5.5 Accounting fundamentals

Objectives

• Why are financial accounts published?• Who wants to see the accounts and why?• What are the accounts?

Why do companies publish accounts?

• Forced to!• It is a legal requirement of Ltd and PLC

companies to publish detailed and audited (checked) information regarding their company.

• Okay; lets rephrase the question.

Who wants to see the financial accounts and why?

• Copy out the title.• Make a list of all the groups of people that

would want to see the financial accounts of a business and why……

Who wants to see the financial accounts and why?

Who wants to see the financial accounts and why?

The Financial Accounts

• There are three financial accounts that must be provided:– Income Statement (previously called profit and

loss account).– Balance Sheet (soon to be called Statement of

Financial Position).– Cash Flow Statement (not on syllabus and not to

be confused with Cash Flow Forecast, which is).

Income StatementIncome Statement for XXXXXXXX for the year ending 1st April

2012+ Revenue- Direct Costs (cost of sales)= Gross Profit- Indirect costs (expenses/overheads)= Net Profit before interest and tax (PBIT)- Interest on loans= Net profit before tax (PBT)- Tax=Net profit after tax (PAT)DividendsRetained profit for year(Dividends + retained profit for year = PAT)

50,00020,00030,000

5,00025,00015,00010,000

3,0007,0003,0004,000

Income Statement• Look at your income statement!• Can you identify;– Revenue– direct costs– indirect costs– Interest paid– Tax– dividends

Activities to understand accounts

• Income Statement– You may find it useful to copy down the key

definitions on pages 535 and 536– Activity 29.3 page 537

Income Statement - Accruals

• Income Statements record the profit or loss made in a 1 year period to a certain date.

• ACCRUALS is also called the MATCHING CONCEPT.• Costs should be charged to the period in which

the revenues that they generate are made.• Eg. Stock is bought, but not used until the next

period. To which period should its cost be charged?

• The period in which it is used.

Income Statement - Accruals

• Example:– A company starts a period with 250 units in stock.

It buys 7,000 more units during the period. At the end of the period it has 300 units in a warehouse and 200 units on a lorry.

– How many units should be charged to the period?– Activity 29.2 page 536

The Balance SheetBalance Sheet for XXXXXXXXX as at 31st March 2012

Assets+ Non-current assets (fixed assets)+ Current Assets= Total Assets

Equity and Liabilities+ Current liabilities+ Non-current liabilities= Total Liabilities+ Share capital (shareholder initial investment)+ Retained earnings = Total equity and liabilitiesNote:Total equity and liabilities = total assets

50,00040,00090,000

20,00030,00050,00010,00030,00090,000

The Balance Sheet

• Balance Sheets record all the assets, liabilities and equity held by a company at a particular date.

• Its called the Balance Sheet as what the company owns (assets) must equal what it owes (liabilities + equity).

FA + CA = CL + LL + Eq

What the company owns (assets) must equal what it owes (liabilities + equity)!

• This sounds insane!• However;– If the company makes a profit– The profit belongs to the company.– However, the company belongs to the

shareholders.– Therefore, the profit is owned by the shareholders

and, therefore, owed to them by the company.

Lets do some maths!!!

• From the balance sheetFA + CA = CL + LL + Eq

• The chances are that your balance sheet is in a slightly different order. Maybe:

FA+ CA –CL = LL + EqOr

FA + CA – CL - LL = Eq

Activities to understand accounts

• Balance Sheet– There is a list of key definitions on page 539. If you

do not know any. Write them down now!– Activity 29.4 page 540– Activity 29.5 page 543

Ratio Analysis

• Ratio analysis = comparing one thing with something else.

• Ratio analysis enables us to examine the accounts of a business and extract additional information.

• Enables us to compare companies in the same business sector, but of different sizes, eg. Walmart and Wong, Toyota and Great Wall, Petrobras and Petro Peru.

Ratio Analysis – Profitability Ratios

• Gross Profit Margin• Net Profit Margin

• Using page 544.– Copy the formulas for each margin and write your

own definition for each.– Calculate the Gross and Net Profit Margin for your

accounts.– Activity 29.7 page 549 Qs 1 to 3 only.

• GPM= Gross Profit = Rev – Direct Costs Rev Rev

• NPM= NP = Rev – Direct Costs - Indirect Costs Rev Rev

Ratio Analysis – Liquidity

• Recap:– Why is cash important?– Why is important not to have too much cash?– What is working capital?– How is working capital calculated?

Liquidity Ratios• Liquidity = the ability of a company to pay its short-term

debts (current liabilities).• Liquidity Ratios = ratio of current assets to current

liabilities• Current Ratio = Current Assets / Current Liabilities– Think about it this way … if all your current liabilities say pay

us now! Can you?– The ideal level for the current ratio is 1.5 to 2. Although this

will vary between industries.• Calculate the Current Ratio for your company for each

year you have data.

Liquidity Ratios 2• Inventory is regarded as the least ‘liquid’ of the

current assets. This means it is the most difficult to turn into cash. It is sometimes removed from the Current Ratio.

• Acid-test (or quick) ratio= CA – Inventory CL– The ideal for the acid-test ratio is 1 (some textbooks

write 1 to 1.5). Although this will vary between industries.

• Calculate the Acid-test ratio for your company.

Liquidity Ratio Activities

• Activity 29.6 page 548• Activity 29.7 page 549. You should already

have completed 1 to 3.