5.5 – Analysis of Accounts
The data contained in the financial statements are used to make some useful observations about the performance and financial strength of the business. This is the analysis of accounts of a business. To do so, ratio analysis is employed.
Ratio Analysis
- Profitability Ratios: profitability is the ability of a company to use its resources to generate revenues in excess of its expenses. These ratios are used to see how profitable the business has been in the year ended.
- Return on Capital Employed (ROCE): this calculates the return (net profit) in terms of the capital invested in the business (shareholder’s equity + non-current liabilities) i.e. the % of net profit earned on each unit of capital employed. The higher the ROCE the better the profitability is. The formula is:
- Gross Profit Margin: this calculates the gross profit (sales – cost of production) in terms of the sales, or in other words, the % of gross profit made on each unit of sales revenue. The higher the GPM, the better. The formula is:
- Net profit Margin: this calculates the net profit (gross profit-expenses) in terms of the sales, i.e. the % of net profit generated on each unit of sales revenue. The higher the NPM, the better. The formula is:
- Liquidity Ratios: liquidity is the ability of the company to pay back its short-term debts. It if it doesn’t have the necessary working capital to do so, it will go illiquid (forced to pay off its debts by selling assets). In the previous topic, we said that working capital = current assets – current liabilities. So a business needs current assets to be able to pay off its current liabilities. The two liquidity ratios shown below, use this concept.
- Current Ratio: this is the basic liquidity ratio that calculates how many current assets are there in proportion to every current liability, so the higher the current ratio the better (a value above 1 is favourable). the formula is:
- Liquid Ratio/ Acid Test Ratio: this is very similar to current ratio but this ratio doesn’t consider inventory to be a liquid asset, since it will take time for it to be sold and made into cash. A high level of inventory in a business can thus cause a big difference between its current and liquidity ratios. So there is a slight difference in the formula:
Uses and users of accounts
- Managers: they will use the accounts to help them keep control over the performance of each product or each division since they can see which products are profitably performing and which are not.
- This will allow them to take better decisions. If for example, product A has a good gross profit margin of 35% but its net profit margin is only 5%, this means that the business has very high expenses that is causing the huge difference between the two ratios. They will try to reduce expenses in the coming year. In the case of liquidity, if both ratios are very low, they will try to pay off current liabilities to improve the ratios.
- Ratios can be comparedwith other firms in the industry/competitors and also with previous years to see how they’re doing. Businesses will definitely want to perform better than their rivals to attract shareholders to invest in their business and to stay competitive in the market. Businesses will also try to improve their profitability and liquidity positions each year.
- Shareholders: since they are the owners of a limited company, it is a legal requirement that they be presented with the financial accounts of the company. From the income statements and the profitability ratios, especially the ROCE, existing shareholders and potential investors can see whether they should invest in the business by buying shares. A higher profitability, the higher the chance of getting dividends. They will also compare the ratios with other companies and with previous years to take the most profitable decision. The balance sheet will tell shareholders whether the business was worth more at the end of the year than at the beginning of the year, and the liquidity ratios will be used to ascertain how risky it will be to invest in the company- they won’t want to invest in businesses with serious liquidity problems.
- Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash position and debts of the business. They will only be ready to supply to the business if they will be able to pay them. If there are liquidity problems, they won’t supply the business as it is risky for them.
- Banks: Similar to how suppliers use accounts, they will look at how risky it is to lend to the business. They will only lend to profitable and liquid firms.
- Government: the government and tax officials will look at the profits of the company to fix a tax rate and to see if the business is profitable and liquid enough to continue operations and thus if the worker’s jobs will be protected.
- Workers and trade unions: they will want to see if the business’ future is secure or not. If the business is continuously running a loss and is in risk of insolvency (not being liquid), it may shut down operations and workers will lose their jobs!
- Other businesses: managers of competing companies may want to compare their performance too or may want to take over the business and wants to see if the takeover will be beneficial.
