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.
Table of Contents
- Trading, Profit and Loss Account.
- Balance Sheet
- Annual Reports of Limited companies.
- Stock Exchange Report relating to quoted companies.
- Financial Ratios prepared by accountants and investment analysts.
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
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
- List six examples of each of the following:
(a) Fixed Assets
(b) Current Assets
- State two importance of the Balance Sheet as a financial statement.
USES OF FINANCIAL RATIO
- Ratios are used in preparing industrial averages.
- They can be used to interpret financial statements.
- They help in comparing performances between and among related organizations.
- Ratios help to measure the ability of a given entity to meet its short-term obligations.
- They are used in evaluating the performance of companies in the same business
DISADVANTAGES OF USING RATIO
- Ratios can easily be affected by inflation
- They can be manipulated upon or abused
- Different accounting policies affect ratio calculation
TYPES OF RATIO
- Profitability and efficiency ratio
- Liquidity ratio
- 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.
- Net profit%
- Gross profit%
- Returns on capital employed
- Assets turnover ratio
- Individual expenses items to sales ratio e.g advertising carriage outwards etc
- NP% = NET PROFIT × 100
- GP% = GROSS PROFIT × 100
- 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
- ASSETS TURNOVER RATIO:
This ratio measures the turnover generated by assets and show how fully a company is utilizing its assets.
- INDIVIDUAL EXPENSE TO SALES:
This helps to reveal the reason for improvement or reduction in the net profit to sales.
Formula : INDIVIDUAL EXPENSES × 100
- 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:
- Current ratio or working capital ratio
- Average stock
- Stock to net current assets
- Debtors ratio
- Creditors ratio
- 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
- 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
- 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: OPENING STOCK + CLOSING STOCK
N.B: Where there is no opening stock,average stock could be calculated by adding closing stock to purchases and dividing by 2
- STOCK TO NET ASSET. This ratio is used to express the stock as a percentage of net assets.
Formula: = STOCK × 100
NET ASSET 1
- DEBTORS RATIO: Debtors ratio measures the average collection period from debtors. It shows the average credit period given to debtors.
Formula: DEBTORS × 365 DAYS
Long collection dates indicate poor credit policy.
- CREDITORS RATIO: This ratio shows the average credit period received from suppliers.
Formula: TRADE CREDITORS × 365 DAYS
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
Gearing Ratio or Leverage Ratio = Long term liabilities
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.
- State two uses of financial ratio.
- List four liquidity ratios that can be used to evaluate the viability of a business firm.
- 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%
- What are fixtures and fittings in a balance sheet. (a) liquid capital (b) working capital (c) fixed assets (d) current assets
- 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
- 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
- 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
- State three uses of the balance sheet prepared by business firms.
- List four uses of the Trading, Profit and Loss Account prepared by business firms.
GENERAL EVALUATION QUESTIONS
- Explain seven roles of transport to businessmen
- List ten sources of capital available to a public limited company
- Give seven reasons why consumers need protection
- State five effects of hire purchase on the buyer
State eight reasons why a bank may dishonor a cheque