THE FINANCIAL POSITION OF BUSINESS FIRMS

DETERMINATION OF THE VIABILITY OF A BUSINESS

To determine whether or not a business is viable an investigation into the following sources of information must be made.

1. Trading, Profit and Loss Account.
2. Balance Sheet
3. Annual Reports of Limited companies.
4. Stock Exchange Report relating to quoted companies.
5. Financial Ratios prepared by accountants and investment analysts.

 

BALANCE SHEET

The Balance sheet of a firm is the summary or statement of the financial position of that firm at a particular date, usually at the end of the financial year.

 

STRUCTURE OF THE BALANCE SHEET

The normal balance sheet shows the capital and liabilities on the left-hand side and the assets on the right-hand side.  An illustration is given below

 

Peter Okocha Trading Enterprises:

Balance Sheet as at 31st December, 2005

N                     FIXED ASSETS                                 N

Capital                               25,000                   Premises                                        20,000

Add: Net Profit                 35,000                   Machinery                                     25,000

60,000                   Fixtures & Fittings                          5,000

50,000

CURRENT LIABILITIES:                            CURRENT ASSETS:

Creditors           27,000                                   Stock                           18,000

Bank Overdraft   3,000                                   Debtors                       12,000

30,000                   Cash in Bank                 6,000

Cash at Hand                4,000       40,000

 

90,000                                                                         90,000

 

REVIEW QUESTIONS

1. List six examples of each of the following:

(a)        Fixed Assets

(b)        Current Assets

2. State two importance of the Balance Sheet as a financial statement.

 

USES OF FINANCIAL RATIO

1. Ratios are used in preparing industrial averages.
2. They can be used to interpret financial statements.
3. They help in comparing performances between and among related organizations.
4. Ratios help to measure the ability of a given entity to meet its short-term obligations.
5. They are used in evaluating the performance of companies in the same business

 

DISADVANTAGES OF USING RATIO

1. Ratios can easily be affected by inflation
2. They can be manipulated upon or abused
3. Different accounting policies affect ratio calculation

 

TYPES OF RATIO

1. Profitability and efficiency ratio
2. Liquidity ratio
3. Investment ratio

 

PROFITABILITY AND EFFICIENCY

Profitability and efficiency ratios measure the effectiveness of the management as shown by the returns obtained on sales and capital invested. This can be broken down into the following.

1. Net profit%
2. Gross profit%
3. Returns on capital employed
4. Assets turnover ratio
5. Individual expenses items to sales ratio e.g advertising carriage outwards etc

 

Formulae:

1. NP% = NET PROFIT × 100

SALES            1

2. GP% =  GROSS PROFIT ×  100

SALES                    1

3. Returns on capital employed ROCE. This measures management ability to utilize effectively the organizations resources.

It is        PROFIT                             ×   100

CAPITAL EMPLOYED            1

Where capital employed can be : a) total asset  b) total assets to current liabilities

4. ASSETS TURNOVER RATIO:

This ratio measures the turnover generated by assets and show how fully a company is utilizing its assets.

Formula:           SALES

CAPITAL EMPLOYED

5. INDIVIDUAL EXPENSE TO SALES:

This helps to reveal the reason for improvement or reduction in the net profit to sales.

Formula : INDIVIDUAL EXPENSES × 100

SALES                         1

6. LIQUIDITY RATIOS:

These ratios help in measuring the ability of an organization to meet its obligations as they fall due.Ratios under this heading are:

1. Current ratio or working capital ratio
2. Average stock
3. Stock to net current assets
4. Debtors ratio
5. Creditors ratio

 

1. CURRENT RATIO OR WORKING CAPITAL RATIO: This ratio indicates the ratio of current assets to current liabilities. It shows the extent the firm can meet up with its short-term creditors. Low ratio implies lack of working capital while high ratio suggests too much of working capital or capital tied up.

Formula: CURRENT ASSETS                          CA

CURRENT LIABILITIES                  CL

 

2. ACID-TEST / LIQUID RATIO:

This ratio provides measures of the firm’s ability to meet its current liability. Should it fall below 1:1,the firm may have some difficulty in paying its debt.

Formula: CURRENT ASSETS – STOCK OR INVENTORY

CURRENT LIABILTIES

 

3. STOCK TURNOVER RATIO:

This is used to measure the number of times stocks are replaced during a given period.

Formula:         COST OF GOODS SOLD

AVERAGE STOCK

 

4. AVERAGE STOCK: OPENING STOCK + CLOSING STOCK

2

N.B: Where there is no opening stock,average stock could be calculated by adding closing stock to purchases and dividing by 2

 

5. STOCK TO NET ASSET. This ratio is used to express the stock as a percentage of net assets.

Formula: =          STOCK             ×  100

NET ASSET                 1

 

6. DEBTORS RATIO: Debtors ratio measures the average collection period from debtors. It shows the average credit period given to debtors.

Formula:     DEBTORS           ×   365 DAYS

CREDIT SALES

Long collection dates indicate poor credit policy.

 

7. CREDITORS RATIO: This ratio shows the average credit period received from suppliers.

Formula: TRADE CREDITORS     × 365 DAYS

CREDIT PURCHASES

 

GEARING OR LEVERAGE: This shows the relationship between owners equity or capital and

debt financing of business assets.  It shows the proportion of the assets being financed with

long-term debt.

Gearing Ratio or Leverage Ratio   =    Long term liabilities

Equity Capital

 

If the Gearing Ratio is above 40% (0.4) the business is said to be highly geared.  If lower than

40% (0.4)  the business is low geared.

 

REVIEW QUESTIONS

1. State two uses of financial ratio.
2. List four liquidity ratios that can be used to evaluate the viability of a business firm.

 

WEEKEND ASSIGNMENT

1. If the turnover of a business is N16,000 and the cost of goods sold is N12,000. What is the percentage of gross profit on sales. (a) 70%         (b) 40% (c) 33.3% (d) 25%
2. What are fixtures and fittings in a balance sheet. (a) liquid capital (b) working capital (c) fixed assets (d) current assets
3. The form of capital which is easily transferred into the form desired is known as ___

(a) working capital         (b) liquid capital         (c) circulating capital     (d) capital employed

4. When a company uses more of loans than equity to finance its business the company is said to be

(a) bankrupt                (b) solvent                   (c) highly geared         (d) insolvent

5. Which of the following shows the financial position of a business on a given date____

(a) bank statement         (b) journal        (c)  balance sheet      (d) cash book

 

THEORY

1. State three uses of the balance sheet prepared by business firms.
2. List four uses of the Trading, Profit and Loss Account prepared by business firms.

 

GENERAL EVALUATION QUESTIONS

1. Explain seven roles of transport to businessmen
2. List ten sources of capital available to a public limited company
3. Give seven reasons why consumers need protection
4. State five effects of hire purchase on the buyer

State eight reasons why a bank may dishonor a cheque

 

See also
PROFIT

CAPITAL

TRANSPORTATION: ROAD, AIR, WATER, RAIL, IMPORTANCE, FORMS, ADVANTAGES & DISADVANTAGES

NIGERIA AIRPORT AUTHORITY (NAA)

NIGERIA PORT AUTHORITY {NPA}