This action might not be possible to undo. Are you sure you want to continue?
TABLE OF CONTENTS
9.1 Purpose of Financial Statements..................... 164 9.2 Balance Sheet........................................... 164 9.2.1 Introduction ...................................................... 164 9.2.2 Accounting Equation ......................................... 164 9.2.3 Format............................................................... 166 9.2.4 Fixed Assets ...................................................... 166 9.2.5 Current Assets................................................... 168 9.2.6 Current Liabilities .............................................. 168 9.2.7 Accruals and Prepayments................................ 168 9.2.8 Capital Employed............................................... 169 9.2.9 Long-Term Liabilities ........................................ 169 9.2.10 Provisions for Liabilities and Charges ............. 169 9.2.11 Called-Up Share Capital................................... 169 9.2.12 Share Premium Account Reserve.................... 169 9.2.13 Revaluation Reserve........................................ 171 9.2.14 Other Reserves................................................ 171 9.2.15 Profit and Loss Account Reserve .................... 171 9.2.16 Minority Interests ............................................ 171 9.3 Profit and Loss Account Statement .................. 172 9.3.1 Introduction ...................................................... 172 9.3.2 Format and Terminology ................................... 172 9.3.3 Capital and Revenue Expenditure ...................... 174 9.4 Cash Flow Statement ................................... 175 9.4.1 Introduction....................................................... 175 9.4.2 Scope ................................................................ 175 9.4.3 Cash Definition .................................................. 176 9.4.4 Format and Terminology ................................... 176 9.5 Analysis of Accounts.................................... 177 9.5.1 Introduction....................................................... 177 9.5.2 Profitability Ratios............................................. 178 9.5.3 Liquidity Ratios ................................................. 179 9.5.4 Financial Gearing Ratios .................................... 180 9.5.5 Investors’ Ratios ............................................... 182 9.5.6 Shareholder Value Added (SVA)........................ 185 9.5.7 Enterprise Value to EBITDA ............................... 186
9 ♦ Accounting Analysis
9 ♦ Accounting Analysis
Company Profit and Loss Accounts
Know the purpose of profit and loss accounts and their basic contents.
− − − − − − − − − − − − − − − −
What is a profit and loss account? It usually covers a company’s activities for one year. Why is it required? How does it benefit the company? Advantages to customers and shareholders. Turnover. Investment and other income. Depreciation. Interest. Dividends. Taxation. Exceptional items. Extraordinary items. Operating profit. Retained earnings. Minority interests.
Company Balance Sheets
Know the purpose of a balance sheet and its basic content.
− − − − − − − − − − − − −
What is a balance sheet? Position as at a point in time. Why is it required? How does it benefit the company? Advantages to customers and shareholders. Prepayments. Plant and machinery. Cash. Investments. Debtors. Stock and work-in-progress. Intangibles. Creditors.
Problems of fluctuating values. Intangible assets. Capital employed (Total assets – Current liabilities). Share capital. Effect of stock splits. Goodwill. Net asset values. Financing. Valuation. 162 . Fixed assets. Current liabilities. Management of liquid resources. Understand the following. ♦ ♦ ♦ ♦ ♦ ♦ Assets less preference capital less liabilities divided by the number of shares. historical cost and depreciation. Acquisitions and disposals.9 ♦ Accounting Analysis − − − − − − − − − − Capital reserves. What is a cash flow statement? When is it required? Why is it required? Covers the period of the balance sheet. Share premium account. − − − − − − − − − − − − FRS 1. Current assets. Return on investment and servicing of finance. Cash Flow Statements Know the requirement to produce a cash flow statement and its format. Capital expenditure. Taxation. Effect of economic cycles. May be tested by simple calculations. Equity dividends paid.
9 ♦ Accounting Analysis Ratios Understand the purpose of ratio analysis. Earnings per share. interest cover. Current ratio. Compare to ♦ ♦ ♦ ♦ ♦ Sector averages. Interest cover. investors. net dividend yield. current ratio. quick ratio and ROCE. Market averages. Profitability. Quick ratio. Dividend cover. 163 . Understand the essential basic details and their investment significance in the following areas. Price/earnings ratio. employees. − − − − Used by the Board. EV/EBITDA. dividend cover. Liquidity. Risk if different calculation methods relied upon. Be able to calculate gearing. Year-on-year performance. Other similar companies. EPS. its uses and limitations. Shareholder value added (SVA). Return on capital employed (ROCE). Net dividend yield. Risk if figures restated. − − − − − − − − − − − − − − − − Establish gearing position. Indication of financial efficiency. Past in-house figures. And the benefits of EV/EBITDA and SVA over accounting ratios. Part of an investment decision. suppliers. P/E ratio. competitors. Gearing.
