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Analysis of accounts

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i) Internal: workers would find this useful to see how profitable the business is and give them an indication of their job security and the chances of them gaining pay increases.

ii) External: shareholders would want to compare this year’s dividends with last year’s; assess how profitable the business is and its likely future prospects.

iii) External: the bank would want to check on the risks of the business not

being able to repay its loans (see liquidity ratios).

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One figure, if not compared with another one, gives no indication of relative size or improvement/worsening. Ratios allow for much more effective comparisons.

 Formula Ratio Net profit × 100 Return on capital employed Capital employed Gross profit × 100 Gross profit margin Sales revenue Net profit × 100 Net profit margin Sales revenue Current assets Current ratio Current liabilities Liquid assets (cash + debtors but not inventories) Acid test ratio Current liabilities
 4 This means that for every \$1 of capital invested in the business, the business is making 20 cents profit after tax (net profit) as a return on it. 5 A result of 0.75 means that only 75 per cent of any current (short-term) liabilities could be paid at the current time from existing current assets. 6
 2013 2012 Analysis/Comment Gross profit margin 13.3% 15% This means the business is making a smaller gross profit on each item sold – perhaps the cost of sales has risen or prices of the finished goods have been reduced. Management should find out which of these two things has occurred. Net profit margin 5.8% 9% This is a bigger fall than in gross profit margin – this means that the firm’s expenses or overheads have increased rapidly during 2013. Management needs to try to reduce expenses without damaging business efficiency. Return on capital employed 8.75% 12.86% This means the business is making substantially less net profit on each \$1 of capital employed. The business is less profitable in 2013 than it was in 2012. Management needs to take decisions to increase net profit next year.

Cambridge IGCSE Business Studies 4th edition Teacher’s CD © Hodder & Stoughton Ltd 2013

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25 analysis of accounts

 7 See comments on ratios given in question 6. 8
 2013 2012 Analysis/Comment Current ratio 0.73 0.8 Liquidity as measured by this ratio has fallen slightly – this could be a problem for management if it is a long-term trend. Acid test 0.33 0.4 This is now quite a low acid test ratio – once inventories have been taken out of the calculation. Perhaps the management should take steps to increase the acid test ratio – e.g. trying to sell inventories or other assets for cash.

9 See comments on ratios given in question 8.

10 The bank manager would ask for more than two years’ figures to see if the falls in profitability or liquidity were part of a long-term trend. If they are then P&K would be unlikely to receive the loan. It may also depend on whether P&K already has large bank loans, so more information is needed before the bank manager can take a final decision.

Activity 25.1

 a) 22.8% i) ii) 37.5% iii) 18.3%

b) Yes: the results for all three ratios are higher in 2013 than in 2012; the business

is making a higher profit on each item sold and is able to make a higher return on each \$1 invested.

Activity 25.2

a) Current ratio = 1.42; acid test ratio = 1

b) The liquidity of the business has fallen using both ratios. Current assets have fallen in value since 2012 and current liabilities have risen in value. The management should be worried if this is part of a longer-term trend as falling liquidity ratios suggest that the business might have problems in paying its short-term debts.

Activity 25.3

a) No, they should not be pleased, overall. Although GPM has increased both NPM and RoCE have fallen suggesting that the overhead expenses of the business have risen during the year. The most significant change has been to NPM which has fallen from 16 per cent to 12 per cent in one year.

b) By comparing these results with those of other hotels, the management can assess whether all hotels are experiencing similar trends. If, for example, other hotels have increased both GPM and NPM then the management of Gloria Hotels would be advised to look very carefully at the expenses of their business to see if these could be reduced without damaging the efficiency of the business.

Cambridge IGCSE Business Studies 4th edition Teacher’s CD © Hodder & Stoughton Ltd 2013

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25 analysis of accounts

c) Banks and creditors should be worried about the declining liquidity, especially the large reduction in the acid test ratio from 1.0 to 0.6. This could suggest that the business will have problems paying its short-term debts from cash and debtors (accounts payable) especially if the decline in acid test ratio is a long-term trend.

d) Increase profitability: the managers could increase prices of hotel bedrooms to try to increase both GPM and NPM but will guests go to other hotels instead? They could try to increase added value by rebranding the hotel as an upmarket hotel offering superior service or food but will the costs of the business rise more than any additional revenue? (Other answers possible.) Overall student recommendation needed.

e) Sell off assets no longer needed for cash, such as part of hotel garden BUT will this be sold for a good price and could the garden be useful in future, for example, for adding value to the hotel’s services? Pay off short-term debts (current liabilities) by taking out a long-term loan BUT this will increase the long-term interest payments of the business. Other answers possible. Overall student recommendation needed.

Sample answers to Paper 1 style questions (with mark annotations for Question 2)

 1 a) The total value of capital invested in the business (or the total value of assets used by the business). b) More units have been sold. i) ii) A higher price has been charged but the same (or similar) quantity sold. c) Higher prices have been charged for each can or processed meal sold by Triton but cost of sales remained the same. i) ii) Triton has used cheaper materials, such as cheaper meat to make its products, and this lowers cost of sales with prices remaining the same. d) Net profit can be increased either by increasing gross profit or by reducing overhead expenses. Triton could do this by employing lower cost labour to produce the food products to reduce the cost of sales and this would increase gross profit and net profit. i) ii) Triton could also increase net profit by reducing expenses, for example, salaries of managers or advertising for its food products. e) 2012 15.5%; 2013 12% Yes: gross profit has increased (but smaller gross profit margin) and return on capital employed is still quite high (but could be compared with similar companies). No: net profit has fallen even though sales revenue has risen. This suggests a big increase in overhead expenses. Return on capital is falling, so shareholders will not be impressed by this. Overall conclusion/judgement needed. 2 a) The ability of a business to pay for its short-term (current) debts or liabilities from current assets. [2K]

b) Customers who have not yet paid (two months’ credit offered) – debtors.

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Cash in tills to serve customers in shops. [2App]

c) Hi Fashion might be taking longer to pay their suppliers – creditors of the business. This is because the business might be short of liquidity as sales are falling. [1K; 1App]

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Hi Fashion might have been forced to increase its overdraft as sales are falling and it has offered customers two months’ credit. [1K; 1App]

Cambridge IGCSE Business Studies 4th edition Teacher’s CD © Hodder & Stoughton Ltd 2013

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25 analysis of accounts

d) i) Shareholders would want to see how much sales are falling and how this is likely to impact on the profits of the business (and future dividends). [1K; 1App; 1An] ii) Suppliers/creditors would want to check the liquidity of the business to see if, despite falling liquidity ratios, Hi Fashion are still able to pay their debts. [1K; 1App; 1An]

 2013 2012 Current ratio (CA/CL) 1.47 2 Acid test ratio (CA- Inventories/CL) 0.67 1.125

Liquidity is falling on both ratio measures – it has fallen a significant amount in one year. Although the liquidity position is not a crisis at present if it continues to worsen at this rate it soon will be. The bank is likely to be worried about the increase in inventories – can these be sold easily by Hi Fashion or will the company have to reduce prices to sell these clothes? Student’s overall conclusion. [1K; 1App; 2An] + [2Eval]

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Cambridge IGCSE Business Studies 4th edition Teacher’s CD © Hodder & Stoughton Ltd 2013

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