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    6 views12 pages

    14) Accounting Fundamentals

    Uploaded by

    CRAZYBLOBY 99

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    © All Rights Reserved
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    Accounting fundamentals Income statement + Identify and explain the contents of an income statement including: revenue, ‘cost of sales, gross profit, operating profit, profit for the year, retained earnings Statement of financial position + Identify and explain the contents of a statement of financial position including: roncurrent asets, current assets, current lablitis, working capital net assets, ‘non-current liabilities, reserves and equity Lqulaty ratios + Determine acid test ratio, current ratio oitabilt ratios + Determine gros profit margin, profit margin Practical use of ratio analysis + Explain how each of these atosis used + Explain reasons fr the results obtained «= Discuss ways that businesses might try to improve ratio results, reducing working capital problems «Compare ratios results between businesses + Explain the limitations ofthese accounting ratios Main users of accounts + Identity ofthe kind of information that individual stakeholder groups might seek war + Explain imitations ofthe usefulness of published accounts: historical, may not reflect the future, may be out of date, does not reflect qualitative aspects ofa business, possibilty of ‘window dressing’, may not have detals of the performance of individual parts ofa business Limitations of published accounts [Note: Knowledge of specific Accounting Standards isnot required] Scanned with CamScanner Financial Statements Introduction ‘The income statements ahistorical record of the trading of a business over a Specific period (normally one year). tt shows the profit or loss made by the business - whichis the difference between the firm's total income and its total costs, The income statement serves several important purposes: + Allows shareholders/owners to see how the business has performed and. Whether it has made an acceptable profit (return) + Helps identify whether the profit earned by the business is sustainable Croft quality) + Enables comparison with other similar businesses (e.g. competitors) and the industry asa whole + Allows providers of finance to see whether the business is able to generate sufficient profits to remain viable (in conjunetion withthe cashflow statement) + Allows the directors ofa company to satisfy ther legal requirements to Feport on the financial record ofthe business Income Statement records the revenue, costs and profit ora business over a ‘ven period of time. Income statement is 2 very important accounting record. It tells the managers and ‘other stakeholders whether a business is making profit o not. ‘The structure and format of atypical income statement is ilustrated below: Example 1 Example Company Utd Income Statement 2015 2014 Year Ended 31 December £000] £000 Revenue 21,450 | 19,780 Cost of sales 13,465 | _ 12,680 Gross profit 7,985 | 7,100 Distribution costs 3210 [2,985 ‘Administration expenses 2,180 [ 1,905 Operating profit 2,595 | 2,210 Finance costs 156 120 Profit before tax 2,439 [2,090 Tax expense 746 580 Profit attributable to shareholders 1,693] 1,510 The lines in the income statement canbe briefly described a5 follows: category Explanation The revenues (sales) during the ptiod are recorded here, Sometimes referred to a the “top line" ~revenue shows the total value of sales made to customers Revenue Scanned with CamScanner Cost of sales Gross profit Distribution & ‘administration expenses Operating profit Finance expenses ‘The direct costs of generating the recorded revenues go into "cost of sales". This would include the cost of raw materials, ‘components, goods bought for resale and the ditect labour 0sts of production. “The difference between revenve and cost of sales. Asimple but very useful measure of how much profit is generated from every £1 of revenue before overheads and other ‘expenses are taken Into account. Is used to calculate the ross profit marga (4) Operating costs and expenses that are not directly related to producing the goods or services are recorded here. These ‘would include distribution cost (e.g. marketing, transport) ‘and the wide range of administrative expenses or overheads that a business incurs ‘Akey measure of profit. Operating profit records how much profit has been made in total from the trading activities of ‘the business before any account s taken of how the business is financed. Interest pald on bank and other borrowings, less interest Income received on cash balances, is shown here. A useful figure for shareholders to assess how much profits being ‘used up by the funding structure of the business. Profit before t2X calculated a5 operating profit es nance expenses ‘An estimate of the amount of corporation tax thats likely to ™ be payable on the recorded profit before tax ‘The amount of profit that is left after the taxhas been oft atrbutable ned for te shaeholers then decide how mach of toshareholders hic is pad out to them in dividends and how much is left in the business ("retained earnings" in the equity section of the balance sheet) ‘The main tems ofan income statement are: ' Sales revenue cost of sales = Gross profit ‘+ Gross profit- overhead expenses = Operating profit ‘+ Operating profit ~taxes, dividends = Retained profit ‘There are three sections to an Income