Accounting and Finance
- Company Accounts
- Capital and Revenue Expenditure
- Interpretation of profit and Loss and Balance Sheets
- Working Capital
- Window Dressing
- Ratio Analysis
- Financial Efficiency
- Share Holders
- Limitations of ratios
- Contribution and Break Even
- Investment Decision Making
- Average rate of return
- Discounted Cash Flow
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)
Cash flow, budget, break even.
Profit and loss
Profit and loss account for Smiths for the year ending March 2007
|Sales Revenue (Turnover)||-||-|
|Cost of Sales||-||-|
|Operating Profit (10000 from sale of factory)||-||55500|
Gross Profit = Sales Revenue – Direct Costs
Operating Profit = gross profit less - operating costs.
Net Profit = Operating Profit – expenses
The fall in value of an asset over a period of time. There are two methods.
- Reducing balance method
- Straight line depreciation
machinery costs £100000
sold value £40000
sold after 4 years
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
Record the Net Book Value of the asset = cost – depreciation
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.
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 – expand, grow, introduce new product.
- What the shareholders want.
- Stakeholders – pension scheme, community
Businesses will make decisions between keeping money in the business and paying dividends to customers for future of the business.
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
|Net current assets (working capital)||-||-|
|Net assets (Assets employed)||-||-|
|Long term loans||550||-|
- Assets that you can’t see or touch.
- One school of thought is that as these assets are not easily quantifiable they shouldn’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.
- 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).
- The day to day finance of a business.
- Working capital = current assets – 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 – buying fixed assets – 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 – 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 isn’t illegal. It is dressing the accounts in a way to present the business in as favorable way as possible.
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.
These show whether a business can meet its short term debt.
There are two liquidity ratios.
This means that the business has £3 of current assets for every £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
Ideally this should be 1 : 1
This shows how reliant a business is on borrowed money.
Capital employed is share capital, reserves and any long term loans.. More than 50% is too high = highly geared.
These ratios look at whether or not shareholders are likely to benefit financially from the firm.
Dividend per share
It has limited use without context. To improve it, you need to increase profit.
Expresses the dividends paid as a percentage of the price of the shares.
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.
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.
The higher the percentage the better.
Increase revenue and lower costs to improve.
Net Profit Margin
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
Capital employed is the money used in the business – 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 measures the number of times a year a business sells its stock.
This needs to have knowledge of the business it’s working on. You can convert this into the average number of days a business holds stock using the formula:
Increase sales not stock.
Reduce stock levels not sales.
Debtors collection period
How long it takes to collect your debts.
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 you’ve been. Show what happens, doesn’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 – 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 – 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 – SWOT analysis.
Ratios are an excellent guide to performance. Don’t ignore them but bear in mind their limitations.
There are three ways or working out break even: 1. Using a formula
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 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 – variable costs = contribution
Contribution – fixed costs = profit
Contribution can be analysed in two ways.
1. Contribution per unit
E.g. selling price £10
Variable costs £3
= contribution = £7
2. Total contribution
Total sales revenue – 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).
These notes are aimed at people studying for A Level Business Studies (Unit 4), but will be suitable for other people too.
Originally submitted by rachd_22 on TSR Forums.