Untitled Quiz

Gearing

• Gearing refers to the proportion of debt (external finance) and equity (internal finance) used to finance a business's activities.
• The debt to equity ratio (Total Liabilities ÷ Owners' Equity) is a key measure of gearing.
• A higher ratio indicates a greater reliance on debt and potentially lower solvency.
• A lower ratio suggests better solvency, meaning the business is less reliant on debt.

Profitability

• Profitability reflects a business's earning performance and its ability to maximize profits through resource utilization.
• Key profitability ratios include:
  • Gross Profit Ratio: Gross Profit ÷ Sales X 100%. A higher ratio indicates a larger portion of sales available for expenses.
  • Net Profit Ratio: Net Profit ÷ Sales X 100%. A higher ratio demonstrates a larger return to the owners.
  • Return on Equity Ratio: Net Profit ÷ Total Equity X 100%. This ratio reveals the effectiveness of owner contributions in generating profits. A higher percentage signifies a greater return on investment.

Efficiency

• Efficiency refers to the business's ability to utilize resources effectively for financial stability and profitability.
• Key efficiency ratios include:
  • Expense Ratio: Total Expenses ÷ Sales X 100%. Lower ratio indicates better efficiency and fewer resources allocated towards expenses.
  • Accounts Receivable Turnover Ratio: Sales ÷ Accounts Receivable X 100%. This ratio reflects the efficiency of a business's credit policy and debt collection.
  • A higher turnover ratio suggests efficient debt collection.

Comparative Ratio Analysis

• Businesses use comparative ratio analysis to assess their performance.
• This involves comparing ratios over different periods, against standards, and with similar businesses.
• This leads to insights into trends, performance, and benchmarks within the industry.

Limitations of Financial Reports

• Limitations of financial reports hinder financial analysis, including:
  • Normalised Earnings: Adjustments to balance sheet earnings to remove unusual or one-time events, providing a clearer picture of true earnings.
  • Capitalising Expenses: Expenses capitalized on the balance sheet as assets can affect profitability by temporarily increasing profits.
  • Valuing Assets: Subjective asset valuations impact financial analysis and profitability.
  • Timing Issues: Financial reporting timing can affect profitability and cash flow, especially in industries with seasonal fluctuations.
  • Debt Repayments: Debt repayment schedules and interest rates can impact financial stability and profitability.
  • Notes to the Financial Statements: Essential information contained in the notes to the financial statements needs to be fully considered during analysis.

Liquidity

• Liquidity involves a company's ability to meet its short-term financial commitments.
• It assesses the balance of current assets versus current liabilities.
• Current Ratio (working capital): Current Assets ÷ Current Liabilities. A ratio of 2:1 suggests good financial stability.

Gearing

• Gearing is the relationship between debt and equity financing.
• Advantages:
  • Provides long-term funding.
  • No immediate repayment obligation.
  • Offers greater financial safety than debt.
  • Lower cost than other sources of finance.
  • Flexible dividend payment timing.
  • Lower debt-to-equity ratio, reducing risk.
• Disadvantages:
  • Requires sufficient profits to sustain operations.
  • Limits returns for the owner.
  • Difficult to obtain and time-consuming.
  • Not tax-deductible.
  • Reduced ownership control.
  • Potential for high dividend demands to reduce retained profits.

Matching Finance to Business Purpose

• Key considerations when choosing financing options:
  • Terms, flexibility, and availability of finance.
  • Cost of each source (equity vs. debt).
  • Business structure (small business vs. public company).

Monitoring and Controlling

• Monitoring and controlling financial performance is crucial for business viability.
• Key financial control tools include:
  • Cash flow statements.
  • Income statements.
  • Balance sheets.
• Important formulas: COGS = Opening Stock + Purchases – Closing Stock (income), Gross Profit = Sales – COGS (income), Net Profit = Gross Profit – Expenses (income), Owners’ Equity = Assets – Liabilities (balance), Total Equity = Owners’ Equity + Net Profit (balance)
• Cash Flow Statement: Summarizes cash transactions over a period of time.