The Balance Sheet
- The balance sheet is a snapshot-a picture of a companys financial situation at a moment in time. It looks at the accumulated wealth of the company and can be used to assess its overall worth.
- It lists the resources that a business owns (assets) and what it owes (liabilities).
- It also includes capital provided by owners who, in a limited company, are the shareholders. Technically it could be argued that capital is owed to the shareholders.
- If a business ceases trading, the shareholders recieve the value of the companys assets after the liabilities have been paid in full.
- Fixed assets-resources that can be used repeatedly in the production process, although they do wear out (depreciation). They may be tangible or intangible. Land, buildings, machinery and vehicles are tangible because they exist physically. Intangible assets do not physically exist but have considerable value to the firm e.g. goodwill, brand, reputation, patents and copyrights.
- Current assets-short term items that circulate in a business can be expected to be turned into cash within one year e.g. stocks, debtors
- Long term liabilities are debts due for repayment after more than one year e.g. debentures and bank loans
- Curremt liabilities are debts scheduled for repayment within one year, e.g. creditros, bank overdrafts, tax and shareholder dividends.
- Funds provided by the shareholders are known as capital. Shareholders supply this capital when they purchase shares.
- Reserves are those items that arose from increases in the value of the company, which are not distributed to shareholders as dividends but are retained for future use.
- The layout of the balance sheet allows the vaule of a company to be calcualted by adding fixed assets to working capital.
The Income Statment
- The income statement is a historical record of the trading of a business over a specific period(normally one year).
- It shows the profit or loss made by the business – which is the difference between the firm’s total income and its total costs.
The income statement serves several important purposes:
- Allows shareholders/owners to see how the business has performed and whether it has made an acceptable profit (return)
- Helps identify whether the profit earned by the business is sustainable (“profit quality”)
- Enables comparison with other similar businesses (e.g. competitors) and the industry as a whole
- Allows providers of finance to see whether the business is able to generate sufficient profits to remain viable (in conjunction with the cash flow statement)
- Allows the directors of a company to satisfy their legal requirements to report on the financial record of the business
- Depreciation: the fall in value of an asset over time, reflecting the wear and tear of the asset as it becomes older, the reduction in its economic use or its obsolescence.
- Obsolescence: when an asset is still functioning but its no longer considered useful because it is out of date.
Causes of depreciation
- Time: assets such as machinery wear out over time, although some last much longer than others. For reasons of prudence a business will want to pessimistic when depreciating an asset, so a shorter period of time is used if there is doubt.
- Use. the more an asset is used, the quicker it will wear out.
- Obsolescence. Changes in technology may mean that an asset needs to be replaced as it becomes inefficient in comparison with newer alternatives.
Purpose of Depreciation
Depreciation is used to ensure that the accounts meet the principles of the accounting. Its purposes can be seen from the impact of depreciation on the main accounts.
In the income statement, depreciation spreads the cost of an asset over the lifetime during which it is helping to create income.
In the balance sheet, depreciation shows the reduction in an asset’s value over its lifetime.
- Working capital- the day-to-day finance used in a business, consisting of current assets.
- Liquidity – the ability to convert an asset into cash without loss or delay
- Liquid assets – items owned by an organisation that can be converted` into cash quickly and without a loss of value. The most liquid asset that a business can possess is cash.
- Working capital cycle : the inflow and cash outflow of liquid assets and liabilities
The length of the working capital cycle can be calculated by studying the three main elements of working capital:
Length of working capital cycle =
length of time that goods are held + time taken for receivables to be paid – period of credit received from suppliers
Working Capital 2
Time taken to sell inventories will influence the level of working capital
A range of factors affect the number of days that inventories are held:
- The nature of the product – items such as clothing that must be displayed in order to entice the customers require higher inventory levels
- The durability of the product. Companies try to have lower levels of inventories of perishable items or finished products that may become unfashionable.
- The efficiency of supplier. If supplier can supply large quantities at short notice, a business will be able to hold lower inventory levels.
- Lead time. If it takes a long time to make a product, companies will be more likely to hold them in stock.
- Customer expectations. If the customer is prepared to wait, it may be unnecessary to hold inventories
- Competition. A business needs to match its rivals, so inventory levels are influenced
- The time taken by customers to pay for goods
- Factors that lead to delay in receiving payments will lead to the need for greater working capital
A firm wants to provide their financial performance in the most favourable terms possible
- Borrow money before for short period of time to improve the cash flow position
- Sale out and lease back non-current assets
- Maintain the value of intangible assets on the balance sheet at excessive levels to increase value of the firm
- Capitalising expenditure including non-current assets what might be regarded as expensive and not on the balance sheet
- Bring forward sales to earlier periods and thereby boost revenue for that financial year
There is a fine line between window dressing accounts and misrepresenting the performance of the firm which is illegal
- Compare performance in previous years
- Compare performance to other similar firms
- Judge performance against stated objectives
Bad Debts: Money owed to a firm by customers it doesn’t expect to receive
Creditors: People/Firms who a firm owes money to
Inventories: Raw materials, items needed for production and complete products
Liquidity: Ability of a firm to meet its short term debts
Capital: Money invested into a firm to purchase assets or pay liabilities
Capital Expenditure: When cash is spent on an item that will be sued over and over again
Revenue Expenditure: Spending on a day-to-day basis on everyday items
Gross Profit: Deducting the direct costs from the sales revenue to give a broad indication of financial performance
Net profit is revenue minus direct and indirect costs and gives a better indication of financial performance
· Trading profit takes into account all earnings from regular activity and all the costs associated with those activities but excludes irregular income and costs
· Net profit before tax is the trading profit plus any one-off incomes or costs
· Net profit after tax is the amount left to the firm after corporation has been deducted to give a final figure
Operating Profit: Gross profit with the reduction of all other expenses
Finance Income: Interest that the firm receives on accounts that it holds with financial institutions
Finance Expenses: Interested paid on its loans
High quality profit is likely to continue into the future
Low quality profit is likely to not continue and is more one off