Statement of financial position: non-current assets + current assets − current liabilities − non-current liabilities = net assets = equity (share capital + retained earnings).
The full notes, worked example and check questions for this subtopic are in the app.
Exam tip: Learn the order of the profit and loss lines: half of the marks in account-construction questions are for the layout.
3.5Profitability and liquidity ratio analysis
Key terms
Gross profit margin (GPM)
Gross profit as a % of sales revenue.
Profit margin (PM)
Profit before interest and tax as a % of sales revenue.
ROCE
Return on capital employed: how well capital is used to make profit.
Current ratio
Current assets ÷ current liabilities: ability to pay short-term debts.
Acid-test ratio
Like the current ratio but excluding inventory.
A current ratio of about 1.5–2 is usually comfortable; an acid-test ratio below 1 may signal liquidity problems (but supermarkets operate well below 1).
The full notes, worked example, interactive diagram and check questions for this subtopic are in the app.
Exam tip: Give ratios with units (% for margins, “:1” or a number for liquidity) and always comment on what they show.
3.6Debt and efficiency ratio analysis HL
Key terms
Inventory turnover
How many times inventory is sold and replaced in a year.
Debtor days
Average time customers take to pay.
Creditor days
Average time the business takes to pay suppliers.
Gearing ratio
The % of capital employed that comes from long-term borrowing.
Gearing above about 50% is “highly geared”: risky if interest rates rise or profits fall, but it can boost returns for shareholders in good times.
The full notes, worked example and check questions for this subtopic are in the app.
Exam tip: State whether each ratio is good or bad for this type of business. A bakery and a car dealer need very different inventory turnover.
3.7Cash flow
Key terms
Cash flow
The movement of money into and out of a business.
Cash flow forecast
A prediction of future cash inflows, outflows and balances, usually month by month.
Working capital
Current assets − current liabilities: money available for day-to-day operations.
Working capital cycle
Time between paying for inputs and receiving cash from customers.
Causes of cash-flow problems: overtrading (growing too fast), giving too much credit, poor stock control, unexpected costs, seasonal demand.
The full notes, worked example, interactive diagram and check questions for this subtopic are in the app.
Exam tip: When suggesting a solution to a cash-flow problem, say how it fits the case and mention its drawback (e.g. factoring reduces revenue).
3.8Investment appraisal
Key terms
Investment appraisal
Methods to judge whether an investment is worth it.
Payback period
The time taken for net cash flows to repay the initial cost.
Average rate of return (ARR)
The average yearly profit as a % of the initial cost.
Net present value (NPV)
Total discounted future cash flows minus the initial cost (HL).
Payback: simple and focuses on risk and cash, but ignores returns after payback and the time value of money. Partial year: \(\frac{\text{amount still needed}}{\text{cash flow that year}}\times12\) months.
The full notes, worked example, interactive diagram and check questions for this subtopic are in the app.
Exam tip: Show the cumulative cash flow table for payback. It earns marks even if the final month calculation goes wrong.
3.9Budgets HL
Key terms
Budget
A financial plan for a future period (income and/or spending).
Cost centre
A part of the business where costs are recorded (e.g. a department).
Profit centre
A part of the business where both costs and revenues are recorded (e.g. a branch).
Variance
Actual figure − budgeted figure.
Favourable / adverse
A variance that increases / decreases profit.
Budgets help with planning, coordination, control, motivation (targets) and accountability.
The full notes, worked example and check questions for this subtopic are in the app.
Exam tip: For each variance, write the amount AND the word favourable or adverse. A number alone is not enough.