Understanding financial objectives

Key termsCan you match the key word to the correct definition?

Key word Definition

Assets raw materials and other items necessary to production to take place. They also include finished products that have not been sold

Capital measures the ability of a business to meet its short term debts

Creditors cash the business has for its day to day running

Inventories represent money owed by a business

Liquidity people or organisations to which a business owes money

Working capital money invested into the business and is used to purchased assets

Liabilities items owned by a business

We will examine

• How to analyse balance sheets• How to analyse income statements• How to use financial data for comparisons,

trend analysis and decision making• The strengths and weaknesses of financial

data in judging a businesses performance

A balance sheet is a financial statement

recording the assets and liabilities od a business on a particular day at the end of and accounting period

What is a balance sheet?

A BALANCE SHEET SHOULD ALWAYS

BALANCE!

Balance sheet relationships

1. ASSETS=LIABILITIES

2. TOTAL ASSETS = CURRENT ASSETS+ NON CURRENT ASSETS

3. LIABILITIES= SHARE CAPITAL+ BORROWINGS +RESERVES

Balance sheets are an essential source of information for a variety of business decisions and for a number of stakeholders;

• Shareholders• Suppliers• Managers

Assets

1. First classification• Non-current assets (e.g. land, property)• Current assets (e.g. cash, inventories)

2. Second classification• Tangible assets (e.g. machinery, equipment)• Intangible assets (e.g. goodwill, brands)

Liabilities

• Current liabilities (e.g. overdraft, tax due)• Non-current liabilities (e.g. bank loan,

mortgages)• Total equity (shareholders’ funds)

Structure of a Balance sheet

Name of the business and date

Assets

Liabilities

Financed by

Structure of the balance sheetMarks and Spencer’s consolidated balance sheet as at 31st March 2008

2008 £m

In-tangible non-current assets 305.5

Tangible non-current assets 5673.8

Inventories 488.9

Receivables and cash 692.8

Total assets 7167.0

Current liabilities (1988.9)

Net current liabilities (807.2)

Non-current liabilities (3208.1)

Total liabilities (5191.0)

Net assets 1964.0

Share capital 628.0

Reserves and retained earnings 1336.0

Total equity 1964.0

Interpreting the balance sheet

Managers , potential investors and accountants can gain a great deal of information about a company from reading its balance sheet

It is possible to assess the short-term financial positions of the business and its longer-term financial strategy

Short term• Ability to pay bills• Shows the businesses short term debts (current

liabilities) and also the current assets it has to pay these debts (creditors)

• This is known as the working capital (current assets-current liabilities)

• If a business has more current assets than current liabilities it has a positive figure

• If it has more current liabilities than current assets it has a negative figure-this causes liquidity problems

Long term

• Movement of non-current (fixed) assets- increase in non-current assets indicates a rapidly growing company

• Where capital has come from- borrowing money can be risky

• Reserves- indication of business profits

Working capital

• Measures the amount of money available to a business to pay its day to day expenses

• Working capital is what remains of a business’s liquid assets once it has settled all its immediate debts

Working capitalEssential for the day to

day running of the business

=Current AssetsCash at the bank, trade and other receivables,

inventories

LESSCurrent

LiabilitiesDebts, trade and other

payables, tax due

Too much WC• Holding excessive amounts of WC is not wise• Liquid assets e.g. cash has little or no return

for the business• A well managed business will hold sufficient

liquid assets to meet its need for WC

Factors influencing the amount of WC• Volume of sales

• Amount of trade credit offered• If the firm is expanding

• Length of the operating cycle• Rate of inflation

Causes of WC problems

• External changes• Poor credit control• Internal problems• Financial mismanagement

How important is WC?

• WC can be described as the ‘lifeblood’ of a successful enterprise

• If a business becomes insolvent it will be forced to close down

WC is important for;1. Small businesses2. Businesses wishing to expand3. Businesses with a long working cycle

Depreciation

The reduction of the value of an asset over a period of time

Year Value of asset on Balance Sheet at end of year (£)

Amount depreciated annually (£)

2008 60000 20000

2009 40000 20000

2010 20000 20000

2011 0 20000

Depreciation of brewing equipment in ‘The Norfolk Ale Company’

Why do firms depreciate assets?

