Notesale: Turn your study into money

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Chapter 3: Using Financial Data to Measure and Assess Financial Performance
Company accounts
- The two key financial documents kept by firms are the balance sheet and the income statement
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- They can also be used to assess potential, particularly when trend analysis is used to estimate
future performances based on recent history
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Purposes and users of company accounts
- Accounting information serves many purposes and these depend on who is using the accounts
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Employees
Employees can assess the security of their employment and the ability of
the firm to provide them with reasonable wages by examining the
financial position of the firm
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Invariably, the financial benefits to owners and investors are
closely related to the financial success of the business
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In addition, UK
firms collect some taxes, such as VAT and the income tax payments from
their employees, and pass them to the tax authorities
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Competitors
Competitors are able to compare their performance against rival
companies and benchmark their performances
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Suppliers
Suppliers want information about a firm’s financial situation before
agreeing supply materials
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Closer scrutiny may help the supplier to identify the
sort of payment terms that are being offered to other suppliers
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Business
customers want to establish whether it is advisable for them
to draw up long-term supply contracts with this company
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The local council may need to modify it housing or road-building
plans if a local firm is getting into financial difficulties and is likely to close
down or reduce staff
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Investors would be considered external users if they are considering
whether to invest in a business but have not yet invested
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- Lists resources it owns (assets) and the amount owed to others (liabilities)
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- Equity provided by either the purchase of shares OR agreement to allow the company to retain
or ‘plough back’ profit into the business know as reserves, rather than using it to pay further
dividends to shareholders
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- CURRENT ASSETS tend to be owned for less than one year
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- Main intangible asset is goodwill, which includes the value of a firm’s brand names, patents and
copyrights
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- Examples of current assets are inventories (stocks), receivables (debtors), cash and other cash
equivalents (mainly bank balance and cash)
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If they are
damaged, past sell by date or gone out of fashion, their value is reduces
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Liabilities
- NON-CURRENT LIABILITIES are long-term and are due for repayment after 1 year
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- Long term: debentures are fixed interest loans with a repayment set a long time in the future
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- Long-term liabilities must be repaid, but mean a company does not have to issue more shares to
raise funds to purchase fixed assets
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- In the balance sheet traders and suppliers are combined under the description ‘trade and other
payables’
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- Reserved and retained earnings: items that usually arise from increases in the value of the
company, which are not distributed to shareholders as dividends, but are retained by the business
for future use
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Purposes of the balance sheet
- Balance sheets allow the net value of a company to be calculated by working out the total assets
and subtracting the total liabilities
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Useful balance sheet formulae
- Current assets: inventories + receivables + cash and any other cash equivalents

- Working capital: current assets – current liabilities
- Net assets: non-current assets + current assets – current liabilities – non-current liabilities
- Net assets: non-current assets + working capital – non-current liabilities
- Assets employed: net current assets + non-current assets
- Capital employed: total equity + non-current liabilities
- Assets employed = capital employed

Capital expenditure, revenue expenditure and depreciation
Classifying business expenditure
- Can be classified as either revenue expenditure or capital expenditure
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- Revenue expenditure: - wages and salaries to employees
- office consumables such as stationery and ink cartridges
- operating expenses such as power and fuel
- marketing expenditure
- raw materials and inventories
- rental payments
Capital expenditure: - freehold property/ extensions to premises
- machinery for production purposes
- office equipment and furniture
- vehicles
The significance of the distinction between capital and revenue expenditure
- Accountants follow certain agreed principles
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This states that, when calculating a
firm’s profit, any income should be matched to the expenditure involved in creating that income
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- This means a firm must be careful and therefore slightly pessimistic in estimating the value of its
assets
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Depreciation
Causes of depreciation
- Time
- Use
- Obsolescence i
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changes in technology
- Calculating time over which an asset should be depreciated:
- Straight line method: annual provision for depreciation:
initial cost – residual value / expected lifetime (years)
The purposes of depreciation
- used to ensure the accounts meet principles of accounting
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- BALANCE SHEET: shows reduction in an asset’s value over its lifetime
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The
calculation itself is based on both facts (objectivity) and opinions (subjectivity)
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Cash outflow to purchase raw
materials (delayed if credit
terms are provided to supplier)
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THE WORKING CAPITAL CYCLE

