unit 10 final accounts - pearson schools

Unit 10 Final Accounts

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Profit and loss accounts‘Business without profit is not business any morethan a pickle is candy.’ So said Charles F. Abbott,the famous American lawyer, and he was right –

Q When does someone decide to become an accountant?A When they realise they don’t have the charisma to become an undertaker!

Is that your impression of accountants? Dry, dreary and dull? Or maybe you’re the sort of personwho runs a mile when accounts are mentioned. If I had a pound for every time a student said tome ‘I don’t like accounts – I’ve never been good at maths’, I’d need an accountant to add up allmy pounds!

Accounts and accountants always seem to suffer from a bad press, but much of it is undeserved.First, accounts are a vital function of businesses; without a good accounting system abusinessperson would never be able to assess the true performance of the business. Second,students often exaggerate the importance of maths to accounting. If you can add, take away,multiply and divide you can do most of the maths an accountant requires.

So don’t be afraid of accounts – they are really not so daunting. When you get your finalaccounts to balance, be content in the knowledge that such skills will help businesses to measuretheir success accurately and to expand prudently.

Unit 10 is divided into four main areas:

10.1 Profit and loss accounts

10.2 Assets, liabilities and balance sheets

10.3 Fixed and working capital

10.4 Reviewing business performance using ratio analysis.

a business without profit really is no business atall, although the directors of Eurotunnel mightwish to argue that point.

Profit and loss

One of the fundamental questions for anybusiness to ask is ‘How profitable is the business?’Many factors need to be taken into account indetermining this. The profit and loss account isthe first of the legally required financialstatements for a business, and it contains muchvital information for the owners or shareholdersof the business. In essence the profitand loss account simply calculates thetotal income for the firm and deductsits expenses to give a total profit figure.It is important that these documentsare always prepared using the samelayout and conventions, so that acompany’s performance can beaccurately assessed and comparedwith other businesses.

Trial balance If you have previously studied Unit 9:Introduction to Accounting, you willalready be familiar with the trialbalance, but if you are new to thisaccounting document, read on.

What is the trial balance?

Before compiling a full set of finalaccounts, the accountant will wish tocheck the accuracy of the figurespresented by the company’sbookkeepers. This is a simple process tounderstand (although it is somewhatharder to do). The accountant willdraw up a document with all the creditentries for the company on one sideand the debit entries on the other; aslong as they equal each other it is safeto proceed. The trial balance is the actof totalling all the debit balances andall credit balances to confirm that totaldebits equal total credits. This confirmsthat the final set of accounts shouldbalance once constructed.

For the purposes of this unit you willnot need to construct a trial balance,but you will need to be familiar withthem as they are the documents used


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to prepare final accounts. For this unit we will usethe accounts of a sole trader called Jon Andersonwho runs a business making wooden toys. Here isJon’s trial balance for the financial year ending31 March 2006. We will refer to this throughoutthis unit.

Jon AndersonTrial balance 31.3.06

Dr Cr

£ £

Capital 65,000

Buildings 0

Equipment 85,000

Motor vehicle 9,500

Opening stock 1,750

Cash 275

Bank overdraft 2,920

Money in bank 0

Bank loan (long term) 28,000

Purchases 155,250

Sales 248,150

Creditors 6,250

Debtors 3,450

Wages 43,500

Drawings 24,950

Purchase returns 1,960

Sales returns 2,575

Non-operating receipts 5,000

Rent and rates 26,845

Advertising 1,560

Sundry expenses 45

Motor expenses 1,950

Telephone and postage 630

357,280 357,280

Additional information

Closing stock 2,350

Depreciation on straight-line basis

Equipment 15% on cost

Motor vehicle 20% on cost

Buildings 0% on cost

Note thatthese twofigures arethe same,therefore thetrial balancebalances!

Common entries in a trial balance

Here is an explanation of each of the entries in the trial balance.

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Profit and loss accounts

Capital Money put into the business to get it started or to buy equipment.

Capital items purchased The original values of capital items (also known as the fixed assets of the firm)bought for the business. In Jon’s case this includes equipment and a motorvehicle, but it could include buildings if these were owned by the firm.

Opening stock The value of stocks of finished products, work in progress (partially completedproducts) and raw materials held in the business at the start of the year.

Cash Cash held on company premises.

Bank overdraft Money owed by the firm to the bank. An overdraft occurs when the firm drawsmore money out of its account than it has available.

Money in bank Money held in a bank account.

Long-term bank loans Loans that do not need to be repaid in the next 12 months.

Purchases For a manufacturing company this is the value of raw materials purchased. For aservice business it would be the cost of items bought to sell to customers orused to provide a service to customers.

Sales (or turnover) The total amount of money received in sales for the year.

Creditors People and organisations who are owed money by the business. These arenormally suppliers who have supplied goods or services on credit and who will bepaid later.

Debtors People and organisations who owe money to the business. These are normallycustomers who have bought on credit and will pay later.

Wages and salaries Paid to employees.

Drawings Money drawn out of the business by the owners, in this case Jon, for their own use.

Purchase returns Money paid back to the company by suppliers when the firm returns items, forwhatever reason.

Sales returns Money paid back to customers when they return items, for whatever reason.

Non-operating receipts Some businesses may receive extra income other than normal sales income; thiscould include rent received or commission received.

Expenses All businesses have many general expenses; for Jon’s business they are rent andrates, advertising, motor expenses, telephone and postage.

Sundry expenses A variety of small purchases such as stationery items.

Additional information required fordrawing up accounts

At the bottom of Jon’s trial balance you can see ashort table of additional items that will berequired for completion of a full set of finalaccounts. These are closing stock anddepreciation, each of which is explained in detaillater (see pages 4 and 6).

Trading account Trading is the basic process of business.Manufacturing companies, for example, buy inraw materials and use them to make products forsale, whereas retail companies buy in finishedgoods for sale at a higher price; this is the basis oftheir trade.

The trading account for either of these types ofbusiness shows how much profit the firm makes by

this basic business process, ignoring other expensesthe company may incur. It simply looks at howprofitably the firm makes goods or processes themfor sale to customers. The profit earned by thisprocess is known as the gross profit.

Components of the trading account

Most of the components we have seen before.These are sales (or turnover), sales returns,opening stock, purchases and purchase returns.But there are two additional items that needexplaining:

closing stock is the value of stocks offinished products, work in progress (partiallycompleted products) and raw materials heldin the business at the end of the year

gross profit is the difference between thecompany’s total revenue and how much itcost to make the product or buy products in.


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Manufacturing companies buy in raw materials and use them to make products for sale

Sales/turnoverminus sales returnsequals net salesminus cost of goods soldequals gross profit

Cost of goods sold is calculated as follows:

Opening stockplus purchasesminus purchase returnsminus closing stockequals cost of goods sold

It is easier to see this in action, so here is the fulltrading account for Jon’s business:

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Jon AndersonTrading account for year ended 31.3.06

£000s £000s £000s

Sales 248,150

Less sales returns 2,575

Net sales (or turnover) 245,575

less cost of goods sold

Opening stock 1,750

Purchases 155,250

Less purchase returns 1,960

Net purchases 153,290

155,040

Less closing stock 2,350

Cost of goods sold 152,690

Gross profit 92,885

Non-operating receipts (rental income) 5,000

97,885

minus cost ofgoods soldequals grossprofit

Sales

Net sales

Study this trading account.

Look back to the trial balance to see where each of these figures comes from.

Check all of the calculations to make sure that you can see how the totals are arrived at.

equals cost ofgoods sold

minus sales returns

equal net sales

opening stock

plus purchases

minus closingstock

minus purchasereturns

Calculating the gross profit using thetrading account

The trading account is always laid out in the sameway, and gross profit is calculated using thispattern:


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Profit and loss account Although the trading account shows us what thefirm has made from its basic line of business, itdoes not reveal the true profit of the firm as itdoes not take into account any of the generalexpenses of the business. The profit and lossaccount takes the gross profit of the firm anddeducts all the expenses to find the final profit forthe year, known as the net profit.

Expenses – Amounts that the firm has hadto pay out, such as rent, wages, petrol andmany others. Note that drawings (sums thatthe owner takes from the business for his orher personal use) and the cost of fixed assetsare not classed as an expense and do notappear in the profit and loss account. Theywill appear later in the balance sheet.

Depreciation – Most of a firm’s capitalassets do not retain their value. Motorvehicles, for example, lose value each year.This reduction is known as depreciation. It isimportant to show this reduction in value inthe firm’s accounts, otherwise the finalaccounts will overstate the value of thebusiness. Depreciation is an expense to thefirm (even though no money actually changeshands) and so it appears in the profit and lossaccount. There are two main methods ofaccounting for depreciation; either may beused.

Straight-line depreciation

A fixed percentage of the original cost of the assetis taken off each year. This means that theamount of depreciation on a particular asset willbe the same each year.

For example, a machine that cost £80,000 to buycould be depreciating by 20% per year on astraight-line basis. The amount per year is:

£80,000 × 20% = £16,000 per year for each offive years.

The number of years used will be based on thefirm’s estimate of the useful working life of theasset. In the above example the firm must

Practice point

Gurditta Khan runs a hardware shop. Here is histrial balance for the year ended 31 March 2006:

Gurditta KhanTrial balance 31.3.03

Dr Cr

£ £

Capital 45,000

Buildings 50,000

Equipment 5,000

Motor vehicle 8,000

Opening stock 3,500

Cash 25

Bank overdraft 300

Money in bank 0


Purchases 21,630

Sales 84,080

Creditors 550

Debtors 0

Wages 15,000

Drawings 29,575

Purchase returns 240

Sales returns 0

Non-operating receipts 0


Advertising 100

Sundry expenses 90



140,170 140,170


Closing stock 3,600





Using the figures above, prepare the tradingaccount for Gurditta.

consider that after five years the asset will bevalueless and will probably need replacement.

