By Fatskills Exam Guides Team — the exam nerds behind 28,500+ quizzes and 2.1M practice questions across 500+ global exams.
Topics covered: - Accounting conventions and principles - The bookkeeping process - Cash-flow forecasts and statements - Calculating profit - Balancing the books - Finding financial facts - Business ratios Since the advent of the banking crisis (2008), it has become evident that a key aspect of the catastrophic implosion of Lehman Brothers had, in part at least, been brought about by an accounting trick known in the trade as Repo 105. With the approval of their auditors, Ernst & Young (E&Y), Lehman managed to make US $50 billion (£32bn/€66bn) of debt invisible and in effect disappear from its balance sheet. This creative use of accounting is more or less the opposite of how the whole subject of accounting came into being.
Sometime before 3000 BC the people of Uruk and other sister-cities of Mesopotamia began to use pictographic tablets of clay to record economic transactions. The script for the tablets evolved from symbols and provides evidence of an ancient financial system that was growing to accommodate the needs of the Uruk economy. There is detailed evidence that almost every country had some form of record keeping, from China to ancient Rome, where the heads of families maintained daily entry of household receipts and payments in an adversaria or daybook, and monthly postings were made to a cashbook known as a codex accepti et expensi. Accounting is the process of recording and analysing transactions that involve events that can be assigned a monetary value. By definition, financial information can be only a partial picture of the performance of an enterprise. People, arguably a business's most valuable asset, don't appear anywhere in the accounts, except for football clubs and the like where people are the subject of a transaction.
Although accounting has become more complex, involving ever more regulations, and has moved from visible records written in books to key strokes in a software program, the purpose is the same: - to establish what a business owns by way of assets; - to establish what a business owes by way of liabilities; - to establish the profitability, or otherwise, at certain time intervals, and how that profit was achieved. Pacioli, about whom we will hear more in the bookkeeping section below, claimed wisely that 'frequent accounting makes for long friendship'. But accounts must not only be timely, but should be reliable too, and no matter where accounting is studied you can be certain that the general principles will be universally applied.
An MBA is unlikely to be required to perform the recording side of the accounting process. But it is only by knowing how accounts are prepared and the rules governing the categorizing of assets and liabilities that you can gain a good understanding of what the figures really mean. For example, it is not obvious to the uninitiated that a company's shares are classed as a liability and that there is not the remotest possibility that the assets as recorded will realize anything like the figures shown in the accounts. The rules of the game Accounting is certainly not an exact science. Even the most enthusiastic member of the profession would not make that claim. There is considerable scope for interpretation and educated guesswork as all the facts are rarely available when the accounts are drawn up. For example, we may not know for certain that a particular customer will actually pay up, yet unless we have firm evidence that they won't, for example if the business is failing, then the value of the money owed will appear in the accounts. Obviously, if accountants and managers had complete freedom to interpret events as they wished, no one inside or outside the business would place any reliance on the figures, so certain ground rules have been laid down by the profession to help get a level of consistency into accounting information. Fundamental conventions These are the enduring principles that govern the way in which the accounting profession assembles and presents financial information. Money measurement In accounting, a record is kept only of the facts that can be expressed in money terms. For example, the state of the managing director's health and the news that your main competitor is opening up right opposite in a more attractive outlet are important business facts. No accounting record of them is made, however, and they do not show up on the balance sheet, simply because no objective monetary value can be assigned to these facts.
Expressing business facts in money terms has the great advantage of providing a common denominator.
Just imagine trying to add computer equipment and vehicles, together with a 4,000 sq m office, and then arriving at a total. You need a common term to be able to carry out the basic arithmetical functions, and to compare one set of accounts with another. Business entity The accounts are kept for the business itself, rather than for the owner(s), bankers, or anyone else associated with the firm. The concept states that assets and liabilities are always defined from the business's viewpoint. So, for example, were a business owner to lend his business money it would appear in the accounts as a liability, though in effect he might see it as his own money. Anything done with that money, say buying equipment, would appear in the accounts as an asset of the business. The owner's stake is accounted for only by the increase or decrease in net worth of the enterprise as a whole. Cost concept Assets are usually entered into the accounts as the cost at date of purchase. For a variety of reasons, the real 'worth' of an asset will probably change over time. The worth, or value, of an asset is a subjective estimate on which no two people are likely to agree. This is made even more complex, and artificial, because the assets themselves are usually not for sale. So in the search for objectivity, the accountants have settled for cost as the figure to record. It does mean that a balance sheet does not show the current worth or value of a business. That is not its intention. Nor does it mean that the 'cost' figure remains unchanged forever. For example, a motor vehicle costing US $/£/€6,000 may end up looking like Table 1 after two years. TABLE: Example of the changing 'worth' of an asset
The depreciation is how we show the asset being 'consumed' over its working life. It is simply a bookkeeping record to allow us to allocate some of the cost of an asset to the appropriate time period. The time period will be determined by factors such as the working life of the asset. The tax authorities do not allow depreciation as a business expense, so this figure can't be manipulated to reduce tax liability, for example. A tax relief on the capital expenditure, known as 'writing down', is allowed, using a formula set by government that varies from time to time dependent on current economic goals, for example to stimulate capital expenditure. Other assets, such as freehold land and buildings, will be revalued from time to time, and stock will be entered at cost, or market value, whichever is the lower, in line with the principle of conservatism (see later in this guide). Other methods for recording assets While cost at date of purchase is the norm for accounting for assets in conventional enterprises, there are certain types of businesses and certain situations when other methods of recording a monetary figure are used: - Market value: This is usually used when an asset is actually to be sold and there is an established market for that particular type of asset. This could arise when a business or part of a business is to be closed down. - Fair value: This is described as the estimated price at which an asset could be exchanged between knowledgeable but unrelated willing parties who have not, and may not, actually exchange. This basis is often used in the due diligence process, where, because of particular synergies, a price higher than market value (resulting in goodwill) could reasonably be set. - Market to market: This is where market value is calculated on a daily basis, usually by financial institutions such as banks and stockbrokers.