for listed companies and larger unlisted ones. Generally. It represents both what the company has (assets less liabilities) and where the funds came from originally (source of funds).1 Introduction The balance sheet is a statement of the financial position of the business at a specific point in time. which is owned by its members or shareholders. the Government etc. The primary purpose of financial statements is to provide a medium enabling the directors to report to the shareholders on the performance of the company concerned. The three main components of a set of financial statements are Balance Sheet. a UK balance sheet appears as follows.9 ♦ Accounting Analysis 9.. however. created in law.2. to help them assess the returns they are receiving and the risks that they may face. It should always be borne in mind that it is only a picture of the company at the specific point of time. Cash Flow Statement. In outline. 9. The financial statements are. frequently used by other interested parties.2. Profit and Loss Account.1 Purpose of Financial Statements A company is a business organisation. Each transaction impacts on the accounting equation. the accounting equation holds – the balance sheet balances. hence the balance sheet just after the year end may be significantly different from that at the year end if a company has undertaken significant transactions.2 Balance Sheet 9. 164 . Balance Sheet Outline £000 Assets Liabilities Net Assets 400 (150) 250 Shareholders’ Funds Share capital Reserves 100 150 250 Source of funds from shareholders As we can see. the shareholders appoint directors to manage the company on their behalf. such as the year end.2 Accounting Equation The accounting equation can be stated as Formula to Learn: Net assets = Shareholders' fund The format usually adopted by UK companies presents this equation vertically with net assets above shareholders’ funds. As a result it must always balance. 9. creditors. having little involvement in the day-to-day operations of such companies. such as lenders. potential investors. tax authorities.
You are required to know this full detail for the exam. i. By convention. 165 . though there may be other types of reserves as we will see later. not simply to be sold on at a profit. Fixed Assets Assets acquired for continued use in the business to earn profit. 4. money subscribed for shares. Examples of such items would include office and production buildings and equipment. These can be sub-categorised under two headings. not for resale. These too are sub-categorised as Creditors: amounts falling due within one year. Assets These represent resources owned or controlled by the company and available for its use. Share Capital This is money invested in the company by shareholders. Liabilities Liabilities represent amounts owed by the company to outside suppliers and lenders.9 ♦ Accounting Analysis The four categories we have outlined are as follows. Clearly these are intended for long-term use. ‘Fixed Assets’ and ‘Current Assets’. 1. The purpose of the above classification is to provide a clear indication of the timescales for settlement. These are also known as long-term liabilities. Reserves These generally represent profits earned and retained by the company since it began trading. such as stocks of goods for sale or production equipment. Examples of such assets would include stocks of goods available for sale to customers. assets which are to be converted into cash within 12 months are deemed to be current. Current Assets Assets acquired for conversion to cash during the ordinary course of business. 3. These are also known as current liabilities. 2. Creditors: amounts falling due after more than one year.e. This is only a broad outline and in reality the balance sheet will contain much more detail. or customers’ account balances which will be settled for cash.
806 1.218) 16.712 (48. As we can see.204 8.2.712 662 19.11 9.2.001 (45.2. these should be sub-classified into Intangibles Tangibles Investments 166 .182 3.553) (2. 9.3 Format The general format for a balance sheet is prescribed in the Companies Acts and can be illustrated by the following example.204 6. The section numbers referred to above (known as ‘Notes to the Accounts’) would normally provide further detailed analysis.9 22.214.171.1245 19.14 9.2.854 39 20.743 2.12 9.895 24.13 9.804 62.923 9.882 1.9 ♦ Accounting Analysis 126.96.36.1997 3.2.557 18.338 (188.8.131.52 4.15 9.4 Fixed Assets As already noted.101 35.2.792 800 16.484) 19.4 877 19.000 19.592 2003 £000 2002 £000 Current assets Stock Debtors Investments Cash Current liabilities Net current assets Total assets less current liabilities Long-term liabilities Provisions for liabilities and charges Net Assets Capital and reserves Called-up share capital Share premium account reserve Revaluation reserve Other reserves Profit and loss account reserve Total shareholders’ funds Minority interests 9.420 27.592 1. XYZ plc – Group Balance Sheet as at 31 December 2003 Section Fixed assets Intangible Tangible Investments 9.5 19.16 1.10 52.695) (1.428 1. fixed assets are assets acquired for continued use within the business and not for resale.428 You will notice that the balance sheet is shown for both this year end (31 December 2003) and the previous year end (31 December 2002) for comparison purposes.8 9.193) 16.798 37 20.2.237 4.6 9.725 2.2.980 2.875 15.783 37.607 (3.687 1.428 9.817) 3. but in this table they are being used to provide additional explanations of the terminology.
Patents. The types of intangible assets that most frequently appear on the balance sheet are as follows.000 cost less £5. the balance sheet net book value of the equipment falls by £11. Year 1 £000 Cost Accumulated depreciation provision Net book value 60 (11) 49 Year 2 £000 60 (22) 38 Year 3 £000 60 (33) 27 Year 4 £000 60 (44) 16 Year 5 £000 60 (55) 5 As we can see. Tangible Fixed Assets These are physical assets that are used within the business over a number of years with a view to deriving some benefit from this use. Leasehold land and buildings. that enable it to operate and generate profits in a way that competitors cannot.g. at the end of each of the next five years the fixed asset will be valued in the balance sheet as follows. Thus.000 charged against the profit each year. licences and trademarks.9 ♦ Accounting Analysis The Companies Act requires that all fixed assets that have limited useful economic lives must be depreciated.000 each year. On the balance sheet fixed assets are usually stated at net book value (NBV).000. or abilities of its staff.000 expected sale proceeds) to use the equipment over these five years. Brands. i. Intangible Fixed Assets Intangibles are literally assets without physical form. Goodwill.000. Depreciation is an example of the accounting principle known as accrual or matching. i.e. until in Year 5 it has dropped to the estimated sales proceeds of £5.000. that it will last five years. cost less the accumulated depreciation provision. Depreciation is the method by which the cost of using the asset is matched against its related benefit. through their use in the manufacture of goods for resale. Applying the matching concept.000 cost should be spread over the five years. a depreciation expense of £11. Research and development expenditure.000 (£60. Depreciation of intangible fixed assets is frequently referred to as amortisation. this £55. after which time it will be sold for £5.000 each year (as the amount is charged as an expense – depreciation). Note that the depreciation charge in the profit and loss account. from previous experience. 167 . It expects. They frequently represent intellectual property rights of the company. but what is depreciation? Example A company buys some production machinery at a cost of £60.e. Publishing rights and titles. e. of £11. is just an accounting entry and does not appear in the cash flow statement. Tangible fixed assets include items such as Freehold land and buildings (including buildings under construction). It will therefore cost the company £55.