However, most assets will have some value left atthe end of their useful lives (known as theresidual value of the asset), so the best way tocalculate straight-line depreciation is to use thefollowing formula:

Cost of asset – residual valueNumber of years of expected useful life

Using the previous example, if we assumed thatafter five years the asset would be worth £5,000to the company, the new calculation would be asfollows:

Depreciation = £80,000 – £5,0005

Depreciation = £15,000 each year.

Reducing balance depreciation

If the firm chooses to use this method aconsistent percentage figure is used, but it isapplied to the reduced balance each year. Usingthe same example, a machine costing £80,000 tobuy and depreciated by 20% per year, using thereducing balance method the depreciation wouldbe as follows:

Original cost £80,000

Year 1 depreciation (£80,000 × 20%) = £16,000

Value at end of Year 1 (£80,000 – £16,000) =£64,000

In Year 2 it will be as follows:

Value at end of Year 1 £64,000



In Year 3 it will be as follows:

Value at end of Year 2 £51,200



You can see that with this method the amount ofdepreciation reduces each year.

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Calculating net profit using the profitand loss account

The profit and loss account follows on from thetrading account and simply deducts all the firm’sexpenses from the gross profit. The resultingfigure is the net profit.

Continuing the example of Jon Anderson, here ishis trading and profit and loss account for theyear ending 31 March 2006.

Practice point

Stephanie Howe is a sole trader. She buys amachine worth £200,000 for her business. Sheexpects depreciation on this asset to be 10% peryear. Complete the following table showing thebalance at the end of each subsequent yearusing the two different methods:

Straight-line Reducing balance

Initial cost £200,000 £200,000

Value end Year 1

Value end Year 2

Value end Year 3

Value end Year 4

Value end Year 5

1 What is the residual value after five yearsusing each of the methods?

2 What do you notice about the rate ofdepreciation using the two methods?

3 We should ensure that the asset depreciatesto the same residual value whichever methodis chosen. What does this tell you about:

the relative percentage rates requiredusing each method to achieve the sameresidual value?

Stephanie’s method of deciding how muchto charge for depreciation on this asset?


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This topsection is thetradingaccount (youshould noticethat this is thesame as theone we lookedat previously)

This bottomsection is theprofit and lossaccount and itincludes all ofthe expensesof the firm

Each of the expense items comes from the trialbalance, except the items for depreciation. Here ishow they are calculated.

At the bottom of the trial balance you will see thefollowing details:


Closing stock 2,350Depreciation on straight-line basis

Equipment 15% on costMotor vehicle 20% on cost


Don’t worry about the closing stock item; we willuse that later.

Towards the top of the trial balance you will seethe following entries, showing the original valuesof the capital items bought by the firm:

Buildings 0Equipment 85,000Motor vehicle 9,500

Depreciation is calculated as follows:Equipment: £85,000 × 15% = £12,750Motor vehicle: £9,500 × 20% = £1,900

Jon AndersonProfit and loss account for year ended 31.3.06

£000s £000s £000s

Sales 248,150




Opening stock 1,750

Purchases 155,250



155,040



Gross profit 92,885

Non-operating receipts (rental income) 5,000

97,885

Less expenses

Administration


Wages and salaries 43,500



Advertising 1,560

Sundry expenses 45

Depreciation

Buildings 0

Equipment 12,750

Motor vehicles 1,900 89,180

Net profit 8,705

Look back atJon’s trialbalance tosee whereeach of theseexpenseitems comesfrom

These are the figures included at the bottom ofthe profit and loss account.

Go back and check all the figures in the profit andloss account so that you are clear where each ofthem comes from.

Now practise what you have learned bycompleting the following two Practice Points. Thefirst is a less complex task, and the second is morechallenging.

Appropriation account Final accounts for a sole trader do not require anappropriation account. When we are compilingfinal accounts for a sole trader there is nothingfurther to do for the profit and loss account, sincethe net profit is simply available for the owner touse as he or she sees fit.

However, in the case of a partnership or a limitedcompany decisions have to be made about how todistribute the net profit. The appropriationaccount is the statement of how net profit isdistributed to the partners or shareholders.

Components of a partnershipappropriation account The details of how net profit is to be distributed toeach partner will be recorded in the originalpartnership agreement, drawn up when thepartnership commenced. It may contain detailsabout the following methods of distribution.

Salaries

Salaries for individual partners may be specified,for example, the agreement may state thatPartner 1 is entitled to a salary of £10,000 eachyear and Partner 2 to £15,000 per year. The sizeof the salaries may represent the amount ofcontribution each partner makes to the runningof the company. Note that salaries to staff willappear in the profit and loss account, butpartners’ salaries will always appear in theappropriation account.

Interest on partners’ capital

The partnership agreement may also allow forinterest to be paid on the capital that each of thepartners introduced into the business. Theagreement will state the rate of interest that willbe paid.

Share of remaining profits

The agreement will state how remaining profits areto be split between the partners. For example, itmay say that they are to be split in the ratio of 40%to Partner 1 and 60% to Partner 2. Thus if the net

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Practice point

Sean McGrath has set up a small business buyingand selling second-hand CDs and DVDs which heruns in his spare time. Here is his trial balance.Compile trading and profit and loss accounts for Sean.

Practice point

Using the trial balance and trading account thatyou compiled for Gurditta Khan in the task onpage 6, compile his trading and profit and lossaccount for the year ending 31 March 2006.

Sean McGrathTrial balance 31.3.06

Dr Cr

£ £

Capital 5,000

Equipment 3,700

Opening stock 1,500

Cash 900

Purchases 9,600

Sales 21,700

Expenses 8,000

Drawings 3,000

26,700 26,700


Closing stock 1,750



profit (after salaries and interest) is £30,000, thepartners will receive the following amounts:

Partner 1: £30,000 × 40% = £12,000Partner 2: £30,000 × 60% = £18,000.

Here is an example of the appropriation account

Appropriation account

Salary: Singh 4,000

Salary: Smith 1,000

Interest allowed on partners’ capital

Singh 10,000

Smith 5,600 15,600

6,900

Share of remaining profits

Singh 65% 4,485

Smith 35% 2,415 6,900


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The shares of profitsadded together shouldequal the profit aftersalaries and interest

Components of a limited companyappropriation account For a limited company the appropriation accountis constructed differently and may include thefollowing entries.

Corporation tax

Corporation tax is a tax on business profits andis accounted for first in the appropriationaccount.

Interim dividends

Interim dividends are dividends that are paidpart-way through a company’s financial yearbefore final profits are calculated.

for a partnership between Singh and Smith. Inthis case the partnership agreement allows forsalaries of £4,000 for Singh and £1,000 forSmith, and for remaining profits to be split 65:35in favour of Singh.

Practice point

Page and Plant are a partnership. Their net profitthis year was £100,000. Capital introduced byeach partner is as follows:

Page: £50,000Plant: £40,000

Interest at 8% is allowable on this capital.

Remaining profits are to be shared as Page 40%and Plant 60%.

Page is entitled to a salary of £15,000 and Plant£25,000.

Draw up the appropriation account for Page andPlant.

£6,900 × 65%

Total interest (£10,000 + £5,600)

Net profit minus salaries andinterest (£27,500 – £4,000 – £1,000 – £15,600)

£6,900 × 35%

Net profit 27,500

Proposed dividends

Dividends paid by the company at the end of thefinancial year, after profits have been calculated,are called proposed dividends.

Reserves

Limited companies will often retain some profit inthe company rather than distribute it all toshareholders; retained profits are called reserves.Various reserves accounts may be set up fordifferent purposes. For example, some reserves

may be put on one side to pay for the replacementof a capital asset, such as a machine, at a laterdate.

Retained profit

Any profit left over after transfers to reserves isalso retained for future use, and is calledretained profit.

Here is an example of an appropriation accountfor a limited company. Makem Limited is amanufacturing company:

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Net profit before tax 10,140

less corporation tax 3,500

Profit for year after tax 6,640

less interim dividend paid 450

final dividends proposed

preference shares 450

ordinary shares 4,000 4,900

1,740

less transfer to general reserve 1,500

Retained profit for year 240

add balance of retained profits B/F 0

Balance of retained profits C/F 240

Outcome activity 10.1

For the purposes of this assignment, assume you are working as an accounts clerk for a firm of accountantsknown as Mason, Wright and Partners.

PassYou have been approached today by one of your clients, Mr Kong Han, who has a shop selling collector’sitems of science fiction memorabilia. You have the following trial balance that has been prepared by one ofyour assistants. Your tasks are to do the following.

Calculate the depreciation of the fixed assets of Mr Han’s business, on a straight-line basis at the rate of15% per year on equipment and 20% per year on the motor vehicle.

Prepare the trading and profit and loss accounts for Mr Han for the year ending 31 March 2006.

£6,640 – £4,900

Total dividends forthe year (£450 +£450 + £4,000)

Net profit minuscorporation tax

These are two typesof shares issued bylimited companies;you can learn moreabout them later inthe section oncapital assets

Profits fromprevious years thatwere not distributedas dividends or putinto reserves


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One of your assistants, Greta Harman, has recently started working on final accounts for limited companiesand consequently she has never seen appropriation accounts before. You decide that you will prepare abooklet that will help trainee accountants understand the workings of limited company accounts, includingappropriation accounts. The booklet will be in three sections and the first part of the booklet will simplydescribe the components of a limited company’s trading, profit and loss account and show how such a setof accounts is laid out. Produce the first section of your booklet.

