Managing Finance and Budgets Lecture 2 Financial Statements (1)
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Transcript of Managing Finance and Budgets Lecture 2 Financial Statements (1)
Managing Finance and Budgets
Lecture 2
Financial Statements (1)
Session 2 - Financial Statements (1)
Learning outcomes:Understand the role and limitations of financial statements in relation to SMEs, VCOs and large organisations.Manipulate and use financial statements to inform decision-making in situations typically found in SMEs/VCOs.
Key concepts:» Cash versus Profit» Capital/Revenue expenditure» Depreciation» Profit & Loss Account/Balance Sheet» Accounting conventions
Session 2 – Structure
SectionA Financial TermsB Financial StatementC Profit & Loss AccountD The Balance SheetE Accounting Standards and Conventions
Section AFinancial Terms
Some Financial Terms
Turnover - total value of sales over a given period - sometimes called Income or Revenue
Cost - the amount of actual or notional expenditure incurred on or attributable to a specified thing or activity (fixed, variable, direct, indirect )
Creditors - suppliers of goods and services whose invoices are still outstanding for payment
Debtors - customers who owe the organisation money Assets - items which the organisations OWNS Liabilities - things which the organisation OWES
Some Financial Terms
Accrued expenses - any amount which the organisation owes for expenses already consumed but for which a bill has not been yet received or paid.
Pre-paid expenses - goods or services which have been paid for in advance
Bad debt - a debt which is unlikely to be paid by the customer
Book-keeping - the recording of monetary transactions in sufficient detail to enable its accuracy to be checked, and so that the relevant summarised information can be extracted.
Section BFinancial Statements
Financial Statements
To measure the Cash in and Cash out of the organisation over a given period of time – Cash-Flow Statement
To measure profit generated over a specific period of time - Profit & Loss Account = breakdown of all incoming and outgoing finance for a given period, finishing with overall profit or loss.
To measure the accumulated wealth at a specific point in time - Balance Sheet = a “snapshot” of the financial position of the organisation, balancing Assets against Capital and Liabilities.
Financial Statements usually show at least 2 years to allow comparison
Financial Statements - Example
You decide to run a soft drinks stand at a car boot sale to earn some extra money. You borrow £50 from a friend and you buy 200 cans of lemonade at 20p per can. It costs you £5 entry fee, and on the first day you sell 150 of your cans at 50p each.
Produce a Cash-Flow Statement, Profit & Loss Account and Balance Sheet for the one day of operation.
Cash-Flow Statement - a Challenge
Create a ‘back-of-the envelope’ cash-flow
Statement for the drinks stall.
HINTS• You need to document everything that happened in
the order that it happened.• You start with nothing.• What do you end up with?
Example Cash-Flow Statement
Opening Balance: £ 0
Loan: £ 50+
Goods purchased: £ 40- (200 x 20p)
Entry Fee: £ 5-
Cash received: £ 75+ (150 x 50p)
Closing Balance: £ 80
Profit & Loss Account - a Challenge
Create a ‘back-of-the envelope’ profit & loss
account for the drinks stall.
HINTS• What money has been paid to you?• What money have you paid out?• Your profit is the first lot of money minus the second.
Example Profit & Loss Account
Sales: £ 75 (150 x 50p)
Cost of Sales: £ 30 (150 x 20p)
Gross Profit: £ 45
Entry Fee: £ 5
Net Profit: £ 40
Balance Sheet - a Challenge
Create a ‘back-of-the envelope’ balance sheetfor the drinks stall.
HINTS
• What assets have you? (in this case: cash, stock)• What liabilities have you? ( in this case: loan, profits*)• Do these balance?
*NB The owners of the company (i.e. you) are liable to take their money away and spend it!
Example Balance Sheet
Assets:
Cash: £ 80
Stock: £ 10 (50 x 20p)
Total: £ 90
Liabilities:
Loan outstanding: £ 50
Retained profits: £ 40
Total: £ 90
Section C The Profit & Loss Account
The Profit and Loss Account
During the next series of slides we will see an example of a ‘real’ Profit and Loss account, and we will analyse this to see what exactly is happening.
