Ms M

arshall Leaving Cert Business

CHAPTER 11: ACCOUNTINGUsually comes up in Q5 or Q6 or as a short question.

Ms M

arshall Leaving Cert Business

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.

Ms M

arshall 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.

Ms M

arshall Leaving Cert Business

KEY DEFINITIONS 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.

Ms M

arshall Leaving Cert BusinessIMPORTANCE 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.

Ms M

arshall Leaving Cert Business

BALANCE 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.

Ms M

arshall Leaving Cert Business

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.

Ms M

arshall Leaving Cert BusinessIMPORTANCE 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.

Ms M

arshall Leaving Cert BusinessLIMITATIONS 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.

Ms M

arshall Leaving Cert BusinessWHO 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?

Ms M

arshall Leaving Cert BusinessRATIO 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.

Ms M

arshall 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

Ms M

arshall Leaving Cert Business

PROFITABILITY

Ratio Formula Information Given

Return on Capital Employed

Net Profit * 100Capital 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 * 100Sales

Profit made from buying and selling before paying expenses.

Net Profit Percentage

Net Profit * 100Sales

Profit made after payment of expenses.

Ms M

arshall Leaving Cert Business

LIQUIDITY RATIOS The two liquidity ratios you should know are: The Current Ratio/Working Capital ratio The Acid Test/Quick Ratio

Ms M

arshall Leaving Cert BusinessRatio Formula Information

Given

Current Ratio

Current AssetsCurrent Liabilities

Has the company enough CA to pay for its CL? Ideal ratio is 2:1

Acid Test Current Assets – Closing StockCurrent 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.

Ms M

arshall Leaving Cert Business

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

Formula Debt CapitalEquity Capital

Ms M

arshall Leaving Cert Business

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.

Ms M

arshall 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.

Ms M

arshall 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.

Ms M

arshall 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).

Ms M

arshall 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).

(ii) Comment on the significance of the trend in the Debt/Equity ratio over the two years for the existing shareholders. (20 marks)

2006 2007Long Term Loans 300,000 364,000Ordinary Share Capital

450,000 450,000

Retained Earnings 50,000 70,000

Ms M

arshall Leaving Cert Business

RECENT EXAM 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

500,000 500,000

Ordinary Share Capital

420,000 320,000

Long term Loans 140,000 270,000Retained Earnings 30,000 40,000

Ms M

arshall Leaving Cert Business

RECENT 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

Calculate the Acid Test Ratio for 2003 and 2004. Indicate whether the trend is improving or disimproving and give one possible reason for this.

2004 2003Current Assets 90,000 85,000Current Liabilities 60,000 40,000Closing Stock 20,000 25,000

Ms M

arshall Leaving Cert Business

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 €15,000This topic came up as 40 mark question in 2010

and 2012, 2006.It came up as a full question in 2004.