MeritContinuing the booklet you began for the previous task, explain the components of a limited company’strading, profit and loss account. You should explain in detail what each of the entries means.

While producing this section of your booklet, it will be helpful to refer to a set of final accounts for a limitedcompany so that you can explain and give examples. To do this you can either use a published set of finalaccounts from a company, or alternatively use the following trading, profit and loss account for Waters andGilmour Limited, a firm manufacturing components for the motor industry.

Outcome activity 10.1 (continued)

Kong HanTrial balance 31.3.06

Dr Cr

£ £

Capital 16,000

Equipment 15,500

Motor vehicle 3,000

Opening stock 7,700

Cash 250

Money in bank 560


Purchases 35,700

Sales 63,850

Creditors 1,610

Debtors 150

Wages 3,920

Drawings 15,000

Sales returns 250


Advertising 1,500

Sundry expenses 240



91,460 91,460


Closing stock 7,400




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Outcome activity 10.1 (continued)

DistinctionComplete your booklet by analysing the appropriation account of the organisation that you used in theprevious question.

Waters and Gilmour LimitedProfit and loss account for year ended 31.3.06

£000s £000s £000s

Sales 453,000




Opening stock 30,500

Purchases 271,000



298,500



Gross profit 174,500

Rent received 2,500

177,000

Less expenses

Administration



Insurance 3,500


Debenture interest 6,000

Depreciation

Buildings 0

Equipment 5,000



Less corporation tax 20,000

Profit for year after tax 22,000

less interim dividend paid 0


preference shares 0


12,000

Less transfer to general reserve 3,000

Retained profit for year 9,000

Add balance of retained profits B/F 23,000

Balance of retained profits C/F 32,000

Assets, liabilities andbalance sheetsThe true value or worth of a firm is tied up inmany things, such as the things that it hasbought, the things it has made, the regularcustomers it has and even the reputation of thecompany or its brand.

While the trading and profit and loss accountshows the profit that a firm has earned in aparticular year, the balance sheet shows whatthe firm is truly worth and what makes up itsvalue.

It starts with acomparisonof the itemsof value withinthe firm (its assets)and the money that itowes (its liabilities).The balance sheet isthe last document in a set of final accounts andcan be defined as an overview of a company’sfinancial position on a particular date, showingthe total assets and liabilities of the firm.

Assets and liabilities Fixed assets

The first section on a balance sheet details the fixedassets of the firm. These comprise the capital itemsof value that the firm has bought and will use foran extended period of time, such as buildings,machinery, equipment and vehicles. These are oftenreferred to as tangible fixed assets (tangible meansyou can touch them). The fixed assets section of thebalance sheet will show the original prices paid forthese assets, the amounts by which their value hasdepreciated, and the net current value of each ofthem (original price minus depreciation).

Occasionally you will see an item in this sectionentitled ‘goodwill’. This is an example of anintangible fixed asset (intangible means that it issomething you cannot touch). Goodwill does notrepresent an item of value but arises when a newowner pays above the book value of the firm to

compensate the previous owner for the goodreputation of the business.

Current assets

The second section in the balance sheet containsassets that are readily available in the companyfor paying debts, called current assets. Thisgenerally includes stocks, debtors, money in thebank and cash held on the premises.

Current liabilities

The third section in the balance sheet containsamounts that are owed to suppliers or lendersthat are due to be repaid fairly shortly (normallywithin one year). These are known as currentliabilities. This section will typically containcreditors, bank overdrafts, VAT and loans that aredue to be repaid in less than one year. For limitedcompanies, this section may also includecorporation tax and dividends.

In the final accounts for a PLC, current liabilitiesare usually called ‘Creditors: amounts falling duewithin one year’.

Long-term liabilities

Section 4 of the balance sheet contains thosedebts that have to be paid for in more than oneyear’s time, such as a mortgage on companyproperty, debentures or a long-term bank loan.

In the final accounts for a PLC, long-termliabilities are usually called ‘Creditors: amountsfalling due in more than one year’.

Financed by

The final section of the balance sheet shows uswhere the money came from to run the business.In the final accounts for a sole trader this willtypically be capital introduced by the owner andretained profits from previous years of trading.This section will also show the amount that theowner has taken from the business for his or herown use, known as drawings.

Note that there is further detail on the contents ofthe balance sheet in the ‘Fixed and working capital’section of this unit, on page 21, and you would dowell to read that as well for further explanation ofsome of the entries in the balance sheets.


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The balance between assetsand liabilities is vital

You will know if the accounts balance bycomparing the net assets figure with the finalfigure in the ‘Financed by’ section – if they arethe same, the accounts balance. If not, you needto go back and check your working, becausesomething must have gone wrong!

Balance sheet Balance sheet for a sole trader

This follows the example of Jon Anderson,whose business we examined earlier in this unit.

Look back at the trial balance and the trading,profit and loss account for Jon (pages 2 and 8) torefresh your memory. Jon’s balance sheet isshown below.

Study this example carefully so that you are surewhere each of the entries comes from and how allthe calculations are done.

Then practise what you have learned by completingthe following two Practice Points. The first is a lesscomplex task, and the second is more challenging.

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Assets, liabilities and balance sheets

Jon AndersonBalance sheet as at 31.3.06

Accumulated Net bookCost depreciation value

£ £ £Fixed assetsBuildings 0 0 0Equipment 85,000 12,750 72,250Motor vehicles 9,500 1,900 7,600

94,500 14,650 79,850

Current assetsStock 2,350Debtors 3,450Bank 0Cash 275

6,075

Less current liabilitiesCreditors (including VAT owed) 6,250Overdraft 2,920

9,170Working capital –3,095

76,755Less long-term liabilitiesBank loan £28,000Net assets 48,755

Financed byCapitalOpening capital 65,000Add net profit 8,705

73,705Less drawings 24,950

48,755

Total value of current assets(£2,350 + £3,450 + £275)

Total value of current liabilities(£6,250 + £2,920)

Current assets minus currentliabilities (£6,075 – £9,170)

Capital originally put intothe business by the owner(see trial balance)

Total value of fixed assets(£72,250 + £7,600)

Original cost minusdepreciation

Fixed assets plus working capital(£79,850 plus –£3,095)

£76,755 – £28,000

This comes from the bottomof the profit and loss account

This comes from thetrial balance

These are the figuresthat MUST end up thesame for the accountsto balance. If theydon’t, then you havedone something wrong!

Final accounts for a partnership

Partnership balance sheets are constructed slightly differently. Here is the full set of final accounts forSingh and Smith, whom we met briefly on page 10.


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Practice point

Using the trial balance and trading and profitand loss account that you compiled for GurdittaKhan in the previous section (page 9) compilehis balance sheet for the year ending 31 March2006.

Practice point

Using the trial balance and trading and profitand loss account that you compiled for SeanMcGrath in the previous section (page 9),compile his balance sheet for the year ending 31March 2006.

Partnership: Singh & SmithProfit and loss account for year ended 31.3.06

£000s £000s £000sSales 55,250

Less sales returns 3,500Net sales (or turnover) 51,750less cost of goods soldOpening stock 13,500Purchases 11,000

Less purchase returns 500Net purchases 10,500

24,000Less closing stock 13,000Cost of goods sold 11,000Gross profit 40,750Non-operating receipts 1,000

41,750Less expensesAdministration

Rent and rates 3,000Wages 1,750Telephone and postage 100Motor expenses 1,640Advertising 300Sundry expenses 60

DepreciationEquipment 6,100Motor vehicles 1,300 14,250

Net profit 27,500Appropriation accountSalary: Singh 4,000Salary: Smith 1,000Interest allowed on partners’ capital

Singh 10,000Smith 5,600 15,600

6,900Share of remaining profits

Singh 65% 4,485Smith 35% 2,415 6,900

Partnership: Singh & SmithBalance sheet as at 31.3.06

Accumulated

Cost depreciation Net book value

£ £ £

Fixed assets

Equipment 72,500 6,100 66,400

Motor vehicles 18,100 1,300 16,800

90,600 7,400 83,200

Current assets

Stock 13,000

Debtors 23,425

Bank 13,585

Cash 2,120

52,130

Less current liabilities

Creditors 8,300

Overdraft 0

8,300

Working capital 43,830

Net assets 127,030

Financed by

Capital accounts

Singh 79,000

Smith 46,000 125,000

Current accounts Singh Smith

Opening balance 1,500 1,160

Add salary 4,000 1,000

Interest on capital 10,000 5,600

Share of profit 4,485 2,415

19,985 10,175

Less drawings 17,190 10,940

2,795 –765 2,030

127,030

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Original capital put inby each partner

Balances left overfrom last year

£125,000 plus £2,030These figures will be carried forward asopening balances next year. Note thatSmith has drawn out more than he earned!

Sub-totals

You can tell that the accounts balance because the net assets figure equals that at the end of the ‘Financedby’ section: £127,030.

The same figures as inthe appropriation account

£2,795 plus –£765

From trial balance

Final accounts for a limited company

Limited company balance sheets are also constructed slightly differently. Here is the full set of finalaccounts for Makem Limited, the company we were introduced to on page 11.

