The accounting framework is built around the process of double entry bookkeeping. This means that for every financial transaction in a business two amounts are written down so that the relationship remains balanced. This has led to the famous accounting equation known by all bookkeepers and accountants:
ASSETS = LIABILITIES + OWNERS’ EQUITY
Assets are things that a business owns, liabilities what it owes to outsiders, whilst Owners‟ Equity represents what is left owing to the owners/shareholders. This information is put together in a Balance Sheet.
Other important terms you need to understand when using financial information includes expenses (recurring costs for a firm), income or revenue (money made, usually through sales), and profits (the difference between income and expenses). These terms are found mainly in another important account called the Revenue Statement (also known as the Profit and Loss account or the Income Statement) that has its own equation:
Sales – Cost of Goods Sold = Gross Profit – Expenses = Net Profit
Such accounts have a general format. Have a look at the one below:
Revenue Statement of M I Wealthy for the 12 months ending 30/6/06
Sales 1 000 000
- Cost of Goods Sold 400 000
Opening Stock 60 000 + Purchases 410 000 - Closing Stock 70 000 = Gross Profit 600 000 - Expenses 350 000 Wages 130 000
Motor Vehicle expenses 20 000
Rent 50 000
Interest on loan 50 000
Insurance 30 000
Marketing 70 000
The Revenue Statement is done first because the Net Profit that is worked out at the end of the account is used in the Balance Sheet. Typically Balance Sheets look like:
Balance Sheet of M I Wealthy as at 30/6/06
Current Assets 150 000 Current Liabilities 100 000
Closing stock 70 000 Overdraft 30 000
Debtors 50 000 Creditors 60 000
Cash at bank 30 000 Wages owing 10 000
Non-Current Assets 850 000 NonCurrent Liabilities 500 000
Machinery 450 000 Bank Loan 500000
Office Equipment 220 000
Motor Vehicles 180 000 Owners’ Equity 900 000
Capital 750000
Intangible Assets 500 000 + Net Profit 250000
Goodwill 300 000 - Drawings 100000
Patent 200 000
1500000 1500000
So what does it all mean?
Well, for a start you may well see accounts like these in section 2 of your exams. The more familiar you are with them, the better you‟ll be prepared to answer questions on them such as those involving financial ratio analysis. The syllabus lists:
Liquidity, which examines the short-term position of the business through the Current ratio = Current Assets : Current Liabilities. From the Balance Sheet above this is = 150 000 : 100 000 or 1.5: 1, a good position.
Solvency, examines the long-term financial position of the firm through the
Debt to Equity ratio = Liabilities : Owners‟ Equity. This is called gearing or
leverage and from the above = 600000 : 900000 or 2:3, another strong point. Profitability can be measured using three ratios, (usually expressed as
percentages). From the Revenue Statement we can calculate the: o Gross Profit ratio = Gross Profit / Sales = 600000/1000000 = 60% o Net Profit ratio = Net Profit / Sales = 250000/1000000 = 25%
Efficiency is measured using two ratios, one from each account. o Expense ratio = Expenses/Sales = 350000/1000000 = 35%
o Accounts receivable turnover ratio = Sales/Accounts receivable (debtors) = 1 000 000/50000 = 20. Now divide this onto 365 (days in the year). So 365/20 = 18.25 (days to collect debts).
o As raw figures these ratios and percentages have some meaning but they are best used in a comparative way. That is, look at this firm‟s figures from this year with other figures over time, or through industry averages from similar
firms or against some common standard.
What‟s all that you say?
Don‟t worry. If you get a question in the exam it will have figures there for you to make comparisons. Remember, information given in questions is usually there for a purpose. Make sure you use it effectively. About the only other thing to compare it to is current interest rates. If a business has a Return on Owners‟ Equity of say 5% and you know that you can get 7% just by investing in the bank down the road, risk free and with no effort, the firm isn‟t going too well.
