CHAP 30

ACCOUNTING FUNDAMENTALS
 ACCOUNTING STATEMENTS

At the end of an accounting period (generally one year) accountants draw up the
financial statement of businesses for limited company’s these are shared with all the
shareholders

These include

Statement of Financial Position (SOFP)

Income Statement

Cash Flow
INCOME STATEMENT
 ACCOUNTING STATEMENTS

Revenue (also called sales/turnover):

The total value of sales made during the trading period = selling price × quantity sold.

Gross profit:

Equal to sales revenue less cost of sales.

Cost of sales (or cost of goods sold):

This is the direct cost of the goods that were sold during the financial year.
 ACCOUNTING STATEMENTS

Operating profit ( formerly net profit )

“Gross profit minus overhead expenses.”

Profit for the year (profit after tax):

“Operating profit minus interest costs and corporation tax.”

 ACCOUNTING STATEMENTS

Dividends:

“The share of the profits paid to shareholders as a return for investing

in the company.”

Retained earnings (profit):

“The profit left after all deductions, including dividends, have been
made, this is ‘ploughed back’ into the company as a source of finance.”
 USES OF INCOME STATEMENT

1. Used to measure performance over time or with other firms

2. Can be used to compare actual vs expected profit levels

3. Banks/ creditors need this information to help decide whether to lend money

4. Important for prospective investors

 THE LIMITATIONS OF THE INCOME STATEMENT
THERE ARE A NUMBER OF REASONS WHY A TRADING, PROFIT & LOSS ACCOUNT MUST BE USED WITH CARE:

IT’S HISTORICAL ACCOUNTING PRACTICES

Firms may use different

It tells us what has already accounting practices
happened
E.g. depreciation may be treated
This might be useful to help predict differently
future trends
This may make direct
BUT external factors may have comparisons difficult
changed
The “like-for-like” figures are used
for internal comparisons
 WHAT IS A SOFP?
A FINANCIAL STATEMENT THAT SHOWS THE ASSETS, LIABILITIES AND CAPITAL OF A BUSINESS ON A PARTICULAR DATE

Liabilities

Assets Are debts that the Capital

Are items owned by business has, which

Is money that has
the business have not yet been
been invested into
paid
the business,
This includes items
perhaps by the
owed to the
owner
business
 THE KEY PRINCIPLE OF A SOFP
SINCE BUSINESSES CAN ONLY SPEND MONEY THAT THEY HAVE INVESTED BY THE OWNERS (SHAREHOLDER)
OR HAVE BORROWED THEN:

All Equal All

Liabilities + Equity Must Assets
 EXPLAINING ASSETS & LIABILITIES
THERE ARE DIFFERENT TYPES OF LIABILITIES AND ASSETS:

Assets Assets and Liabilities Liabilities

Things that are owned by a business Things that the business owes

Non-Current Assets Current Assets Long-Term Liabilities Current Liabilities

Debts that are not Debts that are due to be
These items are often
Items bought or
due to be repaid in repaid in full within a
expensive
used up regularly
full within a year year
but last for a long time
E.g.:
E.g.: E.g.:
E.g.:
Raw materials
Mortgages Creditors
Buildings
Debtors
Long-term Loans Overdrafts
Vehicles
 30: Accounting fundamentals

STATEMENT OF FINANCIAL POSITION AS AT 31 ST DECEMBER

$m $m Notes
ASSETS
Non-current (fixed) assets:
Property 300
Vehicles 45
Equipment 67
Intangible assets 30
442
Current assets:
Inventories 34
Trade receivables (formerly 28
debtors)
Cash 4 Also called ‘cash and cash equivalents’.
66
TOTAL ASSETS 508 This total will balance with equity and liabilities – hence the original
term ‘balance sheet’.
EQUITY AND LIABILITIES
Current liabilities:
449
Accounts payable (or creditors) 42
Short-term loans 31 These loans will include the company’s overdraft with the bank.
Other current liabilities might include provisions to pay tax and
dividends.
73
Non-current liabilities: These used to be referred to as ‘long-term liabilities’.
Long-term loans 125 Other non-current liabilities might include debentures issued
by the company.
125
TOTAL LIABILITIES 198 If these actually equalled total assets, there would be no
shareholders’ equity in the company at all.
Shareholders’ equity:
Share capital 200
Retained earnings reserve 110 The cumulative value of the company’s annual ‘retained earnings/
profits’.
310
TOTAL EQUITY AND LIABILITIES 508 This does balance with total assets!

