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Revision:Accounting and Finance

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TSR Wiki > Study Help > Subjects and Revision > Revision Notes > Politics > Accounting and Finance

Accounting and Finance

1 Topic List
2 Company Accounts
3 Profit and Loss account
- 3.1 Balance sheet
- 3.2 Profit quality
4 Profit Utilisation
5 Balance sheets
6 Ratio Analysis
7 Contributions and Break Even
8 Comments

Topic List

Company Accounts
- Capital and Revenue Expenditure
- Interpretation of profit and Loss and Balance Sheets
- Working Capital
- Depreciation
- Window Dressing
Ratio Analysis
- Liquidity
- Financial Efficiency
- Gearing
- Profitability
- Share Holders
- Limitations of ratios
Contribution and Break Even
Investment Decision Making
- Payback
- Average rate of return
- Discounted Cash Flow

Company Accounts

Financial Accounts

Two main documents at the end of the year.

Balance sheet (owe, own, how it is funded)
Profit and Loss (revenue, spending, profit and loss)

Managerial Accounts

Cash flow, budget, break even.

Profit and loss

Profit and loss account for Smiths for the year ending March 2007

-	Â£	Â£
Sales Revenue (Turnover)	-	-
Cost of Sales	-	-
Opening Stock	3000	-
Purchases	2000	-
Closing Stock	500	-
-	-	4500
Gross Profit	-	45500
Operating Profit (10000 from sale of factory)	-	55500
Expenses	-	-
Heating	2000	-
Rent	2500	-
Depreciation	500	-
-	-	5000
Net Profit	-	50500

Gross Profit = Sales Revenue â€“ Direct Costs

Operating Profit = gross profit less - operating costs.

Net Profit = Operating Profit â€“ expenses

Depreciation

The fall in value of an asset over a period of time. There are two methods.

Reducing balance method
Straight line depreciation

$\displaystyle \mathsf{Straight\ line\ depreciation} = \frac{\mathsf{Initial\ cost - residual\ value}}{\mathsf{Expected\ lifetime}}$

E.g.

machinery costs Â£100000

sold value Â£40000

sold after 4 years

$\displaystyle \frac{\mathsf{Initial\ cost - residual\ value}}{\mathsf{Expected\ lifetime}} = \frac{100000 - 40000}{4} = \pound 15 000$

An asset will depreciate due to use, obsolescence and time.

Depreciation impacts differently on the main business accounts:

Records a large outflow when the asset is bought and an inflow when the asset is sold.

Profit and Loss account

Depreciation is recorded as an expense

Balance sheet

Record the Net Book Value of the asset = cost â€“ depreciation

Profit quality

Profit that is a result of businesses training. If the profit has come from a one off source it is low quality. E.g. selling an asset or profits on foreign exchange transactions (exchange rates). Investors will be looking for high quality profit.

Profit Utilisation

How a business uses its profit. There are two main things a business can do with its profit.

Pay dividends
Retained Profit

The profit amount of a business can choose to spend is the profit after tax figure.

Future plans â€“ expand, grow, introduce new product.
What the shareholders want.
Stakeholders â€“ pension scheme, community
Competition

Businesses will make decisions between keeping money in the business and paying dividends to customers for future of the business.

Balance sheets

What a business owes, is owed, and how it is funded.

Stock 50000
Debtors 50000
Fixed assets 1 200 000
Cash 100 000
Reserves 270 000
Long term loans 550 000
Share capital 400 000
Current liabilities 180 000

-	Â£ 000s	Â£ 000s
Fixed Assets	-	1200
-	-	-
Current Assets	-	-
Cash	100	-
Debtors	50	-
Stock	50	-
-	-	200
Current liabilities	-	180
-	-	-
Net current assets (working capital)	-	-
-	-	20
Net assets (Assets employed)	-	-
-	-	1220
Represented by:	-	-
Long term loans	550	-
Reserves	270	-
Share Capital	400	-
-	-	1220

Intangible assets

Assets that you canâ€™t see or touch.
One school of though is that as these assets are not easily quantifiable they shouldnâ€™t be included as they could misrepresent the true value of a business. On the other hand businesses will argue that these assets should be valued as they do have worth.

Stock

Can be valued at what was paid for it or what it is worth. The rule in accounting is that stock must be recorded at the lower end of cost, or net reliable value (what it is worth on that day).