Before we do this, we need to understand: the difference between cash and profit the difference between capital and revenue costs the idea of depreciation
Cash Versus Profit
In accounting terms, to calculate Profit (or Loss) Sales Income must be matched against relevant expenditure for a given period
Some goods may be purchased on credit, some sales may be sold on credit
Some purchases may have a useful life which lasts longer than the given period
Therefore Profit in accounting terms is NOT equivalent to Cash in less cash out during that period
Capital & Revenue Costs
Capital Costs are incurred in purchasing assets Revenue Costs are incurred in delivering the goods or services
and operating the company Capital Costs are not charged directly to the Profit & Loss
Account. They are reflected in a depreciation charge over their useful life.
Accounting profit = Revenue Income less Revenue Expenditure - Capital expenditure is only deducted from Accounting profit through depreciation
To “capitalise” an item means to treat it as capital expenditure
Depreciation
Depreciation is the method used to spread the cost of a purchase over a number of time periods
Two main methods used: Straight-line depreciation = Cost of item divided by
number of years over which it is to be written off Reducing balance = Current value x Depreciation% Depreciation is shown in the Profit & Loss Account as
an Overhead
Depreciation calculation
Purchase of a piece of equipment costing £10,000
Straight-line over 5 years Reducing balance at 30%
Written down Written down
Depreciation Value Depreciation Value
Year 1 £ 2,000 £ 8,000 £ 3,000 £ 7,000
Year 2 £ 2,000 £ 6,000 £ 2,100 £ 4,900
Year 3 £ 2,000 £ 4,000 £ 1,470 £ 3,430
Year 4 £ 2,000 £ 2,000 £ 1,029 £ 2,401
Year 5 £ 2,000 £ 0 £ 720 £ 1,681
Year 6 £ 0 £ 0 £ 504 £ 1,176
Sample Profit & Loss Account• The next slide shows a profit and loss account for a
company over a one-year period.• The format varies according to the type of business, but
there is a fairly uniform convention to structure the accounts in the following way:
Expenditure IncomeItem 1Item 2Item 3
etc
Turnover (Sales) (Income) £ 100,000 }
Cost of Sales (Direct Costs) }Materials £10,000 } Trading
Transport £ 5,000 } Account
Labour £15,000 }
Total Cost of Sales £ 30,000 30% }
Gross Profit (Gross Margin) £ 70,000 70% }
Overheads (Indirect Costs)Administrative salaries £18,000
Advertising £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27,000 27%
Operating Profit (Net Margin) £ 43,000 43%Interest on loans £ 3,000
Profit before tax £ 40,000 40%Corporation tax due £10,000
Profit after tax & interest £ 30,000 30%Dividends payable £22,000
Retained Profit (Earned Surplus) £ 8,000 8%
Turnover (Sales) (Income) £ 100,000 }
Cost of Sales (Direct Costs) }Materials £10,000 } Trading
Transport £ 5,000 } Account
Labour £15,000 }
Total Cost of Sales £ 30,000 30% }
Gross Profit (Gross Margin) £ 70,000 70% }
Overheads (Indirect Costs)Administrative salaries £18,000
Advertising £ 5,000
Rent & Rates £ 4,000
Total Overheads
Operating Profit (Net Margin)Interest on loans £ 3,000
Profit before taxCorporation tax due £10,000
Profit after tax & interestDividends payable £22,000
Retained Profit (Earned Surplus) £ 8,000 8%
The first part of the account is usually concerned with the total amount of income and working out the Gross Profit.
This is called the Trading Account
Turnover (Sales) (Income)
Cost of Sales (Direct Costs)Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30,000 30% }
Gross Profit (Gross Margin) £ 70,000 70% }
Overheads (Indirect Costs)Administrative salaries £18,000
Advertising £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27,000 27%
Operating Profit (Net Margin) £ 43,000 43%Interest on loans £ 3,000
Profit before tax £ 40,000 40%Corporation tax due £10,000
Profit after tax & interest £ 30,000 30%Dividends payable £22,000
Retained Profit (Earned Surplus) £ 8,000 8%
The next part of the account is usually concerned with the indirect costs and working out the Net Profit.
