Financial Accounting

Lecture 4

SIR SYED ADEEL ALI BUKHARI

adeelali84@hotmail.com
 What are accounts and why are
they necessary?
Accounts are financial records of a firm's transactions
that is kept up to date by the accountants, who are
qualified professionals responsible for keeping accurate
accounts and producing the final accounts.
Every end of the year, a final accounts must be produced
which gives details of:
– Profits and losses made.
– Current value of the business.
– Other financial results.
Limited companies are bound by law to publish these
accounts, but not other businesses.
Financial documents involved in buying and selling.
Accountants use various documents that are used for buying
and selling over the year for their final accounts. They can
help the accountant to:
– keep records of what the firm bought and from which supplier.
– keep records of what the firm sold and to which customer.
 Recording accounting transactions

Businesses usually use computers to store their

transactions so that they can be easily accessed,
calculated and printed quickly.
 Who uses the financial accounts of
a business?
Shareholders: They will want to know about the profit or
losses made during the year and whether the business is
worth more at the end of the year or not.
Creditors: They want to see whether the company can
afford to pay their loans back or not.
Government: Again, they want to check to see if correct
taxes are paid. They also want to see how well the
business is doing so that it can keep employing people.
Other companies: Other companies want to compare
their performance with a business or see if it is a good
idea to take it over.
 What do final accounts contain?
1. The trading account
This account shows how the gross profit of a business is
calculated. Obviously, it will contain this formula:
Gross profit = Sales revenue - Cost of goods sold
Note that:
Gross profit does not take to account overheads.
Only calculate the cost of goods sold, and forget the
inventory.
In a manufacturing business, direct labour and
manufacturing costs are also deducted to obtain gross
profit.
2. The profit and loss account
The profit and loss account shows how net profit is calculated. It starts
off with gross profit acquired from the trading account and by deducting all
other costs it comes up with net profit.
Depreciation is the fall in value of a fixed asset over time. It is also
counted as an indirect cost to businesses.
As for limited companies, there are a few differences with the normal
profits and loss account:
Profits tax will be shown.
It needs to have an appropriation account at the end of the profits
and loss account. This shows what the company has done with its net
profits, in other words, how much retained profit has been put back
into the company.
Results form the previous year are also included.
Income Statement
3. Balance sheet
The balance sheet shows you a business's assets and liabilities at a
particular time. The balance sheet records the value of a business at
the end of the financial year. This is what it contains:
Fixed assets: land, vehicles, buildings that are likely to be with the
business for more than one year. They depreciate over time.
Current assets: stocks, inventory, ash and debtors that are only there
for a short time.
Long-term liabilities: long-term borrowings that does not have to be
paid in one year.
Short-term liabilities: short-term borrowings that has to be paid in
less than one year.
Balance Sheet
If your total assets are higher than your total liabilities, then you
are said to own wealth. In a normal business, wealth belongs to
the owners, while in a limited company, it belongs to the
shareholders. Hence the equation:
Total assets - total liabilities = Owners'/Shareholders' wealth
OR
Total assets = total liabilities + Owners'/Shareholders' wealth
A = L+C
Here are some terms found in balance sheets:
1. Working capital: is used to pay short-term debts and known as net current
assets. If a business do not have enough working capital then it might be forced to
go out of business.
Working capital = Current assets - Current liabilities

Net assets: Shows the net value of all assets owned by the company. These
assets must be paid for or finance by shareholders' funds or long term
liabilities.
Net assets = Fixed assets + Working capital
 Ratio analysis of accounts
You can use several tools to evaluate a company, but some of the
most valuable are financial ratios. Ratios are an analyst’s
microscope; they allow us get a better view of the firm’s financial
health than just looking at the raw financial statements.
Ratios are useful both to internal and external analysts of the firm.
For internal purposes, ratios can be useful in planning for the future,
setting goals, and evaluating the performance of managers.
External analysts use ratios to decide whether to grant credit, to
monitor financial performance, to forecast financial performance, and
to decide whether to invest in the company.
We will divide our discussion of the ratios into five categories based on the
information provided:
1. Liquidity ratios describe the ability of a firm to meets its current obligations.
2. Profitability ratios provide indications of how profitable a firm has been over a
period of time.
3. Efficiency ratios describe how well the firm is using its investment in assets to
produce sales.
4. Leverage ratios reveal the degree to which debt has been used to finance the
firm’s asset purchases.
5. Coverage ratios are similar to liquidity ratios in that they describe the ability of a
firm to pay certain expenses.
 1. Liquidity Ratios
The term liquidity refers to the speed with which an asset can be converted
into cash without large discounts to its value. Some assets, such as
accounts receivable, can easily be converted to cash with only small
discounts. Other assets, such as buildings, can be converted into cash very
quickly only if large price concessions are given. We therefore say that
accounts receivable are more liquid than buildings. All other things being
equal, a firm with more liquid assets will be more able to meet its maturing
obligations (i.e., its bills) than a firm with fewer liquid assets. As you might
imagine, creditors are particularly concerned with a firm’s ability to pay its
bills. To assess this ability, it is common to use :
a. the current ratio, and/or
b. the quick ratio.
a. The Current Ratio
Generally, a firm’s current assets are converted to cash (e.g., collecting on
accounts receivables or selling its inventories) and this cash is used to retire
its current liabilities. Therefore, it is logical to assess its ability to pay its bills
by comparing the size of its current assets to the size of its current liabilities.
The current ratio does exactly this. It is defined as:
Current ratio = Current assets / Current liabilities
Current ratio = 27490 / 4220 = 6.514
Obviously, the higher the current ratio, the higher the likelihood that a firm will
be able to pay its bills. So, from the creditor’s point of view, higher is better.
However, from a shareholder’s point of view this is not always the case.
Current assets usually have a lower expected return than fixed assets, so the
shareholders would like to see that only the minimum amount of the
company’s capital is invested in current assets. Of course, too little investment
in current assets could be disastrous for both creditors and owners of the firm.
b. The Quick Ratio
Inventories are often the least liquid of the firm’s current assets. For this
reason, many believe that a better measure of liquidity can be obtained by
ignoring inventories. The result is known as the quick ratio (sometimes called
the acid-test ratio), and is calculated as:

