FINANCIAL ACCOUNTING

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• FINANCIAL ACCOUNTING

LECTURE TWO
Syamarlah Rasaratnam BSc. MAcc. MSc.
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Profit Loss items

• Sales revenue / Turnover
• Cost of goods sold
• Gross profit
• Operating expenses
• Operating profit
• Interest and Taxation
• Net profit
• Dividend
• Retained profit

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Profit and Loss account for Mr. Ballow for the
year ended 31 December 2000
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Balance Sheet - Assets

• Land
• Buildings
• Equipment

Fixed Assets
Stocks Debtors Prepayments Cash
Current Assets
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Balance Sheet - Liability

• Trade Creditors
• Corporation tax
• Bills payable
• Salaries due

Short term liability lt 1 year
Bank loan Debenture
Long term liability gt 1 year
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Balance Sheet - Shareholders fund

• Share capital
• Retained profit

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Mr. Bollow Balance Sheet as at 31 December
2000 Fixed Assets Land
5,000 Buildings 29,700 Equipment
9,600 Total Fixed Assets 44,300
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Mr. Bollow Balance Sheet as at 31 December
2000 (cont) Current Assets
Stock 7,000 Debtors
3,000 Prepayments 1,500 Cash
15,150 Total current Assets 26,650
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Mr. Bollow Balance Sheet as at 31 December
2000 (cont) Less Current Liability Trade
Creditors 2,500 Corporation
Tax 5,400 Bills payable 200 Salaries
due 1,300 Total current Liability
9,400
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Mr. Bollow Balance Sheet as at 31 December
2000 (cont) Net Current Assets (CA -
CL) 17,250 Less Long term Liabilities Bank
Loan 19,500 Net Total Asset
(NCA FA - LTL) 42,050
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Mr. Bollow Balance Sheet as at 31 December
2000 (cont) Financed by Shareholders
Fund 13,000 Retained profit 29,050
42,050
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Example 1

• Which of the following is most profitable company
• Co A Co B
• Profit 200 1000
• Net Assets 500 10000
• Return 40 10

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Example 2

• Was there an increase or decrease in
  profitability from one year to the next?
  Year1 Year2
• Profit 900 1,000
• Net Assets 8,000 10,000
• Return 11.25 10

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Ratio Analysis

• Investment
• Div. Yield
• Div. Cover
• EPS
• PE
• Capital Gearing
• Profitability
• Return on Capital employed
• Gross profit
• Mark-up
• Net profit

• Liquidity
• Current Asset
• Acid Test
• Efficiency
• Stock turnover
• FA turnover
• Trade debtor collection period
• Trade Creditors payment period

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Investment and Risk

• Dividend yield
• Annual ordinary dividend .
• Market value of ordinary share
• Measures annual return on investment
• Between 2 and 5
• Misleading factors
• Risk factor
• Different dividend policy

X 100
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Investment and Risk

• Dividend cover
• Profit after tax and preference dividends .
  
• Annual ordinary dividend
• Measures how likely the company will be able to
  maintain future dividends
• Normally about 2
• Measure of risk

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Investment and Risk

• Earnings per share (EPS)
• Profit after tax and preference dividends .
  
• Number of ordinary shares
• Measure of financial performance
• Shows growth/decline of financial performance
• Not advisable to compare between companies

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Investment and Risk

• Price earning ratio (P-E)
• Market price of each ordinary share
• Earnings per share
• Between 10 and 25
• Measure of risk
• Reflection of the expected earning growth
• Low -gt decline
• High -gt growth

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Investment and Risk

• Return on Equity (ROE)
• Profit after tax and preference dividends
• Shareholders interest (excluding pref.shr)
• Return on investment -gt evaluate profitability
• Indicates how efficiently and effectively a
  companys management has utilised the
  shareholders wealth
• Can be used to compare other companies

X 100
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Investment and Risk

• Gearing
• Relationship between equity and debt
• High gearing .. Debt gt Equity
• Low gearing Debt lt Equity
• Measures of Gearing
• Debt/Equity ratio
• Gearing ratio

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Investment and Risk

• Debt/Equity ratio
• Debt capital
• Equity capital

X 100

• Gearing Ratio
• Debt capital .
• Debt capital Equity capital

X 100
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Investment and Risk

• The effect of gearing
• Measure of financial risk
• Increase in profit
• high geared -gt High EPS
• Low geared -gt Low EPS
• Disadvantages of Gearing
• High gearing not healthy
• Low