Limitations of using accounts and ratio analysis
- Ratios are based on past accounting data and will not indicate how the business will perform in the future
- Managers will have all accounts, but the external users will only have those published accounts that contain only the data required by law- they may not get the ‘full-picture’ about the business’ performance.
- Comparing accounting data over the years can lead to misleading assumptions since the data will be affected by inflation (rising prices)
- Different companies may use different accounting methods and so will have different ratio results, making comparisons between companies unreliable.
6.1 – Economic Issues
The Business/ Trade Cycle
An economy will not always go through an economic growth; there is usually a cycle, as shown below.
Growth– when GDP is rising, unemployment is falling and there are higher living standards in the country. Businesses will look to expand and produce more and will earn high profits.
Boom– when GDP is at its highest and there is too much spending, causing inflation to rapidly rise. Business costs will rise and firms will become worried about how they are going to stay profitable in the near future.
Recession– when GDP starts to fall due of high prices, as demand and spending falls. Firms will cut back production to stay profitable and unemployment may rise as a result.
Slump– when GDP is so low that prices start to fall (deflation) and unemployment will reach very high levels. Many businesses will close down as they cannot survive the very low demand level. The economy will suffer.
(When the government takes measures to increase demand and spending in the economy to take it from a slump to growth, it is called as the ‘recovery’ period). The cycle repeats.
Economic Objectives
Here, we’ll look at the different economic objectives a government might have and how their absence/negligence will affect the economy as well as businesses.
- Maintain economic growth: economic growth occurs when a country’s Gross Domestic Product (GDP) increase i.e. more goods and services are produced than in the previous year. This will increase the country’s incomes and achieve greater living standards.
Effects of reducing GDP (recession):- As output falls, fewer workers will be needed by firms, so unemployment will rise
- As goods and services that can be consumed by the people falls, the standard of living in the economy will also fall
- Achieve price stability: inflation is the increase in average prices of goods and services over time. (Note that, inflation, in the real world, always exists. It is natural for prices to increase as the years go by. In the case there is a fall in the price level, it is called a deflation) Maintaining a low inflation will help the economy to develop and grow better.
Effects of high inflation:- As cost of living will have risen and peoples’ real incomes(the value of income) will have fallen (when prices increase and incomes haven’t, the income will buy lesser goods and services- the purchasing power will fall).
- Prices of domestic goods will rise as opposed to foreign goods in the market. The country’s exports will become less competitive in the international market. Domestic workers may lose their jobs if their products and firms don’t do well.
- When prices rise, demand will fall and all costs will rise (as wages, material costs, overheads will all rise)- causing profits to fall. Thus, they will be unwilling to expand and produce more in the future.
- The living standards (quality of life) in the country may fall when costs of living rise.
- Reduce unemployment: unemployment exists when people who are willing and able to work cannot find a job. A low unemployment means high output, incomes, living standards etc.
Effects of high unemployment:- Unemployed people do not produce anything and so, the total output/GDP in the country will fall. This will in turn, lead to a fall in economic growth.
- Unemployed people receive no incomes, thus income inequality can rise in the economy and living standards will fall. It also means that businesses will face low demand due to low incomes.
- The government pays out unemployment benefits to the unemployed and this will rise during high unemployment and government will not enough money left over to spend on other services like education and health.
- Maintain balance of payments stability: this records the difference between a country’s exports (goods and services sold from the country to another) and imports (goods and services bought in by the country from another country). The exports and imports needs to equal each other, thus balanced.
Effect of a disequilibrium in the balance of payments:- If the imports of a country exceed its exports, it will cause depreciation in the exchange rate– the value of the country’s currency will fall against other foreign currencies (this will be explained in detail here).
- If the exports exceed the imports it indicates that the country is selling more goods than it is consuming- the country itself doesn’t benefit from any high output consumption.
- Reduce income equality/achieve effective income redistribution: the difference/gap between the incomes of rich and poor people should narrow down for income equality to improve. Improved income equality will ensure better living standards and help the economy to grow faster and become more developed.
Effects of poor income equality:- Inequal distribution of goods and services- the poor cannot buy as many goods as the rich- poor living standards will arise.