Cash outflow to fund
production of finished
goods
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-The length of the working capital can be calculated by studying: inventories, receivables and
payables
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Factors influencing the level of working capital
The time taken to sell inventories (stocks)
- the nature of the product
- the durability of the product
- the efficiency of suppliers
- lead time
- customer expectation
- competition
The time taken by customers to pay for goods
- nature of the market
- the type of product
- bargaining power
Causes of working capital difficulties
Failure to control inventory levels
- worsens a firm’s working capital position
- a business must balance this factor against the dangers of running out of inventories and upsetting
customers
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External factors
- unforeseen changes
Solving working capital problems
Inventory capital
- should be maintained at a low level, as this mean that less money is tied up in inventories
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- However, offering credit may help to increase sales
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- Managing credit control so customers are invoiced and reminded promptly chasing up late
payers and being prepared to take receivables to court if necessary obtaining a credit rating
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- A company can turn its receivables into cash by factoring i
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selling debts owed by receivables to
another company, usually at a discount
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- Shows profit (or loss) made by the business
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Final accounts allow
the firm to assess the success of its policies
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- Enables people to see if profit is high quality
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- Companies Act required firms to publish their income statement
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- Comparisons can be made between firms to measure relative performance
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- Comparisons can be made over time within the business to assess effectiveness of divisions/
branches
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Structure of the income statement
Revenue and cost of sales
Expenses
- Calculates operating profit
- Takes gross profit and deducts costs not directly linked to producing product/service
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- Profit before tax is shown
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- Shows how much profit is attributable to shareholders
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Reasons for the structure of the income statement
- First section allows a business to see how efficiently it is turning materials into sales revenue
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- The last section gives an indication of how much the business borrows and lends money, and the
efficiency with which it handles these financial operations
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- Usually published for a period of a year, but it is not unusual for firms to publish 6 months or 3
months income statements
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- When analysing accounts, profit is used to assess performance, so it is vital to know if there are any
unusual, exceptional or one-off circumstances that are affecting the accounts in the year being
studied
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- Some shareholders rely on dividend payment as a source of income
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Retained profits
- To fund expansion plans and capital investments
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- Increases assets of the business therefore increasing the value of a company
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Using financial data for comparisons, trend analysis and decision making
- When using financial data to analyse a company’s situation it is best to consider data that: 1
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Have been compiled over a period of time
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Comparisons
Intra-firm comparisons
- Comparisons should be made from similar areas of the company
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- Income statement: enable organisations to ascertain which branches are generating the most
profit
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- Balance sheet
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- Income statement
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Comparisons to a standard
- Certain levels of performance recognised as efficient within a business community
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- Balance sheet: how liquidity compares to the standard of the industry
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Comparisons over time: trend analysis
- Register trends in efficiency and allow for exceptional circumstances in a particular year
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Assessing strengths and weaknesses of financial data in judging performance
- Based on the accuracy of the data as a measure of:
- current performance
- potential performance
Strengths of financial data in judging performance
- Balance sheet has been designed to provide data that allows people to judge a company’s
performance
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It can help to:
- calculate profit levels of a firm
- assess whether it is worth buying shares in the business
- note if profit is of high quality
- see if profit is being utilised in a sensible way
- Since 2005, published accounts have to conform to IFRS (International Financial Reporting
Standards)
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- IFRS riles indicate certain format for publication of accounts of PLCs
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- Published accounts must be checked by independent auditors
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Weaknesses of financial data in judging performance
- IFRS do not cover LTDs, which constitute the majority of companies in the UK
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- Different accounting methods may be employed
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- Accounts only show what has happened, not why
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- Firms may manipulate accounts to provide a favourable view (window dressing) e

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