Premlal C R
Unit
5.1
BUSINESS
FINANCE
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)
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 firm’s working 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.
WORKING
CAPITAL (May/June
2016 Q.No-3b)(Oct/Nov 2023 Q.No1a) (Feb/March 2025 Q.No.3a)
The finance needed by a business to pay its
day-to-day costs/pay short-term debts is known as working capital. Working capital helps to measure the
liquidity of a business.
Working capital =Total current assets- Total
current liabilities
Liquidity
Liquidity is the ability of business to pay its
short-term debts. It indicates the availability of net current assets in the
business.
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.
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) (Oct/Nov 2023.Q.No.3e) (Oct/Nov 2024.Q.No.1c) (Feb/March 2025 Q.No.1d)
1. SHORT TERM AND LONG-TERM FINANCES
If the money is invested
in the business for long term purposes (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 (less than one year) it can be
considered as short-term finances- Eg:- Paying wages, buying supplies, etc.
2. INTERNAL AND EXTERNAL 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 (Feb/Mar
2019 Q.No-4b P-2)
(May/June 2023 Q.No4a) (Feb/Mar-2024 Q.No-4a. P-2)
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) (May/June 2025 Q.No.3e)
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 loan.
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 (Oct/Nov 2023 Q.No.1d)
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) (Feb/Mar
2021 Q.No-1d) (May/Jun 2015, Q.No.4b)
(Feb/March 2024 Q.No 3b)
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.
7.
Credit history or score.
Credit
history is a record of how individuals manage their debt, including loans and
credit cards. It's documented in a credit report, which lenders use to
assess an individual's creditworthiness.
Unit 5.2
CASH-FLOW FORECAST
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 (Feb/March 2024 Q.No 3a) (Feb/Mar 2025 Q.No.4a P-2)
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 non-current assets of the business, for example unwanted
property.
5.
Funds from investors, shareholders.
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) (Feb/Mar-2024 Q.No-3e)
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- Working capital
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 know the liquidity of business- ability to repay the short-term
debts.
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
Unit 5.3
PROFIT AND LOSS
What is profit? (May/June -2020 Q.No-4a). (May/June 2025 Q.No.2a)
Profit is the difference between revenue and costs.
It is the return on entrepreneurship. Profit is not cash
IMPORTANCE OF PROFIT
(Oct/Nov-2015Q.No1c)
(Oct/Nov 2023 Q.No.4c)
(May/June 2024 Q.No.3a P.2)
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 Goods Sold
CGS represents
the direct costs of producing
or purchasing the goods that were actually sold during a period. Eg:- Raw
materials, carriage inwards, etc.
CGS
= Opening inventory + (Purchases+ carriage inwards) – closing inventory
What is expense? (May/June
2025 Q.No.2b)
The amount spend for day-to-day
operations of a business is known as expenses. These are indirect costs.
Eg:-
Fuel, rent, rates, insurance, warehouse, salary, repair, power, phone bill,
utilities, 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. Managers- To compare the growth of business and to ensure
retained profit for future purposes.
What do final accounts
contain?
1. The Trading Account
This account shows how the gross profit of a
business is calculated. Obviously, it will contain this formula:
Gross
Profit / Loss = Sales revenue – Cost of goods sold
2. The Profit and Loss account
The profit and loss account show how net
profit is calculated.
Net profit = Gross
profit + Incomes - Expenses
3. Statement of Financial
position (Balance Sheet)
It shows the assets, liabilities and capital of a
business at a particular time. The balance sheet helps to record the value of
a business at the end of the financial year.
Assets = Capital + Liabilities
Unit 5.4
STATEMENT OF FINANCIAL
POSITION
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.
What is Statement of Financial Position?
(Balance Sheet) (Oct/Nov 2022 Q. No-1b) (Oct/Nov-2015 Q.No.2b)
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 (Balance Sheet)
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
Main sections of a Statement
of Financial Position
1. Current assets (May/June 2023 Q.No4b) (Oct/Nov2024 Q.No-3c)
Resources
owned by the business for the purpose of using less than one year is known as
current assets. Eg:- stocks/ inventory, cash and debtors, etc.
2. Non-current assets
(Fixed assets. (Oct/Nov2017
Q.No-3b) (Mar 2016, Q.No.2a)
(May/June 2022 Q.No-1b) (Oct/Nov2024 Q.No-3a)
Resources
owned by the business to use for more than one year. Eg:- Land, vehicles,
machinery, buildings, etc. 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 do not have to be paid in one year. Eg:- Mortgage, Bank loans,
etc.
4. Current liabilities
(Short-term liabilities)
(May/June 2022 Q.No-1a) (Oct/Nov2024 Q.No-3c)
Short-term
borrowings that have to be repaid in less than one year. Eg: Overdraft, trade
payables, short term loans, etc.
5. Owner’s equity/Shareholders equity/ Equity
capital
It
is the money invested in the business by the owners. This includes money
brought into the business by the owners plus retained profits.
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 |
|
Examples of balance sheet items
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 (Feb/March 2022 Q.No-3b) (Feb/March
2025 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? (May/June 2024 Q.No.2c)
1.
Increase sales
2.
Improve GP margin
3.
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)) (May/June
2024 Q.No.2b)
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 /Capital
employed)x 100
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/Working capital ratio. (Mar 2018 Q.No-2b) (Oct/Nov 2017
Q.No.3(c)(i))
(Oct/Nov2024 Q.No-3b)
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) (Oct/Nov 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.
Quick ratio/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.
USERS OF ACCOUNTS (Mar
2016, Q.No.2d) (Oct/Nov 2023.Q.No 2d) (May/June 2024 Q.No.2e)
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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