Premlal C R
Unit
5.1
BUSINESS
FINANCE: NEEDS AND SOURCES
Finance
Each and every business
organization needs money for its activities. So, the finance can be considered
as the life blood of each and every business. Finance means the money which is
invested or required in the business for its smooth running.
WHY DO BUSINESSES NEED
FINANCE? (May/June
2020 Q.No-3c) (Oct/Nov 2020 Q.No-1a. P-2)
Businesses
need finance to pay wages, to buy materials or assets etc. here are three
examples of why businesses need money:
1. To start up a business
When individuals plan to
start their own business, they should consider purchase of all the assets
required such as fixed assets and current assets such as stocks, before goods
can be sold to the first customers. The finance needed by a new business to pay
for essential fixed and current assets before it can begin trading is often
called Start-Up Capital.
2. To maintain working capital
Business needs to
maintain capital to meet the day-to-day expenses such as wages,
salaries, raw materials, fuel, power etc. this is known as working capital.
3. To expand the business
The
owners of a successful business will often take a decision to expand it in
order to increase profits. Additional fixed assets could be purchased, such as
building and machinery. Another business could be purchased through a takeover.
In both cases, it will probably be necessary to increase the capital in order to finance additional stocks and debtors.
4. To
meet unforeseen expenses
Sometimes
business may face unexpected crisis due to other reasons, so it would affect
the smooth running of business ahead, to manage such financial crisis, most of
the business maintain reserves from the profit.
5. To
conduct research and development of new products.
Research and development need more financial investment in business. So the business needs to find various sources of finance for such activities apart from the working capital.
SOURCES
OF FINANCE (May/June 2019 Q.No-4b) (Oct/Nov 2019 Q.No-3e) (Oct/Nov 2018 4a. P-2) (Mar 2018.
Q.No-4b.P-2) (Oct/Nov
2017 Q.No-1b P-2) (Oct/Nov 2016 Q.No-1e) (May/June 2016
Q.No-4b P-2) (Oct/Nov 2021 Q.No-2b.
P-2) (May/June
2022 Q.No-4d.) (Feb/Mar 2023 Q.No-3e)
1.
SHORT TERM AND LONG TERM FINANCES
If
the money is invested in the business for long term purposes(normally more than one year) it can be
considered as long term finances- Eg:- Money invested for building new factory,
buying land, etc.
If
the money is invested in the business for short term purposes(normally less than one year) it can be
considered as short term finances- Eg:- Paying wages, buying supplies, etc.
2.
INTERNAL AND EXTERNAL SOURCES OF FINANCES
A.
INTERNAL SOURCES OF FINANCE (May/June 2021 Q.No-2c)
This is the capital
raised from within the business itself. The most common examples of internal
finance are as follows:
1. Retained profit (Mar 2019 Q.No-4b P-2) (May/June 2023 Q.No4a)
This is the part of
profit kept in the business after the owners have taken their share of profits
or dividend. It can be used as a reserve fund to meet any future needs.
Advantages of retained
profit.
a. Retained
profit does not have to be repaid unlike a loan.
b.
It is easy to raise and no more formalities required.
Disadvantage of retained profit.
a. A
new business will be in trouble to maintain retained profits.
b. Many small firms could find that their profits
are too low to finance the expansion needed.
c. Keeping
more profits in the business reduces payments to owners, for example dividends
to shareholders, so owners may not accept it.
2. Sale of existing non-current
assets and lease back
Existing assets that
could be sold are those assets which are no longer required by the business,
for example, redundant buildings or surplus equipment. The business can sell
the unwanted assets or lease back the same asset by paying the rent back to the
new owner.
Advantages of selling
and lease back
a.
This makes better use of the capital tied up in the business.
b.
It is good if the non-current assets are no longer require
Disadvantages of selling and lease back
a. Market price may be very low
b.
It may take long time to sell these assets.
c. This
source of finance is not available for new businesses as they have no surplus
assets to sell.
d.
Liability of payment of rent or lease premium.
3. Usage of working capital.
Reducing stock level also
reduces the opportunity cost and storage cost of business. However, it must be
done carefully to avoid disappointing customers if not enough goods are kept in
stock.
Reducing debtors (Trade
receivables) which means most business sells goods to customers on credit so
the customer may take the goods now and pay later, normally in 30 days or at
the end of the month so the business should promote the debtors to pay earlier
than the credit period by offering cash discount.
4.