Table 30.5 Example of a Statement of financial position with some explanatory notes

These items make up what is known as the ‘intellectual important for an IT-based or knowledge-based business.
property’ of the business. They can give a business a The reputation and prestige of a business that has been
greater market value than the total value of its tangible operating for some time also give value to the business
assets less its liabilities. These intangible assets can be very over and above the value of its physical assets. This is
DEFINITIONS
DEFINITIONS
 INTANGIBLE ASSETS

Intellectual capital or property:

“The amount by which the market value of a firm exceeds its tangible assets less liabilities – an
intangible asset.”

These intangible assets can be very important for a knowledge based or IT based business. For e.g
the smart phone app used by Uber that matches driver with rider.

Intangible assets (examples):

Patent
Trade mark
Copy right
Goodwill
 INTANGIBLE ASSETS

Patent:

The right to be sole user or producer or product e.g. titanium screws- method of
attaching to limbs so that it is not rejected by the body

Trade mark:

Any word, name, symbol, design or any combination thereof; used in commerce
to identify and distinguish goods of one manufacturer from another e.g. Coke

Copy right:

Involves books, plays, films, music. It is legal protection against copying

someone’s work
 GOODWILL

This arises when a business is valued or sold for more than the balance sheet
value of its assets.

The reputation of a business that has been operating for some time also gives a
value to the business over & above its physical assets.
 SHAREHOLDER’S EQUITY

Shareholders equity consists of:

Share capital:

No. of shares @ nominal value

Reserves:

Retained earnings:

These are cumulative and NOT available as a source of liquid funds as they have already been reinvested in business

Revaluation reserve

If fixed assets (generally land) have increased in value

 THE USES OF SOFP

Provides a guide to a firms value

Used to analyze the assets and capital structure of business

Value of working capital can indicate whether a firm is able

to pay for its everyday expenses
 THE LIMITATIONS OF THE SOFP
SOFP'S MUST ALSO BE USED WITH CARE BECAUSE.…

The value of fixed Intangible assets

Companies don’t
assets may not be (e.g. brand names)
The document is usually publish
accurate – may not be
out of date as soon detailed figures –
depending on the included – which
as it is produced they simply provide
depreciation may understate the
totals
method used value of a business
 CASH-FLOW STATEMENT

“Record of the cash received by a business over a period of

time and the cash outflows from the business.”
 LIMITATIONS OF PUBLISHED ACCOUNT
1. Minimum accounting information:
No details of each good/ service/ department

R and D plans not included

Future plans not included

Evidence of company’s impact on environment/ local community

Data given is all past data

2. Window dressing of accounts. E.g.:

Selling assets at year end

Credit sales at year end

Ignoring bad debts

Different figures for depreciation/ stock valuation

Delaying payment of bills

3. Only concerned with items with a numerical value e.g. disregards reputation, quality of work force
4. This is only based on past data and in fact the SOFP is of only one point in time
 RECAP OF FINAL ACCOUNTS
THERE ARE 3 IMPORTANT DOCUMENTS THAT A BUSINESS MUST PRODUCE:

Income SOFP The Cash flow

Statement Statement

This is a “financial This shows the

This shows the snapshot” of the
“financial business at a “cash history” of
history” of the particular point in the business
business time
 WHO USES PUBLISHED ACCOUNTS?

Both the SOFP and the Income Statement show the ‘health’ of the business

All the stakeholders will be interested in the balance sheet, but especially:

Shareholders

Customers

Suppliers

Employees

When used with the Income statement account it shows how well the business is doing

Read pages 456 – 458 from Peter Stimpson

 USING FINAL ACCOUNTS
ONCE THE FINAL ACCOUNTS HAVE BEEN PRODUCED A BUSINESS WILL USE THEM TO ANALYSE THEIR PERFORMANCE

RATIO ANALYSIS IS OFTEN USED TO DO THIS

Comparing with Comparing with Assessing the

previous the performance liquidity of the

performance of competitors business

 RATIO ANALYSIS

LIQUIDITY RATIOS PROFITABILITY RATIOS

These measure how easily a business These compare the profits of the business
could meet its short-term debts or with sales, assets and the capital employed
liabilities in the business
 PROFITABILITY RATIOS
These include the profit margin ratios which compares the profits of the business
with its revenue

There are two different profitability ratios

which can be used:

The Gross Profit Margin

The Operating Profit Margin

 THE GROSS PROFIT MARGIN
CALCULATED USING THE FOLLOWING FORMULA:

Gross Profit
Gross Profit Margin (GPM) = x 100
Turnover
This compares gross profit with the value of
Calculating GPM
sales
A firm is making gross profit of £15,000 on sales of £45,000.
A higher percentage figure is better It’s GPM would therefore be:

It can be improved by:

£15,000
x 100 = 33.33%
£45,000
Increasing turnover relative to costs (selling
This means that for every £1 of sales
price)
the business makes 33.33 pence gross

A relative decrease in costs (cost per unit) profit.

