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 Statement
Income Statement for XXXXXXXX for the year ending 1st April
2012
+ Revenue
50,000
- Direct Costs (cost of sales)
20,000
= Gross Profit
30,000
- Indirect costs (expenses/overheads)
5,000
= Net Profit before interest and tax (PBIT)
25,000
- Interest on loans
15,000
= Net profit before tax (PBT)
10,000
- Tax
3,000
=Net profit after tax (PAT)
7,000
Dividends
3,000
Retained profit for year
4,000
(Dividends + retained profit for year = PAT)
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 Sheet
Balance 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 liabilities
Note:
Total equity and liabilities = total assets
50,000
40,000
90,000
20,000
30,000
50,000
10,000
30,000
90,000
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 sheet
FA + CA = CL + LL + Eq
• The chances are that your balance sheet is in a
slightly different order. Maybe:
FA+ CA –CL = LL + Eq
Or
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 shortterm 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.