Government Economic Policies
Government can influence the economic conditions in a country by taking a variety of policies.
Fiscal policy is a government policy which adjusts government spending and taxation to influence the economy. It is the budgetary policy, because it manages the government expenditure and revenue. Government aims for a balance budget and tries to achieve it using fiscal policy.
Increasing government spending and reducing taxes will encourage more production and increase employment, driving up GDP growth. This is because government spending creates employment and increases economic activity in the economy and lower taxes means people have more money to consume and firms have to pay lesser tax on their profits. On the other hand, reducing government spending and increasing taxes will discourage production and consumption, and unemployment and GDP will fall.
Monetary policy is a government policy that adjusts the interest rate and foreign exchange rates to influence the demand and supply of money in the economy, and thus demand and supply. It is usually conducted by the country’s central bank and usually used to maintain price stability, low unemployment and economic growth.
Increasing interest rates will discourage investments and consumption, causing employment and GDP to fall (as the cost of borrowing-interest on loans – has increased, and people prefer to earn more interest by saving rather than spend). Similarly, reducing interest rates will boost investment, consumption, employment, and thus GDP.
Supply-side policies: both the fiscal and monetary policies directly affect demand, but the policies that influence supply are very different. It can include:
- Privatisation: selling government organizations to private individuals- this will increase efficiency and productivity that increase supply as well encourage competitors to enter and further increase supply.
- Improve training and education: governments can spend more on schools, colleges and training centres so that people in the economy can become better skilled and knowledgeable, helping increasing productivity.
- Increased competition: by acting against monopolies (firms that restrict competitors to enter that industry/having full dominance in the market- refer xxx for more details) and reducing government rules and regulations (often termed ‘deregulation’), the competitive environment can be improved and thus become more productive.
For more details on government policies, check out our Economics notes.
*EXAM TIP: Remember that economic conditions and policies are all interconnected; one change will lead to an effect which will lead to another effect and so on, like a chain reaction in many different ways. In your exams, you should take care to explain those effects that are relevant and appropriate to the business or economy in the question*
How might businesses react to policy changes? It will depend varying on how much impact the policy change will have on the particular business/industry/economy. Here are a few examples:
6.2 – Environmental and Ethical Issues
Business’ Impact on the Environment
Social responsibility is when a business decision benefits stakeholders other than shareholders i.e. workers, community, suppliers, banks etc.
This is very important when coming to environmental issues. Businesses can pollute the air by releasing smoke and poisonous gases, pollute water bodies around it by releasing waste and chemicals into them, and damage the natural beauty of a place and so on.
| WHY BUSINESSES WANT TO BE ENVIRONMENT- FRIENDLY | WHY BUSINESSES DO NOT WANT TO BE ENVIRONMENT-FRIENDLY |
| Sense of social responsibility that comes from the fact that their activities are contributing to global warming and pollution | It is expensive to reduce and recycle waste for the business. It means that expensive machinery and skilled labour will be required by the business – reducing profits. |
| Using up scarce non-renewable resources (such as rainforest wood and coal) will raise their prices in the future, so businesses won’t use them now | Firms will have to increase prices to compensate for the expensive environment-friendly methods used in production- higher prices mean lower demand. |
| Consumers are becoming socially-aware and are willing to buy only environment friendly products. | High prices can make firms less competitive in the market and they could lose sales |
| Governments, environmental organisations, even the community could take action against the business if they do serious damage to the environment | Businesses claim that it is the government’s duty to clean up pollution |
Externalities
A business’ decisions and actions can have significant effects on its stakeholders. These effects are termed ‘externalities’. Externalities can be categorized into six groups given below and we’ll take examples from a scenario where a business builds a new production factory.
Private Costs: costs paid for by the business for an activity.
Examples: costs of building the factory, hiring extra employees, purchasing new machinery, running a production unit etc.
Private Benefits: gains for the business resulting from an activity.
Example: the extra money made from the sale of the produced goods etc.
External Costs: costs paid for by the rest of the society (other than the business) as a result of the business’ activity.
