C

HAPTER

11: A

CCOUNTING

Usually comes up in Q5 or Q6 or as a short question.

S

YLLABUS 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.

F

INAL

A

CCOUNTS

  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.

K

EY

D

EFINITIONS

     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.

I MPORTANCE OF THE A CCOUNT TO M P ROFIT ANAGERS : & L OSS

   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.

B

ALANCE SHEET

     

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.

K

EY

D

EFINITIONS

   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.

I

MPORTANCE OF THE

B

ALANCE

S

HEET

 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.

L

IMITATIONS OF

F

INANCIAL

S

TATEMENTS

   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.

W

HO 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?

R

ATIO

A

NALYSIS

.     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.

P

ROFITABILITY

R

ATIOS

    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

Ratio Formula

PROFITABILITY

Return on Capital Employed

Net Profit * 100 Capital Employed

Gross Profit Percentage Net Profit Percentage

Gross Profit * 100 Sales Net Profit * 100 Sales

Information Given

Shows the return on the total amount of money invested in the business. Should be compared to

risk-free

investments in financial institutions.

Profit made from

buying and selling

before paying expenses.

Profit made after payment of expenses.

L

IQUIDITY RATIOS

  The two liquidity ratios you should know are:

The Current Ratio/Working Capital ratio



The Acid Test/Quick Ratio

Ratio Formula

Current Ratio Current Assets Current Liabilities

Information Given

Has the company

enough CA to pay for its CL?

Ideal ratio is 2:1 Acid Test Current Assets – Closing Stock Current Liabilities 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.

G

EARING

   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  Formula

Debt Capital Equity Capital

G

EARING

 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.

A

DVANTAGES 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.

C

ONSEQUENCES 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.

R

ECENT

E

XAM

Q

UESTIONS



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).

R

ECENT

E

XAM

Q

UESTIONS

  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).

2006 2007

Long Term Loans Ordinary Share Capital Retained Earnings 300,000 450,000 50,000 364,000 450,000 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)

R

ECENT

E

XAM QUESTIONS

   

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.

2005 2004

Authorised Share Capital Ordinary Share Capital Long term Loans Retained Earnings 500,000 420,000 140,000 30,000 500,000 320,000 270,000 40,000

R

ECENT EXAM QUESTIONS

     2006 continued..

(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.

2005

The following figures relate to Laser Ltd Current Assets Current Liabilities Closing Stock

2004

90,000 60,000 20,000

2003

85,000 40,000 25,000  Calculate the Acid Test Ratio for 2003 and 2004. Indicate whether the trend is improving or disimproving and give one possible reason for this.

R

ECENT

E

XAM

Q

UESTIONS

     

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.