Income Statement and Statement of Financial Position (Cambridge IGCSE 0450)
Financial statements tell owners, lenders and managers how a business has performed and what it owns and owes. For Cambridge IGCSE 0450 you must interpret an income statement and a statement of financial position, and calculate key profitability ratios.
The income statement
The income statement records revenue, costs and profit over a period, usually one year. Work down it line by line:
| Item | $ |
|---|---|
| Revenue | 120,000 |
| Cost of sales | (70,000) |
| Gross profit | 50,000 |
| Expenses | (30,000) |
| Profit | 20,000 |
Revenue is income from selling goods and services. Cost of sales is the direct cost of the goods actually sold, such as materials. Revenue minus cost of sales gives gross profit: here 120,000 − 70,000 = 50,000. Deducting expenses (overheads such as rent, salaries and advertising) gives profit: 50,000 − 30,000 = 20,000. Profit is retained in the business or paid to owners, and tax authorities use the statement when the business files its tax returns.
The statement of financial position
The statement of financial position is a snapshot on one date of what the business owns (assets) and owes (liabilities), plus the owners' investment (equity).
| Item | $ |
|---|---|
| Non-current assets | 80,000 |
| Current assets | 30,000 |
| Total assets | 110,000 |
| Current liabilities | 20,000 |
| Non-current liabilities | 40,000 |
| Equity | 50,000 |
| Total liabilities and equity | 110,000 |
Non-current assets, such as machinery and buildings, are kept longer than a year; current assets, such as inventory, trade receivables and cash, turn into cash within a year. Current liabilities are debts due within a year; non-current liabilities, such as long-term loans, are due later. The statement always balances: total assets equal liabilities plus equity, here 110,000 on both sides.
Profitability ratios
Ratios turn raw figures into percentages that can be compared over time and against competitors. Using the statements above:
- Gross profit margin = gross profit ÷ revenue × 100 = 50,000 ÷ 120,000 × 100 = 41.7%. Each dollar of sales generates about 42 cents of gross profit.
- Profit margin = profit ÷ revenue × 100 = 20,000 ÷ 120,000 × 100 = 16.7%. A falling profit margin while the gross margin is steady points to rising expenses.
- Return on capital employed (ROCE) = profit ÷ capital employed × 100. Capital employed is equity plus non-current liabilities: 50,000 + 40,000 = 90,000, so ROCE = 20,000 ÷ 90,000 × 100 = 22.2%.
Owners compare ROCE with the return available elsewhere, such as bank interest, to judge whether the business uses their capital well. Always comment on what a ratio means, not just the number.
Key terms
Practice questions
Identify two items that appear as current assets on a statement of financial position. [2 marks]
Model answer guidance: Acceptable answers include inventory, trade receivables and cash or bank balances. Any two of these earn the marks. Do not list machinery or buildings, which are non-current assets.
A business has revenue of $200,000 and gross profit of $80,000. Calculate the gross profit margin and state what the result means. [4 marks]
Model answer guidance: Gross profit margin equals gross profit divided by revenue times 100: 80,000 divided by 200,000 times 100 = 40 per cent. This means every dollar of sales produces 40 cents of gross profit before expenses. The figure becomes useful when compared with last year or with competitors.
Explain two reasons why the profit margin of a business might fall even though its gross profit margin stayed the same. [6 marks]
Model answer guidance: The gap between the two margins is caused by expenses, so rising overheads are responsible. Rent, salaries or utility bills may have increased, taking a larger share of each dollar of revenue. Alternatively the business may have spent much more on advertising or hired extra office staff; either way expenses grew faster than revenue while direct costs stayed in proportion.
A company has profit of $15,000 and revenue of $60,000. Its main competitor has a profit margin of 18 per cent. Calculate the company's profit margin and consider what the comparison shows. [8 marks]
Model answer guidance: Profit margin equals 15,000 divided by 60,000 times 100 = 25 per cent, which is 7 percentage points higher than the competitor's 18 per cent. This suggests the company controls its costs better or charges higher prices for each dollar of sales. However, the competitor might be far larger, earning more total profit despite the thinner margin, and one year's figures may be distorted by unusual items. A fair judgement needs several years of data and the revenue of both firms.
The owners of a business with a ROCE of 22 per cent are deciding whether to expand using a new long-term loan. Do you think they should? Justify your answer. [12 marks]
Model answer guidance: A ROCE of 22 per cent means the business currently earns 22 cents of profit for every dollar of capital employed, which is well above typical loan interest rates, so borrowing to expand should add more profit than the interest costs. However, a loan increases non-current liabilities and therefore capital employed, so ROCE will fall unless the new investment performs as well as the existing business, and higher fixed interest payments raise risk if sales dip. On balance expansion is justified if market research supports extra demand, because the return comfortably exceeds the cost of borrowing. A strong answer compares ROCE with the interest rate explicitly before concluding.
Examiner tips
- Show every step in ratio calculations: formula, substitution, answer with a percentage sign; method marks rescue you if the arithmetic slips.
- Remember the statement of financial position must balance: total assets equal current plus non-current liabilities plus equity, a quick self-check in calculation questions.
- Never compare a ratio with nothing: always judge it against last year, a competitor or a benchmark such as loan interest rates for ROCE.
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