&L account for year end 31-12-11 Gross profit 460,000 Add gains Rent received 10,000 470,000 Less expenses Wages and salaries 100,000 Rent and rates 20,000 Insurance 50,000 Telephone 5,000 Depreciation 20,000 Advertising 20,000 215,000 Net Profit 255,000
Advantages of Profit and Loss Account • It measures the success of the business compared to previous years. • It can help obtain loans of finance from banks. • It enables owners and managers to plan ahead. • It shows all the expenses and highlights where any increases have occurred.
Balance Sheet Balance sheet as on 31-12-11 Fixed assets: Land 400,000 Buildings 70,000 Current assets Stock 55,000 Debtors 20,000 Bank 15,000 90,000 Less current liabilities Creditors 16,000 Dividends due 50,00066,000 Working capital 36,000 Total net assets 506,000 Financed by Ordinary shares 150,000 Retained earnings 255,000 Term loan 101,000 Capital employed 506,000
Balance Sheet • Statement of a business’s financial position at a point in time. • Current Assets: Assets that will shortly be turned into cash • Current Liabilities: Amounts owed by a business that must be paid in the near future. • Working capital = CA – CL • If CA’s are greater than CL’s, working capital is positive and the firm is said to be liquid. • If CL’s are greater than CA’s, working capital is negative and the firm has a liquidity problem and to be overtrading, i.e. It cannot pay its debts as they fall due.
Ratio Analysis • Ratio analysis involves examining the relationships between financial figures in the accounts and expressing them as ratios or percentages.
1. Profitability Ratios • These ratios show how successful the management was in making profit in the business. • The profitability ratios are: • Return on Capital Employed/Return on Investment • Gross Profit Percentage/Margin • Net Profit Percentage/Margin
Return on Capital Employed/ROI • This expresses the net profit made by the firm as a percentage of the amount of money invested by its owners.
Gross Profit Percentage/Margin • This is the gross profit as a percentage of sales. This is profit from buying and selling before paying expenses.
Net Profit Percentage/Margin • This is net profit as a percentage of sales. This is profit made after payment of expenses.
Example • The following information relates to the accounts of N.MartinLtd, a boutique owner in Galway. • For 2004 and 2005 calculate the gross profit margin, the net profit margin and the return on investment. • Analyse these profitability trends and discuss how shareholders might use them in making decisions.
2. Liquidity Ratios • Liquidity is the ability of a business to pay its short-term debts as they arise. • It is measured by subtracting the current liabilities from current assets Current Assets – Current Liabilities = Working Capital • If working capital is positive, the firm is said to be liquid. If working capital is negative, the firm is said to be overtrading and cannot pay its debts as they arise.
Current Ratio • Tells us whether the firm has enough current assets to pay for its current liabilities. • Recommended ratio is 2:1.
Acid Test Ratio • This ratio measures a firm’s ability to meet its short-term debts out of liquid assets. Stock is omitted as it may not be quickly turned into cash. • The recommended ratio is 1:1
3. Debt-equity ratio • This shows the relationship between the debt capital and the equity capital in a company Debt Capital = Long-term debt Equity Capital = Ordinary Share Capital + Reserves Debt Capital: Equity Capital
Debt - equity ratio • Debt < Equity = Low gearing • The business has borrowed less than the amount invested by shareholders • Debt = Equity = Neutral gearing • The business has borrowed the same amount as invested by shareholders • Debt > Equity = High gearing • The business has borrowed more than the amount invested by shareholders
Advantages of low gearing • A greater amount of the capital of the company is provided by the owners. • More profit available for Dividends. • Easier to borrow in the future. • Easy to sell shares in the future
Consequences of high gearing • High interest payments on borrowings. • Difficult to sell shares in the future because of poor dividends. • Difficult to borrow in the future. • Low dividends – low share price.