This can result in dramatic changes in value in turbulent market conditions, requiring additional assets, including cash, to be found to cover a fall in market price. This approach is blamed for helping to create liquidity 'black holes' by forcing banks to sell assets to meet liquidity targets, which in turn forces prices lower, requiring yet more assets to be sold. Going concern Accounting reports always assume that a business will continue trading indefinitely into the future – unless there is good evidence to the contrary. This means that the assets of the business are looked at simply as profit generators and not as being available for sale. Look again at the motor vehicle example above. In year 2, the net asset figure in the accounts, prepared on a 'going concern' basis, is US $/£/€3,000. If we knew that the business was to close down in a few weeks, then we would be more interested in the car's resale value than its 'book' value: the car might fetch only £2,000, which is quite a different figure. Once a business stops trading, we cannot realistically look at the assets in the same way. They are no longer being used in the business to help generate sales and profits. The most objective figure is what they might realize in the marketplace. Dual aspect To keep a complete record of any business transaction we need to know both where money came from and what has been done with it. It is not enough simply to say, for example, that a bank has lent a business £1m; we have to show how that money has been used, for example to buy a property, increase stock levels, or in some other way. You can think of it as the accounting equivalent of Newton's third law: 'For every force there is an equal and opposite reaction.' Dual aspect is the basis of double-entry bookkeeping (see below). The realization concept A particularly prudent sales manager once said that an order was not an order until the customer's cheque had cleared, he or she had consumed the product, had not died as a result, and, finally, had shown every indication of wanting to buy again. Most of us know quite different salespeople who can 'anticipate' the most unlikely volume of sales. In accounting, income is usually recognized as having been earned when the goods (or services) are dispatched and the invoice sent out. This has nothing to do with when an order is received, how firm an order is or how likely a customer is to pay up promptly. It is also possible that some of the products dispatched may be returned at some later date – perhaps for quality reasons. This means that income, and consequently profit, can be brought into the business in one period and has to be removed later on. Obviously, if these returns can be estimated accurately, then an adjustment can be made to income at the time. So the 'sales income' figure that is seen at the top of a profit and loss account is the value of the goods dispatched and invoiced to customers in the period in question. The accrual concept The profit and loss account sets out to 'match' income and expenditure to the appropriate time period. It is only in this way that the profit for the period can be realistically calculated. Suppose, for example, that you are calculating one month's profits when the quarterly telephone bill comes in. The picture might look like Table 1.2. TABLE: Example of a badly matched profit and loss account
This is clearly wrong. In the first place, three months' telephone charges have been 'matched' against one month's sales. Equally wrong is charging anything other than January's telephone bill against January's income. Unfortunately, bills such as this are rarely to hand when you want the accounts, so in practice the telephone bill is 'accrued' for. The figure (which may even be absolutely correct if you have a meter) is put in as a provision to meet this liability when it becomes due. Accounting conventions These concepts provide a useful set of ground rules, but they are open to a range of possible interpretations. Over time, a generally accepted approach to how the concepts are applied has been arrived at. This approach hinges on the use of three conventions: conservatism, materiality and consistency. Conservatism Accountants are often viewed as merchants of gloom, always prone to take a pessimistic point of view. The fact that a point of view has to be taken at all is the root of the problem. The convention of conservatism means that, given a choice, the accountant takes the figure that will result in a lower end profit. This might mean, for example, taking the higher of two possible expense figures. Few people are upset if the profit figure at the end of the day is higher than earlier estimates. The converse is never true. Materiality A strict interpretation of depreciation (see above) could lead to all sorts of trivial paperwork. For example, pencil sharpeners, staplers and paperclips, all theoretically items of fixed assets, should be depreciated over their working lives. This is obviously a useless exercise and in practice these items are written-off when they are bought. Clearly, the level of 'materiality' is not the same for all businesses. A multinational might not keep meticulous records of every item of machinery under £1,000. For a small business this may represent all the machinery it has. Consistency Even with the help of those concepts and conventions, there is a fair degree of latitude in how you can record and interpret financial information. You should choose the methods that give the fairest picture of how the firm is performing and stick with them. It is very difficult to keep track of events in a business that is always changing its accounting methods. This does not mean that you are stuck with one method forever. Any change, however, is an important step. The rule makers The accounting professional bodies, with a little prodding from govern-ments, are responsible for ensuring that accounting reports conform to what are known as Generally Accepted Accounting Practices (GAAP). A new entrant, International Accounting Standards, is challenging that term as GAAP rules have been interpreted differently on different continents and indeed largely ignored on others. The rule book has to be adapted to accommodate changes in the way business is done. For example, international business across frontiers is now the norm, so rules on handling currency and reporting taxable profits in different countries have to be accommodated within a company's accounts in a consistent manner. Although an MBA isn't usually expected to know all the rules, you should be able to get up to date before any meetings where the subject is likely to come up. You can keep track of changes in company reporting rules on the websites of the American Institute of CPAs (www.aicpa.org > Publications > Financial Management & Reporting), the Institute of Chartered Accountants (www.icaew.com > Technical resources > Financial reporting > UK GAAP) and the International Financial Reporting Standards (www.ifrs.org > Stay informed). Protecting investors When confidence in US businesses was rocked badly with a series of high-profile financial frauds, Enron and Worldcom for example, the US government introduced the Sarbanes–Oxley Act, known less commonly but better understood as 'The Public Company Accounting Reforms and Investor Protection Act – 2002'. The Act's purpose is to close the loopholes opened up by creative accountants, who are always devising ways to overstate profits and understate liabilities, and so make it easier for shareholders to see how profitable a business really is. The act doesn't just apply to US companies; any businesses with shares listed on a US stock market that does business in the United States is swept into the net. Check out www.sarbanes-oxley.com for the low-down on that Act. The UK version is The Companies (Audit, Investigations and Community Enterprise) Act. You can read up on the UK rules at legislation.gov.uk (www.legislation.gov.uk/ukpga/2004/27/contents). Auditors – the gatekeepers All public companies, that is, those listed on a stock exchange, are required to have an annual audit by a qualified accountant appointed by the directors and approved of by the shareholders. Any company with outside shareholders and indeed all but the smallest private companies are required by law to be audited. The auditors' job is to examine the accounts, ensure that they conform with the prevailing accounting rules and give an opinion about the financial statements. Though the auditors' report may be 50 pages long, with a score or more footnotes, the findings are summarized in a single sentence: 'The financial statements give a true and fair view of the state of affairs of the company at (a certain date) and the financial statements have been properly prepared in accordance with the Companies Act 2006.' The Companies Act 2006(UK), the longest Act ever introduced, has brought in some tough rules on how auditors, among others, should report on company accounts. MBAs, unless they are also accountants, don't get involved in doing audits. But they are expected to know who's who in the auditing world. Accountancy Age (www.accountancyage.com/static/top50-this-year) will keep you informed as to who's who in the auditing world. Bookkeeping – the way transactions are recorded Until Luca Pacioli wrote what was in essence the world's first accounting book, over 500 years ago, accounting records were maintained in single-entry format; one event merited one record. This meant that errors could be prevented only by a major duplication of effort, for example by having different people making and counting up parallel records. Pacioli, a mathematician who worked for the Doge of Venice, came up with a system of double-entry bookkeeping that required two entries for each transaction and so provides built-in checks and balances to ensure accuracy. Each transaction requires an entry as a debit and as a credit. To give an example, selling goods in a double-entry system might result in two separate journal entries – a debit reducing the stock by $/£/€250 and a corresponding credit of $/£/€250 of new cash in – a double entry (see Table 1.3). The debits in a double-entry system must always equal the credits. If they don't, you know there is an error somewhere. So, double entry allows you to balance your books, which you can't do with the single-entry method. TABLE: An example of a double-entry ledger
Pacioli's genius lay in seeing that the ultimate balancing number in a company's accounts was the profit or loss for the owners of that enterprise. In fact he required at least two entries or as many as are required to balance the books. Let us take the above example to its logical conclusion.