Turnover (Sales) (Income) £ 100,000 }
Cost of Sales (Direct Costs) }Materials £10,000 } Trading
Transport £ 5,000 } Account
Labour £15,000 }
Total Cost of Sales
Gross Profit (Gross Margin)
Overheads (Indirect Costs)Administrative salaries £18,000
Advertising £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27,000 27%
Operating Profit (Net Margin) £ 43,000 43%Interest on loans £ 3,000
Profit before tax £ 40,000 40%Corporation tax due £10,000
Profit after tax & interest £ 30,000 30%Dividends payable £22,000
Retained Profit (Earned Surplus) £ 8,000 8%
The final part of the account is usually concerned with the interest which needs to paid, dividends to shareholders and tax.
Turnover (Sales) (Income) £ 100,000 }
Cost of Sales (Direct Costs) }Materials £10,000 } Trading
Transport £ 5,000 } Account
Labour £15,000 }
Total Cost of Sales £ 30,000 30% }
Gross Profit (Gross Margin) £ 70,000 70% }
Overheads (Indirect Costs)Administrative salaries £18,000
Advertising £ 5,000
Rent & Rates £ 4,000
Total Overheads
Operating Profit (Net Margin)Interest on loans £ 3,000
Profit before taxCorporation tax due £10,000
Profit after tax & interest £ 30,000 30%Dividends payable £22,000
Retained Profit (Earned Surplus) £ 8,000 8%
The bottom line here is what the company has actually made as a profit over the year.
This is the Surplus.
Some Common Terms
On a sheet such as the one we have seen, the terminology can be very confusing at first.
The next few slides discuss the following terms used: Turnover Direct Costs Stock Gross Profit (Margin) Indirect Costs (Overheads) Net Profit (or Loss)
Turnover
Sale of goods or Fees for services Subscriptions Interest earned Income = Revenue = Sales = Turnover VAT is excluded from Sales figures (and all other
figures)
Direct Costs (Cost of Sales) Costs which are directly related to the cost of providing the
goods or service (Cost of Sales)
For example: Goods purchased for resaleDirect Labour costsRaw materials, Packaging, Energy
Direct Costs often vary with sales (though some Direct Costs can be FIXED)
Stock Opening and Closing Stocks must be taken into account when
calculating Direct Costs to in order to keep to the matching convention Where sales volume is high (or prices are standard) an average price
may be used Lower cost must be taken if price has gone down Other methods include FIFO and LIFO Should be considered item by item, or in categories, not as overall
figure Manufacturing Companies may incorporate cost of manufacture into
stock value (e.g. materials, power, labour)
Gross Profit or Margin
Gross Profit = Sales (Turnover) less Direct Costs Sometimes called Gross Margin Gross Margin% or Gross Profit% = Gross Profit x 100
Sales
Gross Profit% - Example
Soft Drinks Stand why £30? Sales= £75Direct Costs= £30 Gross Profit = £45
Gross Profit% = £45 x 100 = 60% £75
Indirect Costs or Overheads Operating Expenses Costs which are not directly related to sales. Costs which are incurred even when an organisation
produces no output. Often Fixed Costs For example: Administrative salaries
Advertising, Stationery, Rent &
Rates
Insurance, Bank charges Indirect Costs do not (necessarily) vary with sales Interest usually shown later
Profit or (Loss)
Operating Profit = Sales less Direct Costs less Indirect Costs
Profit before tax = Operating Profit less Interest Profit after tax = Profit before tax less tax Retained profit = Profit after tax less dividends Net Profit% = Net Profit x 100
Sales
Net Profit% - Example
Soft Drinks Stand Sales= £75 why £5? Direct Costs= £30 Indirect Costs = £5 Gross Profit = £40
Net Profit% = £40 x 100 = 53.3% £75
Activity One
Discuss the following:
Why does an increase in cash in the bank during a particular accounting period not necessarily mean that the organisation has made a profit?
Why is it important to distinguish between capital and revenue expenditure?
Why is it important to differentiate between indirect and direct costs?
Activity One – Possible Solution
Increase in cash in the bank could be the result of: a loan, payment of a previous debt, selling off an asset, even selling goods at a loss!
None of these incurs profit.
Capital expenditure buys things still owned by the company. Revenue expenditure ‘disappears’.