in that they are valued at the lower of Costs. Motor vehicles. estimated selling price less any cost incurred in order to sell. or Net realisable value (NRV).9 ♦ Accounting Analysis Plant and machinery. perhaps as a result of selling goods on credit (this will include prepayments.2. Debtors – amounts owed to the company. Since the amount is owed even though it has not yet been invoiced for. 9. Additional reporting regulations apply to significant levels of shareholdings that have caused the investments to be classified as either a subsidiary (50%+) or an associate (20%-50%). Cash in hand and at bank.2. Accruals An accrual is an amount due in respect of goods and services used during the year but not yet invoiced. as well as debtors that are receivable in more than 12 months. short-term speculative investments. it has to be shown as part of the liabilities. In valuing current assets the fundamental accounting principle of prudence is applied.7). work-in-progress (WIP) and finished goods.e. i.2. stocks can be further re-classified into raw materials. 168 .2. though perhaps the best description is that current assets are assets held for conversion into cash in the ordinary course of business.g. Investments – shares held in the short term with the intention of reselling. Stock – goods held available for sale. They include Bank overdrafts (not bank balances in credit).6 Current Liabilities Current liabilities should fully reflect all liabilities payable within 12 months of the year end. see Section 9. Accruals are therefore shown as part of current liabilities. Dividends payable.2. Current assets are sub-categorised in increasing order of liquidity as shown below. Fixtures and fittings. e. Accruals (see Section 9. 9. Within this category.7). Trade creditors.7 Accruals and Prepayments Accruals and prepayments arise in the balance sheet when the amount charged as an expense in the profit and loss account for the year is not the same as the amount paid out of the cash balance. Corporation tax payable. Debtors will also include unpaid share capital. Investments These represent long-term ownership of shares in other companies and are usually reported in the balance sheet at historical cost.5 Current Assets Strictly speaking these are assets other than fixed assets. 9.
shareholders’ liability is limited to any unpaid element of this nominal value. As a result it will be able to raise cash in later years by issuing more shares at a price in excess of their nominal value. 9. for the long term as fixed assets or for the short term as working capital. 9. The company is not allowed to issue fully paid shares at a price below nominal value. It would also include any other known liabilities such as trade creditors that do not require settlement within the next 12-month period. Under the Companies Act. we still have an asset at the balance sheet date. at a premium. If the company becomes insolvent.2. Prepayments are therefore shown as part of debtors.11 Called-Up Share Capital This represents the total nominal value of the shares in issue at the year end. e. i. Included within this section would be amounts provided for deferred tax.g. This represents The minimum value at which shares can be issued. debt (long-term liabilities) or equity (shareholders' funds). Where the share is a fully paid share. 9. It can also be calculated by looking at where those funds came from. 169 . our company has in issue 100. i. within current assets. UK companies must assign a nominal or par value to each share. then its value will grow.2. Their value is.9 Long-Term Liabilities This will typically include such items as Long-term bank loans. which have been deferred to a later period. Since we have paid the money over but not yet received the benefit due from the expenditure. The amounts are estimated because they are not yet known with certainty and will not be until the process is completed some time in the future.e.e. Both of these must be repaid long term.000 shares. each with a £1 nominal value giving £100.10 Provisions for Liabilities and Charges These represent amounts set aside by the company to meet foreseeable future costs arising as a result of past events. 9. the shareholder has no further liability. such as bank loans.2.9 ♦ Accounting Analysis Prepayments Prepayments are amounts paid before the balance sheet date which relate to the period after that date. An example of such a provision is the costs associated with the demolition and site clearance of a factory closed down during the year. This represents tax liabilities. Loan stock and debentures issued by the company. therefore. due to timing differences between accounting and taxable profit. less reliable than ‘full’ creditors. 9.8 Capital Employed The sum of total assets minus current liabilities is known as capital employed.2.12 Share Premium Account Reserve If a company trades profitably and retains those profits to finance expansion. It represents the total amount of funds being used in the business. where it is known with certainty what is owed and when it is due to be paid. The limits of the liability of the shareholder.2.000 share capital.
e. The share premium account reserve can never be reduced to pay dividends to the shareholders. To issue bonus shares. 5. as it is one of the company’s non-distributable reserves. a 1 for 2 bonus issue. Existing holding Bonus shares Final holding 2 shares 1 share 3 shares @ £9 @ £free = = = £18 £0 £18 or £6 per share In terms of the balance sheet. 1. To charge the premium on repayment on debentures. Any surplus over the value of the share premium would have to go to other reserves. with the cash bonus share price at £9. To write off expenses of issue of shares or debentures. A bonus issue. £5.000 by issuing 5. For example. This results in a premium of £3 per share (issue price of £4. To charge the discount on issue of debentures. 3. less nominal value of £1). would give the owner of two shares one new share. like a rights issue.000 must be added to the share premium account reserve. The impact on the share price is as follows. the effect is Impact on net assets Impact on shareholders’ funds None Share capital up Share premium account reserve down* * 2. the company must record the issue of these shares by increasing the called-up share capital by only the nominal value of the shares issued.9 ♦ Accounting Analysis Example A company could raise £20. Note that it is not just the share premium account reserve that can be used to finance a bonus issue – any reserve will do. Bonus shares are issued by a company when it feels that the share price has gone too high.000.000 new £1 ordinary shares at an issue price of £4 each. 4. Under the Companies Act. To write off preliminary expenses of forming a company. The premium of £15. The impact on the accounting equation is £000 Impact on Net Assets Cash +20 +20 Impact on Shareholders’ Funds Share capital Share premium account reserve +5 +15 +20 Having been created. the share premium account reserve can only subsequently be reduced in five circumstances without a court’s permission. is made to the existing shareholders and gives them a number of free shares proportionate to their existing holding. 170 . i.
