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Profitability
UNIT 4 CH 18
| Question | Answer |
|---|---|
| relationship between analysing and interpreting accounting reports: | Analysing: examining reports in great detail to identify changes/differences in performance _ Interpreting: involves examining relationships between items in reports ito explain the cause and effect of those changes or differences. |
| Profitability: | ability of the business to earn profit, measured by comparing its profit against a base, such as sales, A or OE |
| liquidity: | ability of the business to meet its short-term debts as they fall due |
| ability of the business to meet its short-term debts as they fall due efficiency: | ability of the business to manage its A + L |
| Stability: | ability of the business to meet its debts + continue its operations in the long term. |
| 2 basic factors on which the ability to earn a profit is dependent. | earn R and control E |
| How can profitability can be assessed between different firms. | Cannot be compared on basis of profit alone to indicate profitability, but profit expressed relative to another measure: A,L,OE allows for comparisons between firms + different RP |
| Trend: | the pattern formed by changes in an item over a number of periods |
| Benchmark: | an acceptable standard against which the firm’s actual performance can be assessed |
| variance: | the difference between an actual figure, and a budgeted figure, usually expressed as ‘favourable’ or ‘unfavourable’ |
| profitability indicator: | measures that express an element of profit in relation to some other aspect of business performance. |
| How can trends can be used to assess profitability. | By analysing IS of firm, changes in R + E can be identified over different RPs. Horizontal analysis: enhance the analysis of the trend in R + E by expressing the changes in $ and % terms so that relative size of changes can be assessed. |
| How variance report can be used to assess profitability. | It highlights difference between actual and budgeted figures,: problem areas can be identified and addressed. Draw attention to areas in which performance has been below expectation. |
| 3 benchmarks that can be used to assess profitability. | Performance in previous periods __ Budgeted performance for the current year ___ Performance of other similar firms |
| Why Performance in previous periods: | Allows for preparation of a horizontal analysis and identification of trends. Using this benchmark enables an assessment of whether profitability has improved or worsened form one period to the next. |
| Why Budgeted performance for the current year: | This allows for the preparation of a variance report, enables assessment of whether profitability was satisfactory or unsatisfactory in terms of meeting the firm’s goals/expectations. |
| Why Performance of other similar firms: | Sometimes expressed as an ‘industry average’. It allows the firm’s performance to be compared against other firms operating under similar conditions. aka ‘inter-firm’ comparison. |
| 5 indicators that can be used to assess profitability. | ROI, ROA, ATO, NPM, GPM |
| What is measured by ‘Return on Owner’s Investment’ (ROI). | profitability indicator that measures how effectively a business has used the owner’s capital to earn profit. |
| ROI formula: | ROI = NP/Av Capital x 100 |
| Why the formula to calculate Return on Owner’s Investment uses Average Capital. | so any increases or decreases in Capital over the year are accounted for. |
| 3 benchmarks used to assess the adequacy of the ROI | ROI from previous periods __ the budgeted ROI __ ROIon similar businesses/alternative investments |
| Significance of the ‘return on similar investments’ as a benchmark for assessing the ROI | Cuz owner has given up the opportunity to invest his $ in alternative investments in order to invest in his own business. Therefore, he has forgone the return that might have been earned elsewhere and this should be compared to the ROI of the business. |
| Examples of similar investments: | property, shares, term deposit, financial products |
| How can ROI can increase even though profit has decreased. | ROI can still increase if the Av Capital decreases by proportionately more than the decrease in NP (due to excessive drawings). |
| What is measured by the Debt Ratio. | stability indicator that measures the % of a firm’s A that are financed by L. |
| DR ratio: | DR = Total L/Total A x 100 |
| Significance of ‘similar firms’ in assessing the Debt Ratio. | particularly useful as a comparison for assessment because they operate in the same industry, using similar A and selling similar products. |
| Why high Debt Ratio means high risk of financial collapse. | High DR= significant proportion of A financed by L > higher risk that the business = unable to repay its debts + meet interest payments. + interest rate rises could have a significant impact on profit + cash as the business is carrying so much debt. |
