Ratios

Financial Statements

Income Statement

This calculates the profit at the end of the financial year. this is required so that the business can pay the appropriate amount of tax to the inland revenue

  • It includes: Opening inventory, purchases, Closing inventory etc.

Statement of Financial Position

This is like a financial snapshot of the business's financial situation at that moment of time.

  • It includes: Non-Current Assets, Current Assets and Non-Current Liabilities, Current Liabilities etc.
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Income Statement

Income Statement

Calculates how much a business has earned through trading. It calculates the Gross Profit (Sales Revenue – Cost of Goods Sold) and Net Profit (Gross Profit – Expenses)

Total Sales Revenue = Selling price x No. Sold 

Cost of Goods Sold = Opening Inventory + Purchases + Closing Inventory 

  • Opening Inventory-value of stock instore at the beginning of financial year. 
  • Purchases-total raw materials bought during the year.
  • Closing Inventory-value of unused raw materials instore for the following year.

Gross Profit - the direct profit made on trading activities this means it only takes into account costs associated with making the good or providing the service 

Net Profit - this takes into account all the running expenses which have to be payed such as rent, rates and energy costs 

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Statement of Financial Position

Statement of Financial Position

Shows a snapshot of what the business owns (what it did with the money) and owes (where it got the money from) at one particular moment in time. E.G. Assets, Liabilities 

                               Total Assets = Total Equity + Liabilities 

Total assets means what the business is worth and is shown at the top half of the statement HOWEVER the bottom half shows how the business has been funded.  

Equity - made up of the money invested in the business by the owner (capital) plus any net profit made, minus any drawing taken out of the business by owner 

                              Equity = Capital + Net Profit - Drawings 

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Assets and Liabilities

Current Assets

Current Assets are owned by the business but will change within one year. E.G. Trade Receivables, Closing Inventory + Cash.

Non-Current Assets 

Are long term assets owned by the business which are needed forthe day to day running (1yr+). E.G. Machinery, Equipment + Land

Current Liabilities 

Are short term borrowings that will be paid back within a year E.G. Overdraft + Trade Payables 

Non-Current Liabilities 

Are items that a business owes but aren't due for repayment within a year E.G. Bank Loan + Mortgage 

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Trade Recievables & Payables

Trade Receivables 

Are customers that owe the firm money. This is where the firm has given them goods on credit, which they will pay for at a later date usually 30 days.

Items a business owes are called liabilities. These can be non-current or current.

Trade Payables 

Are suppliers that the business owes money to. This is where the business has been given goods on credit, which they will pay for at a later date usually 30 days. This allows the business to have the use of the goods and possibly sell them before they have to pay for them, which is good for cash flow.

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Analysing Financial Statements

Income Statement 

  • Has sales revenue increased or decreased and by what percentage (difference/base yr x 100)
  • Has the gross profit increased or decreased and then explain that they will need to manage cost of sales better to improve it E.G. a cheaper supplier
  • Has net profit increased or decreased? If decreased they need to manage expenses better

Statement of Financial Position 

  • If non-current assets increased this means they've purchased new machinery which will make the more productive (modern technology)
  • If they have little cash in hand or at bank they may not be able to pay immediate bills 
  • If they have too many liabilities they are a higher risk busisiness because interest payments must be made which increases expenses and reduces profit. A business should aim to be funded mostly by equity. 
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Ratios (1)

Ratios are used by owners etc to asses business' profitability, performance & liquidity 

Gross Profit Percentage 

Gross profit percentage is a profitability ratio that shows the relationship between gross profit and sales revenue, showing the amount of gross profit which is made from sales. The higher the percentage figure the better the profitability and performance of the business.

Gross Profit Percentage = Gross profit/Sales × 100

E.G. 40% means for every £1 made in sales revenue the business has made 40p in gross profit. The higher the better. This further means to improve this figure they should reduce cost of sales by finding a cheaper supplier  

Sum Up the GPP indicates how well the business is managing costs of sales 

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Ratios (2)

Net Profit Percentage 

Net profit percentage is the percentage of revenue left after all expenses have been deducted from sales. Net profit percentage is a profitability ratio that shows the relationship between net profit and sales revenue, showing the amount of net profit which is made from sales. The higher the percentage figure the better the profitability and performance of the business.

A high net profit margin indicates that a business is pricing its products correctly and is exercising good cost control.

Net Profit Percentage = Net Profit/Sales x 100

E.G. 15% means that for every £1 made in sales revenue the business has made 15  of net profit. The higher the better. This further means the business needs to reduce expenses to increase the figure further. 

Sum up NPP indicates how well the business is managing expenses 

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Ratios (3)

Inventory Turnover Rate 

Inventory Turnover Rate shows the number of times in a year that a business is able to sell the value of its average inventory. For some businesses this will be high e.g a bakery or vegetable shop and others it will be low e.g a furniture shop.

The inventory turnover rate is a measure of efficiency. This will tell a business how quickly the inventory that it holds is being sold. It shows the number of times in a year the business is able to sell the value of its average inventory.

Inventory Turnover = Costs of Sales/Average inventory

A stock turnover rate of 6 would mean a business is selling its stock 6 times per year i.e. every 2 months. Different goods will have different rates of stock turnover (e.g. food – higher rate of turnover, furniture – slower rate of turnover) 

Average inventory = opening + closing inventory / 2 

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Ratios (4)

Return on Capital Employed (ROCE)

  • measures how well the firm has used it's resources (Capital Employed) to make a profit 
  • Shows the Net profit that the owner has recieved on the capital he/she has put into the business (capital employed)
  • The higher the percentage the better.
  • Can be compared to bank interest rates which is 0.5% at the minute 
  • An ROCE of 25% means that it usesevery £1 of capital to generate 25p in profit 
  • ROCE shows return on investment

ROCE = Net Profit / (Total Assets - Current Liabilities) x 100

How To Improve ROCE

  • to improve this increase the net profit by decreasing expenses and increasing sales. 
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Ratios (5)

Working Capital Ratio 

  • Shows how liquid a business is - measures it's ability to pay short term debts 
  • Expressed as a figure against 1 
  • Ideal is 2:1 in that business should have twice as many current assets to current liabilities 
  • A ratio of 0.75:1 would suggest the firm has only 75p in current assets available to cover every £1 it owes.
  • Soem business may operate a slowas 1.5:1 a ratio in excess of 2:1 may indicate that the business is not using it's resources efficiently (holding too much cash in stock)

Working Capital Ratio = Current Assets / Current Liabilities 

How To Improve Working Capital 

  • Improve this reduce current liabilities such as overdraft or use of trade credit from suppliers as well as improving cash at bank. 
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