Chapter 34- statement of financial position

Question 1

What is a statement of financial position?

Answer 1

• formerly known as the balance sheet
• its a statement about the value of a business at a given point in time, showing what it owns (assets) and what it owes (liabilities)

Question 2

Statement of financial position

Answer 2

A method of recording the value or wealth of a business at a given moment in time

Question 3

Assets

Answer 3

What the business owns

Question 4

Liabilties

Answer 4

What the business owes

Question 5

Current liabilties

Answer 5

Less than one year

Question 6

Non current liabilities

Answer 6

Money owed for more than one year

Question 7

Liquidity

Answer 7

The ability to convert assets into cash

Question 8

Depreciation

Answer 8

An allowance for the wear and tear on the fixed tangible assets

Question 9

Assets

Answer 9

• what the business owns
• positive number on the balance sheet
• there are several types of asset

Question 10

Non current (fixed) assets

Answer 10

• may be the factory or buildings owned by the business
• also includes the fixtures and fittings of the business such as the machines and equipment used
• these are the assets that are necessary to enable the business to function
• important to realise that the business can only count what it actually owns
• rented facilities are not owned and therefore wouldn’t be counted

Question 11

Tangible assets

Answer 11

• assets which can be seen
• factory and machines will be both fixed and tangible fixed assets

Question 12

Intangible assets

Answer 12

• these assets are not visible
• such as the patent or good will of the business, a value for its reputation or a good brand name
• difficult to put an accurate value on intangible assets
• the better known a business is the more likely that it is that its intangible assets (goodwill) will be higher

Question 13

Goodwill

Answer 13

E.g.
value of business= 500,000
Value of tangible assets= 450,000
Assuming there are no other intangible assets then the value of 50,000 is the value of the goodwill

• goodwill of a business is of value if a business is being sold and explains why there are occasions when a business is bought for what appears to be well in excess of its net asset value

Question 14

Patents

Answer 14

• legal protection that gives a business or individual exclusive rights to make use or sell a invention for a certain period of time

Difficult to put a valuation on a patent
- will depend upon the length of the patent, its type and what the patent is actually for (the more technological the patent is, the more likely its value will be higher)
- getting the valuation accurate is not easy and it is important to remember this because a patent may be and is used as security when applying to borrow money
- scientific and technological businesses protect their research, techniques and products in order to have the time and opportunity to generate sufficient income over time to compensate for the possible high level of expenditure on research and development
- in an attempt to put a value on a patent it is common to value according to both the quantitative and qualitative elements
- for the quantitative aspect there may be measurable data which can be used however for the qualitative the characteristics and uses of the inter in question need to be considered
- putting a value on these is usually based on the amount in terms of costs that is spent on the r&d or the level of likely income the invention isn likely to generate expected revenue inflows

Question 15

Prudence

Answer 15

• used to indicate that there is a no need to be cautious when valuing a business
• overestimating the value of a business is inappropriate
• to gain a realistic value of the fixed assets, depreciation needs to be considered

Question 16

Depreciation

Answer 16

• it is an allowance for the wear and tear on the fixed tangible assets
• as the factory and machines age their value decreases
• depreciation reflects this usually as a percentage of the assets to give a realistic value of the business

Question 17

Financial non-current assets (fixed assets)

Answer 17

• investing in long term bonds or shares is considered as a fixed asset

Question 18

Current assets

Answer 18

• describe everything owned by the business which is not a non-current (fixed asset
• these assets are capable of being converted into cash within the accounting period
• the easier these assets can be converted into cash the better

Now normal that the current assets are listed in order of
- inventories
- trade and other receivables (debtors)
- cash

Question 19

Liquidity

Answer 19

The ability to convert assets into cash

Question 20

Inventory

Answer 20

• inventory (stock) can be in the form of materials, unfinished goods (work in progress) and finished goods
  Liquidity of stock very much depends upon the type of stock
• finished goods are usually easier to convert into cash
• raw materials may also be converted into cash if there is a market for such materials
• least liquid type of stock is unfinished goods (little value to anyone until finished)
• finished goods will vary in terms of their liquidity
• perishable goods with a short shelf life will be less liquid than goods with a longer shelf life
• fast moving consumer goods are more liquid than other goods as there is a frequent and regular demand for such products

Question 21

Trade and other receivables (debtors)