On the not unreasonable assumption that the business plans to make a profit from selling goods, the figures will look rather different. To keep the numbers simple, let's suppose the goods they sold cost them $/£/€125 (a 50 per cent margin); then the entries would be as follows. Goods in stock go down by $/£/€125, while cash goes up by $/£/€250. That net change of $/£/€125 is balanced by an increase in profits of $/£/€125, so the assets and liabilities are kept in balance. In this example, had the goods sold for less than was paid there would have been a loss, which would have reduced the value of the owner's stake in the business by a corresponding amount. This is all an MBA student needs to know about bookkeeping; the main part of the knowledge they require is how to interpret the figures once recorded. Cash flow There is a saying in business that profit is vanity and cash flow is sanity. Both are necessary, but in the short term, and often that is all that matters in a business as it struggles to get a foothold in the shifting sands of trading, cash flow is life or death. The rules on what constitutes cash are very simple – it has to be just that, or negotiable securities designated as being as good as cash. Cash flow is looked at in two distinct and important ways: as a projection of future expected cash flows; and as an analysis of where cash came from and went to in an accounting period and the resultant increase or decrease in cash available. Cash-flow forecasts The future is impossible to predict with great accuracy but it is possible to anticipate likely outcomes and be prepared to deal with events by building in a margin of safety. The starting point for making a projection is to make some assumptions about what you want to achieve and test those for reasonableness. Take the situation of High Note, a business being established to sell sheet music, small instruments and CDs to schools and colleges, which will expect trade credit, and members of the public who will pay cash. The owner plans to invest $/£/€10,000 and to borrow $/£/€10,000 from a bank on a long-term basis. The business will require $/£/€11,500 for fixtures and fittings. A further $/£/€1,000 will be needed for a computer, software and a printer. That should leave around $/£/€7,500 to meet immediate trading expenses such as buying in stock and spending $/£/€1,500 on initial advertising. Hopefully customers' payments will start to come in quickly to cover other expenses, such as some wages for bookkeeping, administration and fulfilling orders. Sales in the first six months are expected to be $/£/€60,000 based on negotiations already in hand, plus some cash sales that always seem to turn up. The rule of thumb in the industry seems to be that stock is marked up by 100 per cent, so $/£/€30,000 of bought-in goods sell on for $/£/€60,000. On the basis of the above assumptions it is possible to make the cash-flow forecast set out in Table. It has been simplified and some elements such as VAT and tax have been omitted for ease of understanding. TABLE: High Note six-month cash-flow forecast (£/$/€)
The maths in the table is straightforward; the cash receipts from various sources are totalled, as are the payments. Taking one from the other leaves a cash surplus or deficit for the month in question. The bottom row shows the cumulative position. So, for example, while the business had $/£/€2,450 cash left at the end of April, taking the cash deficit of $/£/€1,500 in May into account, by the end of May only $/£/€950 ($/£/€2,450– $/£/€1,500) cash remains. Overtrading In the example above, the business looks like having insufficient cash, based on the assumptions made. An outsider, a banker perhaps, would look at the figures in August and see that the faster sales grew the greater the cash-flow deficit became. We know, using our crystal ball, the position will improve from September and that if we can only hang on in there for a few more months we should eliminate our cash deficit and perhaps even have a surplus. Had we made the cash-flow projection at the outset and raised more money, perhaps by way of an overdraft, spent less on fixtures and fittings, or set a more modest sales goal, hence needing less stock and advertising, we would have had a sound business. The figures indicate a business that is trading beyond its financial resources, a condition known as overtrading, anathema to bankers the world over. Cash-flow spreadsheet You can do a number of 'what if' projections to fine-tune cash-flow projections using a spreadsheet: Entrepreneur (www.entrepreneur.com/formnet/form/483) has a spreadsheet you can download. Statement of cash flows for the year A cash-flow statement summarizes exactly where cash came from and how it was spent during the year. At first glance it seems to draw on a mixture of transactions included in the profit and loss account and balance sheet for the same period end, but this is not the whole story. Because there is a time lag on many cash transactions, for example tax and dividend payments, the statement is a mixture of some previous year and some current year transactions; the remaining current year transactions go into the following year's cash-flow statement, during which the cash actually changes hands. Similarly, the realization and accrual conventions relating to sales and purchases respectively result in cash transactions having a different timing to when they were entered in the profit and loss account. Example A company had sales of $/£/€5 million this year and $/£/€4 million last year and these figures appeared in the profit and loss accounts of those years. Debtors at the end of this year were $/£/€1 million and at the end of the previous year were $/£/€0.8 million. The cash inflow arising from sales this year is $/£/€4.8 million ($/£/€0.8 million + $/£/€5 million – $/£/€1 million) whereas the sales figure in the profit and loss account is $/£/€5 million. For these reasons it is not possible to look at just this year's profit and loss account and balance sheet to find all the cash flows; you need the previous year's accounts too. The balance sheet will show the cash balance at the period end but will not easily disclose all the ways in which it was achieved. Compiling a cash-flow statement is quite a technical job and some training plus inside information is needed to complete the task. Nevertheless, the bulk of the items can be identified from an examination of the other two accounting statements for both the current and previous years. From an MBA perspective it is understanding the requirement for a cash-flow statement as well as the other two accounts that is important, as well as being able to interpret the significance of the cash movements themselves. XYZ plc The un-audited condensed cash-flow statement for XYZ plc, established as a supplier of container solutions for source-separated waste, is shown in Table 1.5. Initially one man and a desk, the company grew to become a leading supplier of kerbside recycling boxes as well as a key supplier of other types of waste and recycling container solutions. Turnover by 2010 was running at over £30/$47/€34 million a year, with operating profit in excess of £1/$1.6/€1.13 million. TABLE: Un-audited condensed cash-flow statement for XYZ plc (for the 6 months ended 30 June 2011)
The three columns represent the cash activities for two equivalent six-month periods and for the whole of the preceding year. The cash of £2,126 ($3,336/€2,395) thousand generated to 31 December 2010 (bottom of the right-hand column) is carried over to the start of the June 2011 six-month period (second figure from bottom of left-hand column). By adding the net increase (or decrease) in cash generated in this period we arrive at the closing cash position. The cash-flow statement then gives us a complete picture of how cash movements came about: from normal sales activities; the purchase or disposal of assets; or from financing activities. This is an expansion of the sparse single figure in the company's closing balance sheet stating that cash in current assets is £3,751 ($5,886/€4,226) thousand. The income statement/profit and loss account If you look back to the financial situation in the High Note example you will see a good example of the difference between cash and profit. After all, the business has sold $/£/€60,000 worth of goods that it paid only $/£/€30,000 for, so it has a substantial profit margin to play with. While $/£/€39,108 has been paid to suppliers, only $/£/€30,000 of goods at cost have been sold, meaning that $/£/€9,108 worth of instruments, sheet music and CDs are still in stock. A similar situation exists with sales. We have billed for $/£/€60,000 but been paid for only $/£/€48,000; the balance is owed by debtors. The bald figure at the end of the cash-flow projection showing High Note to be in the red to the tune of $/£/€4,908 seems to be missing some important facts. The difference between profit and cash Cash is immediate and takes account of nothing else. Profit, however, is a measurement of economic activity that considers other factors that can be assigned a value or cost. The accounting principle that governs profit is known as the 'matching principle', which means that income and expenditure are matched to the time period in which they occur. (Look back to earlier in this guide where realization and accruals are explained.) So for High Note the profit and loss account for the first six months would be as shown in Table. TABLE: Income statement/profit and loss account for High Note for the six months Apr–Sept
The structure of the income statement/profit and loss statement This account is set out in more detail for a business in order to make it more useful when it comes to understanding how a business is performing. For example, although the profit shown in our worked example is $/£/€8,700, in fact it would be rather lower. As money has been borrowed to finance cash flow there would be interest due, as there would be on the longer-term loan of $/£/€10,000.
In practice we have four levels of profit: - Gross profit is the profit left after all costs related to making what you sell are deducted from income. - Operating profit is what's left after you take away the operating expenses from the gross profit. - Profit before tax is what is left after deducting any financing costs. - Profit after tax is what is left for the owners to spend or reinvest in the business. For High Note this could look much as set out in table. TABLE: High Note extended profit and loss account
A more substantial business than High Note will have taken on a wide range of commitments. For example, as well as the owner's money, there may be a long-term loan to be serviced (interest and capital repayments); parts of the workshop or offices may be sublet, generating 'non-operating income'; and there will certainly be some depreciation expense to deduct. Like any accounting report, it should be prepared in the best form for the user, bearing in mind the requirements of the regulatory authorities.
The elements to be included are: - sales (and any other revenues from operations); - cost of sales (or cost of goods sold); - gross profit – the difference between sales and cost of sales; - operating expenses – selling, administration, depreciation and other general costs; - operating profit – the difference between gross profit and operating expenses; - non-operating revenues – other revenues, including interest, rent, etc; - non-operating expenses – financial costs and other expenses not directly related to the running of the business; - profit before income tax; - provision for income tax; - net income (or profit or loss). Income statement/profit and loss spreadsheet There is an online spreadsheet at SCORE's website (www.score.org/resources/1-year-profit-loss-projection.xls). Download in Excel format and you have a profit and loss account with 30 lines of expenses, the headings of which you can change or delete to meet your particular needs. The balance sheet A balance sheet is a snapshot picture at a moment in time. On the one hand it shows the value of assets (possessions) owned by the business and, on the other, it shows who provided the funds with which to finance those assets and to whom the business is ultimately liable. Assets are of two main types and are classified under the headings of either fixed assets or current assets. Fixed assets come in three forms. First, there are the hardware or physical things used by the business itself and which are not for sale to customers. Examples of fixed assets include buildings, plant, machinery, vehicles, furniture and fittings. Next come intangible fixed assets, such as goodwill, intellectual property etc, and these are also shown under the general heading 'fixed assets'. Finally there are investments in other businesses. Other assets in the process of eventually being turned into cash from customers are called current assets, and include stocks, work in progress, money owed by customers and cash itself.