Owner’s contribution
This is the amount invested by the owners from their
own savings or from personal sources.
B. EXTERNAL SOURCES OF FINANCE
(Mar
2017 Q.No-3e)
External sources of finance are of two types
1. Short term finance
2. Long term finance
1. SHORT TERM SOURCES OF
FINANCE
If the finance is required for less than one year it is considered as
short-term finance.
a. Overdraft (Oct/Nov 2018 Q.No-4e)
Here the bank allows the customers to withdraw money more than the
deposit in their current account. It is s short term borrowing from the bank.
Customers need to pay high rate of interest for overdraft.
Advantages of Overdraft
a.
Easy to arrange money
b.
No need more formalities to raise capital
Disadvantages of overdraft
a. Very
short period to repay the money
b.
Limited amount is available
c.
High rate of interest is charged
b. Trade credit
Here the business buys resources from the suppliers without immediate
payment. So, the business avails the money in the form of supplies for an
agreed period of time.
Advantages of Trade credit
a.
Easy to raise capital
b.
Can extend the credit period if supplier agrees
Disadvantages of trade credit
a.
Business may lose the offer of discounts if not paying in time
b.
Difficult to get further credit if any amount is outstanding
c.
Depending on creditworthiness of buyer
c. Debt factoring
Here the business can arrange money by selling their debts to third party
called factors. For example, A business has the trade receivable of $1000 and
the agreed credit period is 31st March. If the business needs money
immediately today (assume today is 10th March), it can approach to
the factoring house (factor) and may get up to the 90% of their
trade receivables (i.e.-$900). Here, on
31st March, the debtors have to pay to the factors full amount
(i.e.- $1000) the difference $100 will be commission of factors.
There are three parties in this method first
one who gives money to the business is called the factor and the second one who has to pay money to the factor on
behalf of the company called debtors
and the third one, the business.
Advantages
of factoring
1. Easy to raise money
2. It ensures the immediate cash inflow
3. There is no risk of bad debt to the business
Disadvantages
of factoring
1. High commission to the factors (10% of
account receivables)
2. According to the chance of bad debt,
commission may increase.
2. LONG
TERM SOURCES OF FINANCE (May/June
2023 Q.No4e)
If the finance is
required for more than one year it is considered as long-term finance.
a. Shares
(Oct/Nov
2021 Q.No-4d)
The
capital of the company will be divided into a number of equal units called
shares. Only the Public ltd company can issue shares to the public for raising
capital. But private limited companies can sell shares to the existing
shareholders with the consent of all shareholders.
Advantages of shares
1. Large amount of capital can be raised.
2. No need of repayment of capital
3. No need of interest payment
4. Shareholders have the voting right in the
company.
Disadvantages of shares.
1. Dividend is paid out of profit, if there is
no profit, no dividend at all.
2. It is not suitable for small amount of
capital
3. More formalities required for issuing shares
to the public.
b.
Debentures
Debentures
are the instruments issued by the company in order to borrow money from the
public. It is a loan to the company and the debenture holders of the company
get fixed rate of interest whether there is profit or loss in the company.
Advantages of
debentures.
1. Debenture holders get fixed rate of interest
if profit or loss in the business.
2. They will be paid first of all if the
company winds up.
3. The company can repay the debenture when it
no longer requires the money.
Disadvantages of
debentures.
1. It is a liability to the company- Interest
burden
2. If fails to settle the debenture holders,
business is legally liable for payment
3. Debenture holders cannot participate in the company’s administration.
C.
Long term Bank Loan (Mar 2019
Q.No-4b P-2) (May/June 2018 Q.No-1e)
Bank
loan is the common mode of business finance, here,
the business can borrow money from the bank for a long-term purpose with a
fixed or variable rate of interest. Here the business needs to give collateral
securities against the loan.
Advantages of Bank
loans
1. Large amount can be arranged.
2. Can be repayable in many years.
3. Lower rate of interest comparing to
overdraft.
Disadvantages of Bank
loans
1. It brings long term liabilities to the
business.
2. Collateral securities are required; if any
default to repay the loan, the bank will attach the securities.
3. Burden of interest payment.
4. More formalities are required -separate loan account and supporting documents.
d. Mortgage
It is similar to bank loan but is used specially for the purchase of land and buildings. It is an agreement that allows you to borrow money from people or similar organization especially in order to buy land or building. Here the mortgagor (Owner) gives the right of ownership of a property to a mortgagee (Lender) as security for Advantages of Mortgage
1. Large amount can be arranged.
2. Can be repayable in many years.
Disadvantages
of Mortgage
1. It brings long term liabilities to the
business.
