Strict financial controls
must be in place if a business is to be successful. In a small business
the owner/manager will be able to oversee most things. In modern business,
strict controls are essential and they come in the form of financial statements.
The role of the accountant involves not just preparing these statements
but to be involved in the planning process as well. The tools applied in
measuring the health of the business include (i) The Balance Sheet (ii)
Trading, Profit and Loss Account and (iii) Cash Flow Statement.
These statements prepared
and audited by accountants are basic minimum requirements for registered
companies to comply with. These statements are a fundamental part of the
accounting process. The accounting process with the aid of these financial
statements helps management to make economic decisions about the business
entity. Modern accounting plays a major role in the decision making process.
The main role of financial statements is to show the owners of the business
how their capital was employed. Other parties will also be interested in
these statements including:
Shareholders
Shareholders are interested
in the accounts to see how well management performed in their position
of trustees of the business. They are ultimately interested in their investment
in the business and how well it is doing. If the business is doing well
they may be interested in buying more shares. If performance is poor, they
may want to offload the shares. Potential shareholders will also be viewing
investment opportunities. Shareholders will also view dividend payout and
make comparisons with similar companies. Also, shareholders may have the
power to replace management or sell their shares if they are unhappy with
the situation.
Creditors/Suppliers
Creditors are people who
supply goods on credit to the business. They do not charge interest and
have no guarantee of payment. They are very interested in the liquidity
of the business.
Financial Institutions
These include banks and
loan creditors. They provide cash to a business. They charge interest and
may require security and repayment of the cash when the time period of
the loan elapses. If finance is provided by overdraft in the short term
they will view liquidity seriously. If medium or long-term loans are provided
they will analyse the gearing of the business.
Employees
Many progressive businesses
have gain sharing initiatives in place. As a result, employees in those
businesses have become major stakeholders. Where trade unions represent
workers interests they would be interested in how much profit the business
is making. This would be an advantage in wage negotiations.
Government Agencies
Bodies like the Revenue
Commissioners are interested to see that a business is complying with its
taxation requirements. The Department of Enterprise and Employment would
view accounts where potential acquisitions would occur.
Competitors
Competitors would be interested
in the company’s profitability and cost structure. They would analyse the
accounts to view future decisions, particularly in regard to expansion
or rationalisation.
Advisors and Consultants
Some businesses may need
specialist legal , financial, marketing or HRM advice from an external
consultant. This is the case for many small Irish firms.
General Public
The public may be interested
as customers or as neighbours to the business. Customers may look at the
statements to consider the company’s ability to supply goods and services
of the right quality and quantity. Customers in this context would be business
customers.
Management
The accounts play an important
role in the area of planning and control. In planning, budgets are prepared
at the beginning of accounting period. Department managers are responsible
for formulating the budget. The financial statements at the end of the
accounting period aid financial control. Management can ascertain if objectives
have been met.
Usefulness of Financial
Information
Financial statements as
outlined earlier play a major role in planning and control. The financial
statements can help a business in the following ways:
1. Liquidity and Cash
flow
Budgets can identify periods
of surpluses and shortages. As a result, overdraft facilities can be applied
for where potential shortfalls exist. Liquidity indicates ability to pay
debts.
2. Profitability
This indicates how well
the business performed. Comparisons can be made with previous years or
competitors.
3. Gearing
The financial structure
of a business can be examined to see if it is highly or lowly geared.
4. Net Assets
An evaluation can be made
to estimate the value of a business. This would be important for take-over
or a management buyout.
5. Department/Subsidiary
Performance
Indications can reflect
poor performance, which may lead to closure of a department or subsidiary
6. Filing Accounts
It is compulsory for limited
companies to file their accounts with the register of companies.
7. Future Prospects
From an analysis of liquidity,
profitability and gearing, indications to future potential can be ascertained.
If debt levels are high, then it may act as a constraint to future growth.
FINAL ACCOUNTS
As the name suggests these are the last accounts prepared by a business at the end of a trading period. There are two main stages involved in their preparation, Trading, Profit and Loss Account and Balance Sheet.
Trading, Profit & Loss Account
1. Trading Account
This account is often referred
to as an income statement. It is divided between the trading account and
the Profit Loss. The Trading account is prepared with the objective of
calculating the gross profit. This account is prepared before the Profit
& Loss Account. The trading account matches the sales revenue for a
period against the cost of goods sold for the period. The difference between
sales and cost of sales is gross profit. Sales is comprised of cash and
credit sales. Cost of goods sold is opening stock plus purchases minus
closing stock.