Total assets = Fixed assets + Current assets Assets can only be bought with funds provided by the owners or borrowed from someone else, for example bankers or creditors. Owners provide funds by directly investing in the business (say, when they buy shares issued by the company) or indirectly by allowing the company to retain some of the profits in reserves. These sources of money are known collectively as liabilities. Total liabilities = Share capital and reserves + Borrowings and other creditors Borrowed capital can take the form of a long-term loan at a fixed rate of interest or a short-term loan, such as a bank overdraft, usually at a variable rate of interest. All short-term liabilities owed by a business and due for payment within 12 months are referred to as creditors falling due within one year, and long-term indebtedness is called creditors falling due after one year. So far in our High Note example, the money spent on 'capital' items such as the $/£/€12,500 spent on a computer and fixtures and fittings have been ignored, as has the $/£/€9,108 worth of sheet music etc remaining in stock waiting to be sold and the $/£/€12,000 of money owed by customers who have yet to pay up. An assumption has to be made about where the cash deficit will be made up, and the most logical short-term source is a bank overdraft.
For High Note at the end of September the balance sheet is set out in Table below. TABLE: High Note balance sheet at 30 September
Balance sheet structure The layout of the balance sheet using UK accounting rules is something of a jumble, with assets and liabilities intermingled. In the United States the balance sheet is traditionally set out horizontally, with the assets on one side and the liabilities and owner's equity, the two sources of funds, on the other (see Table ). TABLE: High Note balance sheet – US style
Working capital You will also have noticed in this example that the assets and liabilities have been jumbled together in the middle to net off the current assets and current liabilities and so end up with a figure for the working capital. 'Current' in accounting means within the trading cycle, usually taken to be one year. Stock will be used up and debtors will pay up within the year, and overdraft being repayable on demand also appears as a short-term liability. There are a number of other items not shown in the working capital section of the example balance sheet that should appear, such as liability for tax and VAT that have not yet been paid, and these should appear as current liabilities. Intangible fixed assets There are a number of seemingly invisible items that nevertheless have been acquired for a measurable money cost and so have to be accounted for: - Goodwill: This is where the price paid for an asset is above its fair market price. This is fairly common in the case of acquisitions where competition for a company can push prices higher. - Intellectual property such as patents, copyright, designs and logos. These items too are amortized over their working life. So, for example, if a patent is considered to have a 10-year life and cost £1 million to acquire, it would be written down in the accounts by $/£/€100,000 a year. Accounting for stock Deciding on the stock figure to put into a balance sheet is a tricky calculation. Theoretically it is simple; after all, you know what you paid for it. The rule that stock should be entered in the balance sheet at cost or market-price, whichever is the lower, is also not too difficult to follow. But in the real world a business keeps on buying in stock so it has product to sell, and the cost can vary every time a purchase is made. Take the example of a business selling a breakfast cereal. Four pallets of cereal are bought in from various suppliers at prices of $/£/€1,000, $/£/€1,020, $/£/€1,040 and $/£/€1,060 respectively, a total of $/£/€4,120. At the end of the period three pallets have been sold, so logically the cost of goods sold in the profit and loss account will show a figure of $/£/€3,060 ($/£/€1,000 + $/£/€1,020 + $/£/€1,040). The last pallet costing $/£/€1,060 will be the figure to put into the balance sheet, thus ensuring that all $/£/€4,120 of total costs are accounted for. This method of dealing with stock is known as FIFO (first in first out), for obvious reasons. There are two other popular costing methods that have their own merits. LIFO (last in first out) is based on the argument that if you are staying in business you will have to keep on replacing stock at the latest (higher) price, so you might just as well get used to that sooner by accounting for it in your profit and loss account. In this case the cost of goods sold would be $/£/€3,120 ($/£/€1,060 + $/£/€1,040 + $/£/€1,020), rather than the $/£/€3,060 that FIFO produces. The third popular costing method is the average cost method, which does what it says on the box. In the above example this would produce a cost midway between those obtained by the other two methods; in this example $/£/€3,090. All these methods have their merits, but FIFO usually wins the argument as it accommodates the realities that prices rise steadily and goods move in and out of a business in the order in which they are bought. It would be a very badly run grocer's shop that sold its last delivery of cereal before clearing out its existing stocks. Methods of depreciation The depreciation is how we show the asset being 'consumed' over its working life. It is simply a bookkeeping record to allow us to allocate some of the cost of an asset to the appropriate time period. The time period will be determined by such factors as how long the working life of the asset is. The principal methods of depreciation used in business are: - The straight-line method: This assumes that the asset will be 'consumed' evenly throughout its life. If, for example, an asset is being bought for £1,200 and sold at the end of five years for £200, the amount of cost we have to write off is £1,000. Using 20 per cent, so that the whole 100 per cent of cost is allocated, we can work out the 'book value' for each year. - The declining-balance method: This works in a similar way, but instead of an even depreciation each year we assume the drop will be less. Some assets, motor vehicles for example, will reduce sharply in their first year and less so later on. So at the end of year 1, both these methods of depreciation will result in a £200 fall, but in year 2 the picture starts to change. The straight-line method takes a further fall of £200, while the declining-balance method reduces by 20 per cent (our agreed depreciation rate) of £800 (the balance of £1,000 minus the £200 depreciation so far), which is £160. - The sum of the digits method: This is more common in the United States than in the UK. While the declining-balance method applies a constant percentage to a declining figure, this method applies a progressively smaller percentage to the initial cost. It involves adding up the individual numbers in the expected life span of the asset to arrive at the denominator of a fraction. The numerator is year number concerned, but in reverse order.