2. Collateral securities are required.
3. Burden of high interest payment.
e. Leasing (March 2022 Q.No-3e)
Leasing is a type of
finance for fixed assets such as motor vehicles or machinery. Here the business
needs to pay a fixed amount called lease premium, monthly for using the
assets. Here the user never owns the asset.
Advantages
of leasing
1. Business can get the usage of assets by paying less amount
2. It saves the immediate lump sum payment for buying assets.
3. Business no need to undertake the cost of maintenance or repair of
assets.
Disadvantages of leasing
1. Users cannot be the owner of the asset.
2. Lease premium may be a future liability
f. Hire
Purchase Agreement
It is
similar to leasing here the business gets the use of an asset without the
payment of purchase price fully. In this method, the business can hire the
assets as paying the purchase price as installments and can buy the asset at
the end of the hire period. Mostly, motor vehicles and machineries are financed
under this scheme.
Advantages of hire purchase
1. It enables the business to obtain high valued capital goods.
2. Goods can be bought immediately and the payments can be made in
installment.
3. It saves the payment of purchase price as lump sum payment.
Disadvantages of hire purchase to the buyer
1. Business should undertake the cost of maintenance or repair.
2. High price of goods including high rate of interest.
3. Business cannot own the assets until the full price is settled within
hire period.
ALTERNATIVE SOURCES OF
CAPITAL.
1. Micro Finance. (Oct/Nov
2020, Q.no-3a)
Microfinance is a category of financial credit targeted to the small business entrepreneurs those are unable to get bank loans and other sources of finance due to lack of financial back ground or high risk. This loan is often for small amount and should be repaid in six months to a year.
2. Crowd funding
Here entrepreneurs practice of
funding a business project or venture by raising money from a large number of
people who each contribute relatively a very small amount. Entrepreneurs invite
the public through internet or media to invest the money in their business
idea.
FACTORS TO BE CONSIDERED
BEFORE SELECTING THE CHOICE OF FINANCE (Mar 2020 Q.No-2c) (Mar 2021 Q.No-1d) (May/Jun 2015, Q.No.4b)
1. Purpose of business
Different
methods of finance can be selected based on the purpose of business, if
business needs money for long term purposes it can prefer long term sources and
vice versa. for example, for the purchase of a fixed asset, the source should be
long term.
2. Size and legal form of
business
Companies, especially public limited
companies, have greater choice of sources of finance. Issuing shares or
debentures is not an option for sole traders and partnerships. These
businesses, if they wish to expand, may have to depend on the retained profit
or bank loans.
3. Risk
Depending on risk of business or
project the amount allowed may increase or decrease. Normally banks prefer to
fund lower risk projects.
4. Duration of repayment
Business may get large amount
depending on the length of repayment selection. Large amount will not be
repayable in short period of time. But business needs to pay higher rate of
interest for long term debts.
5. Existing loans or
liabilities
Each and every business must disclose
the current liabilities with the lenders or bankers for further loans. Without
the settlement of previous or existing loans, most of the banks reject further
loans.
6. Cost of finance- Interest
The rate of interest is the main factor
to be considered when borrowing money. Different organizations charge different
rate of interest at variable or fixed rate. Interest burden increases if the
term of credit increase.
Unit
5.2
CASH-FLOW
FORECASTING AND WORKING CAPITAL
Cash-flow
Management
Cash is a liquid asset. The term cash is
not the same as profit. Cash flow management is the efficient tracking and management
of cash inflows and out flows for ensuring smooth running of business.
Cash Inflow- Sources
1. By the sale of goods for cash
2. By payments made by debtors (debtors
are customers who have already purchased goods from the business but did not
pay for them at the time.)
3. By borrowing money from external sources
4. By the sale of assets of the business,
for example unwanted property.
5. From investors, Shareholders in the
case of companies putting more money into the business.
Cash Outflow- Sources
1. By purchasing goods or materials for
cash
2. By the payment of wages, salaries and
other expenses in cash.
3. By purchasing fixed assets.
4. By repaying loans.
5. By paying creditors of the business.
CASH-FLOW FORECAST. (Oct/Nov-2020,
Q.No.3b) (Oct/Nov-2018 Q.No 4b) (May/June 2018 Q.No-2a) (Mar-2021
Q.No-3a)
Cash-flow forecast is an estimate of the
future cash inflows and cash outflows on monthly basis.
