Accounting Information System - Accounting - Learning Material: Balance Sheet - Profit and Loss - Ratio Analysis - Sourch of Growth

Theories

There are various theories that are relevant to accounts. Many of them relate to the firm's end of year accounts. All firms have to produce a set of accounts at the end of each year, and these are the main window to the firm's performance. It is therefore very important to understand them and be able to analyse them. Use the links below to find out about these various theories:

T 1. Balance sheet

The balance sheet is one of the financial statements that limited companies and PLCs produce every year for their shareholders. It is like a financial snapshot of the company's financial situation at that moment in time. It is worked out at the company's year end, giving the company's assets and liabilities at that moment.

It is given in two halves - the top half shows where the money is currently being used in the business (the net assets), and the bottom half shows where that money came from (the capital employed). The value of the two halves must be the same - capital employed = net assets, hence the term balance sheet.

The money invested in the business may have been used to buy long-term assets or short-term assets. The long-term assets are known as fixed assets, and help the firm to produce. Examples would be machinery, equipment, computers and so on, none of which actually get used up in the production process. The short-term assets are known as current assets - assets which are used day to day by the firm. The current assets may include cash, stocks and debtors.

The top half of the balance sheet will therefore be made up of the total of the fixed and current assets, less any current or long-term liabilities the firm may have (creditors, loans and so on). It may look as follows:

				£ million
Fixed assets				200
Current assets	- stock	40
	- debtors	50
	- cash	20
	TOTAL	110
less Current liabilities		(40)		70
NET ASSETS				£270m

The bottom half of the balance sheet then looks at where this money came from. This depends on how the business was originally funded. The main source of money for a limited company starting up is the issue of shares. This is termed the share capital - the money the original shareholders put into the business. From then on the assets of the company may be built up by ploughing profit back into the business. This is called retained profit, and is the other source of money usually included in the bottom half of the balance sheet. This may therefore look as follows:

Share capital		100
Retained profit		170
CAPITAL EMPLOYED		£270m

T 2. Profit and loss account

The profit and loss account differs significantly from the balance sheet in that it is a record of the firm's trading activities over a period of time whereas the balance sheet is the financial position at a moment in time.

The profit and loss account looks at how well the firm has traded over the time period concerned (usually the last 6 months or year). It basically shows how much the firm has earned from selling its product or service, and how much it has paid out in costs (production costs, salaries and so on). The net of these two is the amount of profit they've earned. In essence this is what the P and L account shows, it just shows it in more detail!

A profit and loss account would usually be made up as follows:

	£ million
Turnover (sales revenue)	500
less Cost of goods sold	(200)
Gross profit	300
less other costs @	(100)
Trading / operating profit	200
****
Profit for shareholders (dividends)	75
Retained profit	125

@ These other costs may include marketing and distribution costs, office costs and so on. They are also known as indirect costs or overheads.

**** In here may also be included any other income or expenses. These may include interest - paid or received - tax, extraordinary items (profits from selling assets or parts of the company) and so on.

The final retained profit figure is the one that goes to the balance sheet as a source of funds for the company to use. This retained profit may be used to buy fixed assets (machinery, equipment, etc...) or it may remain as current assets (cash in the bank perhaps).

T 3. Ratio analysis

Ratio analysis is a technique for trying to help interpret financial accounts. From the financial accounts various ratios can be calculated. These ratios will then help us to examine the companies position in more detail and compare it to other companies in a similar industry or market segment. Here's a brief explanation of some of the key ratios:

Profitability ratios

These ratios help us to judge how good the firm's profit performance is. There are two key ratios to show profitability. They are:

Return on capital employed - this measures the level of profit of the firm compared to the amount of capital that has been invested in it. It is effectively the return the firm has made, and investors will want this to be higher than the rate of interest they could have got elsewhere. It is measured by:

RETURN ON CAPITAL EMPLOYED

=

Net profit Total capital employed (Net assets)

x100

Profit margin - this measures the level of profit compared to the turnover. It therefore shows the percentage profit on the sales. It can be measured as either a gross or net profit margin. The net profit margin would be:

PROFIT MARGIN

=

Net profit Turnover (Sales)

x100

Liquidity ratios

These are ratios that measure the liquidity of the firm. Firms have to ensure that they have the liquidity required to meet all their commitments. They need to be able to have sufficient assets to convert into cash, and can't afford to have all their assets tied up as capital.

Current ratio - this ratio compares the current assets and current liabilities. Clearly the firm needs to have more current assets than liabilities, and so at a minimum the figure should be more than 1. However, it should probably be quite a bit higher than this to ensure sufficient liquidity. It is measured by:

CURRENT RATIO

=

Current assets Current liabilities

Acid test ratio - this ratio takes a closer look at the firm's liquidity. One of the current assets is stock, and this is clearly not always easy to turn into cash. In fact the firm may have high stock levels because they can't sell it all. So the acid test ratio takes the current assets and subtracts the stock. It is measured by:

ACID TEST RATIO

=

Current assets - stock Current liabilities

If the value of this ratio is much less than one the firm may have a liquidity problem, as it may have insufficient assets to meet all its liabilities.

T 4. Sources of growth

When a company grows, the growth may be either organic or inorganic. Organic growth means that the company itself has grown from its own business activity, while inorganic growth means that the company has grown by merger or take-over. Organic growth is also sometimes known as internal growth and inorganic as external growth.

Companies may want to grow for various reasons:

• To gain economies of scale
• To spread risk - diversification can often help spread risk
• To gain market share
• To increase profits and therefore returns for shareholders

Source:
http://www.bized.co.uk/