Makem LimitedProfit and loss account for year ended 31.3.06

£000s £000s £000s

Sales 232,759



Less cost of goods sold


Purchases 167,194



191,689



Gross profit 68,442

Rent received 3,730

72,172

Less expenses

Administration



Insurance 3,422


Debenture interest 900

Director’s fees 15,500

Depreciation

Buildings 0

Equipment 4,000




Profit for tear after tax 6,640

Less interim dividend paid 450




1,740



Add balance of retained profits B/F 0



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Makem LimitedBalance sheet as at 31.3.06

AccumulatedCost depreciation Net book value

£ £ £Fixed assetsBuildings 0 0 0Equipment 13,615 4,000 9,615Motor vehicles 10,250 1,160 9,090

23,865 5,160 18,705

Current assetsStock 29,072Debtors 32,483

less provision for bad debts 032,483

Bank 14,275Cash 1,135

76,965Less current liabilitiesCreditors 18,980Overdraft 0Proposed dividends

preference shares 450ordinary shares 4,000

Corporation tax 3,50026,930

Working capital 50,03568,740

Less long-term liabilities10% debentures 9,000Net assets 59,740

Financed byAuthorised share capital50,000 ordinary shares of £1 each 65,00010,000 8% preference shares of £1 each 12,500

77,500Issued share capital100,000 ordinary shares of 50p each 50,00016,000 9% preference shares of 50p each 8,000

58,000Revenue reservesGeneral reserve 1,500Profit and loss account 240 1,740

59,740

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Once again, you can tell that the accounts balance because the net assets figure equals that at the end ofthe ‘Financed by’ section: £59,740.

Issued sharecapital(£58,000)plus revenuereserves(£1,740)

These comefrom theprofit andloss account

These figuresare forinformationonly, they arenot added into the finalbalance

Issued sharecapital showsthe actualamount ofshare capitalthe firm hasraised

Authorisedshare capitalshows themaximumamount ofshare capitalthe firm wouldbe allowed toissue if itchose to


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Outcome activity 10.2

You are still working as an accounts clerk for a firm of accountants known as Mason, Wright and Partners asin Outcome Activity 10.1 on page 11.

Pass1 Using the details from Outcome Activity 10.1, prepare a balance sheet for Kong Han, not forgetting to

adjust fixed assets for depreciation.

2 You are pleased with the success of the booklet you prepared in Outcome Activity 10.1 and you decide toprepare a further booklet to cover limited company balance sheets. This booklet will also be in three parts.Prepare the first part describing the components of a limited company’s balance sheet.

MeritContinuing the booklet you began for the previous task, explain the components of a limited company’sbalance sheet. You should explain in detail what each of the entries means.

While producing this section of your booklet, it will be helpful to refer to a set of final accounts for a limitedcompany so that you can explain and give examples. To do this you can either use the published set of finalaccounts you used for the first booklet, or alternatively use the following balance for Waters and GilmourLimited, the company you were introduced to in Outcome Activity 10.1.

Waters and Gilmour LimitedBalance sheet as at 31.3.06

AccumulatedCost depreciation Net book value

£ £ £Fixed assetsBuildings 160,000 0 160,000Equipment 50,000 10,000 40,000Motor vehicles 20,000 14,000 6,000

230,000 24,000 206,000Current assetsStock 30,000Debtors 70,000

70,000Bank 7,000Cash 15,000

122,000Less current liabilitiesCreditors 23,000Overdraft 0Proposed dividends

Preference shares 0Ordinary shares 10,000

Corporation tax 20,00053,000

Working capital 69,000275,000

Less long-term liabilities10% debentures 60,000Net assets 215,000

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Fixed and working capital

DistinctionComplete your booklet by analysing the components of the limited company’s balance sheet that you usedin the previous question.

Fixed and workingcapitalIn essence, the fixed capital is the money putinto the business by the owners, and theworking capital is the ready money that isavailable to pay bills; both are essential. If abusiness were compared to a motor car, youmight think of the fixed capital as the engine ofthe car and the working capital as the oil thatkeeps the parts moving. Both are vital to thesmooth running of the vehicle. The engine getsyou going, but the oil keeps you moving; thus thefixed capital of the firm is essential to getting abusiness up and running, but the working capitalis equally important.

If you let your car run out of oil the enginewill seize up and the car will break down,regardless of how good its engine is. Sofixed and working capital work together toensure a smoothly functioning business. Itis true to say that many businesses failbecause the owners or managers payinsufficient attention to working capital needs.

Fixed capital Fixed capital is money or value contributed by theowner(s) of a business. For a sole trader there isjust one owner, but limited companies may havemany shareholders. The figure for fixed capitalmay increase each year if profits are retained.Additional capital can also be raised through

Keeping the engine of business running

Financed byAuthorised share capital300,000 ordinary shares of £1 each 300,000

300,000Issued share capital180,000 ordinary shares of £1 each 180,000

0180,000

Revenue reservesGeneral reserve 3,000Profit and loss account 32,000 35,000

215,000

share issues for a limited company, or with a soletrader by introducing additional money to thebusiness.

At the bottom of a completed set of accounts youwill have seen a section headed ‘Financed by’ – itsometimes carries the heading ‘Capital andreserves’. This section shows all the fixed capitalthat has been introduced into the company by theowners, and also any profit that has beenretained in the business. The entries in thissection comprise the different types of shares andreserves for the company. Here are some of themain ones you are likely to come across.

Share capital

In the case of a limited company, the fixed capitalcomes mainly from shareholders, and there are anumber of different types of shares that may beheld.

Ordinary shares are the most common formof share, and are often referred to as equitycapital. Holders of ordinary shares becomepart owners of the company and because ofthis they are able to vote at general meetingsof the firm. Ordinary shareholders areentitled to receive dividends, which are ashare of the company profits each year. Sinceprofits will vary from year to year, ordinaryshare dividends may rise and fall annually.

Preference shares offer the holder a specificdividend, usually expressed as a percentagereturn. This is a fixed rate of return that willnot change even if the company makes veryhigh profits. Although preferenceshareholders are part owners of the company,they are not allowed to vote at meetings in thesame way as ordinary shareholders can.

Deferred shares are the same as ordinaryshares except that they only receive dividendsin certain circumstances, such as specificlevels of profit being earned, or a particulardate being reached. Sometimes the conditionsof a deferred share require that dividends areonly paid after certain amounts are paid outto ordinary shareholders.


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Partnership/sole trader capital

Partnerships and sole traders do not issue shares,so you will not find any of the above forms offixed capital in their accounts. Instead, the‘Financed by’ or ‘Capital and reserves’ section ofthe balance sheet of a sole trader will simplycontain an entry indicating the amount of moneyhe or she has put into the business, either initiallyor later on during the life of the company. This isnormally entitled ‘Capital’ or ‘Capital Introduced’.Drawings (the amount the sole trader has paidhimself or herself) will also be deducted at thispoint.

Partnerships are dealt with in a similar fashion,except that a separate capital account is requiredfor each of the partners in the balance sheet. Youwill also see current accounts for each of thepartners. The capital accounts are fixed and willalter only if the partner introduces additionalcapital to the business, or takes some out. Thecurrent account changes annually as shares incompany profits and interest on partners’ capitalare added and each partner’s drawings arededucted.

You can see full examples of each of these in the‘Profit and loss accounts’ and ‘Assets, liabilitiesand balance sheets’ sections of this unit.

Share capitalCase study

Examine the published accounts of somelimited companies and identify how many of thedifferent types of shares they have issued. Youmay be able to find copies of such accounts inyour school or college library, or you could visitthe website www.carol.co.uk, which is an on-line database of company accounts in the UK.

What do you think are the advantages ordisadvantages to a company of:

ordinary shares

preference shares

deferred shares?

Retained profit

There is an amount left in the profit and lossaccount of the business after all the expenseshave been paid and this is used in two ways. Someis allocated to dividends (see below) and the reststays in the business as retained profits. Althoughstrictly speaking this retained profit is the owed tothe ordinary shareholders, it is retained in thebusiness for future use.

Over the years retained profits may become a verysignificant part of the ‘Capital and reserves’ or‘Financed by’ section of the balance sheet for alimited company. However, these profits willgradually be used by the company to buy newfixed assets such as machinery and buildings sothat the firm can expand.

The directors of the company have to maintain acareful balance between paying dividends andretaining profit in the business. Paying all of theprofits out in dividends might please theshareholders initially, but in the long term it willhinder the growth potential of the company andthis is likely to reduce the value of the shares onthe stock market, so eventually the shareholders

might see the value of their shares fall. Thereforeboth paying good dividends and retainingsufficient profit for expansion are important tothe shareholders of the company.

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Shareholders expect dividends, but they also want the value of their shares to rise

Dividends

When investors buy shares in a company theyexpect to receive something back for theirinvestment, just as they are paid interest oninvestments in a bank or building society.Dividends are what the shareholders receive –they are a share in the profits of the companyover a six-month or yearly period. Dividends willnormally only be paid if the company makes aprofit, but sometimes the company will draw onreserves from past profits to pay dividends.


Thinking point

Identify the advantages to a firm of usingretained profits to finance the purchase of fixedassets instead of using:

bank loans

debentures

share issue.

Note that dividends do not appear in the ‘Capitaland reserves’ or ‘Financed by’ section of a firm’sbalance sheet; they are an expense to thecompany and therefore they only appear in theprofit and loss account (see the ‘Profit and lossaccounts’ and ‘Assets, liabilities and balancesheets’ sections of this unit for examples).