Analysis of cash flow forecast
(May/June 2018 Q.No-2b) (Mar
2018. Q no.1(b)(i) P-2) (Mar 2017
Q.No-2b)
|
|
January |
February |
March |
|
Cash
inflow |
|
|
|
|
Receipts |
10 |
15 |
18 |
|
Total
inflow |
10 |
15 |
18 |
|
Cash
outflows |
|
|
|
|
Payments |
7 |
27 |
12 |
|
Total
outflows |
7 |
27 |
12 |
|
Net cash flow |
3 |
(-12) |
6 |
|
Opening Balance |
5 |
8 |
(-4) |
|
Closing Balance |
8 |
(-4) |
2 |
Opening balance is the amount of cash held by a business at the beginning of the month or trading period. (May/June 2021 Q.No2.a)
Closing
balance
in the cash flow forecast shows how much cash the business expects to have at
the end of each month. If closing balance shows negative balance, it means the
business will have shortage of cash.
|
|
January |
February |
March |
|
Cash
inflow |
|
|
|
|
Receipts |
10 |
15 |
18 |
|
Total
inflow |
10 |
15 |
18 |
|
Cash
outflows |
|
|
|
|
Payments |
7 |
11 |
28 |
|
Total
outflows |
7 |
11 |
28 |
|
Net cash flow |
3 |
4 |
(-10) |
|
Opening Balance |
5 |
8 |
12 |
|
Closing Balance |
8 |
12 |
2 |
Here the business takes action to prevent the shortage by reducing the cash payments in the month of February-(16) to manage the cash.
Importance
of cash flow forecasting (May/June 2018 Q.No.4a P-2) (May/June 2021 Q.No.3a
P-2) (May/June 2023
Q.No3a P-2)
1. It
helps to know how much cash is flowing into the business and how much cash is
flowing out of the business.
2. It
helps to ensure the availability of cash in business for day to day expenses
3. It helps to make financial budget for
future projects.
4. It
helps to gain a bank loan by showing the cash flow forecast to the bank.
5. It
helps to assessing how well the business is being managed by comparing the cash
flow forecast with the actual cash flow.
6. It helps to identify where costs could
be reduced.
7. It helps to assess whether the business
is holding too much cash which could be put to better use
Reasons
for the cash flow problems (Shortage of working capital) (Oct/Nov 2020.
Q.No-3c)
1.
Lack of demand for the goods due to fashion changes or other reasons
2.
Poor cash flow management or not prepared a cash flow forecast systematically
3.
Unable to get a bank loan or overdraft in time.
4.
Increased credit sales so difficult to get cash in time.
5.
Difficult to get credit purchases or suppliers demand immediate payment.
6.
Increase in fixed or variable costs.
7.
Holding too much stock results more capital is tied up until the stocks are
sold off.
8.
Expansion of business by large investments.
9. Unexpected production or supply delay due to machine breakdown or loss of key employees.
Measures to improve cash inflow (Working capital) in
business (Mar
2020 Q.No-2e) (Oct/Nov 2019 Q.No-4a P-2) (May/June 2018 Q.No2e) (Mar 2017 Q.No-2d) (Mar-2021
Q.No-3d) (March
2022 Q.No.4b P-2)
1. Ask debtors
to pay quickly by offering discounts
2. Negotiate
with suppliers to extend the credit period
3. Delay the
purchase of non-current assets until the cash flow improves
4. Find other
sources of finance to purchase non-current assets. Eg- OD, HP, Leasing, etc.
5. Sell or lease
back the
unwanted fixed assets if no longer using.
6. Take overdraft
from the bank
7. Debt
factoring- business can sell the trade receivables at discounted rate
WORKING CAPITAL (May/June 2016 Q.No-3b)
Working capital measures the
liquidity of a business. Liquidity is the ability of business to pay its
short-term debts. Working capital includes the money kept in the business to
pay for day-to-day expenses. Working capital also known as net current assets.
Working
capital = Total Current assets- Total current liabilities.
Working Capital cycle
The
working capital cycle shows how the money is being circulated inside the business.
Cash is used to buy raw materials, then it is used to make finished goods,
these finished goods are sold again to collect cash.