Where a company does revalue its fixed assets upwards. it can be used to cover the payment of dividends to shareholders. ensure that you can distinguish them in your mind.15 Profit and Loss Account Reserve The profit and loss account reserve on the balance sheet represents the accumulated profits made by the company since it started to trade. The balance sheet figure represents the accumulated position since the company started trading. since it has a majority of voting rights. but these are added to the opening cash balance to arrive at the closing one.e. the company cannot use the revaluation reserve to pay a dividend. therefore.13 Revaluation Reserve UK companies are permitted by the Companies Act to revalue all assets other than goodwill upwards. As such it is a distributable reserve under the Companies Act rules.2. When XYZ plc prepares its consolidated accounts. This could be viewed like a bank statement. giving the accumulated position at the end of the year. i. which are detailed in the separate profit and loss account statement.2. XYZ plc may own 80% of ABC Ltd.16 Minority Interests Minority interests arise when a company has a partly owned subsidiary company. To indicate that a portion of profits will never be paid out as a dividend. 9. considered unrealised and non-distributable. i. 9.14 Other Reserves Any other reserves generally represent an apportionment or allocation of profits from the profit and loss account reserve. To account for the treatment of unusual terms such as goodwill written off. The profit and loss account statement (covered in Section 9. the increase in the net book value of the assets is reflected within shareholders’ funds in the revaluation reserve. It is.9 ♦ Accounting Analysis 9.e. which have not been paid out as dividends or transferred to other reserves. where the statement only shows the movements for the month.2. Any profits retained this year.e. The reason for this is that it controls all of ABC Ltd’s assets. i.3) details the movements for the year. it will include all the assets and liabilities of ABC Ltd on the top half of its balance sheet as being part of the group’s assets and liabilities. To indicate that a certain element of profit is being retained for a specific reason. referred to as the minority interest. This is frequently done for the following reasons. In this situation. The separate profit and loss account statement details the impact of this year’s trading activities on this accumulated figure. It has not been generated by the operational performance of the company and it is certainly not represented by cash. The balance of the shares in ABC Ltd are owned by other shareholders. it would be imprudent to treat this increase in shareholders’ funds as part of the company’s realised profits for the year. increasing net assets and shareholders’ funds. Impact on net assets Impact on shareholders’ funds Fixed assets up Revaluation reserve up 9.2. 171 . will be added to the accumulated retained profits (or reserves) brought forward. For example. It is all too easy to become confused by two items having the same name of profit and loss account.
002 (21.08p Profit on ordinary activities before taxation Tax on profit on ordinary activities Profit on ordinary activities after taxation Minority interests Extraordinary items Profit/(loss) for the financial year Dividends paid and proposed Retained profit/(loss) for the financial year Earnings per ordinary share 172 . with the other 20% being owned by the minority interest.000) 5.1 Introduction The profit and loss account statement provides a detailed analysis of how the company has generated its profit or loss for the accounting period. As already noted.961) (19. The minority interest shows how much of the net assets belong to the minority shareholders in ABC Ltd.258 (20) – 5.406 100 30 2002 £000 141.521) 7.752) 200 11.527) (1.013 (91.104) 3.2 Format and Terminology Format The Companies Acts prescribe the format of the profit and loss account as follows.518 100 161 (3.9 ♦ Accounting Analysis However.761 (85.064) 1.604) 50.3 Profit and Loss Account Statement 9.157 (22.196 (2.011) 50.296) 10.289) 9.06p ➀ ➁ ➂ ➃ ➃ ➄ ➅ ➆ ➇ ➈ ➉ (3.256 (60) – 3.636) (16.132 5. 9.676 (270) 7.814 (1.3.3. it reconciles the change in the balance sheet profit and loss figure (the profit and loss account reserve) from one year to the next. 9.620) 100 7.176) 4.238 (6. it only owns 80% of ABC Ltd’s net assets.258 (2. XYZ plc – Group Profit and Loss Account for the Year Ended 31 December 2003 Notes Turnover Cost of sales Gross profit Distribution costs Administrative expenses Other operating income Operating profit Exceptional items Income from fixed asset investments Interest receivable and similar income Interest payable and similar charges 2003 £000 135. XYZ plc recognises this fact by analysing the total shareholder financing into two separate entities – group shareholders’ funds and minority interest.360 (1.