Indirect costs need to be paid even if you don’t sell anything; in difficult times overheads need to be cut.
Section DThe Balance Sheet
Sample Balance Sheets
A Balance Sheet can be produced in two different ways:
Horizontal Format Vertical Format
The next two slides illustrate this.
Sample Balance Sheet (Horizontal format)Fixed Assets Capital & ReservesLand £ 120,000 Share capital £ 100,000Buildings £ 150,000 Retained profit £ 120,000Fix & Fit £ 75,000 Total £ 220,000Total £ 345,000 L/T Liabilities
Loan £ 250,000Current Assets Total £ 250,000Stock £ 55,000 Current LiabilitiesDebtors £ 75,000 Creditors £ 22,000Bank £ 25,000 Tax & VAT £ 8,000Total £ 155,000 Total £ 30,000
________ ________£ 500,000 £ 500,000
Sample Balance Sheet (Horizontal format)Fixed Assets Capital & ReservesLand £ 120,000 Share capital £ 100,000Buildings £ 150,000 Retained profit £ 120,000Fix & Fit £ 75,000 Total £ 220,000Total £ 345,000 L/T Liabilities
Loan £ 250,000Current Assets Total £ 250,000Stock £ 55,000 Current LiabilitiesDebtors £ 75,000 Creditors £ 22,000Bank £ 25,000 Tax & VAT £ 8,000Total £ 155,000 Total £ 30,000
________ ________£ 500,000 £ 500,000
This column describes the Assets (owned)
This column describes the Liabilities (owed)
SAMPLE BALANCE SHEET (VERTICAL FORMAT)
Fixed Assets Land £ 120,000
Buildings £ 150,000
Fix & Fit £ 75,000
Total £ 345,000
Current Assets Stock £ 55,000
Debtors £ 75,000
Bank £ 25,000
Total £ 155,000
Current Liabilities
Creditors £ 22,000
Tax & VAT £ 8,000
Total £ (30,000)
Net Current Assets £ 125,000
Total Assets £ 470,000
Less Long term liabilities (Loan) £(250,000)
£ 220,000
Capital & Reserves
Share capital £ 100,000
Retained profit £ 120,000
£ 220,000
SAMPLE BALANCE SHEET (VERTICAL FORMAT)
Fixed Assets Land £ 120,000
Buildings £ 150,000
Fix & Fit £ 75,000
Total £ 345,000
Current Assets Stock £ 55,000
Debtors £ 75,000
Bank £ 25,000
Total £ 155,000
Current Liabilities
Creditors £ 22,000
Tax & VAT £ 8,000
Total £ (30,000)
Net Current Assets
Total Assets
Less Long term liabilities (Loan)
Capital & Reserves
Share capital £ 100,000
Retained profit £ 120,000
£ 220,000
Firstly come
•Fixed Assets
These are the long-term investments made by the company
SAMPLE BALANCE SHEET (VERTICAL FORMAT)
Fixed Assets Land £ 120,000
Buildings £ 150,000
Fix & Fit £ 75,000
Total
Current Assets Stock £ 55,000
Debtors £ 75,000
Bank £ 25,000
Total £ 155,000
Current Liabilities
Creditors £ 22,000
Tax & VAT £ 8,000
Total £ (30,000)
Net Current Assets
Total Assets
Less Long term liabilities (Loan)
Capital & Reserves
Share capital
Retained profit
£ 220,000
Then:
•Current Assets
The short-term investments which can easily be turned into cash.
•Current Liabilities
This is money to be paid out to creditors, tax, share-holders as dividends, etc.