Working capital

The day to day finance of a business.
Working capital = current assets â€“ current liabilities.
The working capital of a business shows whether it can pay its short term debts using its most liquid assets. Working capital problems can occur if you have poor control of debtors. It can also occur if too much money is tied up in stock. It may also mean that creditors are being paid too quickly.

Capital and Revenue expenditure

Businesses can be split into two categories.

Capital spending â€“ buying fixed assets â€“ a life over a year.
Capital spending is recorded as fixed assets on the balance sheet with any depreciation shown as an expense on the profit and loss.

Revenue spending â€“ buying day to day items such as stock, wages, marketing.
It is mainly recorded in the profit and loss account.

Limitations of public accounts

Profit and loss and balance sheets in isolation mean little. To have a true reflection of the financial position of a business you need to see previous years and like businesses. It is also important that ratio analysis is used to assess the true performance of a business. One of the main problems with accounts is window dressing. Window dressing isnâ€™t illegal. It is dressing the accounts in a way to present the business in as favorable way as possible.

Ratio Analysis

Business accounts in isolation have little meaning. To make a true assessment of the financial performance of a business you would need previous years, like businesses, and an assessment using ratio analysis.

Ratio analysis allows a business to make meaningful comparisons with other businesses and investigate the efficiency of different departments within the business.

You must learn the ratios, understand what they mean and what the business must do to improve.

A ratio is a comparison of two figures. The second digit is always 1. However, some of the ratios appear as a percentage.

Liquidity Ratios

These show whether a business can meet its short term debt.

There are two liquidity ratios.

Current ratio

$\displaystyle \mathsf{Current\ Ratio} = \frac{\mathsf{Current\ Assets}}{\mathsf{Current\ Liabilities}}$

E.g.

$\displaystyle \frac{\pound 30000}{\pound 10000} = 3 : 1$

This means that the business has Â£3 of current assets for every Â£1 of short term debt. A businesses current assets are cash, debtors, and stock. In terms of the current ratio, ideally is should be about 1.5 : 1. Anything less will make the business struggle, and more and you are not using money wisely.

sell shares
raise underused fixed assets
increase long term borrowings

A problem with the current ratio is it includes a businesses stock. It can be a little unrealistic to assess liquidity and include stock because to sell this would mean being unable to continue business activity.

The acid test ratio is perhaps a fairer assessment.

Acid test ratio

$\displaystyle \mathsf{Acid\ test\ ratio} = \frac{\mathsf{current\ assets - stock}}{\mathsf{Current\ liabilities}}$

Ideally this should be 1 : 1

Gearing Ratios

This shows how reliant a business is on borrowed money.

Gearing

$\displaystyle \mathsf{Gearing} = \frac{\mathsf{Long\ term\ loans}}{\mathsf{Capital\ employed}} \times 100 = \%$

Capital employed is share capital, reserves and any long term loans.. More than 50% is too high = highly geared.

Shareholder Ratios

These ratios look at whether or now shareholders are likely to benefit financially from the firm.

Dividend per share

$\displaystyle \mathsf{Dividend\ per\ share} = \frac{\mathsf{total\ dividends\ paid}}{\mathsf{Number\ of\ shares\ issued}}$

It has limited use without context. To improve it, you need to increase profit.

Dividend yield

Expresses the dividends paid as a percentage of the price of the shares.

$\displaystyle \mathsf{Dividend\ yield} = \frac{\mathsf{dividend}}{\mathsf{Market\ price}} \times 100 = \%$

The higher the better. But, compare with competitors.

The above calculations ignore any gains or losses from owning shares. If the share price increases, the dividend yield will fall. However, the higher prices might make the shares attractive to buy.

Profitability Ratios

These ratios compare profit with the size of the business. There are three main ratios. The higher the percentage the better.

Gross Profit Margin

This calculates how much of the turnover is gross profit.

$\displaystyle \mtahsf{Gross\ profit\ margin} = \frac{\mathsf{gross\ profit}}{\mathsf{Turnover}} \times 100 = \%$

The higher the percentage the better.

Increase revenue and lower costs to improve.

Net Profit Margin

$\displaystyle \mathsf{Net\ Profit\ Margin} = \frac{\mathsf{Net\ Profit}}{\mathsf{Turnover}} \times 100 = \%$

It is always worth comparing gross profit and net profit margins as it will give a clue to expenses, and over previous years if gross profit margin is increasing and new profit margin is decreasing.