Advantages
of sufficient working capital. (Mar-2020 Q.No-3a P-2). (May/June 2016 Q.No-3c) (Oct/Nov 2022 Q.No-2c) (May/June
2023 Q.No4c)
1. It helps to pay to
the creditors in time and enable the business to avail cash discounts.
2. It helps to buy
seasonal goods bulkily by ensuring enough capital in business.
3. It helps to maintain
the creditworthiness of the business by paying to the creditors in time.
4. It helps to meet the
daily expenses like wages, salaries, interest, rent, etc.
5. It ensures the liquidity of capital which enable the continuity of production and the smooth running of business.
Disadvantages
of shortage of working capital
1. It affects the
smooth running of the business due to unable to buy raw materials or
inventories in time.
2. It may lose the
creditworthiness of the business due to clash with the creditors
3. It may lead to the
refusal of the overdraft and loan from the banks.
4. It may lose the cash discounts which can be available by paying in time to creditors.
FACTORS
AFFECTING THE LENGTH OF WORKING CAPITAL
1.
Levels of inventories held by the business.
If
business holds more stocks, it may take long time to sell off the goods so
consequently the business may face shortage of working capital.
2.
Time required for producing goods
If
the firm takes long time to finish the production process, this results to the
longer holding of resources so the business cannot offer the finished goods to
the market.
3.
Distribution channels
The
length of distribution channels with more middlemen causes delay in supply of
goods in the market. It results the shortage of working capital.
4.
Length of credit period
If the debtors take long period to repay the money, the business may face shortage of capital to continue the production process with further resources.
Unit 5.3
INCOME STATEMENTS
What
is profit? (May/June
-2020 Q.No-4a).
Profit is the difference between revenue and costs.
It is the return on entrepreneurship. Profit is not cash
IMPORTANCE
OF PROFIT (Oct/Nov-2015 Q.No1c).
1.
Profit measures the success of a
business so it is the basis of business survival
2. Profit is the reward for risk taking by investors
or shareholders
3. Profit measures the performance of managers
5. Higher profit attracts the new investors into the
business
6. Source of internal funds for emergency- Reserve as retained profit
Types
of profit (Oct/Nov
2021 Q.No-3b)
1.
Gross profit
GP
is the difference between the revenue earned from selling goods and the cost of
making those products.
GP=
Sales(Revenue)- Cost of sales
2.
Net Profit
NP
is the difference between Gross profit and expenses.
NP=
GP - Expenses
3.
Retained profit
This is the amount of money kept in the business
from the profit after the owners have taken their share of the profits. It is
often called ploughed back profit.
How
profit is made?
A business earns profit by selling its products at a
price higher than the total cost of making and supplying those products.
Profit
= Revenue – Total costs
What
is revenue?
(Oct/Nov 2022 Q.No-2a)
The
total amount of money a business gets from selling its products is known as
revenue.
Revenue
= Selling price x quantity sold
Importance
of revenue (Oct-2019 Q.No2c)
1. Revenue is necessary to pay the day to day expenses
of business.
2. It helps to measure of success/size of business
against increased competition
3. It is necessary to generate profit in business-
Revenue – expenses = Profit.
4. It helps to maintain funds in business so business can gain loan from bank- Sales statement
Total
cost
Total costs of a business can be divided into two- Cost of sales and Expenses
Cost
of sales
The
amount paid for purchasing the raw materials for producing finished product.
Eg:-Raw materials.
What
is expense?
The
business spend money for day-to-day operations is known as expenses.
Eg:- fuel, power, phone bill, etc.
Difference between Profit and Cash (March 2022 Q.No-3c)
1. Money invested or borrowed in business increases
the cash but does not increase the profit.
2. Capital expenditure such as buying machinery,
decreases cash but does not decrease profit.
3. Credit sales would increase profits but does not
increase cash until the debtors pay back.
4. Cash is used for day-to-day operation but profit represents
long-term success of the business.
INCOME STATEMENTS
An income statement is a financial record of
business revenue, costs and profit. It must be produced at least once a year by
all the businesses.
Features of an
income statement (May
2020 Q.No-2c)
An income statement must show the following contents
1. Revenue or total sales value
2. Cost of sales or cost of goods sold
3. Gross Profit
4. Net Profit (for the year)
5. Retained Profit
6. Expenses
USES
OF INCOME STATEMENTS
The purpose of income statement is to show the
actual profit for a particular period of time.