Working capital Working capital (also known as net current assetsor current capital) measures how much acompany has available to pay bills. Workingcapital is calculated by deducting currentliabilities (those debts that must be paid shortly)from current assets (money that is readilyavailable in the company). This should be apositive figure, otherwise the business may find ithard to meet its debts. You will find the figure forworking capital at the heart of the balance sheet(see the ‘Profit and loss accounts’ and ‘Assets,liabilities and balance sheets’ sections of this unitfor examples).

Note that in the final accounts for a PLC, workingcapital is usually called ‘net current assets’.

Current assets

A firm’s current assets typically comprise thefollowing items:

stock – the total value of raw materials thatwill be made into goods for sale, partlymanufactured items, and also items that havebeen completely made or bought in by thefirm and are available for sale to customers

debtors – the total of all monies owed to thecompany, which is likely to be made up ofcustomers who have received goods but havenot yet paid for them

bank – the total amount of money held in thecompany’s bank account(s)

cash – the total amount of cash held in thetills or cash boxes on the company’s premises.

Current liabilities

Note that in the final accounts for a PLC, currentliabilities are usually called ‘Creditors: amountsfalling due within one year’.

A firm’s current liabilities typically comprise thefollowing items.

Creditors – the total of sums owed to suppliersthat have offered the company credit. When afirm has a good relationship with its suppliers,it is common practice for the supplier to offercredit terms. So the firm may buy rawmaterials but will be asked to pay for them in,say, 28 days’ time. The supplier is therefore acreditor of the firm, as it is owed money thatwill need to be repaid soon. The figure forcreditors may also include corporation tax thatis shortly to be paid.Sums that have to be paid for in more than oneyear’s time are referred to as long-termliabilities, and these are not included in thecurrent liabilities of the firm. Examples of thesemight be a mortgage on company property ora long-term bank loan. These will still appearin the balance sheet but are accounted forseparately from the current liabilities.

Bank overdraft – if the company has drawnout more than it has in its bank account, itwill be running an overdraft. This will need tobe repaid and therefore appears as a currentliability.


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Keeping the business liquid can be a full-time job

Workingcapitalcycle

Cash

Firm purchases rawmaterials

Firm processesraw materials to make

finished products

Stocks of finishedproducts held for a

while before being sold

Firm sells goods,possibly on credit

Customer pays forgoods

Managing working capital using theworking capital cycle

The working capital cycle monitors themovement of cash within the business, and carefulmanagement of the cycle can help a companyimprove its working capital position. In generalterms, the firm’s cash becomes tied up once rawmaterials are purchased and it only becomesavailable again once the finished product is sold.Reducing the period between these two events canrelieve any working capital problems. The cycle fora manufacturing company is shown above.

It is possible to calculate a firm’s working capitalcycle using the following formula:

Stock turnover (the number of days goods are heldin stock)

plus debtor collection period (number of days ittakes debtors to pay)

minus creditor payment period (number of days’credit from suppliers)

equals working capital cycle

It may be that you do not have the information forsuch calculations to hand, in which case theperiods can be calculated from the company’s finalaccounts. In the next section (page 28) you willfind ratios that will help you to calculate these.

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Working capital cycle

Example:

Stock turnover 30 days

+ Debtor collection period 21 days

– Creditor payment period 28 days

Working capital cycle = 23 days

This shows that this firm has its cash tied up for23 days on average. It is difficult to tell whetherthis is good or bad – the firm should compare thisfigure with those of similar companies to seewhether it is better or worse, and also compare itwith the same figure for previous years to seewhether there is a developing trend.

The higher the figure in days, the longer thefirm’s cash is tied up. To improve its workingcapital position the company should try to reducethis figure. There are a number of ways this couldbe achieved:

reduce stocks held, which will speed up stockturnover

encourage debtors to pay more quickly, possiblyby offering shorter credit periods to customers

negotiate longer credit periods from suppliers,giving the firm longer to pay for raw materialspurchased.


received. To improve stock turnover a firmcould review these levels to see whether theycan be adjusted downwards withoutcompromising customer service.

The stock review (maximum stock level)method is where a firm reviews stockperiodically and places orders on each reviewto bring stock levels back up to a maximumlevel. In this case the firm might reviewwhether it is possible to reduce the maximumlevel used and increase the regularity of thereviews.


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Managing working capital using stockcontrol

As we have seen, improving stock control andreducing the stock turnover period can help inimproving a firm’s working capital position. Whatcan a firm do to achieve this? This depends to acertain extent on the stock control method usedby the firm.

The minimum stock level method iswhere a firm identifies the minimum stockthat it requires to satisfy potential customerdemand and reorders once that level is

Under the JIT system, ordering and delivery of stocks must be timed precisely

Thinking point

1 Calculate the working capital cycles for the following four firms.

Firm 1 (days) Firm 2 (days) Firm 3 (days) Firm 4 (days)

Stock turnover 30 3 14 40

Debtor collection period 21 28 0 40

Creditor payment period 28 28 28 7

Working capital cycle

2 What conclusions can you draw about each of the firms?

3 What recommendations would you make to the managers of each of the firms?

The just-in-time method (JIT) is anexcellent method for keeping stocks to aminimum and is often used by supermarketsthat have good computerised stock controlsystems. A JIT system helps the firm keepstocks at a barest minimum level. Thecomputer system generates an order to thesuppliers when stocks are about to run out.The timing of the order is crucial, as the ideais for the new stock to arrive just as the oldstock runs out. This is the best method forkeeping stocks as low as possible, but the firmneeds very reliable systems and suppliers tomake it work. Such a system reduces stocks tohelp working capital.

Managing working capital by managingdebtors

Debtors will not manage themselves, and acompany that does not actively manage itsdebtors runs the risk of failure when the expectedmoney does not arrive quickly enough. Here are afew simple rules that a company may adopt tomanage debtors more effectively.

If in doubt only take cash – unless you areconfident of prompt payment from acustomer, insist on cash. Then you have noworries about prompt payment.

Check creditworthiness of customers –before you offer credit it is a good idea tocheck whether the customer you are selling tohas been a good payer in the past with othercompanies. This could be done by takingreferences from the customer’s bank,inquiring with other firms who haveadvanced the customer credit, or evenmaking inquiries with credit referenceagencies.

Start with a small credit limit – this can beincreased later when the customer has provedto be a good payer.

Keep in regular contact with thecustomer – customers are then less likely toforget to pay you!

Send out invoices promptly – this seemsobvious, but is overlooked by too many firms.In addition, outstanding debts should bechased up promptly and referred to debtcollection when doubt begins.

Don’t supply more to a customer if he orshe has bills overdue for payment – makesure systems are in place to identify suchcustomers so that sales staff do not processfurther orders until the original debts arecleared.

Offer incentives for prompt payment –many firms offer discounts, thus encouragingdebtors to pay quickly.

Penalise late payers – a firm may choose toadd interest to overdue payments. Suchdetails will be included on the originalinvoice.

Do not be afraid to take legal action ifnecessary – often a simple letter from thecompany solicitor may be enough to prompt adebtor into paying, but it is important thatfurther action is taken if this does not provokea response. Remember that you do not wantto appear to be a ‘soft touch’ for your debtors.Napoleon once said ‘You have to shoot ageneral every now and then to encourage theothers’ – and this is not a bad motto for debtcollection!

Manage your cash flow – forecasting cashflow and monitoring those forecasts will alsohelp the firm to manage its working capitalbetter. You can learn more about this in BTECNational Business, in the units ‘BusinessEnterprise’ (see pages 197–205) and‘Finance, Cash Flow and Insolvency’ (seepages 266–281).

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Reviewing businessperformance usingratio analysisYou now know how to compile a set of accounts,but what do they really tell us about the company?The accounts contain many messages for thosewho choose to read them, but the messages arenot all obvious when we first look at them.

When we visit a foreign country we need a phrasebook to help us interpret other languages; we alsoneed some tools to help us interpret the messagesin a set of accounts.

Some messages are very straightforward. Forexample, you should easily be able to identify thetotal profit made in a year by a firm. But what ifyou wanted to know how good an investment afirm was for its shareholders? Or how efficient it isin chasing customers who owe money? Orwhether it keeps costs under control? Or whetherits position is improving or deteriorating?


28

All of this information is available if you knowwhere to look and how to interpret it.

Ratio analysis is the accountant’s phrase book.Armed with a number of simple tools we canmake accurate judgements about the company’sperformance. This section describes some of themost important ratios that you can use. Ratioanalysis is used by many of a firm’s stakeholders,such as:

owners – to inform them when they aremaking decisions about the future of the firm

investors – to check that their investment isdoing well and providing a fair return on theirmoney

suppliers – if they are owed money by thefirm, they will want to know how likely it isthat they will get their money back, and ifthey are asked to supply on credit they canuse the accounts of the firm to decidewhether it is worthy of credit

Outcome activity 10.3You are still working as an accounts clerk for a firm of accountants known as Mason, Wright and Partners asin Outcome Activities 10.1 and 10.2.

PassYour manager is very pleased with the booklets that you produced in the previous two tasks. She hasnoticed that clerks in the company often get confused between fixed capital and working capital, so she asksyou to produce a third booklet outlining what these are. Once again the booklet will have three sections.

Using the accounts for Kong Han and Waters and Gilmour Limited from the previous outcome activities,identify and describe fixed and working capital in the case of these two business organisations.

MeritContinuing the booklet begun in the previous task, you now need to do the following.

1 Explain the differences between fixed capital for a sole trader/partnership and for a limited company,making references to the accounts of Kong Han and Waters and Gilmour Limited.