For example, if our computer asset bought for £1,200 had an expected useful life of five years (unlikely), then the denominator in our sum would be 1+2+3+4+5 which equals 15. In year 1 we would depreciate by 5/15 times the initial purchase price of £1,200, which equals £400. In year 2 we would depreciate by 4/15ths and so on. These are just three of the most common of many ways of depreciating fixed assets. In choosing which method of depreciation to use, and in practice you may have to use different methods with different types of asset, it is useful to remember what you are trying to do. You are aiming to allocate the cost of buying the asset as it should apply to each year of its working life. Balance sheet and other online tools SCORE (www.score.org/resources/projected-balance-sheet-template.xls) is an Excel-based spreadsheet you can use for constructing your own balance sheet. You can find guidance on depreciation, on handling stock and on the layout of the balance sheet and profit and loss account as required by the Companies Act from the Accounting Standards Board (www.frc.org.uk > Accounting and Reporting Policy > FRSSE). Accounting Glossary (www.accountingglossary.net) and Accounting for Everyone (www.accountingforeveryone.com > Accounting Glossary) have definitions of all the accounting terms you are ever likely to come across in the accounting world. Package of accounts The cash-flow statement, the profit and loss account and the balance sheet between them constitute a set of accounts, but conventionally two balance sheets, the opening and closing one, are provided to make a 'package'. By including these balance sheets we can see the full picture of what has happened to the owner's investment in the business. Table below shows a simplified package of accounts. We can see from these, that over the year the business has made £600 of profit after tax, and has invested that profit in £200 of additional fixed assets and £400 of working capital such as stock and debtors, balancing that off with the £600 put into reserves from the year's profits. TABLE: A package of accounts
Filing accounts A company's financial affairs are in the public domain. As well as keeping the government tax authorities such as The Internal Revenue Service (IRS) and HM Revenue and Customs (HMRC) informed, companies have to file their accounts with Companies House (www.companieshouse.gov.uk). Accounts should be filed within 10 months of the company's financial year-end. Small businesses in the UK (turnover below £5.6 ($8.8/€6.3) million) can file abbreviated accounts that include only very limited balance sheet and profit and loss account information and these do not need to be audited. Businesses can be fined up to £1,000 ($1,570/€1,127) for filing accounts late. US company accounts can be obtained from The Securities Exchange Commission (www.sec.gov). The Investor Relations Society (www.irs.org.uk > IR Resources > Best Practice Guidelines) makes an award each year to the company producing the best set of report and accounts. Financial ratios The two important financial statements of profit and loss account and balance sheet were examined. To recap – the trading performance of a company for a period of time is measured in the profit and loss account by deducting running costs from sales income. A balance sheet sets out the financial position of the company at a particular point in time, usually the end of the accounting period. It lists the assets owned by the company at that date matched by an equal list of the sources of finance. Reading company accounts, with practice, you can get some insight into a company's affairs. Comparing the current year's figure with the previous year's figure can identify changes in some of the key items, but conclusions drawn from this approach can be misleading. Consider the situation shown in Table below . TABLE: Factors that affect profit performance
You can see that the table is nothing more than a simplified profit and loss account on the left and the assets section of the balance sheet on the right. Any change that increases net profit (more sales, lower expenses, less tax etc), but does not increase the amount of assets employed (lower stocks, fewer debtors etc), will increase the return on assets. Conversely, any change that increases capital employed without increasing profits in proportion will reduce the return on assets. Now let us suppose that events occur to increase sales by $/£/€25,000 and profits by $/£/€1,000 to $/£/€8,910. Superficially that would look like an improved position. But if we then discover that in order to achieve that extra profit new equipment costing $/£/€5,000 had to be bought and a further $/£/€2,500 had to be tied up in working capital (stock and debtors), the picture might not look so attractive. The return being made on assets employed has dropped from 31 per cent (8,910 / 28,910 × 100) to 27 per cent (9,910 / [28,910 + 5,000 + 2,500] × 100). Analysing accounts The main analytical approach is to examine the relationship of pairs of figures extracted from the accounts. A pair may be taken from the same statement, or one figure from each of the profit and loss account and balance sheet statements. When brought together, the two figures are called ratios. Miles per gallon, for example, is a useful ratio for drivers checking one aspect of a vehicle's performance. Some financial ratios are meaningful in themselves, but their value mainly lies in their comparison with the equivalent ratio last year, a target ratio, or a competitor's ratio. Before we can measure and analyse anything about a business's accounts we need some idea of what level or type of performance a business wants to achieve. All businesses have three fundamental objectives in common, which allow us to see how well (or otherwise) they are doing. Making a satisfactory return on investment The first of these objectives is to make a satisfactory return (profit) on the money invested in the business. It is hard to think of a sound argument against this aim. To be satisfactory the return must meet four criteria: - It must give a fair return to shareholders, bearing in mind the risk they are taking. If the venture is highly speculative and the profits are less than bank interest rates, your shareholders (yourself included) will not be happy. - You must make enough profit to allow the company to grow. If a business wants to expand sales it will need more working capital and eventually more space or equipment. The safest and surest source of new money for this is internally generated profits, retained in the business: reserves. (A business has three sources of new money: share capital or the owner's money; loan capital, put up by banks etc; retained profits, generated by the business.) - The return must be good enough to attract new investors or lenders. If investors can get a greater return on their money in some other comparable business, then that is where they will put it. - The return must provide enough reserves to keep the real capital intact. This means that you must recognize the impact inflation has on the business. A business retaining enough profits each year to meet a 3 per cent growth is actually contracting by 1 per cent if inflation is running at 4 per cent. Maintaining a sound financial position As well as making a satisfactory return, investors, creditors and employees expect the business to be protected from unnecessary risks. Clearly, all businesses are exposed to market risks: competitors, new products and price changes are all part of a healthy commercial environment. The sorts of unnecessary risk that investors and lenders are particularly concerned about are high financial risks, such as overtrading. Cash-flow problems are not the only threat to a business's financial position. Heavy borrowing can bring a big interest burden to a small business, especially when interest rates rise unexpectedly. This may be acceptable when sales and profits are good; however, when times are bad, bankers, unlike shareholders, cannot be asked to tighten their belts – they expect to be paid all the time. So the position audit is not just about profitability, but about survival capabilities and the practice of sound financial disciplines. Achieving growth Making profit and surviving are insufficient achievements in themselves to satisfy either shareholders or directors or ambitious MBAs – they want the business to grow too. But they do not just want the number of people they employ to get larger, or the sales turnover to rise, however nice they may be. They want the firm to become more efficient, to gain economies of scale and to improve the quality of profits. Accounting ratios Ratios used in analysing company accounts are clustered under five headings and are usually referred to as 'tests': - tests of profitability; - tests of liquidity; - tests of solvency; - tests of growth; - market tests. The profit and loss account and balance sheet in Tables 1.7 and 1.8 will be used, where possible, to illustrate these ratios.
Tests of profitability There are six ratios used to measure profit performance. The first four profit ratios are arrived at using only the profit and loss account and the other two use information from both that account and the balance sheet. Gross profit This is calculated by dividing the gross profit by sales and multiplying by 100. In this example the sum is 30,000 / 60,000 × 100 = 50 per cent. This is a measure of the value we are adding to the bought-in materials and services we need to 'make' our product or service; the higher the figure the better. Operating profit This is calculated by dividing the operating profit by sales and multiplying by 100. In this example the sum is 8,700 / 60,000 × 100 = 14.5 per cent. This is a measure of how efficiently we are running the business, before taking account of financing costs and tax. These are excluded as interest and tax rates change periodically and are outside our direct control. Excluding them makes it easier to compare one period with another or with another business. Once again the rule here is the higher the figure the better. Net profit before and after tax Dividing the net profit before and after tax by the sales and multiplying by 100 calculates these next two ratios. In this example the sums are 8,100/60,000 × 100 = 13.5 per cent and 6,723/60,000 × 100 = 11.21 per cent. This is a measure of how efficiently we are running the business, after taking account of financing costs and tax. The last figure shows how successful we are at creating additional money to either invest back in the business or distribute to the owner(s) as either drawings or dividends. Once again the rule here is the higher the figure the better. Return on equity This ratio is usually expressed as a percentage in the way we might think of the return on any personal financial investment. Taking the owners' viewpoint, their concern is with the profit earned for them relative to the amount of funds they have invested in the business. The relevant profit here is after interest and tax (and any preference dividends) have been deducted. This is expressed as a percentage of the equity that comprises ordinary share capital and reserves. So in this example the sum is: return on equity = 6,723 / 18,700 × 100 = 36 per cent. Return on capital employed This takes a wider view of company performance than return on equity by expressing profit before interest, tax and dividend deductions as a percentage of the total capital employed, irrespective of whether this capital is borrowed or provided by the owners. Capital employed is defined as share capital plus reserves plus long-term borrowings. Where, say, a bank overdraft is included in current liabilities every year and in effect becomes a source of capital, this may be regarded as part of capital employed. If the bank overdraft varies considerably from year to year, a more reliable ratio could be calculated by averaging the start- and end-year figures. There is no one precise definition used by companies for capital employed. In this example the sum is: return on capital employed = 8,700/18,700 + 10,000 × 100 = 30 per cent. Tests of liquidity In order to survive, companies must also watch their liquidity position, by which is meant keeping enough short-term assets to pay short-term debts. Companies go out of business compulsorily when they fail to pay money due to employees, bankers or suppliers. The liquid money tied up in day-to-day activities is known as working capital, the sum of which is arrived at by subtracting the current liabilities from the current assets. In the case of High Note we have $/£/€21,108 in current assets and $/£/€4,908 in current liabilities, so the working capital is $/£/€16,200. Current ratio As a figure the working capital doesn't tell us much. It is rather as if you knew your car had used 20 gallons of petrol but had no idea how far you had travelled. It would be more helpful to know how much larger the current assets are than the current liabilities. That would give us some idea if the funds would be available to pay bills for stock, the tax liability and any other short-term liabilities that may arise. The current ratio, which is arrived at by dividing the current assets by the current liabilities, is the measure used. For High Note this is 21,108/4,908 = 4.30. The convention is to express this as 4.30 : 1 and the aim here is to have a ratio of between 1.5 : 1 and 2 : 1. Any lower and bills can't be met easily; much higher and money is being tied up unnecessarily. Quick ratio (acid test) This is a belt and braces ratio used to ensure that a business has sufficient ready cash or near cash to meet all its current liabilities. Items such as stock are stripped out as although these are assets, the money involved is not immediately available to pay bills. In effect the only liquid assets a business has are cash, debtors and any short-term investment such as bank deposits or government securities. For High Note this ratio is: 12,000/4,908 = 2.44 : 1. The ratio should be greater than 1 : 1 for a business to be sufficiently liquid. Average collection period We can see that High Note's current ratio is high, which is an indication that some elements of working capital are being used inefficiently. The business has $/£/€12,000 owed by customers on sales of $/£/€60,000 over a six-month period. The average period it takes High Note to collect money owed is calculated by dividing the sales made on credit by the money owed (debtors) and multiplying it by the time period, in days; in this case the sum is as follows: 12,000/60,000 × 182.5 = 36.5 days. If the credit terms are cash with order or seven days, then something is going seriously wrong. If it is net 30 days then it is probably about right. In this example it has been assumed that all the sales were made on credit. Average payment period This ratio shows how long a company is taking on average to pay its suppliers. The calculation is as for average collection period, but substituting creditors for debtors and purchase for sales. Days stock held High Note is carrying $/£/€9,108 stock of sheet music, CDs etc and over the period it sold $/£/€30,000 of stock at cost (the cost of sales is $/£/€30,000 to support $/£/€60,000 of invoiced sales as the mark-up in this case is 100 per cent). Using a similar sum as with average collection period we can calculate that the stock being held is sufficient to support 55.41 days sales (9,108/10,000 × 182.5). If High Note's suppliers can make weekly deliveries then this is almost certainly too high a stock figure to hold. Cutting stock back from nearly eight weeks (55.41 days) to one week (seven days) would trim 48.41 days or $/£/€7,957.38 worth of stock out of working capital. This in turn would bring the current ratio down to 2.68 : 1.
