The Purpose of Accounts
The core aim of any business is to survive. After this, if it is in the private sector it will want to make a profit. If it is in the public sector it may want to improve or expand the services it provides. Either way, it will need to control its finances. By collecting all of the financial information and recording it in various accounts a business can access how well it's performing. This is important both for a business internally as well as externally.
Internally, managers want to know how much they are selling, the level of their costs and the amount of ptofit they are making. From this information they can set budgets and performance targets to plan for the next trading year. An accountant can show managers where financial problems might be occurring within their company.
Externally, all businesses are legally required to keep records of their finances. A firm has to make its accounts available to the Inland Revenue so they can determine how much tax must be paid.
The Purpose of Accounts (2)
Most companies have to prepare a trading, profit, and loss account and a balance sheet.
Limited companies also have to publish an annual report and final accounts because they have a seperate legal identity.
These accounts have to be checked by an independent person- an auditor- to ensure that they give a 'true and fair view' of what has happened to the business during the previous year. Potential investors or shareholders, for example, will want to know if a business is worth investing in. Potential creditors will also want to know whether the company will be able to repay any loans or credit they give them.
These assesments are based on two key accounting concepts: liquidity and profitability.
Liquidity - A firm's ability to meet short term debts as they occur
Profitability - The relationship between a firm's income and expenditure.
Sources of Finance
Firms need finance for five reasons:
1) New firms need start up capital to buy assets needed to run the business.
2) New firms also need to finance their poor initial cash flow - they need to pay suppliers.
3) All firms need enough cash to meet the day to day running costs of the business (working capital)
4) Sometimes customers delay payment- finance is needed to cover this liquidity shortfall
5) Firms may need finance to fund expansion.
Sources of finance can be categorised as internal or external. They can also be classed as short term, medium term or long term depending on how long the finance is needed for.
A budget is a plan for the firm's income and spending. It is based on predicitions for the future and can help the firm know whether it is likely t make a profit or loss.
A firm's managers need ro be aware of the inflow and outflow of cash to plan future finances. The firm has various costs and different sources of income. To keep the business profitable and avoid running into financial difficulties, accountanct ensure the firm has enough working capital to pay any short-term debts when they fall due. They plan a budget that:
1) sets performance targets over a certain time period
2) limits expenditure to what the business can afford
The firm's accountants monitor and record the actual financial performance of the firm against the budget, so that its likely financial performance can be forecast. When the two are compared there will usually be a difference- a variance (either favourable or adverse). Adjustments will then be made for the next budget or forecast.
A firm needs to know how much cash is coming in and out. Drawing up a cash flow forecast shows whether there is enough cash available to pay salaries and settle debts on time. It calculates the firm's reserves, which could be invested in expansion or new equipment. Accountants identify when shortfalls are likely to happen and surplus funds are likely to become available. This helps them plan for when the firm might need an overdraft, or be able to reinvest its revenues into the business.
Cash flow forecasts do not show predictions about how much profit or loss the firm will make only the cash surplus or deficit. A firm could make a profit in a aprticular month but if the cash has not been collected from the customer they can still have a cash deficit.
Net Cash = Total Income - Total Expenditure
Opening Balance = The Previous Month's Closing Balance
Closing Balance = Net Cash Flow + Opening Balance
Costs are payments to the owners and suppliers of resources that allow goods to be produced and services provided.
Direct or Indirect Costs- Direct costs are expenses that can be attributed to making a particular product. Examples include cost of factory labour, raw materials and operating machinery. Indirect costs are the general overheads of running the business. Examples include management salaries, phone bills and office rent.
Fixed or Variable Costs- Fixed costs are those costs that do not change when the level of output is changed. They still have to be paid even if there are no customers. E.g rent, interest on loans, rates and insurence. Variable costs are costs that do not vary with output and the number of customers. E.g raw materials and packaging.
Revenue is the income gained by firms from sellings its goods or services, before any costs are taken away. Sometimes referred to turnover or sales turnover. Price per unit x the number of units sold.
Profit is made when the revenue gainde from selling a certain number of goods or services is greater than the cost of producing them. Total revenue - total costs.
Break Even Analysis
The break even point is the level of sales at which the total costs of making the item equals the total revenue received from selling them. There is no profit or loss at this level of sales.
Why firms want o know the break-even point:
- To show how many units have to be sold over a period of time for costs to equal revenue
- To show when a profit might be achieved or a loss suffered
- To use as a target or objective
- To help spot problems if break-even is not being achieved
- To help review the effects of possible action to move towards break-even, i.e, lowering selling price
- To help anaylse the effects of events taking place outside the firm which may affect break-even, i.e, a rise in the price of raw materials
Calculating the Break Even Point:
Break-even point (units) = fixed costs/contribution.
Contribution = selling price - variable cost (per unit)
Trading and Profit and Loss Accounts
At the end of every trading year a business prepares final accounts. These provide a financial summary of their trading activity over the year. The trading account forms the first part of the profit and loss account and shows the gross profit (or loss) that the company has made. Profit is the money made by the business and equals income minus expenses. The profit and loss account shows the net profit (or loss) made. They are often combined as one trading anfd profit and loss account so that both the gross and net profit (operating profit) can be displayed in the same set of accounts.
Turnover shows the amoutnt of revenue earned by the firm through the sale of goods at marked up prices.
Cost of sales shows how much they have spent on buying the goods at cost price before the firm has added its own profit margin. It is divided into three sections:
1) Operating stock - the value of stock remaining unsold from the previous year
2) Purchases - the amount spent on new stock during the current year
3) Closing stock- the value of stock left unsold this year to be carried forward.
Trading and Profit and Loss Accounts
The aims off businesses in the private sector is to make a profit. Profit is important in three ways:
1) It rewards the business people who have taken risks to run it
2) It provides the funds to develop the business further
3) It is a source of cash, which allows the business to meet its debts
Gross Profit = Turnover - Cost of Sales
Net Profit/Operating Profit = Gross Profit - Expenditure
- Provides information to stakeholders- should they invest into the business?
- Used to help judge performance
- Compare to previous years
- Plan ahead/help make decisions - gives financial control - is the business/job safe
- Used to help judge a business' financial performance in relation to size, industry and competition
- Income statement and balance sheet used to provide the information needed for ration analysis
- Overall, it helps the bsuiness achieve its corporate objectives
Firms measure their performance by using two profitability ratios to generate the analysis; gross profit margin and net profit margin.
Gross and Net Profit Margin
Gross Profit Margin
- This will show managers and investors what types of variable costs the business has had to pay and how much profit was left over from sales revenue
- One way to find what has happened to the revenue compared to the cost of sales is to calculate the gross profit margin (percentage).
Gross Profit / Sales Revenue X 100
Net Profit Margin
- Gross profit is important but it doesn't include operation expenses (overheads).
- Net profit can be a more important guide for the owners of a business because it takes all costs into account
Net Profit / Sales Revenue X 100