| Why a high Debt Ratio is likely to result in a high ROI | A high Debt Ratio= firm is more heavily reliant on borrowed funds than it is on the owner’s capital > lead to a higher ROI. Firm is using someone else’s funds to buy the A to earn profit, but the owner still receives all that profit. |
| What is measured by Return on Assets (ROA). | profitability indicator that measures how effectively a business has used its assets to earn profit. |
| ROA formula: | ROA= NP/Av Total A x 100 |
| 3 benchmarks that could be used to assess the adequacy of the ROA: | ROA of a similar business __ ROA from previous periods __ Budgeted ROA |
| Explain why ROI will always be higher than ROA | Because OE will always be lower than total A, due to its L. Thus, the ROI has a smaller base on which to compare profit. |
| 2 factors that could cause an increase in the ROA | change in RP __ change in Av Total A |
| What is measured by Asset Turnover (ATO). | efficiency indicator that measures how productively a business has used its A to earn R. |
| ATO formula: | ATO = Sales/Av Total A |
| 3 benchmarks that could be used to assess the adequacy of a firm’s Asset Turnover. | ATO of a similar business __ ATO from previous periods __ Budgeted ATO |
| Explain how the relationship between a firm’s ATO and its ROA can be used to assess its E control. | Both assess firm’s ability to use its A; difference: ROA relates to profit __ ATO relates only to R. Where ATO + ROA move in different directions (e.g ATO increases, while ROA decrease), or to differing degrees, it indicates a change in E control. |
| E control: | firm’s ability to manage its E so that they either decrease or, in the case of variable E, increase no faster than sales R. |
| 2 reasons why the owner of a small business will tolerate increases in some E. | Some E e.g COS + Wages vary directly with lvl of sales, as sales volume increases, these E will increase too __ As long as E increase in line with sales or does not increase more than sales, owner will tolerate increases in some E. |
| 2 profitability indicators that assess expense control. | NPM + GPM |
| What is measured by the Net Profit Margin (NPM). | profitability indicator that measures E control by calculating the % of sales R that is retained as NP |
| NPM formula: | NPM = NP/Sales R x 100 |
| Relationship between ATO, NPM + ROA: | ROA highlights ability of firm to use its A to earn NP, dependent on ability to earn R + control E. ATO measures ability of firm to use its A to earn R + NPM measures ability of firm to control its E + retain sales R as NP, then ROA depends on ATO + NPM |
| What is measured by the Gross Profit Margin (GPM). | profitability indicator that measures the av mark-up by calculating the % of sales R that is retained as GP |
| GPM formula: | GPM= Gross Profit/Sales R x 100 |
| 2 ways a business could increase its average mark-up. | increasing sp __ decreasing cp (by finding a cheaper supplier) |
| How an increase in mark-up could lead to a decrease in GP | Increasing SP will increase the av mark-up, but carries the risk of lowering demand, > reducing volume of sales. Business may make more GPper item, but make fewer actual sales. If drop in sales outweighs the increase in profit per item, GP falls |
| Explain what is shown in a vertical analysis of the IS | A report that expresses every item as a % of a base figure; in this case, sales R. |
| 1 benefit of preparing a vertical analysis as a pie chart. | Ensures Understandability in the acc reports, so that non-accountants can view the graphical representation of vertical analysis in a way they can comprehend. |
| 4 limitations of relying solely on the IS and profitability indicators to evaluate profitability. | The reports use historical data (no future guarantee)__ Many indicators rely on averages (conceals individual items details) __ Firms use different accounting methods (undermines comparability)_ The IS contain limited info |
| non-financial information: | any info that cannot be found in the financial statements, and is not expressed in dollars and cents, or reliant on dollars and cents for its calculation. |
| 6 measures that could be used to assess the firm’s relationship with its customers: | customer satisfaction survey __ no of repeat sales __ no of sales returns __ no of customer complaints __ no of sales enquiries/catalogue requests __ degree of brand recognition *based on market research |
| 3 measures that could be used to assess the suitability of stock | – no of sales returns __ no of purchase returns __ no of customer complaints |
| 3 measures that could be used to assess the firm’s relationship with its employees | – performance appraisals __ no of days lost due to sick leave/industrial action __ staff turnover/av length of employment |
| 4 measures that could be used to assess the state of the economy | – interest rates __ unemployment rate __ no of competitors __ lvl of inflation. |
| 3 strategies that could be used to improve a firm’s ability to earn R. | Change sp __ strengthen marketing ploys:advertise __ stock mix __ NCA __ customer service |
| 3 strategies that could be used to improve a firm’s ability to control its E. | Management of stock, staff + NCA |
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