Circulation of working capital This is a measure used to evaluate the overall efficiency with which working capital is being used. That is the sales divided by the working capital (current assets – current liabilities). In this example that sum is: 60,000/16,420 = 3.65 times. In other words, we are turning over the working capital more than three and a half times each year. There are no hard and fast rules as to what is an acceptable ratio. Clearly the more times working capital is turned over, stock sold for example, the more chance a business has to make a profit on that activity. Tests of solvency These measures see how a company is managing its long-term liabilities. There are two principal ratios used here. Leverage/gearing This measures as a percentage the proportion of all borrowing, including long-term loans and bank overdrafts, to the total of shareholders' funds – share capital and all reserves. The gearing ratio is sometimes also known as the debt/equity ratio. For High Note this is: (4,908 + 10,000) / 18,800 = 14,908/18,800 = 0.79 : 1. In other words, for every $/£/€1 the shareholders have invested in High Note they have borrowed a further 79p. This ratio is usually not expected to exceed 1 : 1 for long periods. Interest cover This is a measure of the proportion of profit taken up by interest payments and can be found by dividing the annual interest payment into the annual profit before interest, tax and dividend payments. The greater the number, the less vulnerable the company will be to any setback in profits, or rise in interest rates on variable loans. The smaller the number, the more risk that level of borrowing represents to the company. A figure of between 2 and 5 times would be considered acceptable. Tests of growth These are arrived at by comparing one year with another, usually for elements of the profit and loss account such as sales and profit. So, for example, if next year High Note achieved sales of $/£/€100,000 and operating profits of $/£/€16,000 the growth ratios would be 67 per cent, that is, $/£/€40,000 of extra sales as a proportion of the first year's sales of $/£/€60,000; and 84 per cent, that is, $/£/€7,300 of extra operating profit as a percentage of the first year's operating profit of $/£/€8,700. Some additional information can be gleaned from these two ratios. In this example we can see that profits are growing faster than sales, which indicates a healthier trend than if the situation were reversed. Market tests This is the name given to stock market measures of performance. Four key ratios here are: The after-tax profit made by a company divided by the number of ordinary shares it has issued. The market price of an ordinary share divided by the earnings per share. The PE ratio expresses the market value placed on the expectation of future earnings, ie the number of years required to earn the price paid for the shares out of profits at the current rate. The percentage return a shareholder gets on the 'opportunity' or current value of their investment. The number of times the profit exceeds the dividend; the higher the ratio, the more retained profit to finance future growth. Other ratios There are a very large number of other ratios that businesses use for measuring aspects of their performance such as: - sales per £ invested in fixed assets – a measure of the use of those fixed assets; - sales per employee – showing if your headcount is exceeding your sales growth; - sales per manager, per support staff etc – showing the effectiveness of overhead spending. Failure prediction Unsurprisingly the financial crisis has inspired an interest in whether or not financial ratios can be used as indicators of business failure. A study in 2012 by a research analyst from the FT Group, which was published in the International Research Journal of Finance and Economics, set out to identify appropriate analytical tools to predict factors that could lead to failure in good time for preventative measures to be taken. The study employed financial information for a group of 50 distressed and 50 non-distressed UK listed companies during the period 2000–2010. The study looked at the three most popular failure prediction models and concluded that although the multiple discriminant analysis (MDA) model as used in Altman's Z-Score achieved a lower percentage of overall correct failure prediction (an average of 68.9 per cent all three years and 80 per cent for cumulative three years), it resulted in slightly higher overall percentage in the first year prior to failure. The Altman Z-Score (www.creditguru.com/CalcAltZ.shtml) uses a combined set of five financial ratios derived from eight variables from a company's financial statements linked to some statistical techniques to predict a company's probability of failure. Entering the figures into the on-screen template at this website produces a score and an explanatory narrative giving a view on the business's financial strengths and weaknesses. You can read up on the alternative ways to predict business failure in the article 'Predicting Corporate Failure of UK's Listed Companies: Comparing Multiple Discriminant Analysis and Logistic Regression' (http://connection.ebscohost.com/c/articles/78308524/predicting-corporate-failure-UKS-listed-companies-comparing-multiple-discriminant-analysis-logistic-regression). Some problems in using ratios Finding the information to calculate business ratios is often not the major problem. Being sure of what the ratios are really telling you almost always is. The most common problems lie in the four following areas. Which way is right? There is natural feeling with financial ratios to think that high figures are good ones, and an upward trend represents the right direction. This theory is, to some extent, encouraged by the personal feeling of wealth that having a lot of cash engenders. Unfortunately, there is no general rule on which way is right for financial ratios. In some cases a high figure is good, in others a low figure is best. Indeed, there are even circumstances in which ratios of the same value are not as good as each other. Look at the two working capital statements in Table below . TABLE: Difficult comparisons
The amount of working capital in each example is the same, $/£/€16,410, as are the current assets and current liabilities, at $/£/€23,100 and $/£/€6,690 respectively. It follows that any ratio using these factors would also be the same. For example, the current ratios in these two examples are both identical, 3.4 : 1, but in the first case there is a reasonable chance that some cash will come in from debtors, certainly enough to meet the modest creditor position. In the second example there is no possibility of useful amounts of cash coming in from trading, with debtors at only $/£/€100, while creditors at the relatively substantial figure of $/£/€6,600 will pose a real threat to financial stability. So in this case the current ratios are identical, but the situations being compared are not. In fact, as a general rule, a higher working capital ratio is regarded as a move in the wrong direction. The more money a business has tied up in working capital, the more difficult it is to make a satisfactory return on capital employed, simply because the larger the denominator the lower the return on capital employed. In some cases the right direction is more obvious. A high return on capital employed is usually better than a low one, but even this situation can be a danger signal, warning that higher risks are being taken. And not all high profit ratios are good: sometimes a higher profit margin can lead to reduced sales volume and so lead to a lower ROCE (return on capital employed). In general, business performance as measured by ratios is best thought of as lying within a range, liquidity (current ratio), for example, staying between 1.2 : 1 and 1.8 : 1. A change in either direction represents a cause for concern. Accounting for inflation Financial ratios all use pounds as the basis for comparison: historical pounds at that. That would not be so bad if all these pounds were from the same date in the past, but that is not so. Comparing one year with one from three or four years ago may not be very meaningful unless we account for the change in value of the pound. One way of overcoming this problem is to adjust for inflation, perhaps using an index, such as that for consumer prices. Such indices usually take 100 as their base at some time in the past, for example 2000. Then an index value for each subsequent year is produced showing the relative movement in the item being indexed. Apples and pears There are particular problems in trying to compare one business's ratios with another. A small new business can achieve quite startling sales growth ratios in the early months and years. Expanding from £10,000 sales in the first six months to £50,000 in the second would not be unusual. To expect a mature business to achieve the same growth would be unrealistic. For Tesco to grow from sales of £10 billion to £50 billion would imply wiping out every other supermarket chain. So some care must be taken to make sure that like is being compared with like, and allowances made for differing circumstances in the businesses being compared (or if the same business, the trading/economic environment of the years being compared). It is also important to check that one business's idea of an account category, say current assets, is the same as the