How stakeholders use the income
statements? (Feb/Mar 2023 Q.No-2d)
1.
Owners- Profit after tax
shows how much they have earned from their investment.
2.
Shareholders- To know the
return- dividend and the value of shares in the market.
3.
Employees- High profit in
business ensures job security and higher wages and salary
4.
Lenders- To know the
capacity of business to repay the credit amount
5.
Government- To know the tax
amount
6.
Suppliers- To know the status
of business to supply goods more
7. Managers- To compare the growth of business and to ensure retained profit for future purposes.
FINAL ACCOUNTS
Accounts
are records of a firm's financial transactions that are kept up
to date by the accountants.
Why accounts are necessary?
1. Accounts are proof of transactions.
2. It helps to analyse the cost of operations
3. It helps to estimate profit or losses of the
business
4. It helps to assess government tax
5. It helps to identify the assets and liabilities of the business
What
do final accounts contain?
The
Trading Account
This account shows how
the gross profit of a business is calculated. Obviously, it will
contain this formula:
“Gross profit = sales revenue – cost of
goods sold”
The
Profit and Loss account
The profit and loss account show
how net profit is calculated.
Net
profit = Gross profit - Expenses
Depreciation
Depreciation is the fall in value of a fixed asset over time. It is also counted as an indirect cost to businesses.
BALANCE
SHEET (Oct/Nov-2015 Q.No2b).
The balance sheet shows assets,
liabilities and capital of a business at a particular time. The balance sheet
records the value of a business at the end of the financial
year.
1. Current assets(May/June 2023 Q.No4b)
Resources
used for less than one year is knows as current assets. Eg:- stocks/ inventory,
cash and debtors, etc.
2. Non-current /Fixed assets. (Oct/Nov2017 Q.No-3b) (Mar 2016, Q.No.2a)
(May/June 2022 Q.No-1b)
Resources
owned by the business to use for more than one year. Eg:- Land, vehicles,
and buildings those are likely to be with the business for more than one year.
3. Non-current liabilities: (May/June
2016 Q.No-3a)
Long-term borrowings
that does not have to be paid in one year. Eg:- Mortgage, Bank loans, etc.
4. Short-term liabilities (Current
liabilities) (May/June 2022 Q.No-1a)
Short-term borrowings
that have to be paid in less than one year. Eg: Overdraft, trade payables,
short term loans, etc.
If the total assets are higher than the total liabilities, then the business is said to own wealth. In a normal business, wealth belongs to the owners, while in a limited company, it belongs to the shareholders.
Unit 5.4
STATEMENT OF FINANCIAL POSITION
What
is statement of financial position? (Oct/Nov 2022 Q. No-1b)
An accounting statement that shows the assets, liabilities, and owners’ equity/capital of a business at a particular date of time.
Importance of statement of financial position
1. It shows the
record of assets and liabilities of the business.
2. It shows what
the business is owed
3. It shows what
the business owes
4. It shows how a
business finances its operations
5. It is mandatory to the limited companies to produce a statement of financial positions at the end of each year
Forms of a financial statement (May/June 2017
Q.No.1a P-2)
1.
Income statement/Profit and loss account.
It helps to assess gross profit/ gross loss and Net profit/ net loss of the
business
2. Balance sheet/Statement of
financial position. It helps to assess liquidity
position/ assets for security against loan/liabilities.
3.cash flow forecast/statement. It helps to show cash position/ability to cover expenses of expansion/liquidity position of the business.
Assets
Assets are the resources which as
business owns. Assets are of two types,
Fixed assets (Non-current assets)
These are resources that a business
owns and expect to use for a period of more than one year.
Eg:- Land and buildings, Machinery,
Vehicles, Computers, etc
Current assets
Current assets are cash or any other
resources owned by the business which can be converted into cash within one
year.
Eg:- Cash, inventories, trade
receivables(debtors),
Liabilities
Liabilities are the amount owed by the business to stakeholders such as suppliers and lenders. Liabilities are of following,
Current liabilities
These are short term debts of
business which are payable in one year.
Eg:- Trade payables(Creditors), Bank
overdraft, taxation, dividends, etc.
Non-current (long term) liabilities
These are long term debts of business which are payable in more than one year. Eg:- Long term bank loans, Debentures, Mortgages, etc.
