Download Chapter 11: Accounting

Usually comes up in Q5 or Q6 or as a short
question.
Ms Marshall Leaving Cert Business
CHAPTER 11: ACCOUNTING
SYLLABUS OBJECTIVES
By the end of this chapter students should be
able to:
 Calculate and interpret the main profitability,
liquidity and debt equity ratios.
 Understand the importance of accounts and
business data in the monitoring of the business
enterprise.
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Ms Marshall Leaving Cert Business
FINAL ACCOUNTS
The Final Accounts of a business refer to the
Trading, Profit and Loss and Balance Sheet of a
company.
 The purpose of the Trading, Profit & Loss is to
calculate how much profit or loss the business
has by their year end.
 The Trading Account looks at the Gross Profit.
The Profit and Loss takes into account expenses
relevant to that year only. i.e. it calculates net
profit.
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Ms Marshall Leaving Cert Business
KEY DEFINITIONS
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Ms Marshall Leaving Cert Business
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Sales: the total value of all the products the business
sold during the year. Also called Turnover.
Cost of Sales: the amount the business spent buying
or making all the products it sold during the year.
Gross Profit: the difference between the total value
the business sold its products for and the total cost it
paid to make/buy them. i.e. Sales Less Cost of
Sales. It is the profit before the general expenses are
paid.
Expenses: all the running costs and bills associated
with a business such as wages, phone, internet, rent.
Net Profit: Gross Profit Less Expenses. It is the
actual profit made after all the expenses have been
paid. Dividends are paid from this.
IMPORTANCE OF THE PROFIT & LOSS
ACCOUNT TO MANAGERS:
Gross Profit too low – shows managers that
selling price may need to be raised or cheaper
materials may need to be sourced in order to
bring down the cost of sales.
 Net Profit too low – shows managers that the
expenses may be too high.
 Net Profit too low – means that there is little
money left to pay dividends and to reinvest in the
company “retained earnings” or “ploughing back
profits”. This will make shareholders wary to
invest more and may cause them to sell their
shares.
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Ms Marshall Leaving Cert Business
BALANCE SHEET
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Ms Marshall Leaving Cert Business
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Balance Sheet
Gives a snapshot of the assets and liabilities of the
company on a particular date.
Key Definitions
Fixed Assets: these are long term, valuable, items
that the company owns, e.g. machinery, premises.
Current Assets: these are short term, valuable items
that the company owns. E.g. Debtors, Cash, Bank,
Closing Stock.
Current Liabilities: these are loans and bills that
are owed by the company that have to be paid back
within one year. E.g. Creditors, Light & Heat due,
Bank overdraft.
KEY DEFINITIONS
Working Capital: Current Assets less Current
Liabilities. It represents the cash left over to pay
bills as they come in.
 Financed By: the amount of money invested in
the business by the investors, such as
shareholders and banks.
 Capital Employed: the amount of money
invested in the business by the investors, such as
shareholders and banks.
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Ms Marshall Leaving Cert Business
IMPORTANCE OF THE BALANCE SHEET
Fixed Assets are used as collateral for loans
 Working Capital indicates the liquidity position
of the company
 The Financed By section gives an indication as to
whether the company is financed more by loans
or shares.
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Ms Marshall Leaving Cert Business
LIMITATIONS OF FINANCIAL STATEMENTS
Absolute figures – don’t indicate performance.
A lot depends on previous performance, industry
norms and the economic climate.
 Company Specific: comparisons are vital to
judge whether a company is worth investing in.
 Non financial information: no indication of
underlying issues such as staff morale,
productivity or changing economic circumstances.
In depth research is needed before you decide to
invest.
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Ms Marshall Leaving Cert Business
WHO IS INTERESTED IN ACCOUNTS &
RATIOS?
Owners/Shareholders/ Potential Investors:
 Profitability/dividends/security of their
investment.
 Management: for decision making.
 Financial Institutions: liquidity - ability to pay
interest and loans. Gearing – give loans in the
future?
 Creditors and Suppliers: liquidity: will they be
paid back on time?
 Employees: profitability – wages/job security.
 Revenue Commissioners – Profit – Tax liability?
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Ms Marshall Leaving Cert Business
RATIO ANALYSIS.
There are three main areas examined under ratio
analysis:
 Profitability: these measure the efficiency of a
firm in generating profit.
 Liquidity: measures the ability of a firm to pay
its short term debt.
 Gearing: The debt-equity ratio measures how
the business is structured financially.
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Ms Marshall Leaving Cert Business
PROFITABILITY RATIOS
The three profitability ratios you need to know
are:
 The Return on Capital Employed/Return on
Investment.
 Gross Profit Percentage/Margin
 Net Profit Percentage/Margin
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Ms Marshall Leaving Cert Business
Ratio
Formula
Information Given
Return on Capital
Employed
Net Profit * 100
Capital Employed
Shows the return on
the total amount of
money invested in
the business. Should
be compared to
risk-free
investments in
financial institutions.