Examples: machinery noise, air pollution that leads to health problems among near residents, loss of land (it could have been a farm land before) etc.
External Benefits: gains enjoyed by the rest of the society as a result of a business activity.
Example: new jobs created for residents, government will get more tax from the business, other firms may move into the area to support the firm-helping develop the region, new roads might be built that can be enjoyed by residents etc.
Social Costs = Private Costs + External Costs
Social Benefits = Private Benefits + External Benefits
Governments use the cost-benefit-analysis (CBA) to decide whether to proceed with a scheme or not and businesses have also adopted it. In CBA, the government weighs up all the social costs and benefits that will arise if the scheme is put into effect and give them all monetary values (this is not easy- what is the value of losing natural beauty?).
They will only allow the scheme to proceed if the social benefits exceed the social costs, if the costs exceed the benefits, it is not allowed to proceed.
Sustainable Development
Sustainable development is development that does not put at risk the living standards of future generations. It means trying to achieve economic growth in a way that does not harm future generations. Few examples of a sustainable development are:
- using renewable energy- so that resources are conserved for the future
- recycle waste
- use fewer resources
- develop new environment-friendly products and processes- reduce health and climatic problems for future generations
Environmental Pressures
Pressure groups are organisations/groups of people who change business (and government) decisions. If a business is seen to behave in a socially irresponsible way, they can conduct consumer boycotts (encourage consumers to stop buying their products) and take other actions. They are often very powerful because they have public support and media coverage and are well-financed and equipped by the public. If a pressure group is powerful it can result in a bad reputation for the business that can affect it in future endeavours, so the business will give in to the pressure groups’ demands. Example: Greenpeace
The government can also pass laws that can restrict business decisions such as not permitting factories to locate in places of natural beauty.
There can also be penalties set in place that will penalize firms that excessively pollute. Pollution permits are licenses to pollute up to a certain limit. These are very expensive to acquire, so firms will try to avoid buying the pollution permit and will have to reduce pollution levels to do so. Firms that pollute less can sell their pollution permits to more polluting firms to earn money. Taxes can also be levied on polluting goods and services.
Ethical Decisions
Ethical decisions are based on a moral code. It means ‘doing the right thing’. Businesses could be faced with decisions regarding, for example, employment of children, taking or offering bribes, associate with people/organisations with a bad reputation etc. In these cases, even if they are legal, they need to take a decision that they feel is right.
Taking ethical/’right’ decisions can make the business’ products popular among customers, encourage the government to favour them in any future disputes/demands and avoid pressure group threats. However, these can end up being expensive as the business will lose out on using cheaper unethical opportunities.
6.3 – Business and the International Economy
Globalization
Globalization is a term used to describe the increases in worldwide trade and movement of people and capital between countries. The same goods and services are sold across the globe; workers are finding it easier to find work by going abroad for work; money is sent from and to countries everywhere.
Some reasons how globalization has occurred are:
- Increasing number of free trade agreements– these are agreements between countries that allows them to import and export goods and services with no tariffs or quotas.
- Improved and cheaper transport (water, land, air) and communications (internet) infrastructure
- Developing and emerging countries such as China and India are becoming rapidly industrialized and so can export large volumes of goods and services. This has caused an increase in the output and opportunities in international trade, allowing for globalisation
Advantages of globalisation
- Allows businesses to start selling in new foreign markets, increasing sales and profits
- Can open factories and production units in other countries, possibly at a cheaper rate (cheaper materials and labour can be available in other countries)
- Import products from other countries and sell it to customers in the domestic market- this could be more profitable and producing and selling the good themselves
- Import materials and components for production from foreign countries at a cheaper rate.
Disadvantages of globalisation
- Increasing imports into country from foreign competitors- now that foreign firms can compete in other countries, it puts up much competition for domestic firms. If these domestic firms cannot compete with the foreign goods’ cheap prices and high quality, they may be forced to close down operations.