What is limited liability? (Mar-2021 Q.No-1a)
The liability of the shareholders of a limited company is limited to the amount of their investment if the company makes loss or winds up.
|
Items |
Fixed assets |
Current Assets |
Current liabilities |
Non-Current liabilities |
Owner’s equity |
|
Inventories |
|
Yes |
|
|
|
|
Bank loan |
|
|
|
Yes |
|
|
Share capital |
|
|
|
|
Yes |
|
Machinery |
Yes |
|
|
|
|
|
OD |
|
|
Yes |
|
|
|
Trade receivables |
|
Yes |
|
|
|
|
Retained profit |
|
|
|
|
Yes |
|
Premises |
Yes |
|
|
|
|
|
Trade payables |
|
|
Yes |
|
|
|
Debenture |
|
|
|
Yes |
|
What is equity capital?
Equity capital is the Invested money
that, in contrast to debt capital, is not repaid to the investors in the normal
course of business. It represents the risk capital staked by the owners through
purchase of a company's ordinary shares.
On
the balance sheet of the company, equity capital is listed as stockholders'
equity or owners' equity. Also called equity financing or share capital.
Example of Statement of Financial Position/Balance
Sheet
|
Items |
Amount |
Amount |
Amount |
|
Non-current Assets |
|
|
|
|
Land and buildings |
30 |
|
|
|
Machinery |
60 |
|
|
|
Motor vehicles |
10 |
|
|
|
|
|
|
100 |
|
Current Assets |
|
|
|
|
Inventories |
15 |
|
|
|
Trade receivables |
30 |
|
|
|
Cash and bank balances |
5 |
|
|
|
|
|
50 |
|
|
Less |
|
|
|
|
Current liabilities |
|
|
|
|
Trade payables |
16 |
|
|
|
Taxation |
9 |
|
|
|
Dividends |
5 |
|
|
|
|
|
30 |
|
|
Net current Assets (W.C) |
|
|
20 |
|
Net Assets |
|
|
120 |
|
|
|
|
|
|
|
|
|
|
|
Shareholder’s equity |
|
|
|
|
Share capital |
40 |
|
|
|
Retained Profit |
50 |
|
90 |
|
|
|
|
|
|
Non-current Liabilities |
|
|
|
|
Bank loan |
|
|
30 |
|
Capital
Employed |
|
|
120 |
Unit 5.5
ANALYSIS OF ACCOUNTS
Ratio
Analysis
Ratio analysis helps to compare the performance of business at different
periods of time. It shows the growth trend of business from time to time.
Measuring business performance
The
performance of business can be measured through the profitability and liquidity
of business.
IMPORTANCE
OF RATIO ANALYSIS.
1. It helps to make judgement on business
results
2. It allows performance comparisons with
previous years.
3. It helps the business to compare the
performance with similar business
4. It helps to identify the business
performance trends upward or downward.
5. It helps the business to take competition measures in the market
PROFITABILITY
RATIOS (Oct/Nov
2020 Q.No-4a P-2) (Oct/Nov 2017 Q.No-4b.P-2) (Mar 2017 Q.No-3b.P-2)
(May/June 2016 Q.No-3b P-2) (Oct/Nov
2021 Q.No-3c)
Profit maximization is the main objective of private sector business so,
profitability indicates how well a business is performing when comparing with
similar business. Profitability ratios are,
1.
Gross Profit Margin
2.
Net Profit Margin
3. Return on capital employed
1. Gross
Profit Margin (March
2022 Q.No-3b)
GP Margin in % = GP / Revenue x 100
How to
improve GP Margin?
1. Increase sales but maintain cost of sales
2. Increase price of goods
3. Reduce cost of sales by purchasing
materials from cheaper sources
2. NP
Margin (Profit Margin)
(Oct/Nov 2022 Q.No-2b)
Net Profit Margin in % = NP /
Revenue x 100
Net Profit = Revenue – (Cost of
sales + Expenses)
How to
improve NP Margin?
1. Improve GP margin
2. Reduce expenses such as wages salaries, etc.
Analysis
of GP and NP margin
Gross Profit Margin measures how much value added by the business on the products. Net Profit Margin measures how well the business controls the expenses.
3. Return
on Capital Employed (ROCE) (Oct/Nov 2020 Q.No4b)
(May/June 2017 Q.No-2(c)(i))
Return
on capital employed ratio indicates the percentage of profit earned before tax on
capital invested. It shows how much profit earned for investment.