Answer 21

• includes money that is owed to the business
• assuming that the debts owed to the business are due for payment within one year they are counted as a current asset

Question 22

Cash

Answer 22

• money is obviously the most liquid of the current assets as it is already cash

Question 23

Bad debt

Answer 23

• not all debtors (trade receivables) will pay and this is known as ‘bad debt’
• therefore important for businesses to make allowances for bad debts in order to gain a more realistic valuation of assets (current assets)

There are several ways of estimating the level of likely ‘bad debts’ a business will incur
- allowance method
- aging method
- credit sales

Question 24

Allowance method

Answer 24

• calculated by taking the figure as a percentage of the receivables (debtors)
• a business will look at its records and take an average percentage of bad debts
  E.g. 4%
  Business has for the present financial year- 200,000
  Bad debt will be
  200,000 x 4%= 8000
  This amount is an allowance for bad debts therefore giving a more realistic figure of 192,000

Question 25

Ageing method

Answer 25

- assumes in a simplistic manner that the longer an account is overdue for payment, the more likely it will not be paid at all

Question 26

Credit sales

Answer 26

- another method used in assessing the likely level of bad debts based on the historical records of a business

Question 27

Liabilties

Answer 27

- what the business owes - negatives on the statement of financial position

Question 28

Current liabilties

Answer 28

- negatives on the statement of financial position - they describe what is owed by the business and due for repayment within one year - they are the opposite of current assets and may consist of overdrafts and short term loans

Question 29

Overdraft

Answer 29

- an agreement with the bank to borrow money to avoid cash flow problems - may be used when a payment needs to be made and suficient funds are not available until days or months layer - may be agreed for anything from one day to just under a year - amount to be borrowed will vary according to the needs of the business an dis usually for up to an agreed sum

Question 30

Short term loan

Answer 30

- a loan for a fixed amount over a fixed period of time, less than one year

Question 31

Trade and other payables (creditors)

Answer 31

- creditors are the opposite of debtors - they refer to other businesses (suppliers) who have not yet been paid - business will have received raw materials or components but does not have to pay until an agreed time

Question 32

Net current assets (working capital)

Answer 32

- subtract current liabilties from current assets

Question 33

Non current (long term) liabilities

Answer 33

- loans for ore than one year - they can be in various forms 1. Mortgage (associated with the buying of property) 2. Debenture (only issued by a company that is a plc)- a debenture is a long-term loan with a fixed rate of interest 3. Bank loan (a loan of more than one year)

Question 34

Net assets

Answer 34

- add the value of the net current assets to the non current assets minus the non current (long term) liabilities - figure reflects the value of the business at a given point in time May be calculated Total assets (current assets + non current assets) - current liabilties - non current liabilties - important to ensure the net assets of the business ‘balance’ with the funding of the business (Normally shown via the total equity of the business)

Question 35

Shareholders’ equity or total equity (capital and reserves)

Answer 35

- value of funds tied up in the business, in the form of shares and retained profits

Question 36

Ordinary shares

Answer 36

- shares that show an ownership of the business - each share allows the holder a vote at the annual general meeting (AGM) of the business - the value of these shares may change reflecting the well being of the business

Question 37

Preference shares

Answer 37

- have priority (preference) over ordinary shares when the profits are distributed - share of the profit is usually based on a fixed percentage rather than the size of the dividend declared, as it is the case for ordinary shares

Question 38

Reserves and retained earnings (profit and reserves)

Answer 38

- refers to money that has been retained in the business in order to help it grow rather than being distributed to the shareholders - represents money that has been ploughed back into the business - its not cash as cash appears as an asset under current assets - reserves are a balancing item to show that when a business increases its assets some of the profit that did not go to shareholders has been invested in the business

Question 39

Statement of financial position will balance in terms of the calculations

Answer 39

- Nat assets will always be equal to total equity which includes the shareholders funds -

Question 40

How useful is a statement of financial position

Answer 40

- Will be helpful if a business wants to obtain a loan from a bank - by looking at the statement of financial position, the bank would be able to assess if the business had sufficient assets that could be used for security against the loan - The statement of financial position is also helpful to a business as it can assess if it has enough cash to keep itself afloat - Looking at the current assets and liabilities it can calculate its net current assets to see if it has enough cash to keep the business business going - Statement of financial position also provide a lot of information which can be used to calculate several ratios