SAMPLE BALANCE SHEET (VERTICAL FORMAT)
Fixed Assets Land £ 120,000
Buildings £ 150,000
Fix & Fit £ 75,000
Total
Current Assets Stock £ 55,000
Debtors £ 75,000
Bank £ 25,000
Total £ 155,000
Current Liabilities
Creditors £ 22,000
Tax & VAT £ 8,000
Total £ (30,000)
Net Current Assets £ 125,000
Total Assets £ 470,000
Less Long term liabilities (Loan) £(250,000)
£ 220,000
Capital & Reserves
Share capital £ 100,000
Retained profit £ 120,000
£ 220,000
This gives the Net Current Assets
(current assets – current liabilities)
SAMPLE BALANCE SHEET (VERTICAL FORMAT)
Fixed Assets Land £ 120,000
Buildings £ 150,000
Fix & Fit £ 75,000
Total £ 345,000
Current Assets Stock £ 55,000
£ 75,000
£ 25,000
£ 155,000
Current Liabilities
Creditors £ 22,000
Tax & VAT £ 8,000
Total £ (30,000)
Net Current Assets £ 125,000
Total Assets £ 470,000
Less Long term liabilities (Loan) £(250,000)
£ 220,000
Capital & Reserves
Share capital £ 100,000
Retained profit £ 120,000
£ 220,000
Then we subtract the Long Term Liabilities
e.g. loans of money, goods, buildings etc.
SAMPLE BALANCE SHEET (VERTICAL FORMAT)
Fixed Assets Land £ 120,000
Buildings £ 150,000
Fix & Fit £ 75,000
Total £ 345,000
Current Assets
Current Liabilities
Creditors
Tax & VAT
Total
Net Current Assets £ 125,000
Total Assets £ 470,000
Less Long term liabilities (Loan) £(250,000)
£ 220,000
Capital & Reserves
Share capital £ 100,000
Retained profit £ 120,000
£ 220,000
The final section which shows the balance gives the initial money used to ‘start’ the company (share capital), and the profit retained this year (surplus), and any money held in reserve for ‘emergencies’
Balance Sheet Formats
Horizontal Format
Fixed Assets Capital & Reserves +
+ Current Assets = Long-term Liabilities +
Current Liabilities
Vertical Format
Fixed Assets
+ Current Assets = Capital & Reserves
- Current Liabilities
- Long term Liabilities
Fixed Assets
Items owned and used by the organisation on a long-term basis
Tangible Assets = equipment, buildings, land Intangible Assets = brands, logos, patents, goodwill Goodwill - quality of workforce, reputation,
management, location, relationship with customers Goodwill only tends to be included when purchased
at an agreed price Assets are valued at Cost less Depreciation or
Revalued Cost (less depreciation)
Current Assets
Items which can easily be converted into cash (e.g. cash, stock, debtors)
Generally listed in the order in which they can be converted into cash
Valued at cost or market price (whichever is the lower)
Include “Provision for loss” (safeguard against unsold goods or bad debts) and Prepayments (items which have been paid for in advance)
Current liabilities
Current Liabilities (claims) - debts which the organisation is likely to have to pay within one year
Examples include creditors, bank overdraft, loan interest due in next 12 months, VAT, PAYE, accruals
Long-term liabilities
Long-term Liabilities (Fixed Liabilities) - debts which the organisation will not have have to pay within one year
Examples include hire purchase loans, mortgage, long-term bank loans
Shareholders Funds
Most permanent form of funding. Classed as “Liability” Issued Share Capital - value of shares actually issued Authorised Share Capital - value of shares company
may legally issue Retained Profit (or Earned Surplus) - profit left after all
deductions have been made Capital Surplus - money earned on disposal of Fixed
Assets Capital employed - all the capital put into the business
(share capital, long-term loans, retained profit)
Interpreting the Balance Sheet
Liquidity Mix of Assets Financial Structure
Activity Two
Discuss the following:
How far does the balance sheet tell us about how much an organisation is worth?
What is the main difference between Fixed and Current Assets?
Why is money input into the organisation by shareholders shown as a liability?
Activity Two - Solutions
The final amount on either side of the balance tells us how much a company is currently valued at.
Current Assets – we could get the money almost immediately with minimum fuss. Fixed assets would take some time and be very disruptive.
The share capital is an amount invested in the company by shareholders, and so is owed to them.
Section EAccounting Standards and
Conventions
Accounting standards & conventions
Company Law requires that accounting statements provide a “true and fair view”
Accounting Standards (established by UK accounting professions) try to define what a “true and fair view” is in different situations
Accounting standards & conventions
The final section of this presentation examines the ‘rules for accounting’ laid down by the industry and by convention.