Gross Profit
Percentage
Gross Profit * 100
Sales
Profit made from
buying and selling
before paying
expenses.
Net Profit
Percentage
Net Profit * 100
Sales
Profit made after
payment of expenses.
PROFITABILITY
Ms Marshall Leaving Cert Business
LIQUIDITY RATIOS
The two liquidity ratios you should know are:
 The Current Ratio/Working Capital ratio
 The Acid Test/Quick Ratio
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Ms Marshall Leaving Cert Business
Ratio
Formula
Information
Given
Has the company
enough CA to
pay for its CL?
Ideal ratio is 2:1
Acid Test
Can the firm
meet its short
term debts out of
its liquid assets?
Stock is taken
out as it may not
sell quickly. Ideal
ratio 1:1, i.e. a
healthy firm
should have €1 in
liquid assets for
every €1 in short
term debts.
Current Assets – Closing Stock
Current Liabilities
Ms Marshall Leaving Cert Business
Current Ratio Current Assets
Current Liabilities
GEARING
The Debt Equity Ratio shows the financial
structure of the firm, i.e. it shows the
relationship between debt capital and equity
capital.
 Debt Capital = Long term debt
 Equity Capital = Ordinary Share Capital +
Reserves
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Formula
Debt Capital
Equity Capital
Ms Marshall Leaving Cert Business
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GEARING
If your debt capital is less than your equity
capital your business is lowly geared.
 If your debt capital is higher than your equity
capital then your business is highly geared.
 If debt capital = equity capital then the firm has
neutral gearing.
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Ms Marshall Leaving Cert Business
ADVANTAGES OF LOW GEARING
1. Owners Capital: a greater amount of capital
has been provided by the owners.
 2. Better dividends: more profit is available for
dividends as there are no major interest
commitments.
 3. Easier to Borrow in the Future: a bank would
consider the debt equity ratio when determining
if a business is likely to be able to repay its loan.
 4. Easy to sell shares in the future: higher
dividends should attract more shareholders in
the future.
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Ms Marshall Leaving Cert Business
CONSEQUENCES OF HIGH GEARING
High Interest: Interest payments on borrowing
must be paid before dividends.
 Difficult to sell shares in the future: lower
dividends as a result of high interest payments
would attract fewer shareholders.
 Difficult to borrow in the future: Assets will
already have been used as collateral for other
loans.
 Low Share Price: low dividends could lead to
shareholders becoming unsatisfied and selling
their shares. This could result in a lower share
price.
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Ms Marshall Leaving Cert Business
RECENT EXAM QUESTIONS
2011
 (a)Explain the term ‘Return on Investment’
 (b) Using the figures below calculate the ROI for
‘Natural Options Ltd.’ show your workings.
 Net Profit €57,000
 Ordinary Share Capital €140,000
 Reserves €56,000
 Long term Loan €24,000
 2008
 Differentiate between Working Capital and
Equity Capital. (10 marks).
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Ms Marshall Leaving Cert Business
RECENT EXAM QUESTIONS
2009 (20 marks)
 Using the figures given below calculate the
Debt/Equity ratio of SES Ltd for the years 2006
and 2007 (show your workings).
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2007
Long Term Loans
300,000
364,000
Ordinary Share
Capital
450,000
450,000
Retained Earnings
50,000
70,000
(ii) Comment on the significance of the trend in
the Debt/Equity ratio over the two years for the
existing shareholders. (20 marks)
Ms Marshall Leaving Cert Business
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2006
RECENT EXAM QUESTIONS
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2005
2004
Authorised Share
Capital
500,000
500,000
Ordinary Share
Capital
420,000
320,000
Long term Loans
140,000
270,000
Retained Earnings
30,000
40,000
Ms Marshall Leaving Cert Business
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2007
Liquidity ratios are used to assist in managing a business.
Name two of these ratios and describe their respective
benefits. (20 marks).
2006
The following figures relate to a company for the past two
years.
RECENT EXAM QUESTIONS
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2006 continued..
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(i)Calculate the debt/equity ratio for 2004 and 2005 and
(ii)indicate whether the trend is improving or disimproving and
give one possible reason for this.
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2005
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The following figures relate to Laser Ltd
2004
2003
Current Assets
90,000
85,000
Current Liabilities
60,000
40,000
Closing Stock
20,000
25,000
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Calculate the Acid Test Ratio for 2003 and 2004. Indicate whether
the trend is improving or disimproving and give one possible
reason for this.
Ms Marshall Leaving Cert Business
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RECENT EXAM QUESTIONS
2004
10 marks
 (i) Explain why a business would calculate the
Debt/Equity Ratio.
 (ii) Calculate the debt/equity ratio for the year 2003.
Show all workings.
 2003
 Long term loans: €100,000
 Ordinary Share Capital €50,000
 Reserves
€25,000
 Overdrafts €15,000
This topic came up as 40 mark question in 2010
and 2012, 2006.
It came up as a full question in 2004.
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Ms Marshall Leaving Cert Business