2 Explain the importance of working capital to these organisations.

DistinctionConclude your booklet by explaining how an organisation should manage its fixed and working capital andthe implications of failing to do so effectively. You may make reference to the accounts of Kong Han andWaters and Gilmour Limited when preparing this section.

employees – individual employees or tradeunions may check the firm’s accounts tomonitor how profitable the firm is andtherefore whether they can request pay risesor improvements in their working conditions

customers – to check that the firm is likely tostay in business and therefore be able to keepsupplying them

tax authorities – to check that the firm ispaying the correct amounts of tax

creditors – such as the bank, which maycheck that the firm is still in a position tomake repayments on loans it has advanced.

Profitability ratios One of the facts that is most important to acompany’s stakeholders is its profitability. Thefollowing ratios help us to monitor the company’sprofit performance.

Return on capital employed (ROCE)

For a sole trader, return on capital employed iscalculated using the following formula:

Net profit × 100 = Percentage returnAverage capital employed

Average capital employed would be calculated byadding together the opening stock and closingstock figures and dividing by two.

For a limited company, the formula would beslightly more complicated, as follows:

Net profit for year before interest and tax × 100 = Capital employed

Percentage return

The phrase ‘capital employed’ here coversordinary share capital + preference share capital+ reserves + debentures/long-term loans.

What does ROCE show?

This shows us the percentage return that theinvestors have received on the capital theyinvested. It is like the interest rate that you wouldreceive on a building society account, andinvestors will often compare the return on capitalemployed to the current rates of interest beingoffered at building societies, to see whether theyare getting a better or worse deal.

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Reviewing business performance using ratio analysis

Making sense of accounts

What does gross profit percentageshow?

This ratio shows how much gross profit is beingmade compared with the amount of sales made.For example, a gross profit percentage of 15%means that £1.50 of gross profit is made fromevery £10 of sales.

It is usual to compare these figures from one yearto the next, and ideally the percentage will stayrelatively stable, showing that the company isremaining stable in its trading. If it changes,especially if the percentage falls, this should beinvestigated and the reasons determined. Adeteriorating percentage could mean, forexample, that purchase costs are increasing orthat sales are falling.

Net profit percentage

Net profit percentage is calculated using thefollowing formula:

Net profit for year × 100Sales for year

In the case of a limited company, for the purposesof this ratio, net profit for the year is profit beforethe deduction of tax and dividends.

What does net profit percentage show?

This ratio is similar to the gross profit percentagebut this time shows how much net profit is beingmade compared with the amount of sales made.For example, a net profit percentage of 5% meansthat 50p net profit is made from every £10 ofsales made by the firm.

It is useful to compare the gross profit percentagewith the net profit percentage as this shows howmuch of gross profit is being taken up by theexpenses of the firm, such as running vehiclesand paying wages and salaries. Ideally the gapbetween the two should decrease over the years asthis would show that the company was workingwell on controlling expenses.

A fall in net profit percentage would indicate thatexpenses were increasing, and this should beexamined to see where the problem lies and whatsteps can be taken to rectify it.


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Return on net assets

Return on net assets is calculated using thefollowing formula:

Net profit for year × 100 = Percentage returnNet assets on net assets

Net assets here is defined as fixed assets + currentassets – current liabilities.

What does return on net assets show?

This is very similar to the ROCE ratio above and isused in the same way. It shows how well a firm isusing its assets to generate profit. Once again apercentage figure is produced, which shows howmuch profit has been earned per pound of assets.A return on net assets of 15% shows that 15phas been earned for every £1 worth of assets.

Gross profit percentage

Gross profit percentage is calculated using thefollowing formula:

Gross profit for year × 100Sales for year

Practice point

The ROCE for a number of companies is asfollows:

Crowther PLC 6%

Chatterjee PLC 4%

Turner PLC 2%

Griffiths Limited 19%

Using the Internet, check the current interestrates offered at two major building societies foraccounts requiring a maximum of four weeks’notice.

1 Which of the above firms are offeringattractive deals to their investors?

2 What other factors would be important whendeciding whether to invest in a buildingsociety or shares in a limited company?

3 What problems might an investor encounter intrying to invest in Griffiths Limited?

Gearing ratios

The gearing ratio is calculated using thefollowing two formulae.

For a sole trader or partnership, the formula is asfollows:

Long-term loans × 100Capital

For a limited company, the formula is as follows:

Preference share capital + Long-term loans and debentures × 100Ordinary share capital + reserves

What do gearing ratios show?

Gearing ratios show how much borrowing thebusiness has in comparison to the amount ofcapital invested by the owners. A gearing ratio of50%, for example, shows that the firm hasborrowed £1 for every £2 invested by the owners.

In a limited company this is of interest to theshareholders, as the lenders are likely to have apreferential claim before the ordinary shareholderson the company’s assets if the business should fail.It therefore gives a measurement of the risk beingborne by the shareholders.

31

The gearing ratio will also be of interest to thecompany’s bankers if they are approached formore lending, as it shows the degree of risk beingborne by the shareholders or owners compared tothe bank. Banks are cautious and do not like tobear more risk than the shareholders or owners,so this may be significant in deciding whether tolend more money to a company.

Price/earnings ratio

The price/earnings ratio is calculated using thefollowing formula:

Market price of ordinary share (in pence)Earnings per ordinary share (in pence)

The market price of ordinary shares needs to beobtained from a publication or website that

Gross profit and net profitCase study

The gross profit percentage and net profit percentage for organisations in different industries will not be thesame, so we should take care about comparing the results. However looking at the results of two firms in thesame industry can be revealing. Consider the following extracts from the accounts of two companies for 2006:

2006 Gross profit Net profit Sales

Walker Brothers Limited 450 100 4,000

Wahid & Co Limited 900 150 12,000

1 Calculate the gross profit percentage and net profit percentage for each of the firms.2 What conclusions can you draw from your results?

Here are the results for the same companies for the previous year:

2005 Gross profit % Net profit %

Walker Brothers Limited 14% 4%

Wahid & Co Limited 7.4% 1.3%

3 What further conclusions can you draw when comparing the 2006 figures with the 2005 figures?


Thinking point

Genesis PLC has a gearing ratio of 75% todaycompared with 50% this time last year.

1 What factors might have caused this change?

2 Consider each of the stakeholders of thecompany. Are there any reasons for concernfor them?

quotes current market prices for quoted shares,such as the Financial Times orwww.londonstockexchange.com.

What does the price/earnings ratioshow?

This ratio compares the price charged for buyingthe share with the amount earned by investors individends from each share. The result of theformula shows the number of years it would taketo repay the investment. For example, with amarket price of £1.50 and earnings per share of10p, the result would be:

150 = 1510

This result of 15 means that it would take 15years to repay the investment, assuming thatearnings per share do not change. Investors willuse this ratio to compare the value of differentpotential investments.

Dividend cover

Dividend cover is calculated using the followingformula:

Net profit after tax and preference share dividendsOrdinary dividends (interim and final)

What does dividend cover show?

This ratio compares the profits earned by thecompany with the amount of dividend it ispaying, and it shows how easy it will be for acompany to make those dividend payments toshareholders – it indicates to investors how safetheir dividend payments are.

Since dividends will only be paid to ordinaryshareholders if profits allow, a high level ofdividend cover indicates that profits would have tofall a long way before the dividends werethreatened. If the result is less than 1, thisindicates that the company will have to useretained profits from previous years to paydividends, and if this were to continue it isunlikely that the company would be able to carryon making dividend payments. A higher resultindicates a safer dividend – a result of 4, forexample, tells the investor that profits are fourtimes the size of dividend payments, andtherefore would have to fall a long way before thecompany would be unable to pay dividends.


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Case study

ABC PLC MNO PLC XYZ PLC

Market price of ordinary share (in pence) 150 600 15

Earnings per ordinary share (in pence) 20 50 10

Net profit £125,000 £725,000 £80,000

Ordinary dividends £20,000 £500,000 £100,000

PE ratio

Dividend cover

Consider the following extract from three companies’ accounts:

1 Complete the table by calculating the price/earnings (PE) ratios and dividend covers for each of thecompanies.

2 Compare the three companies as possible investments. Comment on each of the ratios – compare andcontrast them for each of the companies.

Dividend cover

Productivity ratios Productivity looks at how efficiently a companyis using its factors of production to produceproducts or services, and profit. The followingratios give us an indication of that efficiency.

Stock turnover

Stock turnover is calculated using the followingformula:

Average stock × 365 = Stock turnover in daysCost of goods sold

Average stock is calculated by adding openingstock to closing stock and dividing by two.

What does stock turnover show?

This ratio shows the number of days that anaverage item of stock is held at the company, inother words how long it takes to sell the item. It isdifficult to decide what is a good rate of stockturnover for a business, as the situation isdifferent for firms in different industries. Forexample, a manufacturer of electrical goods mayhold stock for several weeks before it leaves for aretailer, but a supermarket would expect a muchshorter turnover as food items perish quickly. Ingeneral terms, however, businesses will be lookingto reduce the number of stock days whereverpossible. The important things to consider are asfollows.

How does the company’s ratio compare withthose of similar businesses in the sameindustry?

How does the ratio compare with this timelast year? A shorter period than last yearindicates that the company is becoming moreefficient; a longer one implies that the firmneeds to determine why this is happening andcorrect the trend.

Asset turnover

Asset turnover is calculated using the followingformula:

Sales : 1Net assets

Net assets here is defined as fixed assets + currentassets – current liabilities.