Derives from events or transactions that fall within the ordinary activities of the business. income and expenses are recognised in the profit and loss account statement when earned regardless of when paid. in accordance with the accruals principle. if a company has in issue £100. 7 Tax on Profit on Ordinary Activities UK companies pay corporation tax on their taxable profits. any interest payable goes to reduce the company’s profit before tax and hence taxable profit by the gross amount payable. 173 . For example. excluding any extraordinary items. the higher the margin for a particular level of operations. then the interest charge in its accounts each year will be £10. An exceptional item Is material. 6 Interest Payable In common with most other business expenses.000 of 10% loan stock. Gross Profit Gross profit is the difference between the value of the sales and the value of the cost of goods sold.000. this does not mean that low margins result in low profits. One measure frequently used in determining the performance of the business is to consider its gross profit margin. Formula to Learn: Gross profit margin = Gross profit × 100% Turnover Clearly. They are separately classified as exceptional items to highlight their one-off nature. 2 3 Cost of Sales The cost of sales represents the total cost to the business of buying or making the actual items sold. the higher the profit. However. Any difference between the recognition of these items and the corresponding cash flow will be reflected in a balance sheet debtor or creditor. 4 Various Operating Costs These costs include all other expenses incurred in generating the turnover for the period by way of administrative involvement and delivery/distribution. 1 Turnover The turnover or sales figure represents the total value of goods or services provided to customers during the accounting period whether they have been paid for or not. The element of the total tax charge shown here is the tax on the ordinary activities of the business. which can be calculated as follows.9 ♦ Accounting Analysis Terminology In accordance with the accruals or matching principle. Needs to be separately disclosed by virtue of its size or incidence if the financial statements are to give a true and fair view. A number of businesses generate very healthy profits through selling very large numbers of items (achieving correspondingly large turnover) at low margins. 5 Exceptional Items Exceptional items are unusually large items of income or expense arising during the year.
9 Extraordinary Item An extraordinary item is a large one-off item.3 Capital and Revenue Expenditure Capital Expenditure Capital expenditure is expenditure on acquiring or enhancing fixed assets or their operating capacity. XYZ plc’s dividend for 2002 is uncovered in our example. Hence.) is not distorted. Is not expected to recur. Note that this definition is exceedingly restrictive and it is highly unusual that a profit and loss account statement will have an extraordinary item shown. the benefits will be derived from this expenditure over the remaining life of the asset. However. Where XYZ plc owns 80% of ABC Ltd. Interim dividend paid – this is paid out during the year based on the half year’s performance. In such a case. Dividends These represent the cash dividends paid out or proposed to be paid out to shareholders net of starting rate income tax. similar to an exceptional item. leaving the amount of profit attributable to the shareholders in XYZ plc. that requires separate disclosure in order to ensure that the truth in the accounts (the trends. Tax is payable on extraordinary items.e. are accumulated in the balance sheet profit and loss account reserve balance. Final dividend proposed – this is paid to shareholders following the approval of the year end accounts at the AGM. with 20% belonging to the minority interests. it will include all of ABC Ltd’s profit after tax in its own consolidated accounts on the basis that it controls all of ABC Ltd’s operations. this expenditure is added to the value of fixed assets (is capitalised) on the balance sheet and will subsequently be depreciated through the profit and loss account. Possesses a high degree of abnormality which arises from events or transactions that fall outside the ordinary activities of the business. It may be financed from previously retained profits which. a company would dispense with the line altogether. 174 . As such. However. as we have seen.3. it does not own all of that profit. UK companies pay dividends in two stages.9 ♦ Accounting Analysis 8 Minority Interests Minority interests arise in a similar way as in the balance sheet. ratios. the dividend is being paid from this year’s profits and is said to be covered. For that reason our illustrative accounts have shown the positioning of the item in the accounts but given a nil amount. etc. The 20% of ABC Ltd’s profit after tax that belongs to the minority interests is deducted from the profit after tax. In most cases. i. it is not essential for a dividend to be covered. 9. An extraordinary item Is material. The figure that would be shown on the face of the profit and loss account would be a net of tax figure. Most of the time companies pay out dividends which are less than their profits after tax.
2 Scope FRS 1 applies to all financial statements intended to give a true and fair view. 1 (FRS 1) – Cash Flow Statements lays down the rules to be followed in the preparation of such statements.g. e. − − − Turnover Total Assets Employees Not more than £5. They give no indication of the effects of the operations of the business on its cash flows. e.9 ♦ Accounting Analysis Revenue Expenditure Revenue expenditure is expenditure incurred in Acquiring assets to be sold for conversion into cash. excluding Small companies where a small company is defined as one which fulfils two of the following three criteria. Cash. Manufacturing. Financial Reporting Standard No. wages. stock. where 90% or more of the voting rights are controlled within the group. It should always be noted that profits do not correspond exactly to cash.4. electricity.1 Introduction The balance sheet and profit and loss account statement are prepared on an accruals basis. selling.g. repairs. Day-to-day administrative expenses. 9. 9. distributing goods.g. who must prepare cash flow statements. Revenue expenditure is charged directly against profits for the period to which it relates. Since cash is such an important figure in determining the continuing existence of a company. The format to be adopted in cash flow statements.g. e. defining The scope.e. telephone.e. e. i.4. Open-ended investment funds. we need a statement showing how the company’s financial resources have been acquired and have been used in order to highlight the liquidity position and trends of the company. Mutual life assurance companies. 175 .8m Not more than 50 Subsidiaries of parents. who file publicly available versions of their consolidated financial statements. i.4 Cash Flow Statement 9. what is and what is not cash. Pension Funds. A company may be very profitable but almost bankrupt (unable to pay its liabilities as they fall due). Maintenance of fixed assets.6m Not more than £2.