Firms need to spread the cost of an asset over its useful lifeDepreciating assets ensures the value of the business is relatively accurateIt allows firms to calculate the true cost of production

Resale value declines for a number of reasons;• Wear and tear• Availability of modern equipment• Poor maintenance

Depreciation: A non-cash expense

• It is an expense or a cost that is recorded on the income statement

• However, it is not a cash expense- it doesn’t require the business to make any cash payment

Effects of depreciationToo much Too little

Balance sheet Value of the business will be understated

Will give a false impression of the company’s worth

Income statements Expenses are over estimated, reducing the level of profits

Reduces expense incurred by the business, this will over estimate profit

Wider effects Business may look unattractive to possible investors. Tax liability on profits which HMRC might investigate. Business may record a surplus when the asset is sold

May make the company look more attractive to possible investors but will also increase its tax liability

Income Statements

An accounting statement showing a firms REVENUE over a trading

period and all the relevant COSTS generated to earn that revenue

Key phrases

A LOSS is a situation where a business’s expenditure exceeds its revenue over a specific trading period.

PROFIT can be defined in a number of ways, but is essentially the surplus of revenue over costs.

What is profit?

1. Gross Profit- calculated by deducting direct costs from a business’s sales revenue. It gives a broad indication of a company’s performance without taking into account costs such as overheads (indirect costs).

2. Net profit- a further refinement of the concept of profit and is revenue less direct costs and indirect costs. It gives a better indication of the performance of a business.

Quality of profit• Firms regard profit that is likely to continue onto the

future as high quality profit e.g. a successful new product

• Selling off an asset may add to a company’s overall net profit, however will not continue into the future- this is known as low quality profit

• The amount of trading or operating profit earned is more likely to represent high quality profit

• Shareholders are interested in the quality of profit as it gives an indication of the company’s potential to pay its dividends

Structure of an income statementName of business

Revenue

LESS direct costs

Gross Profit

LESS indirect costs

Operating profit

PLUS financing costs

Net profit before tax

LESS corporation tax

Net profit after tax

Usually referred to as COGS

An indicator of a firms performance

Profit on which the Inland Revenue bases its tax calculations

Important form of tax as the firm can decide what to do with this

Income statements and PLCs

• PLCs are required by law to publish their accounts

Group Income statements• In The last 25years many companies have been taken over by others to

form groups. Each company within such a group retains a separate legal identity. But the group is also legally obliged to produce a group income statement (and balance sheet)

Income statements and the law• The legal requirements relating to income statements are set out in the

Companies Act 2006. (see book pg 26-27)

Interpreting Income Statements

Income Statements

Managers• Cost of sales

and expenses• Turnover and

operating profit• One-off items

Employees• Expenses(especially

wage costs)• Profits after tax• Retained profits v

dividends

Shareholders• Operating

and net profits

• Turnover• Retained

profit• dividends

HM Revenue and Customs• Net profit

before tax• Depreciation

Financial data for comparisons, trend analysis and decision-making pg28-29

Balance sheets• The business’s working capital position• The extent of the business’s long term debts

Income statements• Trends• The period to which the income statement relates• Comparing gross and net profit• The Business(es) to which the income statement relates

Strengths and weaknesses of financial data in judging performance

• Window dressing• Financial statement is a historical document- not

necessarily a good indication of what will happen in the future

Balance sheet Income statementProvides a measure of the value/worth of a business

Shows sources of capital used by a business

Shows if the business has used expensive sources of capital

Illustrates cash/liquidity

Offers valuable information to stakeholders- it indicates growth

Provides details of costs

Shows net profit (interested stakeholders)

Limitations of financial data

• Quality of leadership is not shown by financial data

• What is the position of the business in the market?

• What about the motivation and performance of the workforce?