Accounting principles THE FIVE FUNDAMENTALS: Matching The principle of matching implies that, when calculating profits for an accounting period, the revenues must be matched against all the costs incurred in generating that revenue, although the money relating to those revenues and costs may not have been received or paid in that accounting period.
Accounting principles Going concern This principle assumes that the business will continue in operation and that there is no immediate possibility that it is about to be put into liquidation. If the business is not a going concern, it must be accounted for on a break-up basis. Net asset valueNet asset value of a business, computed on the basis of it being sold as a 'gone concern.' It is the most conservative method of business valuation because the assets are priced individually (as disparate pieces, and not as functional units together with other assets) at their forced liquidation ('fire sale') value. Also called breakup basis.businessgone concernconservativemethodbusiness valuationassetsfunctionalunitsother assetsforced liquidationsalevaluebreakup basis
Accounting principles Consistency The consistency principle requires that similar items within the same set of accounts should receive the same accounting treatment, and that the same accounting treatment should be applied from one accounting period to the next
Accounting principles Prudence Prudence implies that when a number of different treatments or valuations are possible the procedure that provides the most cautious view of the financial statements should be employed. i.e. you record inventory in your accounts at the lower of cost and net realizable value, rather than at sale price, which (hopefully) contains a profit element. Instead the profit is only recognised when a legally enforceable sale has taken place.
Accounting principles Cost The last fundamental principle states that assets or resources are presented in the accounts at the lower of cost or their net realizable value: the amount that could be achieved were the assets to be disposed of. Slides by Payman Shafiee
The profit and loss account Income statement captures all the sales and the costs associated with achieving either a profit or a loss for the period, even if the associated cash flows did not take place during that time.
Profit and Loss account example
Gross and operating profit The difference between gross profit and total operating costs gives the operating profit for the business The spreading of the cost of a capital item is called depreciation, which is dealt with in more detail later in this chapter. Depreciation charges relate to the spreading of the cost of physical capital items. Non- tangible items, such as licences and patents that exist for a number of years, are treated exactly the same way but the charge to the P&L account is described as amortisation. Slides by Payman Shafiee
Completing the financial statements Calculating Interest charges: To calculate interest, the average debt balance for the period is calculated and multiplied by the interest rate. Average loan balance × interest rate = interest charge ($17,969 + $8,985) ÷ 2 × 5% = $674
Declaring dividends One of the most common requirements is that it has sufficient distributable reserves. In the case of Newco, an inspection of the balance sheet reveals that the company has retained losses until year 6 (see row 33 of Chart 16.2). Only when these accumulated losses have been eliminated can the company declare a dividend. So despite generating profits at the after-tax level in years 5 and 6 (row 46 of Chart 16.1), Newco can only declare its first dividend in year 7 (cell K48 of Chart 16.1).
Reviewing the financial statements Ration analysis: the comparison of two or more figures in the financial statements to provide an indicator of the performance of the business They are most useful when they can be compared with those of similar businesses that operate in the same market, competing for the same customers with similar products, and that have a similar business model and are at the same stage of development
ASSESSING PROFITABILITY Gross profit margin: COGS = Cost of Goods Sold ABC Corp. earned $20 million in revenue from producing widgets and incurred $10 million in COGS-related expense. ABC's gross profit margin would be.... Slides by Payman Shafiee
ASSESSING PROFITABILITY Operating profit margin: (EBITDA) if a company has an operating margin of 12%, this means that it makes $0.12 (before interest and taxes) for every dollar of sales. Often, nonrecurring cash flows if a company has an operating margin of 12%, this means that it makes $0.12 (before interest and taxes) for every dollar of sales
ASSESSING PROFITABILITY Earnings per share: (EPS) assume that a company has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be = (24/12.5)
REVIEWING THE BALANCE SHEET Current ratio : Quick ratio : The quick ratio is more conservative than the current ratio, a more well-known liquidity measure, because it excludes inventory from current assets. Inventory is excluded because some companies have difficulty turning their inventory into cash
REVIEWING THE BALANCE SHEET Debtor days (Days Working Capital): Most businesses make a large proportion (or even all) of their sales on credit. Debtor days is a measure of the average time payment takes. Increases in debtor days may be a sign that the quality of a company's debtors is decreasing. This could mean a greater risk of defaults (so it does not get paid at all).
REVIEWING THE BALANCE SHEET Stock turnover: A measure of stock liquidity calculated by dividing the total number of shares traded over a period by the average number of shares outstanding for the period. The higher the share turnover, the more liquid the share of the company. Slides by Payman Shafiee
Return on average capital employed ROACE: Return on average capital employed (ROACE) measures how efficiently the business is using its operating assets. To separate how the business is funded from operational efficiency, profits are calculated before interest and after deducting taxes, as if the business were 100% equity financed. ROCE should always be higher than the rate at which the company borrows, otherwise any increase in borrowing will reduce shareholders' earnings.
Return on equity Shareholders will be interested in the returns that the business is achieving on just the shareholders’ funds. The definition of return on equity (roe) is as follows:
Dividend cover Dividend cover examines the amount of profit that is available from which dividends can be paid. Dividend cover is defined as earnings per share divided by the dividend per share.earnings per share i.e. So, if a company has earnings per share of $10.00 and it pays out a dividend of $2.00, the dividend cover is x
ASSESSING FINANCIAL RISK Significance: a fundamental principle of corporate finance says that an investor will typically demand a higher rate of return the higher the risk associated with the investment Shareholders are interested in the financial risk of the business because the risk attached to their share capital will increase as the business takes on more debt. As it increases its debts, there is a greater risk that the business will find itself in financial difficulties.
leverage leverage examines what proportion of the business is financed by debt and provides a proxy for potential financial risk where higher levels of gearing are normally associated with higher levels of risk The acceptable levels of gearing will depend on the sector and the stage of growth of the business.
leverage Long-Term Debt To Capitalization Ratio: A variation of the traditional debt-to-equity ratio, this value computes the proportion of a company's long-term debt compared to its available capital. By using this ratio, investors can identify the amount of leverage utilized by a specific company and compare it to others to help analyze the company's risk exposure Slides by Payman Shafiee