7.2 - Financial ratio analysis

• Balance Sheets


  Lists of Assets and Liabilities
• Balance sheets


  • They are a snapshot of a firm's finances at a fixed point in time
  • They show the value of all the business' assets (the things that belong to the business, including cash in the bank) and all its liabilities (the money the business owes)
  • They show the value of all the capital (the money invested in the business), and the source of that capital (e.g. loans, shares or retained profits) so they show where the money's come from as well as what's being done with it
• Net assets value


  The total fixed and current assets minus total current and non-current (long-term) liabilities
• The net assets value is always the same as the total equity value (the total of all the money that's been put into the business)
• Balance sheets balance because the net assets value is always the same as the total equity value
• Assets


  Things the Business Owns
• Businesses can use capital


  1. To buy assets that will generate more revenue in the future

  2. This is investment
• Assets (like machinery and stock)


  • Provide a financial benefit to the business
  • Given a monetary value on the balance sheet
• Types of assets


  • Non-current assets (fixed assets)
  • Current assets
• Non-current assets


  Assets that the business is likely to keep for more than a year, e.g. property, land, production equipment, desks and computers
• Total non-current assets


  The combined value of all the business' non-current assets
• Depreciation


  Non-current assets often lose value over time, so they're worth less every year
• Current assets


  Assets that the business is likely to exchange for cash within the accounting year, before the next balance sheet is made
• Examples of current assets

  • Receivables (money owed to the business by other companies and individuals)
  • Inventories (or stock products, or materials that will be used to make products, that will be sold to customers)
• Total current assets


  The value of all the business' current assets added together
• Net assets


  The business' current and non-current assets added together, then current and non-current liabilities are deducted
• Liabilities


  Debts the Business Owes
• Current liabilities


  Debts which need to be paid off within a year, e.g. overdrafts, taxes due to be paid, payables (money owed to creditors), dividends due to be paid to shareholders
• Assets employed


  Total fixed and current assets minus total current liabilities
• Non-current liabilities


  Debts that the business will pay off over several years, e.g. mortgages and loans
• Bad debts


  Debts that debtors Won't Ever Pay
• Ideally, every debt owed by debtors to the business would be paid. Unfortunately, the real world isn't like that. Most debts get paid eventually, but some debtors default on their payments they don't pay up.
• Bad debts


  Debts which don't get paid
• The business writes off these bad debts

  1. Puts them as an expense on the profit and loss account

  2. This shows that the business has lost money
• It's important to be realistic about bad debts. The business shouldn't be over-optimistic and report debts as assets when they're unlikely to ever be paid. On the other hand, they shouldn't be too cautious and write debts off as bad debts when they could make the debtors pay up.
• Working Capital


  The Finance available for Day-To-Day Spending
• Working capital


  The amount of cash (and assets that can be easily turned into cash) that the business has available to pay its day-to-day debts
• The more working capital a business has

  The more liquid (able to pay its short-term debts) it is
• Calculating working capital


  Current assets - Current liabilities
• Businesses can't survive if they don't have enough working capital
• Businesses must make sure they collect money quickly to get cash to pay their liabilities</b>
• Businesses can't use inventories or receivables to pay their current liabilities until they're turned into cash
• Enough Cash but Not Too Much

  Businesses need just enough cash to pay short-term debts, but not too much as spare cash is great at paying off debts but lousy at earning money for the business
• Businesses with a long cash-flow cycle


  Need more cash
• To make money, the business


  Needs non-current assets that make sales possible
• Inflation increases


  The costs of wages and buying/holding stock, so firms need more cash when inflation is high
• When a business expands

  It needs more cash to avoid overtrading
• Capital Expenditure


  Money used to buy non-current assets (fixed assets) used over and over again to produce goods or services for sale
• Allocating capital expenditure


  Setting aside enough money to stop non-current assets from wearing out, then deciding how much to invest in growth
• You'll find capital expenditure on the balance sheet as non-current assets