Equity dividends paid. Acquisitions and disposals. Returns on investments and servicing of finance.4. specifically Net cash inflow from operating activities.4 Format and Terminology Terminology It can be seen from the cash flow statement overleaf that it is sub-classified according to the activities that give rise to the cash flows. Capital expenditure.4. the same period as the profit and loss account.3 Cash Definition Cash is defined as cash in hand plus deposits repayable on demand less overdrafts repayable on demand. The cash flow statement must cover the period between the company’s balance sheet dates. 176 . Deposits repayable on demand are those which can be withdrawn at any time without notice and without penalty.e.9 ♦ Accounting Analysis 9. Financing. i. or where a maturity/period of notice of not more than 24 hours has been agreed. Note that the cash flow does not include depreciation as that is an accounting entry in the profit and loss account. Taxation. Management of liquid resources. 9. Disclosure The cash flow statement must show a total for each class.
177) (10.902) Acquisitions and disposals Purchase of subsidiary undertakings Equity dividends paid Management of liquid resources Purchase of Treasury bills Sale of Treasury bills Financing Issue of ordinary share capital Repurchase of debenture loan Expenses paid in connection with share issues Loans taken out (9.510) – 1. the balance sheet.545) (421) 532 111 20. incorporating the profit and loss account statement. the cash flow statement and all of the associated notes.908) 11.750) 2. The role of ratios is to distil this information into a more usable form for the purpose of analysis. 177 . XYZ plc – Group Cash Flow Statement for the Year Ended 31 December 2003 2003 £000 Net cash inflow from operating activities Returns on investments and servicing of finance Interest received Dividends received/(paid) Interest paid 2002 £000 15.892) (131) 6.919) Taxation Capital expenditure Payments to acquire intangible assets Payments to acquire tangible assets Receipts from sales of tangible fixed assets (589) (289) (2.235 (2.682 (17.239) (3. contain a vast amount of information.5 Analysis of Accounts 9.370 (12.089) (5.021) (2.1 Introduction The financial statements.021 (3.258) 645 (1.233) (620) 580 (40) 72 (13.766 261 1.743) 9.068) Decrease in cash (16.9 ♦ Accounting Analysis Format The illustration below shows how a cash flow statement should appear in the account of XYZ plc.5.364 (1.705 9.521) (2.847) (5.110) (662) (3.844 113 0 (3.
Financial Gearing Ratios Ratios that assess the risks to the providers of finance. who may be either shareholders or lenders. changes in accounting policies and restatement of prior year figures may lead to changes in ratios. competitors and employees. levels of trading profits generated. suppliers. they may have several other users. i. slightly different calculation methods may have been used. giving rise to some distortion in the comparison. It is specifically before interest payable since this will clearly be dependent on the financing of the business – the larger the loan. Profitability Ratios Ratios that assess the trading or operating performance of the company.e. Each of these groups will use the accounts to provide an indication of the Returns they are receiving. by analysing the company’s exposure to debt. the larger the interest payable. Investors’ Ratios Ratios that assess the returns to the providers of finance. However. Also.2 Profitability Ratios Return on Capital Employed This is a measure of the level of profitability generated by the management of a company. However.9 ♦ Accounting Analysis The financial statements are primarily prepared for company shareholders. Risks they are facing. there is a risk that.e. However. the profits that management have generated from the resources they have available. Ratios are rarely useful when viewed in isolation. Basic Calculation The return on capital employed is calculated as follows. and the productivity of trading assets. market averages or other similar companies.5. we will draw examples from the balance sheet and profit and loss account data for Illustration plc. Liquidity Ratios Ratios that assess the risk that the company may be unable to pay its creditors as they fall due with cash and assets generated from trading. Formula to Learn: ROCE = Profit before interest payable and tax × 100% Capital employed Profit This profit figure can be viewed as operating profit. such as the Board. as there are no official rules concerning ratio calculation. and these can be grouped under four headings. if two ratios from different sources are being compared. 9. which can be found at the end of this chapter. i. A number of fairly standard ratios have been developed to assist with this process. which are not necessarily indicative of underlying performance. A company’s progress can also be measured by comparing ratios with past in-house figures (for internal assessment) or previous published accounts to give a picture of year-on-year performance. Throughout our review of ratios. 178 . they can be used to assess a company by comparison to sector averages.
484 Capital Employed Capital employed could be viewed from the financing side as Formula to Learn: Capital employed = Shareholders' funds + Loans £37. £ Profit before tax Add back interest payable Operating profit 3.445 or from the trading side as Formula to Learn: Capital employed = Total assets .666 Current ratio = 1.666 Example – Illustration Plc ROCE = £6.041 + £4. as follows.811 6.3% 9. The ratio calculates whether assets recoverable within one year are sufficient to cover liabilities falling due within that year.486 = £33.9 ♦ Accounting Analysis In the examination. you may be given the profit before tax figure and the interest payable and be asked to calculate operating profit.32× 179 .653) – £43.653 £43. Formula to Learn: Current ratio = Current assets Current liabilities Example – Illustration Plc Current ratio = £57.Current liabilities £37.5.673 2.484 × 100% £37.3 Liquidity Ratios These ratios review the ability of a company to repay its debts.486 ROCE = 17. Current Ratio This ratio is calculated from using the company’s year-end position.499 + £57.486 = (£23.