Return on capital employed

$\displaystyle \mathsf{Return\ on\ capital\ employed} = \frac{\maths{Net / Operating\ profit}}{\mathsf{Capital\ Employed}} \times 100 = \%$

Capital employed is the money used in the business â€“ loans, reserves, and shareholders. Return on capital employed is what kind of return there is on the money you put in the business.

Efficiency / Activity ratios

Stock turnover

Stock turnover measures the number of times a year a business sells its stock.

$\displaystyle \mathsf{Stock\ turnover} = \frac{\mathsf{cost\ of\ goods\ sold}}{\mathsf{Stock}}$

This needs to have knowledge of the business itâ€™s working on. You can convert this into the average number of days a business holds stock using the formula:

$\displaystyle \frac{\mathsf{Average\ stock} \times 365}{\mathsf{Cost\ of\ good\ sold}}$

[Unparseable or potentially dangerous latex formula. Error 2 ]

Increase sales not stock.

Reduce stock levels not sales.

Debtors collection period

How long it takes to collect your debts.

$zdisplaystyle \frac{\mathsf{Debtors}}{\mathsf{Annual\ sales / turnover}} \times 365 = number of days The shorter the period the better but need to consider the credit period being offered. ====Asset turnover==== How many pounds of sales a company is generating from its assets. <latex>\displaystyle \frac{\mathsf{Annual\ sales}}{\mathsf{Assets\ employed}} = \pounds$

Limitations of ratio analysis

Ratio analysis analyses financial information but its not the only measure of a businesses success and to rely on these will give a limited focus.

Reliability - The data itself might be unreliable. Asset valuation can be subjective, especially intangible assets. Different accounting methods. Situations change daily and they can window dress their accounts to be more favorable.

Historical - Accounts only show where youâ€™ve been. Show what happens, doesnâ€™t show why.

Comparisons - Within a firm (intrafirm) or inter (between two businesses). No two sets of data are the same. Within both of these, businesses will suffer differences. More established branches can have economies of scale and global businesses. Comparison over time â€“ inconclusive because of the peaks and troughs of a business cycle. Comparison may effect the economy more than the business. Ratios may measure the economy, not the business. Ratios may measure the economy not the business. Comparison with a standard E.g. current ratio = 1.5: 1 we take a risk that the standard is out of date.

Limitations of corporate objectives

Ratios assume that profit is the main objective by there are others.
Reputation â€“ exploiting customers and you will eventually lose money.
Human relations
Product quality

Contributions and Break Even

Limitations of external influences

Company performance is dependent on outside factors and it is vital that these are considered before conclusions are drawn â€“ SWOT analysis.

Ratios are an excellent guide to performance. Donâ€™t ignore them but bear in mind their limitations.

Break even

There are three ways or working out break even: 1. Using a formula

$\displaystyle \frac{\mathsf{Fixed\ costs}}{\mathsf{Contribution\ per\ unit}}$

$\displaystyle \mathsf{Contribution = selling\ price â€“ variable\ costs}$

2. Using a table

3. Break even graph

The main assumptions with break even:

that you sell everything you make
that fixed costs stay the same
that every product is sold for the same place
that variable costs rise proportionality to units produced

There are 6 changes that can occur:

increase in selling price
decrease in selling price
increase in variable costs
decrease in variable costs
increase in fixed costs
decrease in fixed costs

Contribution

Contribution is one of the most important aspects in business studies. It is the term given to the amount of money remaining, after all the direct and variable costs have been deducted from the sales revenue. It is called contribution because it represents the amount of money, which is available to contribute towards covering the businesses fixed costs. Once these costs are covered it represents the amount of money which will contribute towards the profit of a business.

Sales revenue â€“ variable costs = contribution

Contribution â€“ fixed costs = profit

Contribution can be analysed in two ways.

1. Contribution per unit

E.g. selling price Â£10

Variable costs Â£3

= contribution = Â£7

2. Total contribution

Total sales revenue â€“ total variable costs.

Special order decision

A business decision relating to a one off contract. Usually the special order decision is needed in response to a request to supply a fixed quantity of a product at a particular price. (Invariably a lower price than usual).