one you want to compare it with. The concepts and principles used to prepare accounts leave some scope for differences. Seasonal factors Many of the ratios that we have looked at make use of information in the balance sheet. Balance sheets are prepared at one moment in time, and reflect the position at that moment; they may not represent the average situation. For example, seasonal factors can cause a business's sales to be particularly high once or twice a year, as with fashion retailers, for example. A balance sheet prepared just before one of these seasonal upturns might show very high stocks, bought in specially to meet this demand. Conversely, a look at the balance sheet just after the upturn might show very high cash and low stocks. If either of those stock figures were to be treated as an average it would give a false picture. Getting company accounts It will be very useful to look at other comparable businesses to see their ratios as a yardstick against which to compare your own business's performance. For publicly quoted and larger businesses whose accounts are audited this should not be too difficult. However, for smaller private companies the position is not quite so simple. In the first place, small companies need only file an abbreviated balance sheet. Even medium-sized businesses can omit turnover from the information filed on their financial performance. Only public companies listed on a stock market and larger companies have to provide full financial statements, though in many cases even the smallest companies choose to provide comfort to suppliers and potential employees.
Despite the limitation, it is still possible to glean some valuable information on financial performance using these sources:
Examples:
- Companies House (www.companieshouse.gov.uk) is the official repository of all company information in the UK. You can use WebCHeck to purchase a company's latest accounts giving details of sales, profits, margins, directors, shareholders and bank borrowings at a cost of £1 per company. - Credit reports. - FAME (Financial Analysis Made Easy) is a powerful database that contains information on 3.4 million companies in the UK and Ireland. - Key Note (www.keynote.co.uk) operates in 18 countries, providing business ratios and trends for 140 industry sectors and sufficient information to assess accurately the financial health of each industry sector. . - London Stock Exchange's website (www.londonstockexchange.com). - Proshare (www.proshareclubs.co.uk > Research Centre > Performance Tables) is an Investment Club website, which, once you have registered, which you can do for free, has a number of tools that crunch public company ratios for you. S. - Precision IR (www.precisionir.com) has direct links to several thousand public companies' 'Report and Accounts' online, so you can save yourself the time and trouble of hunting down company websites. Ratio analysis spreadsheets Many wesites have have free tools that calculate financial ratios from your financial data. They also provide useful introductions to ratio analysis as well as defining each ratio and the formula used to calculate it. At least by entering this you don't need to register on the Harvard website to be able to download their spreadsheet. Break-even analysis A tool for making cost, volume, pricing and profit decisions Break-even is a technique that straddles several business disciplines. Marketeers use it for pricing, economists borrow it for demand curves and accountants use it for costing purposes. Break-even analysis had started to appear by 1962 (Break-Even Analysis: Its Uses and Misuses, by Howard F Stettler, 1962, American Accounting Association). But most managers still have barely heard of this tool and those who have don't know how to use it. This gives the MBA a powerful edge and allows them to muscle into decisions that are normally the prerogative of those several pay grades higher and in different departments to boot!
Working out the cost of making a product or delivering a service and consequently how much to charge doesn't seem too complicated. At first glance the problem is simple. You just add up all the costs and charge a bit more. The more you charge above your costs, provided the customers will keep on buying, the more profit you make. Unfortunately as soon as you start to do the sums the problem gets a little more complex. For a start, not all costs have the same characteristics. Some costs, for example, do not change however much you sell. If you are running a shop, the rent and rates are relatively constant figures, completely independent of the volume of your sales. On the other hand, the cost of the products sold from the shop is completely dependent on volume. The more you sell, the more it costs you to buy in stock. You can't really add up those two types of costs until you have made an assumption about volume – how much you plan to sell. Look at the simple example above. Until we decide to buy, and we hope sell, 1,000 units of our product, we cannot total the costs. With the volume hypothesized we can arrive at a cost per unit of product of: Total costs ÷ Number of units = £/$/€3,500 ÷ 1,000 = £/$/€3.50
Now, provided we sell out all the above at £/$/€3.50, we shall always be profitable. But will we? Suppose we do not sell all the 1,000 units, what then? With a selling price of £/$/€4.50 we could, in theory, make a profit of £/$/€1,000 if we sell all 1,000 units. That is a total sales revenue of £/$/€4,500, minus total costs of £/$/€3,500. But if we only sell 500 units, our total revenue drops to £/$/€2,250 and we actually lose £/$/€1,250 (total revenue £/$/€2,250– total costs £/$/€3,500). So at one level of sales a selling price of £/$/€4.50 is satisfactory, and at another it is a disaster. This very simple example shows that all those decisions are intertwined. Costs, sales volume, selling prices and profits are all linked together. A decision taken in any one of these areas has an impact on the other areas. To understand the relationship between these factors, we need a picture or model of how they link up. Before we can build up this model, we need some more information on each of the component parts of cost. The components of cost Understanding the behaviour of costs as the trading patterns in a business change is an area of vital importance to decision makers. It is this 'dynamic' nature in every business that makes good costing decisions the key to survival and provides the MBA with a wealth of opportunities to demonstrate their skills and knowledge. The last example showed that if the situation was static and predictable, a profit was certain, but if any one component in the equation was not a certainty (in that example it was volume), then the situation was quite different. To see how costs behave under changing conditions we first have to identify the different types of cost. Fixed costs Fixed costs are costs that happen, by and large, whatever the level of activity. For example, the cost of buying a car is the same whether it is driven 100 miles a year or 20,000 miles. The same is also true of the road tax, the insurance and any extras, such as a stereo system or navigator. In a business, as well as the cost of buying cars, there are other fixed costs such as plant, equipment, computers, desks and answering machines. But certain less tangible items can also be fixed costs, for example, rent, rates, insurance, etc, which are usually set quite independent of how successful – or otherwise – a business is. Costs such as most of those mentioned above are fixed irrespective of the timescale under consideration. Other costs, such as those of employing people, while theoretically variable in the short term, in practice are fixed. In other words, if sales demand goes down and a business needs fewer people, the costs cannot be shed for several weeks (notice, holiday pay, redundancy, etc). Also, if the people involved are highly skilled or expensive to recruit and train (or in some other way particularly valuable) and the downturn looks a short one, it may not be cost effective to reduce those short-run costs in line with falling demand. So viewed over a period of weeks and months, labour is a fixed cost. Over a longer period it may not be fixed. We could draw a simple chart showing how fixed costs behave as the 'dynamic' volume changes. The first phase of our cost model is shown in Figure above. This shows a static level of fixed costs over a particular range of output. To return to a previous example, this could show the fixed cost, rent and rates for a shop to be constant over a wide range of sales levels. Once the shop owner has reached a satisfactory sales and profit level in one shop, he or she may decide to rent another one, in which case the fixed costs will 'step' up. This can be shown in the variation on the fixed cost model in Figure below. FIGURE: Cost model 1: showing fixed costs FIGURE: Variation on cost model 1: showing a step up in fixed costs Variable costs These are costs that change in line with output. Raw materials for production, packaging materials, bonuses, piece rates, sales commission and postage are some examples. The important characteristic of a variable cost is that it rises or falls in direct proportion to any growth or decline in output volumes. We can now draw a chart showing how variable costs behave as volume changes. The second phase of our cost model will look like Figure below. There