What does asset turnover show?

This ratio gives us a measurement of howefficiently the assets of the company are beingused to generate sales for the company. The ratioshould also be compared year on year, and anincreasing ratio would indicate that the companyis working more efficiently. A declining ratiomight suggest that the firm’s efficiency isdeclining, but look at such a result carefully as itcould easily be caused by the recent purchase orrevaluation of fixed assets.

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Supermarkets expect a quick turnover of fresh food items


Debtor collection period

The debtor collection period is calculated usingthe following formula:

Debtors × 365 = Debtor collectionCredit sales for year period in days

If it is not clear how many sales were on credit,the sales figure from the profit and loss accountshould be used.

What does the debtor collection periodshow?

It shows how long it takes on average for debtorsto pay for goods bought on credit. This will bedifferent for businesses in different industries, assome sell on credit more than others. Shops, forexample, do not sell on credit nearly as much astrade suppliers.

You should compare this figure with that ofprevious years to make any sense of the result. Ifthe number of days is increasing, then thecompany’s procedures for chasing debtors oughtto be examined, as this is likely to be having anadverse effect on the company’s cash flow. If thefigure is stable, this suggests that debt collection isunder control. It is also interesting to compare


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this ratio with the following one, the creditorpayment period.

Creditor payment period

The creditor payment period is calculated usingthe following formula:

Creditors × 365 = Creditor payment Credit purchases for year period in days

If it is not clear how many purchases were oncredit, the purchases figure from the profit andloss account should be used.

What does the creditor payment periodshow?

This ratio reveals how long the firm is taking topay for goods it has bought. If this period isincreasing, this implies that either the firm isnegotiating better terms from its suppliers or it ishaving difficulty paying its bills. You may like tocompare the creditor payment period with thedebtor payment period.

If the creditor payment period is greater than thedebtor payment period, the company is gettingbetter terms for buying on credit than it is givingto its customers. This will clearly help cash flow

Practice point

Consider the following extract from a company’s accounts:

2004 2005 2006

Sales 1,002,500 1,052,625 1,042,556

Opening stock 150,000 180,000 189,000

Closing stock 180,000 189,000 196,560

Net assets 1,262,500 1,262,500 1,450,000

Cost of goods sold 880,000 914,000 950,560

Stock turnover

Asset turnover

1 Complete the table by calculating the stock turnover and asset turnover for the company for each ofthe three years.

2 Comment on how the company’s position might be improving or declining as indicated by your calculations.

as money will be received from purchases beforebills have to be paid for supplies.

If the debtor payment period is greater than thecreditor payment period, the situation is not sogood as the firm is allowing longer periods for itscustomers buying on credit than it is receivingfrom its suppliers. This will clearly hinder cashflow as bills for supplies will need to be paid beforemoney is received from sales.

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Solvency ratios As we saw previously, working capital is vital tothe health of a company. The following ratios arecommonly used to measure how solvent the firmis – how easily it can pay its debts.

Current ratio (also known as the workingcapital ratio)

The current ratio is calculated using the followingformula:

Current assets Current liabilities

What does the current ratio show?

This shows the proportion of current assets tocurrent liabilities – how easily the company canraise enough money to pay the debts it has to payin the near future.

If a company had a ratio of 2:1, this wouldsimply mean that it has £2 worth of currentassets for every £1 of current liabilities. A resultof 2:1 is usually considered to be adequateliquidity for most organisations, although acompany dealing mainly in cash may well be ableto survive with a lower ratio.

If the ratio is 3:1 or more, the company shouldquery whether it is managing its current assetswell enough. Such a ratio implies that the firm isholding too much in current assets, so thecomponents of this should be examined. Perhapsit is holding too much stock, or has large sums ofcash sitting idle in the business. In the latter casethe firm should consider finding a productive usefor this cash, rather than letting it sit in the bankaccount producing no revenue.


Practice point


1 Complete the table by calculating the debtor collection period and the creditor collection period for thecompany for each of the three years.

2 Comment on what your results show, and how the company’s position might be improving or declining.

2004 2005 2006

Debtors 15,750 17,325 19,058

Creditors 13,650 14,332 15,049

Credit sales for the year 143,000 150,150 157,658

Credit purchases for the year 100,000 110,000 121,000

Debtor collection period

Creditor collection period

Acid test ratio

The acid test ratio is calculated using thefollowing formula:

Current assets – stockCurrent liabilities

What does the acid test ratio show?

This ratio is very similar to the current ratio,except that the stock figure is omitted. The reasonfor this is that sometimes it is difficult to sell stockquickly and for the anticipated price if the moneyis needed straight away. Consequently it isperhaps unrealistic to rely on stocks to pay thefirm’s debts as they become due. This ratiotherefore shows the readily available assets thecompany could rely on if a creditor insisted onimmediate payment.

If a company had a ratio of 1:1 this would simplymean that the firm has £1 worth of currentassets for every £1 of current liabilities. A resultof 1:1 indicates that the company should nothave a problem paying bills as they become due,


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but if it falls below 1:1, such as 0.9:1, thecompany has fewer liquid assets and this couldcause problems. The lower the ratio, the moreilliquid the firm is and the closer it is toinsolvency. If a firm has a healthy current ratiobut a poor acid test ratio, this suggests that it isholding too much stock.

Analysis of ratios It is important to remember that ratios on theirown are relatively meaningless. It is only whenthey are put into the context of the organisationthat they make any sense. Very often you willneed to do some comparison of ratios to draw anymeaningful conclusions, and this may involve:

comparing one business year on year

comparing the ratio with those of similarbusinesses.

Let us now look at a fully worked example for amanufacturing company, Makem Limited.

Practice point


2004 2005 2006

Current assets 61,425 67,568 74,325

Current liabilities 29,580 33,538 37,227

Stock 28,080 32,292 37,489

Current ratio

Acid test ratio

1 Complete the table by calculating the current ratio and acid test ratio for the company for each of thethree years.

2 Comment on what your results show and on how the company’s position might be improving ordeclining.

Makem LimitedProfit and loss account for year ended 31.3.06

£000s £000s £000s

Sales 232,759



Less cost of goods sold


Purchases 167,194



191,689



Gross profit 68,442

Rent received 3,730

72,172

Less expenses

Administration



Insurance 3,422


Debenture interest 900

Director’s fees 15,500

Depreciation

Buildings 0

Equipment 4,000




Profit for tear after tax 6,640

Less interim dividend paid 450




1,740



Add balance of retained profits B/F 0


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Makem LimitedBalance sheet as at 31.3.06

Accumulated Net book

Cost depreciation value

£ £ £

Fixed assets

Buildings 0 0 0

Equipment 13,615 4,000 9,615

Motor vehicles 10,250 1,160 9,090

23,865 5,160 18,705

Current assets

Stock 29,072

Debtors 32,483

Less provision for bad debts 0

32,483

Bank 14,275

Cash 1,135

76,965

Less current liabilities

Creditors 18,980

Overdraft 0

Proposed dividends


ordinary shares 4,000

Corporation tax 3,500

26,930

Working capital 50,035

68,740

Less long-term liabilities

10% debentures 9,000

Net assets 59,740

Financed by

Authorised share capital

50,000 ordinary shares of £1 each 65,000

10,000 8% preference shares of £1 each 12,500

77,500

Issued share capital

100,000 ordinary shares of 50p each 50,000

16,000 9% preference shares of 50p each 8,000

58,000

Revenue reserves

General reserve 1,500

Profit and loss account 240 1,740

59,740

We can now calculate the ratios for the firm and comment on them.

Makem LimitedRatio analysis year ending 31.3.06

Return on capital employed = £10,140 = 14.75%£59,740 + £9,000

× 100

A return of almost 15% compares very favourably with most other investments, so this suggests thecompany is a good investment.

Return on net assets 14.75%

Details are the same as for return on capital employed.

Gross profit percentage = 68,442 = 29.62%231,059

× 100

A result of over 29% looks very healthy, £29 being earned for every £100 of sales made. However, thisshould be compared with previous years to check that it is not deteriorating.

Net profit percentage = 10,140 = 4.39%231,059

× 100

This result seems rather low, only £4.39 of net profit from every £100 of sales. However, this should becompared with previous years and with similar businesses. There does, though, appear to be a large gapbetween gross and net profit percentages, which could indicate that the company’s expenses are rather high.

Gearing ratio = £8,000 + £9,000 = 32.86%£50,000 + £1,740

× 100

Debt is only 33% of capital invested which does not seem too high. If the percentage were closer to 100%an investor might be worried about the safety of his or her investment should the loans have to be repaid,but in this case there would seem little to worry about.

Price/earnings ratio

This cannot be calculated unless we have a figure for the company’s share price. This is not reported in thecompany accounts.

Dividend cover = 6,640 – 450 – 450 = 1.444,000

A figure of 1.44 does not give high dividend cover – it suggests that profits will not have to fall by a longway before dividends could be under threat. This would be a warning sign for the investor.

Stock turnover = (26,820+29,072) / 2 = 62.73 days162,617

× 365

Almost 63 days to sell stock seems quite a long time, but this is a manufacturing company and lengthystock turnover periods are not rare. It would be helpful to compare this with previous years to check thatthe situation is not deteriorating.

Asset turnover = 231,059 = 3.36:168,740

This is a fairly low figure, but that is to be expected from a manufacturing company which uses a lot of fixedassets. Again we should compare this figure with previous years to check whether the situation is changing.