Formula to Learn: Debt to equity = Interest bearing loans × 100% Equity shareholders' funds Considerations We consider only interest-bearing debt since this is what is causing the risk to profit before tax.372 + £2.073 × 100% £33. dividend distribution) is optional. 180 . Formula to Learn: Quick ratio = Current assets (excluding stock) Current liabilities Example – Illustration Plc Quick ratio = £57.233 £43.e. Example – Illustration Plc Debt to equity = £2.041 Debt to equity = Debt to equity = 13.5.653 − £19.5% Equity shareholders’ funds are given by the equity share capital and all of the reserves. therefore.4 Financial Gearing Ratios These ratios deal with the financing side of the balance sheet and consider the relationships between Interest-bearing borrowed capital on which the return (i. coupon or dividends) must be paid.666 £38. hence ultimately the profits after tax and amounts available for payment as dividends to our shareholders.041 £4.9 ♦ Accounting Analysis Quick (Acid Test) Ratio The quick ratio is an adaptation of the current ratio to remove the problem of stock.420 £43.875× 9. It is generally accepted that high levels of gearing imply high financial risks for the company.445 × 100% £33. Debt to Equity Ratio Basic Calculation This is a relationship that shareholders would consider as a measure of the risk to their dividends. Stock is a problem in that it is not easily convertible into cash and may. Shareholders’ capital on which the return (i.e.666 Quick ratio = Quick ratio = 0. distort the ratio.
and takes account of the cash that a business may also hold that could be used to repay debt.445 (as above) − £1.000 − £926 × 100% £33.041 Net debt to equity = Net debt to equity = 7. Formula to Learn: Interest cover = Profit before interest payable and tax Interest payable Considerations The interest cover provides a measure of the ability of the company to pay the fixed interest on borrowings from profits for the year.9 ♦ Accounting Analysis Net Debt to Equity Ratio This is an alternative to the above.31× 181 . Example – Illustration Plc Interest cover = £6. However.519 × 100% £33.041 £2. Formula to Learn: Net debt to equity = Debt (as above) − Cash and current asset investments × 100% Equity shareholders' funds Considerations We should consider the ability of the company to use the cash it has available to repay debt. Example – Illustration Plc Net debt to equity = £4.6% Interest Cover Basic Calculation This ratio considers gearing from the viewpoint of the profit and loss account statement and measures the capacity of the firm to meet its interest obligations. Clearly.484 (see ROCE above) £2. there is no optimal level.811 Interest cover = 2. the less risk there is to either shareholders or lenders. the higher the level of interest cover.
Fully diluted earnings per share is calculated on the basis that conversion of the debentures/preference shares or the exercise of warrants/options has already occurred.762.5. Example – Illustration Plc EPS = £2. The impact of the notional conversion/ exercise on earnings per share is calculated. Warrants in issue. and the result is fully diluted earnings per share. Preference dividends. Earnings therefore represent the remaining profits available to the ordinary shareholders. Each of these circumstances may result in more shares being issued in future years. Minority interests.000 18.5 Investors’ Ratios Earnings Per Share Earnings per share (EPS) is the one ratio for which there are some rules regarding the calculation. These are laid out in FRS 14. Options issued by and exercisable on the company. Extraordinary items. Convertible loan stock in issue. Convertible preference shares in issue.9 ♦ Accounting Analysis 9. Price/Earnings Ratio (P/E Ratio) The P/E ratio is calculated as follows. as a result of an obligation to issue new shares. which defines the EPS as Formula to Learn: EPS = Earnings attributable to ordinary shareholders Number of ordinary shares Earnings are defined as consolidated profit after Tax. There are a number of reasons why earnings could be diluted in the future. These would be taken into account when calculating the fully diluted earnings per share.3p Fully Diluted Earnings Per Share The objective of the fully diluted earnings per share figure is to warn shareholders of the company’s possible future deterioration in the earnings per share figure.301. Formula to Learn: Price/Earnings = Current market price per share Earnings per share 182 .000 shares EPS = 12.
it is also true that companies with high P/E ratios tend to have low dividend yields.9 years Analysis Points The significance of a P/E ratio can only be judged in relation to the ratios of other companies in the same type of business. Therefore. indicating that the company has low growth prospects. the P/E ratio is Price/Earnings = 220p 12. driving the price up and reducing the yield.9 ♦ Accounting Analysis Considerations The P/E ratio expresses the number of years’ earnings represented by the current market price. 183 . However. A low ratio. in part. Formula to Learn: Net dividend yield = Net dividend per share × 100% Current market price per share Example – Illustration Plc Dividend yield = 6. Investors who believe that the company has good growth prospects would buy the share. Alternatively. say 4 for example. Example – Illustration Plc If we take our current share price as £2.3p Price/Earnings = 17. and vice versa. a high yield may be due.42p × 100% 220p Dividend yield = 2. If the median P/E ratio for an industry sector was 8. would indicate a company – not greatly favoured by investors – which probably has poor growth prospects. a ratio of 12 for a particular company would suggest that the shares of that company were in great demand.20 and our EPS figure as 12. a high P/E ratio might indicate that a company is overpriced (overvalued). and a low P/E ratio might indicate that a company is underpriced (undervalued). possibly because a rapid growth of earnings was expected. Note that growth (and therefore a high P/E) can be generated by retaining a large proportion of earnings and paying low dividends and reinvesting the earnings to grow the business. to a relatively low share price. Net Dividend Yield The dividend yield of an ordinary share is calculated as follows.92% Analysis Points A high dividend yield suggests that the company is paying reasonable levels of income.3p.