Quick ratio = (Current assets – Stock) / Current liabilities

Current ratio = (27490 – 10000) / 4220 = 4.144

Notice that the quick ratio will always be less than the current ratio. This is by
design. However, a quick ratio that is too low relative to the current ratio may
indicate that inventories are higher than they should be.
 2. Profitability Ratios
Investors and are particularly interested in the profitability of the firms. Profitability
ratios provide an easy way to compare profits to earlier periods or to other firms.
Without exception, high ratios are preferred. However, the definition of high
depends on the industry in which the firm operates. Generally, firms in mature
industries with lots of competition will have lower profitability measures than firms in
younger industries with less competition. For example, grocery stores will have
lower profit margins than computer software companies. In the grocery business, a
net profit margin of 3% would be considered quite high, but the same margin would
be abysmal in the software business. The Profitability ratios are:
a. The Gross Profit Margin
b. The Net Profit Margin
c. Return on Total Assets
d. Return on Capital Employed
a. The Gross Profit Margin
The gross profit margin measures the gross profit relative to sales. It indicates
the amount of funds available to pay the firm’s expenses other than its cost of
sales.
Gross Profit Margin = (Gross Profit / Sales) x 100%
Gross Profit Margin = (122990 / 193700) x 100% = 0.634 = 63.4%

If this rises, it could mean that either they are increasing added value or costs
have fallen.
b. The Net Profit Margin
The net profit margin relates net income to sales. Since net income is profit
after all expenses, the net profit margin tells us the percentage of sales that
remains for the shareholders of the firm:
Net Profit Margin = (Net Profit / Sales) x 100%
Net Profit Margin = ( 27174/ 193700) x 100% = 0.14 = 14%

The higher the result, the more successful the managers are. This could be
compared with other businesses too. Net profit does not include tax.
c. Return on Total Assets
The total assets of a firm are the investment that the shareholders have made.
Much like you might be interested in the returns generated by your
investments, analysts are often interested in the return that a firm is able to
get from its investments.
Return on Total Assets = Net Profit / Total Assets
Return on Total Assets = 27174 / 152490 = 0.178
d. Return on Capital Employed
While total assets represent the total investment in the firm, the owners.
Investment (common stock and retained earnings) usually represent only a
portion of this amount (some is debt). For this reason it is useful to calculate
the rate of return on the shareholder’s invested funds. We can calculate the
return on (total) equity as:
Return on Capital Employed = Net Profit / Total Equity
Return on Capital Employed = 27174 / 128270= 0.211

This result could show the efficiency of a business. If the result rises, the
managers are becoming more successful
 3. Efficiency Ratios
Efficiency ratios, as the name implies, provide information about how well
the company is using its assets to generate sales. For example, if two firms
have the same level of sales, but one firm has a lower investment in
inventories, we would say that the firm with lower inventories is more
efficient with respect to its inventory investment.
There are many different types of efficiency ratios that could be defined.
How ever, we will illustrate five of the most common:
a. Inventory Turnover Ratio
b. Accounts Receivable Turnover Ratio
c. Average Collection Period
d. Fixed Asset Turnover Ratio
e. Total Asset Turnover Ratio
 4. Leverage Ratios
In finance, leverage refers to a multiplication of changes in profitability measures.
For example, a 10% increase in sales might lead to a 20% increase in net income.
The amount of leverage depends on the amount of debt that a firm uses to finance
its operations, so a firm which uses a lot of debt is said to be highly leveraged.
Leverage ratios describe the degree to which the firm uses debt in its capital
structure. This is important information for creditors and investors in the firm.
Creditors might be concerned that a firm has too much debt and will therefore have
difficulty in repaying loans. Investors might be concerned because a large amount
of debt can lead to a large amount of volatility in the firm’s earnings. However, most
firms use some debt. This is because the tax deductibility of interest can increase
the wealth of the firm’s shareholders.
a. The Total Debt Ratio
b. The Debt to Equity Ratio
 5. Coverage Ratios
In finance, leverage refers to a multiplication of changes in profitability measures.
For example, a 10% increase in sales might lead to a 20% increase in net income.
The amount of leverage depends on the amount of debt that a firm uses to finance
its operations, so a firm which uses a lot of debt is said to be highly leveraged.
Leverage ratios describe the degree to which the firm uses debt in its capital
structure. This is important information for creditors and investors in the firm.
Creditors might be concerned that a firm has too much debt and will therefore have
difficulty in repaying loans. Investors might be concerned because a large amount
of debt can lead to a large amount of volatility in the firm’s earnings. However, most
firms use some debt. This is because the tax deductibility of interest can increase
the wealth of the firm’s shareholders.
a. The Total Debt Ratio
b. The Debt to Equity Ratio