Accounting Fundamentals Chapter 29-Cambridge Tutorial

Learning goals Understand why keeping business accounts is so important Analyse the main users and uses of business accounting records identify and understand the main components of an income statement (profit and loss account) Identify and understand the main components of a balance sheet Analyse business accounts by suing ratio analysis – liquidity and profit-margin ratio

Financial records A business keeps various types of financial records to monitor its performance and ensure that taxes are paid. These include cash flow statements, profit and loss accounts and a balance sheet. Why keep accounting records? To know if you are spending more money than your are making or visa versa Help with decision making for internal and external users

Internal and external users of accounting information Internal Users External Users Business managers Measure company’s performance Make decisions about expansion, investment, new products… Inventory management Budget for future Banks: if to lend money to a business or not Creditors, such as suppliers: if to sell on credit Customer: if the business is secure and will continue to exist in the future. Government & tax authorities: calculate how much tax is due Investors: assess the value of the business and if they should invest Workforce: decide if the business is secure enough o pay wages Local community: if the business is likely to expand and benefit the community

The 3 main financial statement Income statement (profit and loss account) Records the revue, costs an profit (loss) of a business over a given period of time The balance sheet Records the values of a business’s assets, liabilities and shareholder’s equity at one point in time. Cash-flow statement Record the cash received by a business over a period of time and the cash outflow from the business.

Income Statement Trading account: Profit and loss account section: Shows the gross profit that has been made Gross profit = sales revenue – cost of sales Sales revenue = selling price x quantity sold Cost of sales purchasing prices x quantity of goods purchased Profit and loss account section: Calculates both net profit and profit after tax Net profit (operating profit) = gross profit – overhead expenses (variable cost) Profit after tax = net profit – interest costs - operating tax

Income Statement Appropriate account Final section of the income statement Not always shown Shows how the profit after tax of the business are distributed between the owners in the form of dividends and retained profit to shareholders. dividend: the share of the profit paid to shareholder a return for investing in the company. Retained profit = profit after tax – dividends paid

Uses of Income Statement Measure and compare the company’s performance to previous year and it’s competitors Compare actual profits with forecasted profits External users such as creditors and investors. Credit use to decide if to lend money investor decide if to invest money.

Balance Sheets Three sections Balance sheet must always balance: Assets: items of monetary value that is owned by a business Liabilities: financial obligations of a business that it is required to pay back in the future Shareholder's equity = assets – liabilities Balance sheet must always balance: assets = liabilities + shareholder’s equity The balance sheet is a snapshot of the company’s assets, liabilities and shareholder's equity on that given date

Balance Sheets-Important Terminology None-current assets: assets to be kept and used by the business for more than one year (fixed assets) Intangible assets: items of value that do not have a physical presence such as: patent, trademark, copyright and goodwill. Current assets: assets that re likely to be turned into cash before the next balance sheet date (less than a year) Inventories: stocks held by the business in the form of materials, work in progress or finished goods Accounts receivable (debtors): the value of payments to be received from customers who have bought goods on credit.

Balance Sheets-Important Terminology Current liabilities: debts of the business that will usually have to be paid within one year. Accounts payable (creditors): value of debt for goods bought on credit payable to suppliers. Non-current liabilities: value of debts of the business that will be payable after more than one year.

The Cash flow statement Focuses on the company how the company’s cash position has changed over the past year. Shows were the cash came from during the year and how it was spent.

Accounting ratios – profitability ratios Measures the success of management in converting sales revenue into both gross profit and net profit. Gross profit margin = gross profit (before deductions of overhead) with sales turnover Net profit margin = compares net profit (after all costs have been accounted and deducted but before interest and tax deductions) with sales revenue

Methods to increase profit margin Examples Evaluation of method reducing direct costs. Cheaper materials Cutting labour costs Lowering labour and using automatic methods Cutting wages Consumers’ perception of quality may be damaged Hard to keep quality under control due to distant communication Increase overhead cost so gross profit will rise but net will fall Motivation levels will decrease reducing productivity and quality Increase price Increase price without increase in cost Oil companies do it all the time Consumers will switch to cheaper competitive goods leading to fall in profits Consumers might see this as corporate greed and company’s reputation will suffer Reduce overhead cost Move to cheaper location Reduce marketing Delayer the organization Cheaper area could damage the image of the company Could lead to less sales Could lead to inefficiencies due to lack of supervision.

Accounting ratios – liquidity ratios These ratios assess the ability of the firm to pay its short- term debts. Important measures of the short-term financial health of the business. Current ratio: compares the current assets with the current liabilities Many accountants recommend a result of around 1.5-2, however it depends on the industry

Accounting ratios – liquidity ratios Acid test ratio: also known as quick ratio a more strict test of firm’s liquidity. By ignoring the least liquid current assets – inventory A ratio of less than 1 is considered poor liquidity.

Limitation of ratios analysis Provide incomplete analysis of company’s financial position Ratios need to be compared to other similar business for better understanding. They are not stand alones Different companies have different assets valuation so comparing the ratio will produce inaccurate results. Only measure quantitative performance – do not see the full picture