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 compared with 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
HomeNotesBusiness Studies – 04506.1 – 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
HomeNotesBusiness Studies – 04506.2 – 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 WHY BUSINESSES DO NOT WANT
ENVIRONMENT- FRIENDLY TO BE ENVIRONMENT-FRIENDLY

It is expensive to reduce and

Sense of social responsibility that recycle waste for the business. It
comes from the fact that their means that expensive machinery
activities are contributing to and skilled labour will be required
global warming and pollution by the business – reducing profits.

Using up scarce non-renewable Firms will have to increase prices

resources (such as rainforest to compensate for the expensive
wood and coal) will raise their environment-friendly methods
prices in the future, so businesses used in production- higher prices
won’t use them now mean lower demand.

Consumers are becoming socially- High prices can make firms less
aware and are willing to buy only competitive in the market and
environment friendly products. they could lose sales

Governments, environmental
organisations, even the
community could take action
against the business if they do Businesses claim that it is the
serious damage to the government’s duty to clean up
environment 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
HomeNotesBusiness Studies – 04506.3 – 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).