 ANALYZING GROSS PROFIT MARGIN (GPM)

Port Louis Press’s GPM could be lower because:

It is adopting a low price strategy

It has higher cost of sales

Material Cost

Labor Cost

Management is less effective in controlling costs

 THE NET PROFIT MARGIN
Calculated using the following formula:
Net Profit Margin
Net Profit
= x 100
(NPM)
Turnover
This compares net profit
with the value of sales
Calculating NPM
A higher percentage
A firm is making net profit of £5,000 on sales of
figure is better
£45,000.

It is used to: It’s GPM would therefore be:

Compare performance £5,000 x 100 = 11.11%

over time £45,000
This means that for every £1 of sales
Assess how well overhead the business makes 11.11 pence net profit,
costs are being managed which can be compared with the NPM .
ANALYSIS OF OPERATING PROFIT MARGIN (OPM)

Though the difference in GPM margins was substantial the OPM margins are
much more alike.

This is probably because Nairobi has relatively higher overhead than Port Louis’
overheads.
 IMPROVING PROFIT MARGINS
There are a number of ways a firm can improve these COST WISE
margins:
Reduce Wastage
REVENUE WISE
Buy cheaper raw materials. This could reduce quality
Stock More Seasonal Items though!

Reduce the number of special offers Reducing Overhead Costs

Increase Prices

Risky, since customers may go elsewhere

Stock a wider range of products

EVALUATING THE METHODS OF IMPROVING PROFIT MARGINS
 LIQUIDITY RATIOS

The ability of a firm to pay its short term debts is called liquidity

There are two types of liquidity ratios

1. Current Ratio

2. Acid-Test Ratio - Quick Ratio

These ratios are concerned with the working capital of the business. If there is too much working
capital then money could have been used more productively and profitably.

If there is too little working capital then the business could become illiquid and unable to settle
short term debts
 THE CURRENT RATIO
Calculated using the following formula:

Current Assets
Current Ratio =
Current Liabilities

Calculating Current Ratio

A firm has current liabilities of £4,500, whilst
It measures the ability of a business to pay its current assets are worth £9,000.
debts over the next year
It’s current ratio would therefore be:
The answer is given as a ratio £9,000
= 2:1
£4,500
A figure between 1.5 and 2 would be seen as
This means that for every £1 the
normal – but it does vary across industries
business owes, it has £2 worth of assets
that can be used to pay.
 ANALYSIS OF CURRENT RATIO

1. Most companies aim for current ratios between 1.5 and 2.0.

2. Very low current ratios might not be unusual for businesses, such as food retailers,
that have regular in flows of cash that they can rely on to pay short-term debts.

3. Current ratio results over 2 might suggest that too many funds are tied up in
inventories, trade receivables and cash and would be better placed in more
assets, such as equipment to increase efficiency.

4. A low ratio might lead to corrective management action to increase cash held by
the business.
 THE ACID TEST RATIO
CALCULATED USING THE FOLLOWING FORMULA:
Current Assets - Stock
Acid Test Ratio =
Current Liabilities
It measures the ability of a business to pay it’s
Calculating The Acid Test Ratio
debts immediately
A firm has current liabilities of £4,500, whilst
Hence stock is not included as it may not be in a current assets are worth £9,000,

saleable state of which £4,000 is in the form of stocks. It’s

current ratio would therefore be:
A figure of around 1 is seen as normal – but it £9,000-£4,000 = 1.11:1
varies across industries £4,500
This means that for every £1 owed the
Below 1 means too much inventory
Business has £1.11 worth of assets that can

Above 1 means too many liquid assets be used to pay immediately.

CALCULATION OF ACID TEST RATIO
 LIMITATIONS OF LIQUIDITY RATIOS
Varies from industry to industry e.g. jewelers have a huge stock of inventory vs a school vs supermarket
Different at different times:
Agriculture

Schools

Toy shops- Christmas

Bangles/ mehndi- Eid

One ratio on its own has a limited value

Only highlights problems- does not give solutions
Only based on quantitative NOT quantitative data
NOTE:

Selling inventory for cash will NOT improve current ratio only acid test ratio
 ANALYSIS OF LIQUIDITY RATIOS
1. A better measure of an ability to meet short term debts would be an analysis of a firm’s cash flow pattern

2. Low liquidity ratios might also mean that the firm is very efficient in managing its cash and does not need
as liquid a position as other firms

3. Low liquidity may only be temporary

4. Low acid-test ratios may mean seasonal variances, for example stock piling before Christmas.

5. A low current ratios might lead to corrective management action to increase cash held by business.

6. Firms with very high stock levels will record very different current & acid-test ratios.

7. Whereas selling stock for cash will not improve the current ratio as both items are included in current
assets, this policy will improve acid-test ratios