statement: 4. Trading Account - calculates the gross profit made on trading activities Cost of Sales/Goods Sold ~the direct cost ofthe goods that were sold during the financial year {€OSTOF GOODS SOLD = Opening Stock+ Purchases Closing Stock Scanned with CamScanner ‘GROSS PROFIT= Sales REvERUE=COst of Goods Sold» 2. Profit and Loss Section ~ calculates the overall level of profit made 3. Appropriation Account ~ shows how any profits made by the business have been distributed ‘+ Dividends ~ the share ofthe profits paid to shareholders asa return for Investingin the company Contents of an income statement ‘+ Cost of sales (or cost of goods sold: the direct cost of the goods that were sold during the financial year. ‘© Gross profit: equa to sales revenue less cost of sales. ‘+ Operating profit / net profit: gross profit minus overhead expenses. Before Interest and tax + Profit forthe year (profit after tax}: operating profit minus interest costs and corporation ta. ‘© Retained earnings (profit): dividends, have been made 1 profit eft after all deductions including Example 2: Income Statement Soles Revenue 7315860, Cost of Sales 48526 Gross Profit 7267034 Erpenses Fixtures 15000 «+ Loan Repayments 2500 + Mortgage 750 + Other Expenses 2600 Advertising 2100 «Insurance 1800 Se 42336 ee 67086 Net Prof T5558 Interest 710500 Profit before Tax Tissaas TTaxat 20% 237890 Profit After Tax 951558 Dividends 55000 Retained Prof 396558 Scanned with CamScanner ‘Assignment 1 Inthe year to 31/12/15, Metro Cola recorded the following (simplified) data on the company income statement: (milion) Revenue 30,990 Cost of sales 17,088. Expenses 11,671 Tax paid 1,080 Dividends paid 800 1. Calculate the companys: Gross profit ii. Operating prof i Retained profit 2, Assess whether Metro Cola’ stakeholders shouldbe pleased with the ‘company’s recent performance Ifits retained profit was $4. bilin in the year ending 31/12/16, ‘Statement of Financial Postion Balance Sheet) —an accounting statement that records or shows the value of the business assets and liabllties and shareholders equity a particular time "This tells managers and stakeholders what the ‘net worth’ ofthe business are. = Thiscan be compared with past years and other similar businesses, ‘The major items on a statement of financial postion include: as “business formore thanrone year” =a =< «+ intangible assets items of vaue'that donot havew physi presence suche Conknay ee — ‘Accounts/Trade Payable (Creditors) — value of debts for goods bought on credit, payable tosuppliers. = —— 2. Shateholder Equity tots value of assets TOs AIUEOF Tabs ‘share Capital =the total vale of capital aed From shareholders bythe ‘issue shares Scanned with CamScanner Contents ofa statement of financial postion: *+ "Non-current/fixed assets: assets tobe kept and used by the business for ‘+ Working captal/ net current assets: capital needed to pay for raw materials; day-to-day running cost and credit offered to customers:in- ‘accounting terms, rent liabilities; calculated from the Statement of inancil position, * Equity: howe much the businessworth;share; Equity finance: permanent finance raised by companies through the sale of shares. an Example 1: Statement of Financial Position (Balance Sheet) ‘Won-Current Assets 5 Premises 39000, Machinery 1126000 Vehicle 7200000, Current Assets Stock 3500 Cash 72260 ‘Accounts Receivable 38798 Total Assets 1262558 Current Liabilities ‘Accounts Payable "35000 Overdraft 7000, ‘Non-Current Uabiities Mortgage 300000 Loan 000. ‘Total Uabilties "360000 ‘Share Equity 6000. Retained Profit 396558 ‘Total Equity and Lables 1262558 Scanned with CamScanner Statement of Financial Position (Balance Sheet) fatement of Financial Position as at 31/12/15, Smrilion Non-curvent assets (fined assets, Kept for more than 1 year) Property, plant ete. 8.425, Intangible assets, 14,414 (not physical assets, eg. trademarks) (Other assets 7,550 Total non-current assets: 30,389 > [Current assets: (Assets kept for less than 3 year) Tnventories 2,298; “Trade receivable (debt0%3) 3600 (money owed by customer) (cash 6.816 ~ [Total eurrent assets 32,718 ‘Current liabilities ‘Trade payables 5 Gbi (money owed to suppliers) Shortterm loans 7518 ‘Total current labiities 13,169 ‘Non-current liabilities 826 (eg loans, debentures) Net assets 21,108 (= total assets iabiities) ‘Shareholders equity Share capital 308 Retained earnings ete 70,228 (owed by shareholders, not business) ‘otal shareholders equity 721,108 (balance with net assets) Assignment 1. Why do you think the value of Metro Cola’s intangible assets is s0 high? 2. Why do you think Metro Cola offers credit to it retal customers (creating account receivables (debtors)) 3, Do you thiok Metro Cola managers should be worried about the level of long ‘term loans taken out by the company? Explain your answer. 