There are a few limitations of financial reports noted in the syllabus:
Historical Costs – Accountants usually write down how much an item cost when it was purchased. If it depreciates they will „write down‟ its value, because that is good for tax purposes. However, if it appreciates they are unlikely to write it up unless the firm is actually wanting to look good for, say, a prospective purchaser or public float.
Value of Intangibles – You may have noticed in the Balance Sheet a sub- heading called Intangible Assets. These are assets whose value is based on how much people are prepared to pay for them, rather than some tangible figure like cost of production plus markup. The most common intangible asset is
Goodwill. This is basically the reputation value of a business. If it is a popular
firm with customers, goodwill will be high. However, estimating its value is a tricky task. When purchasing a business you need to be wary if this figure is too high. How high is too high? Again, there is no definitive answer, but if goodwill, as a percentage of total assets, makes up more than the return on Owners‟ Equity, be careful. The other intangible listed is a patent. This is a right to a process, design or trademark. You can just imagine how much the secret formula for Coke is worth. Did you know that there are only two people at any one time who have it? The CEO and his deputy, and they are never
Sheet 4 Using financial information – Review Task
Dale has contacted you, as her financial consultant, to write her a report in regards to a business that she is considering buying. She could only get the following information for you to use to help you prepare the report:
Capital = $500 000 Sales = $250 000
Current Liabilities = $40 000 Gross Profit = $150 000 Debtors = $25 000
Long Term Assets = $500 000 Long Term Liabilities = $260 000 Net Profit = $50 000
Current Assets = $20 000 Goodwill = $200 000
In your report ensure that you provide Dale with a complete ratio analysis and an opinion, based on the data, as to whether the price of $1 million is a fair one.
Sheet 4 Using financial information – Review Task- Answers
Dale has contacted you, as her financial consultant, to write her a report in regards to a business that she is considering buying. She could only get the following information for you to use to help you prepare the report:
Capital = $500 000 Sales = $250 000
Current Liabilities = $40 000 Gross Profit = $150 000 Debtors = $25 000
Long Term Assets = $500 000 Long Term Liabilities = $260 000 Net Profit = $50 000
Current Assets = $20 000 Goodwill = $200 000
In your report ensure that you provide Dale with a complete ratio analysis and an opinion, based on the data, as to whether the price of $1 million is a fair one.
Dear Dale,
Thanks for the opportunity to work with you again. Based on the data you have given me I have been able to develop the following information that you may find useful:
The business’ profitability can be seen by the following ratios:
o Gross Profit ratio = 150000/250000 = 60% (industry average = 40%) o Net Profit ratio = 50000/250000 = 20% (industry average = 25%)
o Return on Owners’ Equity = 50000/500000 = 10% (industry average = 12%) These figures seem to indicate that the firm is currently spending too much on expenses. If you can cut these, the good Gross Profit levels should improve the Net Profit situation.
Following on from this the efficiency ratios are:
o Expense ratio = 100000/250000 = 40% (industry average 20%)
(You should have found the $100000 by subtracting net profit from gross profit) o Accounts receivable turnover ratio = 250000/25000 = 10; 365/10 = 36.5 days
(industry average 28 days)
As previously stated, expenses are too high. The accounts receivable turnover ratio also shows that the firm is too slow in collecting debts.
The liquidity of the firm is another minor concern as the industry average is 1:1.5 Current Ratio = Current Assets : Current Liabilities = 20000/40000 = 1:2
The gearing of the firm shows its solvency or long term viability. This firm’s Debt : Equity ratio = 300000 : 500000 = 1 : 1.66 (industry average 1 : 1.3)
So this firm is a low geared one, which is a positive point in your considerations. With total assets of $720 000 the asking price would seem too high, especially as the intangible asset of Goodwill has already been included at $200 000. Return on investment would also be low (50000/1000000=5%) but the opportunity does exist to boost net profit by cutting expenses. I think that the business has prospects, but is overpriced. Try an offer around $700 000. Please don’t hesitate to contact me if you require further assistance.