What are the 3 accounts?
- The income statement
- The balance sheet/ Statement of financial position
- Cash flow statement
What does the income statement show?
The gross and net profit of the company. Details of how the net profit is split up between dividends and retained profits
What does the balance sheet show?
The net worth of the company. This is the difference between the value of what a company owns and what it owes
What does the cash flow statement show?
Where cash was received from and what it was spent on
Definition of income statement
Records the revenue, costs and profit (or loss) of a business over a given period of time
What are the elements of an income statement?
cost of sales, gross profit, operating profit, profit for the year, retained earnings
What are the three sections of an income statement?
- The trading account
- The profit and loss account
- Appropriation account
What are the 2 elements of the trading account and what does it show?
- Gross profit: equal to sales revenue minus cost of sales
- Sales revenue
- Cost of sales: direct cost of purchasing the goods that were sold during the year. opening stocks plus purchases minus closing stocks
- The account shows how gross profit or loss has been made from the trading activities
What are the elements of the profit and loss account and what does it show?
- Net profit: gross profit minus overhead expenses
- Profit after tax: operating profit minus interest costs and corporation tax
- Overheads are costs or expenses of the business that are not directly related to the number of items made or sold - rent, management salaries, depreciation
- Limited companies pay corporation tax before they pay dividends or keep profits
What are the elements of the appropriation account and what does it show?
- Dividends: the share of the profits paid to shareholders as a return for investing in the company
- Retained profits: the profit left after all deductions, including dividends, have been made. This is ploughed back into the compant as a source of finance
Definition of low quality profit
one off profit that cannot easily be repeated or sustained
Definition of high quality profit
Profit that can be repeated and sustained
Define balance sheet (statement of financial position)
An accounting statement that records the values of a business' assets, liabilities and shareholders' equity at one point in time
An item of monetary value that is owned by a business
A financial obligation of a business that it is required to pay in the future
Define shareholders' equity
- total value of assets - total value of liabilities
- Comes from 2 main sources: share capital and retained earnings
- All net wealth belongs to the shareholders
Define share capital
The total value of capital raised from shareholders by the issue of shares
Define non-current assets
- Assets to be kept and used by the business for more than one year. Used to be referred as fixed assets
- Examples: land, machinery (tangible), patents, trademark, copyrights and goodwill: arises when a business is valued at or sold for more than the balance sheet value of its assets (intangible)
Define current assets
- Assets that are likely to be turned into cash before the next balance-sheet date
- E.g. accounts receivables, cash, inventory
Stocks held by the business in the form of materials, work in progress and finished goods
Define accounts receivables (debtors)
The value of payments to be received from customers who have bought goods on credit
Define accounts payable (creditors)
Value of debts for goods bought on credit payable to suppliers
Define current liabilities
- debts of the business that will usually have to be paid within a year
- accounts payable, bank overdraft, unpaid dividends
Define non-current liabilities
value of debts of the business that will be payable after more than one year
Define working capital
net current assets
current assets - current liabilities
What are the 2 main types of ratios and define them?
- Profitability ratios: include the gross profit margin and net profit margin which compares the profits of the business with sales revenue (AS Level) and ROCE which compares net profit with capital employed (A Level)
- Liquidity ratios include current/liquid ratio and acid test ratio. Measure of how easily a business could meet its current liabilities
What does current/liquidity ratio show?
At what rate (how many times) can the business afford to pay current liabilities out of its current assets.
What does acid test ratio show?
At what rate (how many times) can the business afford to pay current liabilities out of its current assets minus stock since it is the least liquid assets
Methods to increase liquidity
- Sell off fixed assets. If business still needs it => lease it but leasing charges will add to overheads
- Sell off inventories => alter consumer's perceptions of brand as they are cheaper, inventories might be needed to meet changing customer demand levels
- Loans => increase interests cost
What does gross profit margin show?
Shows how much gross profit a business makes for $1 of sales. Shows performance of the business. Shows managing ability of consistently controlling the business's production costs and the margin between what to buy and sell.
What does net profit margin show?
Shows how much net profit a business makes for $1 of sales. Shows performance of the business. Shows management ability and control of expenses/ overheads.
Method to increase profit margins
- Reducing direct costs. e.g. cheaper materials, cut wage, increase productivity to cut labour costs => quality may be damaged, motivation might fall
- Increase price => total profit could fall if consumers switch to competitors, reputation
- Reducing overheads costs. e.g. delayering the organisation, reducing promotion => fall in slaes, fewer workers => adverse effects on productivity
Limitations of ratio analysis
- Give incomplete analysis of a company's financial position
- One ratio result on its own is gives limited info, needs to be compared with results from previous years or other businesses
- Can only measure quantitative performance not qualitative
- Can identify potential business problem but cannot analyse the cause of it or suggest potential solutions
What are the uses of the income statement?
- It can be used to measure and compare the performance of a business over time or with other firms
- The actual profit data can be compared with the expected profit levels of the business
- Bankers and creditors of the business will need the info to help decide whether to lend money to the business
- Prospective investors may assess the value of putting money into a business from the level of profits being made
- Detailed income statement is usually produced for internal use. Produced frequently
- A less detailed summary will appear in the published accounts of companies for external users. Produced once a year
What do external users want to know?
- Suppliers: Want to know whether the business generates enough to pay for the supplies.
- Customers: Want to make sure of they are not being charged too much (If their profits are too high).
- Tax collectors: In order to calculate the business's tax on profits that is needed to be collected.
- Lenders: Want to know that the business is able to pay interests and repay any loans
What do internal users want to know?
- Owners/Shareholders: They want to know that their investment is being used properly.
- Managers: Want to check the profitability of the business, whether they are doing a good job.
- Employees: Want to know the job security; whether the business is financially stable and can pay wages.
Define window dressing
presenting the company accounts in a favourable light - to flatter the business performance
Limitations of published accounts