4.1F Metro Cola made the following transactions during the year, indicate which category these would appear on inthe statement of financial postion. (The first has been done for you) |. Purchase of property with a mortgage: non-current assets up and long-term lables up fi, Increased ieventories financed by short-term loans Ii, Sale of trademark and the proceeds used to repay five-year bank loan. ‘Goodwill=arises when a business is valued a/sold for more than the balance» “sheet value of assets ‘Intellectual Capital/Property =amount by which the market value ofa frm ‘exceeds ts tangible assets less abit “Window Dressing ~presenting the company accounts irra favourable ight - to flatter the business performance. ‘Common ways of window dressing include: ‘Selig assets at the end ofthe financial year then lease them back + Reduce the amount of depreciation of fixed assets; increase profits and asset value + ignoring some trade receivables, ‘© Giving stock levels a higher value than what they are worth ‘= Delaying the payment of bill or incurring expenses until after they have been published Information not in Published Accounts *Detals ofthe sales and profitability of each good or service produced by the company and of each division or department ‘+The research and development plans ofthe business and proposed new products ‘+The precise future plans for expansion or rationalisation ofthe business ‘The performance of each department or division ‘+ Evidence ofthe company's impact on the environment and the local ‘community ‘Future budgets or financial plans Scanned with CamScanner Ratio Analysis of Accounts ‘The need for ratios Using ratios allows much easy analysis of company performance> + Towlaanbecnpnad thet tet ream caetsed> ores sr + Ratio results can be compared easly with past years™ _ same or similar industry and with ule of thumb’ values in some instance» + Analysing accounts using ratios can indicate potential problem areas to focus on. “Uguielty:~is the abilty ofa business tomeet its shortterm lables with ts shorsterm assets. Importance of liquidity = Themore liquid the better because this means that the business ean pay Liquidity Ratios “Current ratio compares the currentassets with the current labilities ofthe business: Current Ratio—measures the relationship between current assets and current liabilities . LUquidity ratio calculated by ‘Current ratio= current assets Current abil “115 =2 regarded as‘normalfor many businesses. 1:1.5+2 would be the best ratio” “sbecause this shows thatthe business has more cash than Itneeds to meet ts “short-term labiltesar ircash well because they” ‘shave too much spare cash or that thelrassetsare unprofitable» + Acid test ratio Acid.test ratio. measures liquidity but dows not take stockinto-2ccount, Lquidity rato calculated by test ratio= Liquid assets Current labiities ‘Liquid assets:current assets ~ inventories (stock) = liquid assets 1 regarded as ‘normat'for many businesseseds: would be the best rato Because “itis lower than that then there Isa risk of the business not having enough money topayits liabilities and fits too high ther cash Is being ted Up in unprofitable cassetse "Note: many businesses survive without ratios atthe ‘norma level. tts the trend In ratios tha are usually more important than the ratio at a given time. Profitability ratios ‘+ Gross Profit Margin=~shows the relationship between grossprofit (before, overheads and expenses) andsales revenue (turnover) Scanned with CamScanner Gross profit: equal to sales revenue less cost of sales. ‘The higher the percentage the better becouze t means that the business earns ‘more gross profit for every dollar they get from revenue + “Operating (Net) Profit Margin = shows the relationship between net prof cand sales revenue (turnover) oft margin % = operating profit % Sales revenue ‘The higher the percentage the better because it means thatthe business earns ‘more profit for every dollar they get from revenue ‘Assignment 1 Galeulate the eurent rato for Metro Cola in 2015 2. Caleulate the acid test ratio for Metro Cola in 2015 3, Comment on this company’s liquidity Practical use of ratio analysis + Current ratio: = Very low current ratios ae usual for businesses that have regular inflows of ‘cash that they can rely on to pay short-term debts + I this valve over 2, too many funds are tied up in unprofitable Inventories, trade receivables and cash. - Alow ratio leads to carective management action to increase cash held by the business. + Acidtest ratio: + Users of accounts are given a clearer picture ofthe firm's ability to pay short-term debts by eliminating the value of Inventories from the rato.- Results below 1: might have liquidity problem. Ful picture needs to be gained by looking at previous years results. = Raising cash by selling inventories will Improve the acid test ratio~but it Will kep the current ratio about the same as both cash and inventories are current assets. + Comparison of ratios results between businesses help bankers and investors ete. to make decisions How to improve Profit Margins 1 Reducing direct costs ~ consumers’ perception of quality may be damaged and therefore affect the products reputation or they may expect lower prices, Motivation levels may fll iF wage costs eut or replaced by ‘machinery which may also require retraining. ‘Increase selling price ~total profit could fallis consumers switch to competitors, Consumers may consider ths to bea ‘profitering’ decision and the long-term image ofthe business may be damaged ' Reducing overhead costs — efficient operation may be damaged if fewer ‘managers or lower salaries. lower rental costs could mean moving to @ cheaper area, which may affect the company's image. Promotion costs may be cut which could lead to sales fling, Scanned with CamScanner How to improve Liquidity ‘Sell off fixed assets for cash ~if assets are sold quichly they may not raise ‘their true value. if assets are stil needed by the business, then leasing charges will add to overheads and reduce operating profit margin +

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