Net asset value will also be reduced proportionately if the company performs a stock split or capitalisation issue.9 ♦ Accounting Analysis Dividend Cover Dividend cover is used to assess the likelihood of the existing dividend being maintained. presumably with the intention of reinvesting to generate growth. the company is drawing on past reserves and is said to be paying an uncovered dividend. The shareholders may be more interested in asset values if the company adopts a revaluation policy. Formula to Learn: Net asset value = Net assets attributable to ordinary shareholders Number of shares in issue Example – Illustration Plc Net asset value = £33. 184 . Where this occurs.42p Dividend cover = 1. A company may choose to pay a larger dividend than that year’s earnings (in which case dividend cover will be <1). Net Asset Value Basic Ratio The net asset value or net asset value per share is calculated as follows.041 18.762 = £1. The dividend cover is calculated as follows. as the number of shares will increase with no corresponding change in net assets. Formula to Learn: Dividend cover = Earnings per share Net dividend per share Example – Illustration Plc Dividend cover = 12.3p 6.76 Considerations Net assets attributable to ordinary shareholders should exclude the book value of any preference share capital the company has in issue. The net asset value could show an unrealistic figure if a strict policy of historical cost accounting has been applied.92× Analysis Points An unusually high dividend cover implies that the company is retaining the majority of its earnings.
Although you are required to understand the basic details of SVA. It was primarily designed to be a measure of management performance.g. Effect of economic cycles. property companies and capital-based industries where a large proportion of the value of the business is tied up in the value of assets owned.9 ♦ Accounting Analysis Other factors that would have an impact on asset valuation include Depreciation method influencing book value of assets. The methodology of SVA focuses on the following basic ideas. then value is being added by the management of the company. Capital invested. it has become fashionable to use SVA as part of an assessment of a company’s expected future returns. If the SVA is a positive value. Profitability after allowing for the cost of capital. it cannot be affected by accounting choices in the way that accounting profits are. Asset-based valuation will be appropriate for investment trusts.6 Shareholder Value Added (SVA) Shareholder Value Added (SVA) is a measure of performance that is designed to identify the economic profit a company is earning. The benefit of using economic profit for this purpose is that. i. the after-tax cost to the company of servicing its finance based on the required returns of equity and debt investors and the market values of these sources of finance. you will not be asked to calculate this ratio in your exam.5. Assets with volatile values. property. which are not represented on the balance sheet. debt and equity. 185 . normal operational profits irrespective of the financing of the company. This should encourage management to use capital efficiently. 9. in recent times. raising capital where they believe they can earn high returns compared to its cost. However.Cost of capital Net Operating Profit After Tax Net operating profit after tax equals operating profit excluding exceptionals before interest. e.e. genuinely assessing the value that management has brought to a company’s shareholders as a result of their actions. Definition SVA is defined as Formula to Learn: SVA = Net operating profit after tax . if carefully calculated. It will be less useful for service industries with a large amount of intangibles. and repaying capital if the rate of return on investment is too low. The idea is that management have to generate a sufficient return to fully satisfy the requirements of the various investors. Cost of Capital Formula to Learn: Cost of capital = Value of the capital invested × Weighted average cost of capital That is. Cost of capital.
frequently used in capital intensive industries with high depreciation charges. which looks at earnings (returns available to equity holders only) and compares this with the amount of equity a company has.7 Enterprise Value to EBITDA Definition EV to EBITDA is calculated as follows.9 ♦ Accounting Analysis 9. Contrast this with the P/E ratio.Cash and investments EBITDA (Earnings Before Interest. This means that EV/EBITDA can be used to compare companies with different amounts of debt. Although you are required to understand the basic details of EV/EBITDA. Tax.5. preference shares and net debt. therefore. e. Depreciation and Amortisation) Earnings Add: corporation taxes Add: net interest expense Add: depreciation and amortisation EBITDA x x x x x Key Issues Regarding EV/EBITDA This ratio looks at the amount of debt and equity that a company has and then looks at the returns available to debt and equity holders. It is. It is not affected by differences in depreciation and amortisation methods. Formula to Learn: EV to EBITDA = Enterprise value EBITDA Enterprise Value Enterprise value is the total value of all the ordinary shareholders’ equity.g. 186 . utility companies. Formula to Learn: Enterprise value = Market value of ordinary shares + Market value of preference shares + Market value of debt . you will not be asked to calculate this ratio in your exam.
372 (4.486 2.307 926 1.987 37.143 33.762 2.000 57.926 18.9 ♦ Accounting Analysis Illustration Plc Balance Sheet as at 31 December £000 £000 Fixed assets Intangible Tangible Investments Current assets Stock Debtors Investments Cash Current liabilities Trade creditors Tax Others Net Current Assets Total assets less current liabilities Long-term liabilities Secured loans Unsecured loans Net Assets 3.731 842 23.445) 33.625 6.666 13.073 2.260 43.041 18.455 2.781 1.420 36.041 Share Capital £1 (NV) ordinary shares Reserves Share premium account reserve Revaluation reserve Profit and loss account reserve Shareholders’ Funds 187 .681 9.653 35.499 19.
712) 6.204) 1.811) 3.484 (2.42p 188 .673 (1.9 ♦ Accounting Analysis Profit and Loss Account Statement £000 Turnover Cost of sales Gross profit Distribution costs Administration costs Operating profit Interest paid Profit before tax Tax Profit after tax Dividends Retained profit Earnings per share Dividend per share 135.372) 2.761 (83.097 12.157 (22.961) (22.604) 52.3p 6.301 (1.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.