ROCE = Profit x 100
Capital Employed
Capital
Employed (Oct/Nov
2019 Q.No-4b)
It is the amount invested by the owners such as sole traders, partners
and shareholders in business. Any long-term borrowing such as debenture should
be included as capital employed and the money used to purchase buildings and
machinery too.
Capital employed = Capital
on the closing date = (Total assets - Total liabilities)
In the case a
limited company, it is the total of the shareholders’ funds.
How to
improve ROCE
1.
Reduce the quantity of capital tied in the business.
2. Get capital with lower rate of interest or return.
LIQUIDITY RATIOS (SOLVENCY RATIOS) (Oct/Nov 2020 Q.No-4a P-2) (May/June 2017 Q.No-2a.) (Oct/Nov-2015 Q.No2e) (Oct/Nov 2021 Q.No-3c)
Liquidity
The term liquidity refers to the ability of a business to repay its short-term debts. Liquid assets are cash or any assets that can be turned into cash quickly.
Importance of liquidity (May/June
2022 Q.No-1c.)
To make sure the business has access to
enough cash to pay day-today expenses.
To settle the short-term debts in time and
to maintain healthy relationship with suppliers.
It helps to ensure business survival by
keeping working capital.
It helps to meet unexpected (unforeseen) costs during operation.
Liquidity ratios
1. Current Ratio
(Working Capital Ratio)
2. Acid test Ratio (Quick Ratio)
1. Current Ratio. (Mar 2018 Q.No-2b) (Oct/Nov 2017 Q.No.3(c)(i))
This ratio compares the current assets with the
current liabilities in the business.
Current Ratio = Current assets
Current liabilities
All the business
should maintain the level of current assets above the current liabilities,
otherwise the business may face working capital shortage to meet the short-term
expenses.
A
ratio of 2:1 is considered to be a good standard, but it may vary depending
upon the nature of the business and other organizations in the same line of
business.
2. Acid test Ratio (Quick Ratio) (Mar 2016, Q.No.2b) (Feb/Mar
2023 Q.No-2b)
This ratio compares
liquid assets with current labilities in the business. This ratio shows the
solvency of a business with sufficient liquid resources to meet its current
liabilities.
To calculate this ratio, closing stock should be
removed from the current assets where the stocks are not likely to be sold very
quickly.
Acid test ratio = Current
assets – Closing stock
Current liabilities
The standard for this ratio is 1:1, a lower ratio indicating insolvency of the business which is the risk of the business not having cash to pay its short-term liabilities.
Limitations
of Using Accounting Ratios
1. Only past events expressed in terms of
money alone can be analyzed.
2. Different accounting methods give
different results that cannot not be compared.
3. No allowance is made for inflation, which
makes comparison of results between different periods meaningless.
4. Other non-monetary and non-financial
factors are ignored (eg: staff relations, efficiency of the management,
business location, environmental conditions etc...)
5. Only similar items can be compared (similar sized businesses, different periods for the same business, Plans and budgets.
USES OF ACCOUNTS (Mar 2016, Q.No.2d)
Both internal and external stakeholders have interest on business so
they all use the accounts for different purposes.
1. Owners/
Shareholders
To
know the rate of return on investment- dividend or part of profit
To
compare the profit with previous years and with similar business- Growth status
To
ensure the safety on investment
2. Investors/Debenture
holders
To
know the expected rate of return
To
be free from risk of bad debt
3. Managers
To
ensure the smooth running of business or survival
To
compare the cost and revenue from previous years
To
ensure retained profit as reserve
4. Employees
To
ensure the job safety by expecting fair return.
To ensure higher wages or salary
5. Suppliers
To
provide goods on credit by ensuring timely repayment
To
know the liquidity of the business
To
ensure good relationship with the business
6. Lenders
To
ensure the timely return of capital
To
know the creditworthiness of the business
To
lend further amount for the business
7. Government
To
ensure revenue in the form of tax
To
ensure the growth of business for promoting employment
8. Customers
To get quality goods and services so the business may provide better services due to higher the profit.
General
uses of financial accounts (Oct/Nov- 2019. Q.No-4.c)
1. It helps
to measure the financial performance of a business for a particular period of
time.
2. It helps
to compare the performance of business with its competitors.
3. It helps
to decide which source of finance to use or whether to borrow money.
4. It helps
to make investment decisions.
5. It helps
to decide how much dividend/profit to pay to the shareholders or owners.
6. It helps
to trace and control the expenses to improve profit.
7. It helps
to assess the tax and rates payable to the government.
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