- Increasing investment by multinationals in home country- this could further add to competition in the domestic market (although small local firms can become suppliers to the large multinational firms)
- Employees may leave domestic firms if they don’t pay as well as the foreign multinationals in the country- businesses will have to increase pay and conditions to recruit and retain employees.
When looking at an economy’s point of view, globalisation brings consumers more choice and lower prices and forces domestic firms to be more efficient (in order to remain competitive). However, competition from foreign producers can force domestic firms to close down and jobs will be lost.
Protectionism
Protectionism refers to when governments protect domestic firms from foreign competition using trade barriers such as tariffs and quotas; i.e. the opposite of free trade.
Import quota is a restriction on the quantity of goods that can be imported into the country.
Tariffs are taxes on imports.
Imposing these two measures will reduce the number of foreign goods in the domestic market and make them expensive to buy, respectively. This will reduce the competitiveness of the foreign goods and make it easy for domestic firms to produce and sell their goods. However, it reduces free trade and globalisation.
Free trade supporters say that it is better to allow consumers to buy imported goods and domestic firms should produce and export goods and services that they have a competitive advantage in. In this way, living standards across the globe will improve.
Multinational Companies (MNCs)
Multinational businesses are firms with operations (production/service) in more than one country. Also known as transnational businesses. Examples: Shell, McDonald’s, Nissan etc.
Why do firms become multinationals?
- To produce goods with lower costs– cheaper material and labour may be available in other countries
- To extract raw materials for production, available in a few other countries. For example: crude oil in the Middle East
- To produce goods nearer to the markets to avoid transport costs.
- To avoid trade barriers on imports. If they produce the goods in foreign countries, the firms will not have to pay import tariffs or be faced with a quota restriction
- To expand into different markets and spread their risks
- To remain competitive with rival firms which may also be expanding abroad
Advantages to a country of a multinational setting up in their country:
- More jobs created by multinationals
- Increases GDP of the country
- The technology that the multinational brings in can bring in new ideas and methods into the country
- As more goods are being produced in the country, the imports will be reduced and some output can even be exported
- Multinationals will also pay taxes, thereby increasing the government’s tax revenue
- More product choice for consumers
Disadvantages to a country of a multinational setting up in their country:
- The jobs created are often for unskilled tasks. The more skilled jobs will be done by workers that come from the firm’s home country. The unskilled workers may also be exploited with very low wages and unhygienic working conditions
- Since multinationals benefit from economies of scale, local firms may be forced out of business, unable to survive the competition
- Multinationals can use up the scarce, non-renewable resources in the country
- Repatriation of profit can occur. The profits earned by the multinational could be sent back to their home country and the government will not be able to levy tax on it.
- As multinationals are large, they can influence the government and economy. They could threaten the government that they will close down and make workers unemployed if they are not given financial grants and so on.
Exchange Rates
The exchange rate is the price of one currency in terms of another currency.
For example, €1= $1.2. To buy one euro, you’ll need 1.2 dollars. The demand and supply of the currencies determine their exchange rate. In the above example, if the €’s demand was greater than the $’s, or if the supply of € reduced more than the $, then the €’s price in terms of $ will increase. It could now be €1= $1.5. Each € now buys more $.
A currency appreciates when its value rises. The example above is an appreciation of the Euro. A European exporting firm will find an appreciation disadvantageous as their American consumers will now have to pay more $ to buy a €1 good (exports become expensive). Their competitiveness has reduced. A European importing firm will find an appreciation of benefit. They can buy American products for lesser Euros (imports become cheaper).
A currency depreciates when its value falls. In the example above, the Dollar depreciated. An American exporting firm will find a depreciation advantageous as their European consumers will now have to pay less € to buy a $1 good (exports become cheaper). Their competitiveness has increased. An American importing firm will find a depreciation disadvantageous. They will have to buy European products for more dollars (imports become expensive).
In summary, an appreciations is good for importers, bad for exporters; a depreciation is good for exporters, bad for importers; given that the goods are price elastic (if the price didn’t matter much to consumers, sales and revenue would not be affected by price- so no worries for producers).