2. Profit and
Loss
The gross profit is transferred
to the profit and loss account where it is added to other revenue of the
firm. The overall total revenue figure is matched against all the other
expenses of the business such as wages, electricity, telephone etc. The
difference between gross profit plus non trading revenue, less expenses
is referred to as net profit/net loss. Non trading income includes commission
received, rents received and deposit interest received. Expenses or revenues
must relate to the time period covered in order to be included in Profit
& Loss Account. Taxation must be deducted from the net profit before
any profit is distributed to the owners of the business. Profit distributed
to the owners of the business is known as dividend. Many firms decide to
plough profits back into the enterprise, which is known as retained earnings.
The profit & Loss expense also includes depreciation of fixed assets.
Depreciation is the reduction in the value of fixed assets due to wear
and tear.
3. Balance Sheet
A balance sheet is prepared
after the trading, profit and loss account. A balance sheet is a statement
of the assets, liabilities and capital on a particular date. It is like
taking a photograph of a business at one point in time to assess its financial
health. A balance sheet can be expressed in the following equation: ASSETS
= LIABILITIES+ CAPITAL. A balance sheet is structured under the following
headings:
A. Fixed Assets
These are the permanent
assets of the business and are not bought with the intention of resale.
Fixed assets include buildings, vehicles, plant and machinery etc. Fixed
assets are often referred to as fixed capital.
B. Current Assets
These assets are short-term
assets of the business whose value is constantly changing. They are assets
usually held for less than one year. Current assets usually include stock,
debtors, cash and bank. Other current assets include expenses paid in advance
(prepayments) and revenue due.
C. Current Liabilities
Current Liabilities are
short-term debts of the business. These liabilities must be paid back within
1 year. Usual examples of current liabilities include trade creditors who
supply the business with goods or services on credit and bank overdrafts
where current account holders avail of short-term finance from their bank.
Other examples include expenses due (accruals) or revenue prepaid.
D. Capital Employed
Capital invested in a business
can come from debt or equity. In the case of debt, this involves drawing
down long term loans with fixed interest. The loan is usually available
for a period of more than 1 year and must be repaid. Some companies avail
of debentures, which are also long term loans. Capital for a company is
referred to as share capital. The share capital is invested in the business
by the shareholders. A company’s balance sheet must distinguish between
issued shared capital and authorised share capital. Authorised Share
Capital is the maximum amount of share capital a company can raise
under its memorandum of association. Issued Share Capital is the
actual amount of capital raised from issuing shares to the shareholders.
Capital employed of a company also includes reserves. Reserves are
the accumulation of profits over the years.
Ratio Analysis
Ratio analysis helps the
reader to convert and interpret information from accounting statements
into a meaningful format. A ratio in purest terms is a mathematical expression
of a relationship between two items. For financial ratios there must be
a significant relationship between the two figures. Ratios aid the comparison
of a firm’s results with a previous period or against firms in the same
industry. Ratios in their own right are not important but can be advantageous
in examining a set of accounts. They may help to identify trends or even
to expose weaknesses. They are a source of great interest to shareholders,
employees, competitors, banks and the financial media in particular.
Shareholders are interested
in management’s performance and the likely return on their investment.
The banks would view the liquidity (cashflow) situation seriously in regard
to capability in making loan and interest repayments. Employees would be
interested in profitability and liquidity in regard to the security of
their job. Competitors would screen the financial data in relation to future
expansion plans. The financial media would advise investors whether to
buy, sell or retain shares in a firm. The main ratios will be examined
under liquidity, profitability, activity and gearing.
Liquidity Ratios
Liquidity relates to the
ability to meet debts when they fall due. Prior to illustrating liquidity
ratios, it is important to understand the concept of working capital. In
accounting terms it is the difference between current assets and current
liabilities. To a business person it is the amount of cash he/she has to
run day to day business.
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(a) The Working Capital
Ratio (Current Ratio)
This ratio reflects a firm’s
ability to meet their short-term financial commitments. The ratio is usually
expressed in the form of A : B than in the form of a percentage. It is
calculated as follows:
Current Assets
170,000
Current Liabilities 100,000
= 1.7:1
As a rule of thumb it is
considered that 2:1 would be an ideal ratio. A lot will depend though on
the nature of the industry. Generally current assets are larger than current
liabilities. If this is not the scenario, then the business is considered
to be overtrading. Overtrading is depending too much on other people’s
money. This is especially the case for banks and creditors. It can also
arise due to a mismatching of funds. For example the financing of a capital
project out of short-term funds. It will also depend on the time of year.