Debtor collection period = 32,483 = 51.31 days231,059

× 365

Debtors are taking a long time to pay their bills – almost two months on average – so we might concludethat the company is either offering long periods of credit or is not managing its debt collection as well as itmight. This is made worse when we look at the creditor payment period below.

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Creditor payment period = 18,980 = 41.44 days167,194

× 365

An average of 41 days to pay bills suggests that the company has either negotiated good credit terms withsuppliers or is struggling to pay its bills. The company is also having to pay bills 10 days, on average,before it is paid by debtors. This suggests possible cash flow problems.

Current ratio = 76,965 = 2.86:126,930

The current ratio looks reasonably healthy; current assets are nearly three times as much as currentliabilities, so the firm should not find too much difficulty meeting debts that need to be paid in the near future.

Acid test = 76,965 – 29,072 = 1.78:126,930

The acid test also shows a good picture. Even with stocks taken out of the current assets the firm still hassufficient liquid assets to cover its bills, so it seems to be in a liquid position.

It should be noted here that there are significant limitations to the value of the analysis above. The ratiosgive an accurate picture, but only of the company at one specific moment in time. Although we can drawsome conclusions from the results, it would be helpful to put the results into context. For example, how dothe ratio results compare with other companies in the same line of business? A ratio might look good, butcomparison across the industry could reveal that the firm is underperforming.

Equally, it would be useful to compare the results with those for the same company but from previous years.The acid test result of 1.78:1, for example, looks healthy, but how does this compare with last year? Is itimproving or worsening? If the situation were worsening, this would put a very different light on the result.


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Outcome activity 10.4You are still working as an accounts clerk for a firm of accountants known as Mason, Wright and Partners asin Outcome Activities 10.1, 10.2 and 10.3 previously.

PassHaving completed his set of final accounts, Kong Han asks you to make an analysis of them to identify anystrengths and weaknesses of his business. Therefore, using the final accounts that you prepared in OutcomeActivities 10.1 and 10.2 and using appropriate ratios, analyse his trading account, profit and loss accountand balance sheet.

MeritComment on each of the ratios that you calculate, explaining what it shows and identifying the strengthsand weaknesses of the business. Your answer to this task should be presented in the form of a letteraddressed to Mr Han at Kong’s Collectibles, 95 Front Street, Sheffield S2 5PJ.

DistinctionConclude your letter by identifying and explaining the limitations of your ratio analysis to Mr Han. Youshould do the following.

1 Examine each of the ratios you have calculated and critically examine the result that it gives.

2 Explain how reliable you believe the results of each of the ratios are.

3 Explain what Mr Han should do or what other information he would need, to make sure that themessages he gets from the ratio analysis are sufficiently reliable for him to base significant businessdecisions on them.

Key terms

Assetsitems of value held by an organisation includingmoney owed to the firm (debtors)

Balance sheetan overview of a company’s financial position ona particular date, showing its total assets andliabilities

Capitalmoney put into the business by the owner(s) toget it started or to buy equipment

Closing stockthe value of stocks of finished products held inthe business at the end of the year

Company reports and accountsdocuments produced annually by each publiccompany giving details of its financial positionand a summary of the past year’s trading

Corporation taxtax on business profits

Creditorsthe total of sums owed to suppliers who haveoffered the company credit

Current assetsmoney that is readily available in the companyfor paying debts

Current liabilitiesamounts that are owed to suppliers or lendersthat are due to be repaid fairly shortly (normallywithin one year)

Debenturea method for a company to borrow money; abond that pays a fixed rate of interest and isusually secured on the assets of the company

Debtorsthe total of all monies owed to the company

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Deferred sharessimilar to ordinary shares except that dividendsare only paid in certain circumstances, such asat a certain level of profit; they appear in the‘Capital and reserves’ or ‘Financed by’ sectionof the balance sheet

Depreciationthe loss in value of the assets of the firm overtime, due mainly to wear and tear

Dividenda share of company profits received byshareholders every six months or annually; theyappear in the appropriations section of the profitand loss account

Drawingsmoney taken from the business by the owner ora partner for his or her own use

Fixed assetscapital items of value that the firm has boughtand will use for an extended period of time, suchas buildings, machinery, equipment and vehicles

Fixed capitalmoney or value contributed by the owner(s) of abusiness; often used to buy fixed assets for thebusiness

Gearinghow much borrowing the business has incomparison to the amount of capital invested bythe owners

Gross profitthe profit figure at the end of the tradingaccount; the difference between a company’stotal revenue and how much it cost to make theproduct or buy products in – not including thegeneral expenses of the firm

Interim dividendsdividends that are paid part way through acompany’s financial year before final profits arecalculated

Key terms


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Key terms

Just-in-time (JIT)a stock control system where an order isgenerated for new supplies when stocks areabout to run out and is timed so that the newstock arrives just as supplies run out

Liabilitiesmonies that the firm owes

Liquid assets/liquiditymonies immediately available to a company forbusiness use

Long-term liabilitiessums that have to be paid for in more than oneyear’s time, such as a mortgage on companyproperty or a long-term bank loan

Opening stockthe value of stocks of finished products held inthe business at the start of the year

Ordinary sharesthe most common form of share ownership –holders become part owners of the company andmay vote at general meetings of the firm; ordinaryshares appear in the ‘Capital and reserves’ or‘Financed by’ section of the balance sheet

Preference sharesshares that offer the holder a fixed percentagedividend; they appear in the ‘Capital andreserves’ or ‘Financed by’ section of the balancesheet

Productivityhow efficiently a company uses its factors ofproduction to produce products/services and profit

Proposed dividendsdividends paid by the company at the end of thefinancial year, after profits have been calculated

Purchasesfor a manufacturing company, the value of rawmaterials purchased; for a service business, thecost of items bought to sell to customers orused to provide a service to customers

Purchase returnsmoney paid back to the company by supplierswhen it returns items, for whatever reason

Ratio analysismathematical tools used to judge the financialcondition and performance of a company

Reservesprofit that is not distributed to shareholders butis put on one side and may be used forreplacement of capital assets in the future

Retained profitprofits that have not been distributed to theshareholders but are saved to finance futureexpansion of the business; they appear in theappropriations section of the profit and loss account

Sales (or turnover)the total amount of money received in sales forthe year

Sales returnsmoney paid back to customers when they returnitems, for whatever reason

Solvencyhow easily a firm can pay its debts

Stockthe total value of raw materials that will bemade into goods for sale, partly manufactureditems, and also items that have been completelymade or bought in by the firm and are availablefor sale to customers

Stock controlensuring that there is always enough stock tomeet demand from customers but never toomuch, as that ties up money that could be usedfor other purposes in the business

Trading accountthe first of the set of final accounts, showinghow profitably the firm makes goods orprocesses them for sale to customers; itcalculates the gross profit earned

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End-of-unit test1 What is a trial balance and what is it used

for?

2 What is a trading account and how is itconstructed?

3 What is the difference between gross profitand net profit? Where would you find eachof these figures in a set of final accounts?

4 State the two main methods used todepreciate the fixed assets of a company,and using examples explain how each ofthem works.

5 When would you draw up an appropriationaccount and what will it contain?

6 What are reserves, and how are they used?

7 Where does corporation tax appear in a setof limited company final accounts?

8 What is the difference between a firm’sassets and its liabilities? Give examples ofeach.

9 Explain the difference between a firm’sfixed assets and its current assets.

10 How can you tell if a balance sheetbalances?

11 What entries appear in the balance sheet ofa limited company that we would not see inthose of a sole trader?

12 Explain the difference between authorisedshare capital and issued share capital.

13 What is fixed capital and what is workingcapital?

14 Name and describe the different types ofshare capital that a firm may issue.

15 What are dividends, and where will theyappear in a limited company balance sheet?

16 What are liquid assets? Give examples ofthem.

17 What does ‘current liabilities’ mean? Givesome typical examples of current liabilities.

18 What is the working capital cycle of a firm,and how can it be calculated?

19 Explain five methods for managing theworking capital cycle through goodmanagement of debtors.

20 State the formulae for five accounting ratiosand explain their uses.

End-of-unit test

Key terms

Trial balancethe act of totalling all the debit balances and allthe credit balances to confirm that total debitsequal total credits

Working capitalmoney needed for the day-to-day running of thebusiness, calculated by current assets minuscurrent liabilities

Working capital cyclethe movement of cash within the business fromwhen it is paid out to buy raw materials to thetime it comes back in when goods are sold

ResourcesTexts Bendrey, Hussey and West: Accounting and Financein Business 4th Edition, DP Publications, 1996

Cox, D: Business Accounts, Osborne Books, 1999

Glew, Watts, Surridge and Merrills: AdvancedVocational Business, Harper Collins Publishers,2000

Melville, A: Financial Accounting 2nd Edition,Pearson Education, 1999

St John Price, A: Understand Your Accounts 4th

Edition, Kogan Page Limited, 1999

Websites www.statistics.gov.uk The Office for NationalStatistics

www.telegraph.co.uk The Daily Telegraph

http://www.bbc.co.uk/schools/gcsebitesize/business/finance/accountsrev2.shtml BBC Bitesize accountsrevision

http://www.bized.ac.uk/learn/business/accounting/busaccounts/notes/pl.htm Bized, a databank ofknowledge for business students

www.londonstockexchange.com The London StockExchange

www.carol.co.uk Company Annual Reports On-Line; a great source for on-line sets of finalaccounts for UK companies

http://www.bizhelp24.com UK business andfinance information source

http://www.businesslink.gov.uk Business Link, agovernment initiative to support small business


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unit 10 final accounts - pearson schools

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