You should study these on your own, making sure that you understand the definition of each of the items on the next slide:
Accounting standards and conventions
Boundary rules
Definition of an asset
Money measurement and stable monetary unit
Historic cost convention
Realisation
Matching or Accruals principle
Materiality
Prudence
Consistency, Objectivity, Substance over form
Boundary rules
Information is restricted to the entity being examined. Information is restricted to a given period of time
(“periodicity”) Information is restricted to data which can be
measured easily (“quantitative”) Assumption is made that the organisation is a “Going
concern” - it will continue indefinitely Financially viable in the short termCompetitiveWell-structured financially for long term
Definition of an asset
Must be likely to produce future economic benefits Must have arisen from some past transaction or
event Must have restricted right of access For example, a piece of equipment, a building, a
patent ARE assets, but the workforce is NOT an asset!
Money measurement & stable monetary unit
Information that cannot be expressed in monetary terms cannot be included in accounting statements
Accounting tends to assume that the value of money remains constant - i.e.. there is no inflation
Historic cost convention
Assets are shown at a value based on their cost when acquired, NOT current market value or potential value to the organisation
Can mean that the Balance Sheet does not represent the true value of the organisation
Specialised assets may have higher value than is shown
Revaluation of assets can bring the valuation of assets closer to true market value
Realisation
Revenue (Income) should be included in the accounts (“realised”) at the point when:
The amount can be measured accurately
The work is substantially completed
It is reasonably certain that cash will be received
Generally taken to be the point when a client takes delivery of service or goods
Revenue (Income) is unlikely therefore to be the same as cash received
Matching or Accruals principle
Revenue (Income) and Expenses (Costs) must be included together in the same period’s accounts wherever possible
This should enable the assessment of the net effect on profit which a particular activity produces
Accruals may therefore be incorporated into the accounts to allow for costs which have been incurred in producing income, but which have not yet been paid, or for which invoices have not yet been received.
Materiality
Unimportant items are considered not to be “material” and need not be disclosed.
Other accounting rules may be ignored when dealing with immaterial items
Level of materiality varies from one organisation to another
Prudence
Figures should always err on the side of caution “Anticipate no profit and provide for all future losses” For example, stock value is shown at cost or market
value - whichever is the lower Where an asset has increased in value, the increase
may not be shown until the asset is disposed of The value of a sale should not be credited to the
accounts until it has been delivered to the client
Consistency, Objectivity, & “Substance over form”
Accounts should be consistent in the methods and values used. Changes of policy must be made openly, and in order to improve “true & fair view”
Values should be arrived at objectively and supported by evidence
The strict legal nature of a transaction may be ignored if it distorts a true and fair view - accounts should show the substance rather than the form.
Dual Aspect
Every entry has two aspects, both affecting the Balance Sheet
e.g. Purchase of a piece of equipment - increases Fixed Assets and decreases Current Assets (Bank Balance) or increases Liabilities (Loan)
Saving on costs increases Bank Balance and increases Retained Profits
Slow paying customers decrease Bank Balance and increase Debtors
Deficiencies of financial accounts
Historical (and often out of date) Cross-company Incorporate subjective judgements Do not highlight trends and plans Do not recognise organisational objectives Focus on accounting profit (or loss) not cash Do not include value of organisation’s staff or other
unquantifiable assets
Activity Three
Discuss the following: “Accounting is a science - given a single organisation
over the same period two accountants will always come up with exactly the same profit or loss results unless they make a factual mistake”
Give reasons why you agree or disagree?
Activity Three - Solutions
“Accounting is a science - given a single organisation over the same period two accountants will always come up with exactly the same profit or loss results unless they make a factual mistake”
I would disagree. At a simplistic level, the figures for Gross profit and Net
profit depend on how you classify direct and indirect costs. Some items could be in either category
At a wider level, recent events (ENRON, Xerox) have shown that some previously well-thought of accountants have been ‘creative’ in the way that they produce accounts, and that there is disagreement and disquiet with the way that the figures have been presented.
Seminar Two - Activities
Preparation: read Chapters 2 and 3 Describe key concepts:
Cash versus Profit
Capital expenditure v Revenue expenditure
Depreciation
Profit & Loss Account/ Balance Sheet
Accounting conventions Exercises 2.6 (page 55) and 3.6 (page 93-94)
