Unit 3 - Finance and Accounts
3.5 Profitability and Liquidity Ratio Analysis
Role of finance for businesses (AO2):
Capital expenditure
Revenue expenditure
The following internal sources of finance (AO2):
• Personal funds (for sole traders)
• Retained profit
• Sale of assets
The following external sources of finance (AO2):
• Share capital
• Loan capital
• Overdrafts
• Trade credit
• Crowdfunding
• Leasing
• Microfinance providers
• Business angels
Appropriateness of short- or long-term sources of finance for a given situation (AO3)
The following types of cost, using examples (AO2):
fixed
variable
direct
indirect (overhead)
Total revenue and revenue streams, using examples (AO2)
Decision Tree (AO2)
Total contribution versus contribution per unit (AO2)
A break-even chart and the following aspects of break-even analysis. (AO2, AO4)
Break-even quantity/point
Profit or loss
Margin of safety
Target profit output
Target profit
Target price
The effects of changes in price or cost on the break-even quantity, profit and margin of safety, using graphical and quantitative methods (AO2, AO4)
Limitations of break-even as a decision-making tool (AO3)
The purpose of accounts to different stakeholders (AO2)
Final accounts (AO2, AO4):
• Profit and loss account
• Balance sheet
Different types of intangible assets (AO2)
Depreciation using the following methods (HL only) (AO2, AO4):
• Straight line method
• Units of production method
Appropriateness of each depreciation method (HL only) (AO3)
The following profitability ratios (AO2, AO4):
• Gross profit margin (GPM)
• Profit margin
• Return on capital employed (ROCE)
Possible strategies to improve these profitability ratios (AO3)
The following liquidity ratios (AO2, AO4):
• Current ratio
• Acid-test / quick ratio
Possible strategies to improve these liquidity ratios (AO3)
The following further efficiency ratios (AO2, AO4):
Stock turnover
Debtor days
Creditor days
Gearing ratio
Possible strategies to improve these ratios (AO3)
Insolvency versus bankruptcy (AO2)
The difference between profit and cash flow (AO2)
Working capital (AO2, AO4)
Liquidity position (AO2)
Cash flow forecasts (AO2, AO4)
The relationship between investment, profit, and cash flow (AO2)
Strategies for dealing with cash flow problems (AO3)
Investment opportunities using payback period (AO3 and AO4)
Investment opportunities using average rate of return (ARR) (AO3 and AO4)
Investment opportunities using net present value (HL only) (AO3 and AO4)
The difference between cost and profit centres (AO2)
The roles of cost and profit centres (AO2)
Constructing a budget (AO2, AO4)*
Variances (variance analysis) (AO2, AO4)
The importance of budgets and variances in decision-making (AO2)
Conceptual understandings
Change in the business structure can impact a business’ financial resources
Creativity in financial reporting can have diverse impacts in a business
Ethical financial and accounting practices can be a form of sustainable business behaviour
Suggested inquiry statements to explore
How cost and revenue management could ensure sustainability.
Why final accounts analysis could be essential in changing stakeholder perspectives.
Why profitable businesses may face insolvency.
How time value of money affects future consumer choice.
How triple bottom line accounting can support the shift towards more ethical business practices.
Suggested theory of knowledge questions
Are objective facts or appeals to emotion more effective when applying for an external source of finance?
How do our expectations and assumptions have an impact on how we read company accounts?
What roles do reason and emotion play when analysing financial performance?
Are the results of some types of ratio analysis less open to interpretation than others?
To what extent are the methods used to gain knowledge in investment appraisal “scientific”?
What assumptions underlie the techniques used when budgeting?
Statement of Profit or Loss: Profit-Making Entity
(Income Statement)
Statement of Profit or Loss: Non-Profit Entity
(Income Statement)
Statement of Profit or Loss / Income Statement (Lewinski)
Statement of Financial Position: Profit-Making Entity
(Balance Sheet)
Statement of Financial Position: Non-profit Entity
(Balance Sheet)
Statement of Financial Position / Balance sheet (Lewinski)
Working Capital Formula
Cash Flow Forecast: Profit and Non-Profit Entity
Cash Flow Forecast: Profit and Non-Profit Entity (from Lewwinski)
Budget: Profit and Non-Profit Entity
OR
Budget: Profit and Non-Profit Entity (Lewinski)
OR
Break Even Chart with Profit and Loss
Solving the decision tree
Depreciation
Straight-line Method of Depreciation
Units of production method of Depreciation
ARR (Average Rate of Return)
ARR = (total returns – capital costs) ÷ years of use ÷ capital costs ⨉ 100
Payback period (not in Formula Booklet)
NPV (Net Present Value)
NPV = Sum of present values – Original cost
Formulas Provided in the Exam:
Profitability Ratios
Liquidity Ratios
Efficiency Ratios
Investment Appraisal
Payback period (not in Formula Booklet)
Capacity Utilization and Productivity
Discount Table