(b) Acid Test (Quick
Asset) Ratio
This ratio is viewed as
being a better measure of liquidity. It is calculated as follows:
Current Assets - Stock
170,000 - 80,000
Current Liabilities
100,000
= .9:1
This ratio excludes the least liquid of the current assets. It is a tougher criterion for measuring liquidity as it only considers the assets near to cash. Generally 1 : 1 is viewed as an ideal acid test ratio but some businesses can function quite well below this level.
(c) Debt/Equity Ratio (Gearing)
This ratio examines the capital structure of a business. If a business is financed mostly from debt it is viewed as a highly geared company. Conversely, a company with a low level of debt is considered to be lowly geared. It can be calculated as follows:
Debt :
Equity Capital
(Loans): Ordinary Shares
+ Reserves
200,000: 370,000
= 1: 1.85
This firm would be considered lowly geared. Both debt and equity are in the financed by section of a balance sheet. Both are the main alternatives used in the purchase of fixed assets or expanding the business. Equity capital is viewed as owners’ capital while debt capital is from outsiders like the banks.
Benefits of a high debt/equity
ratio
(i) If a firm earns high
profits, then loan repayments will not prove difficult.
(ii) Using debt for expansion
purposes will not result in any loss of control for
shareholders.
(iii) Interest on loans
are tax deductible
(iv) If return on investment
is higher than interest repayments then the acquisition
of debt is worthwhile.
Dangers of a high debt/equity
ratio
(I) If profits are low,
little will be left for shareholders as debt holders have prior
claims.
(ii) Assets pledged as
collateral cannot be used to obtain further loans.
(iii) High levels of debt
may affect a firm’s future earning potential.
(iv) In the case of debenture
holders interest payments must be made whether the
business makes profits
or not. For shareholders there is a potential loss of
control.
Profitability
For useful comparison purposes
profitability should only be judged on businesses of similar size.
Abridging trading profit and loss account
| Cash Sales | 40,000 | ||
| Credit Sales | 260,000 | ||
| 300,000 | |||
| Cost of Sales | |||
| Opening Stock | 60,000 | ||
| Purchases | 130,000 | ||
| 190,000 | |||
| -Closing Stock | 80,000 | 110,000 | |
| Gross Profit | 190,000 | ||
| Less Expenses | 90,000 | ||
| Net Profit | 100,000 | ||
| - Taxation | 40,000 | ||
| 60,000 | |||
| -Dividends | 20,000 | ||
| 40,000 | |||
| +Balance brought forward | 30,000 | ||
| Retained Earnings | 70,000 |
(a) Gross Margin
This ratio measures how
much profit a firm is earning in relation to the amount of sales made.
It may be calculated as follows:
Gross Profit
190,000
Sales
x 100 = 300,000 x100
=63.3%
A fall in gross margin may
be due to:
(I) An increase in the
cost of supplies not passed on in selling prices.
(2) Not selling enough
of the profitable lines.
(3) Increased level of
theft.
(4) Adopting a low price
strategy to capture market share.
(5) Change in stock valuation
methods.
(b) Net Margin
This ratio compares the
profit of the business after deducting expenses against sales. It can be
calculated as follows:
Net Profit
100,000
Sales x 100
= 300,000 x 100
A fall in this ratio may mean that expenses are rising at a greater pace than sales. A fall in this ratio is a sign of harder times ahead.
(c) Return on Investment
(Return on Capital)
This ratio represents an
assessment of how efficient the business was run by management. Comparisons
can be made against prevailing interest rates in financial institutions,
expected returns or returns on firms in the same industry. Ultimately a
business must make a justifiable return on its investment to remain in
business. This ratio is calculated a follows:
Net Profit before Tax
100,000
Capital Employed x 100
= 570,000 x 100 =17.5%
Capital employed represents the accumulation of debt capital and equity capital. This figure is equivalent to the net assets of a business.
Activity Ratios
Two of the main ratios
in this category are stock turnover and debtor’s collection ratios.
(a) Stock Turnover
This ratio calculates how
often stock sells in a given year. As an estimate it gives an indication
to the liquidity of the stock. This means how quickly the stock is converted
into cash or into debtors if it is a credit sale.
Stock Turnover may be calculated as follows:
Cost of Sales
110,000
Average Stock
= .5(60,000+80,000) = 1.6 times
Average stock is calculated by averaging opening and closing stocks. A supermarket would have a high turnover while a jeweller would have a low one.
(b) Debtors Collection
period
This measures how quickly
money is collected from debtors. Debtors are people to whom goods were
sold on credit. The ratio may be calculated as follows:
Debtors
Debtors
Credit Sales x 12
Credit Sales x 365
60,000
60,000
260,000 x 12 = 2.8 months
260,000 x365 =84 days
Limitations to Ratio Analysis