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Illustration of the effects of gearing page 11
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Example

• The director of Harvest plc are proposing to pay
  a dividend of 35p per share for the year ended
  31/08/00. The market price for shares at this
  date was 1.75. The capital of the company
  comprises 1 million 1 ordinary shares and the
  net profit after taxation for 2000 was 500,000.
  Calculate
• Earning per share
• Price earning ratio
• Dividend yield
• Dividend cover

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Answer

• EPS 500,000/1,000,000 50p
• PE 175p/35p 3.5 years
• DY 35p/175p 20
• DC 500,000/350,000 1.4 times

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Break for 30 minutes
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Announcements

• Assignment group -gt if you are not in a group
  then please see me at L207 (2.15 to 5.05 Tuesday)
• Tutorial group attendance is compulsory
• Exam 7 March 2001 2.15 to 5.15 in Diamond
• ACF110C2B
• BSc Business with computing
• BSc Retail Management
• HND Business with computing
• BSc Computing option modules

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Measure of companys performance

• Return on Capital Employed
• Profit margin
• Asset turnover ratio

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Measures of performance

• Return on Capital Employed (ROCE)
• Profit before tax .
• Net capital employed
• Net capital employed shareholders interest
  long term liability
• Total Assets Current Liability
• Measure of profitability -gt how efficiently and
  effectively a company utilise the assets/capital

X 100
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Measures of performance

• Net Profit margin
• Profit before tax and interest
• Turnover/sales
• of sales revenue is profit.
• Diff. Industry has diff. Profit margin
• Comparison gt companies of same industry and size
• Variation due to -gt changes in sales mix, selling
  prices and/or unit costs

X 100
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Measures of performance

• Asset turnover ratio
• Turnover/sales
• Net capital employed
• Sales revenue generated per of capital employed
• Labour intensive -gt high ratio
• Capital intensive -gt low ratio
• Differences due to gt under capacity, labour
  inefficiency, overstocking
• Comparison -gt same industry

X 100
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The nature of solvency and liquidity

• Solvency -gt ability to pay the debt when it is
  due
• Liquidity -gt Ease with which an asset can be
  turned into cash without loss

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Measures of solvency and liquidity

• Working capital/current ratio
• Liquidity/quick ratio OR acid ratio

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Measures of solvency and liquidity

• Working capital/current ratio
• Current Assets
• Current Liabilities
• The extent to which current liabilities are
  covered by current assets.
• Between 1.5 and 2

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Measures of solvency and liquidity

• Liquidity/Quick ratio OR Acid Ratio
• Current Assets - stocks
• Current Liabilities
• Stock not liquid current asset
• Better measure then working capital
• At least 1 -gt depends on the company
• Eg. Retailers lt1 because they have high turnover
  of stock

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The prediction of insolvency

• Altman (1968) in the USA and Taffler (1982) in
  the UK suggest that corporate bankruptcy can be
  predicted two or three years in advance in about
  95 of cases.

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The appraisal of working capital

• Working capital current assets and current
  liabilities
• The appraisal identify whether there is too much
  or too little is invested in working capital
• Indicators of the effectiveness of credit control
  and stock control

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Measures of the control of working capital

• Debtors ratio
• Creditors ratio
• Stock turnover

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Measures of solvency and liquidity

• Debtors ratio
• Trade debtors
• Turnover
• Normal -gt 45 75 days
• If high compared to similar company or increasing
  overtime indicates inadequate credit control
  procedures

X 365
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Measures of solvency and liquidity

• Creditors ratio
• Trade creditors
• Purchases/COS
• If high compared to similar company or increasing
  overtime indicates delaying payment to its
  creditors
• May affect the credit rating

X 365
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Measures of solvency and liquidity

• Stock turnover ratio
• Cost of sales .
• Stock of finished goods
• Shows the number of times the company sells its
  average stock during the year.
• If high compared to similar company or increasing
  overtime indicates inadequacy in stock control

X 365
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Limitations of ratio analysis

• Different accounting policies results in
  misleading comparisons
• Historical cost data distorts comparison
• Surrogate data may have to be used
• Performance criteria/yardsticks are not
  appropriate for all types of industries

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Limitations of ratio analysis

• Current economic climate, type of industry and
  the circumstances including management policies
  are not reflected in the ratio analysis
• Single ratio provide limited information, but a
  group of related ratios gives a general picture
  of the performance or financial position of the
  company