is a popular misconception that defines fixed costs as those costs that are predictable, and variable costs as those that are subject to change at any moment. The definitions already given are the only valid ones for costing purposes. FIGURE: Cost model 2: showing behaviour of variable costs as volume changes Semi-variable costs Unfortunately not all costs fit easily into either the fixed or variable category. Some costs have both a fixed and a variable element. For example, a mobile phone has a monthly rental cost which is fixed, and a cost per unit consumed over and above a set usage rate which is variable. In this particular example low consumers can be seriously penalized. If only a few calls are made each month, their total cost per call (fixed rental + cost per unit ÷ number of calls) can be several pounds. Other examples of this dual-component cost are photocopier rentals, electricity and gas. These semi-variable costs must be split into their fixed and variable elements. For most small businesses this will be a fairly simple process, nevertheless it is essential to do it accurately or else much of the purpose and benefits of this method of cost analysis will be wasted. Bringing both fixed and variable costs together we can build a costing model that shows how total costs behave for different levels of output (Figure). FIGURE: Cost model showing total costs and fixed costs So any company capturing a sizeable market share will have an implied cost advantage over any competitor with a smaller market share. That cost advantage can then be used to make more profit, lower prices and compete for an even greater share of the market or invest in making the product better and so stealing a march on competitors. By starting the variable costs from the plateau of the fixed costs, we can produce a line showing the total costs. Taking vertical and horizontal lines from any point in the total cost line will give the total costs for any chosen output volume. This is an essential feature of the costing model that lets us see how costs change with different output volumes: in other words, accommodating the dynamic nature of a business. It is to be hoped that we are not simply producing things and creating costs. We are also selling things and creating income. So a further line can be added to the model to show sales revenue as it comes in. To help bring the model to life, let's add some figures, for illustration purposes only. Figure below shows the break-even point (BEP). Perhaps the most important single calculation in the whole costing exercise is to find the point at which real profits start to be made. The point where the sales revenue line crosses the total costs line is the break-even point. It is only after that point has been reached that a business can start to make a profit. We can work this out by drawing a graph, such as the example in the figure, or by using a simple formula. The advantage of using the formula as well is that you can experiment by changing the values of some of the elements in the model quickly. FIGURE: Cost model showing break-even point The equation for the BEP is: This is quite logical. Before you can reach profits you must pay for the variable costs. This is done by deducting those costs from the unit selling price. What is left (usually called the unit contribution) is available to meet the fixed costs. Once enough units have been sold to meet these fixed costs, the BEP has been reached.
Let's try the sum out, given the following information shown on the break-even chart: Now we can see that 5,000 units must be sold at £/$/€5 each before we can start to make a profit. We can also see that if 7,000 is our maximum output we have only 2,000 units available to make our required profit target. Obviously, the more units we have available for sale (ie the maximum output that can realistically be sold) after our break-even point, the better. The relationship between total sales and the break-even point is called the margin of safety. Margin of safety This is usually expressed as a percentage and can be calculated as shown in Table 1.13. Clearly, the lower this percentage, the lower the business's capacity for generating profits. A low margin of safety might signal the need to rethink fixed costs, selling price or the maximum output of the business. The angle formed at the BEP between the sales revenue line and the total costs line is called the angle of incidence. The size of the angle shows the rate at which profit is made after the break-even point. A large angle means a high rate of profit per unit sold after the BEP. TABLE: Calculating a margin of safety
Meeting profit objectives By adding in the final element, desired profits, we can have a comprehensive model to help us with costing and pricing decisions. Supposing in the previous example we knew that we had to make £/$/€10,000 profit to achieve a satisfactory return on the capital invested in the business, we could amend our BEP formula to take account of this objective: Putting some figures from our last example into this equation, and choosing £/$/€10,000 as our profit objective, we can see how it works. Unfortunately, without further investment in fixed costs, the maximum output in our example is only 7,000 units, so unless we change something the profit objective will not be met. The great strength of this model is that each element can be changed in turn, on an experimental basis, to arrive at a satisfactory and achievable result. Let us return to this example. We could start our experimenting by seeing what the selling price would have to be to meet our profit objective. In this case we leave the selling price as the unknown, but we have to decide the BEP in advance (you cannot solve a single equation with more than one unknown). It would not be unreasonable to say that we would be prepared to sell our total output to meet the profit objective.
So the equation now works out as follows: Moving the unknown over to the left-hand side of the equation we get: We now know that with a maximum capacity of 7,000 units and a profit objective of £/$/€10,000, we have to sell at £/$/€5.86 per unit. Now if the market will stand that price, then this is a satisfactory result. If it will not, then we are back to experimenting with the other variables. We must find ways of decreasing the fixed or variable costs, or increasing the output of the plant, by an amount sufficient to meet our profit objective. Negotiating special deals Managers are frequently laid open to the temptation of taking a particularly big order at a 'cut-throat' price and it is the MBA's role to make sure that however attractive the proposition may look at first glance, certain conditions must be met before the order can be safely accepted. Let us look at an example – a slight variation on the last one. Your company has a maximum output of 10,000 units, without any major investment in fixed costs. At present you are just not prepared to invest more money until the business has proved itself. The background information is:
The break-even chart will look like this.
FIGURE: Break-even chart for special deals
The managers you are advising are fairly confident that they can sell 7,000 units at £/$/€5.86 each, but that still leaves 3,000 units unsold – should they decide to produce them. Out of the blue an enquiry comes in for about 3,000 units, but a strong hint is given that nothing less than a 33 per cent discount will clinch the deal. What should you recommend? Using the costing information assembled so far, you can show the present breakdown of costs and arrive at your selling price.
As all fixed costs are met on the 7,000 units sold (or to be sold), the remaining units can be sold at a price that covers both variable costs and the profitability contribution, so you can negotiate at the same level of profitability, down to £/$/€4.43, just under 25 per cent off the current selling price. However, any selling price above the £/$/€3.00 variable cost will generate extra profits, but these sales will be at the expense of your profit margin. A lower profit margin in itself is not necessarily a bad thing if it results in a higher return on capital employed, but first you must do the sums. There is a great danger with negotiating orders at marginal costs, as these costs are called, in that you do not achieve your break-even point and so perpetuate losses. Dealing with multiple products and services The examples used to illustrate the break-even profit point model were fairly simple. Few if any businesses sell only one product or service, so a more general equation may be more useful to deal with real world situations. In such a business, to calculate your break-even point you must first establish your gross profit. This is calculated by deducting the money paid out to suppliers from the money received from customers. For example, if you are aiming for a 40 per cent gross profit, expressed in decimals as 0.4, your fixed costs are £/$/€10,000 and your overall profit objective is £/$/€4,000, then the sum will be as follows: So, to reach the target you must achieve a £/$/€35,000 turnover. (You can check this out for yourself: look back to the previous example where the BEPP was 7,000 units and the selling price was £/$/€5 each. Multiplying those figures out gives a turnover of £/$/€35,000. The gross profit in that example was 2/5, or 40 per cent, also.)
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