1. Accounting Fundamentals
Chapter 29-Cambridge Tutorial

2. 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

3. 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

4. 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

5. 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.

6. 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

7. 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

8. 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.

9. 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

10. 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.

11. 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.

12. 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.

13. 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

14. 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.

15. 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

16. 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.

17. 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