HSC Business Studies 2008 Topic 2-4 Financial Statements Using Financial Information

The Accounting Framework The accounting framework consists of the way in which a business processes raw transactions data, stores it and then summarises it into a meaningful and acceptable way. Output from the accounting process is reported and communicated to interested parties. Accurate financial information is essential to making good and informed business and management decisions.

Raw Data (collection of transactions data) Data processed and stored (recorded and classified) Accounting reports compiled Analysis and interpretation of reports

The key financial statements used by a business organisation are: 1.Revenue Statements (profit and loss statements) 2.Balance Sheets 3.Statements of Cash Flow

The Revenue Statement (Statement of Financial Performance) The Revenue Statement shows the operating profitability – ie. Expenses incurred and revenue earned over a particular period of time. Hence, it will show whether the business made a profit or loss over this time period. The revenue statement shows operating expenses and operating revenue. By examining figures from previous revenue statements, managers can make comparisons and analyse trends before making financial decisions. The revenue statements will reveal: 1.Whether expenses are increasing, decreasing or constant 2.Why profits have increased/decreased or why losses were incurred 3.Areas of significant change in cost centres or sources of revenue.

The Balance Sheet (Statement of Financial Position) The Balance Sheet shows a business organisation’s assets and liabilities at a point in time and represents the net worth of the business to the owners (owner’s equity, capital, owner’s funds, proprietorship, share capital, proprietorship etc). It is prepared at the end of an accounting period and shows: 1.Assets – what is owned by the business 2.Liabilities – what is owed by the business, claims against assets other than the claims of the owners 3.Owner’s Equity – owner’s financial stake in the business or net worth. Accounting Equation: OE = A-L Owner’s Equity = Assets – Liabilities

Financial Ratios Financial statements, which summarise the activities of a business over a period of time, have to be analysed if they are to provide useful information. Analysis of accounts means working the financial data contained in them into useful forms. It involves comparing similar items in the revenue statement and balance sheet, comparing results with previous years and identifying trends, gauging key relationships such as debt to equity, profit to turnover, rate of accounts receivable turnover, ratio of current assets to current liabilities, return on owner’s equity etc.

Ratios are one of the main tools used to analyse financial information and they shed light on important questions such as profits/lossess, solvency, liquidity, efficiency, growth, return on equity etc. The main types of ratios come under the following headings: 1.Profitability 2.Liquidity 3.Solvency 4.Efficiency

Profitability: relationship between profit and sales. (i) Gross profit ratio = Gross Profit Sales (ii) Net profit to sales = Net Profit Sales (iii) Return on owner’s equity = Net Profit Owner’s Equity

2. Liquidity: ability to meet short-term financial commitments as they fall due. Current (working capital) Ratio = Current Assets Current Liabilities

3. Solvency: Ability to pay long-term debt as it falls due. Debt to Equity Ratio = Total Liabilities Owner’s Equity

4. Efficiency: management of assets to generate profits (i) Expenses ratio= Expenses Sales (ii) Accounts receivable turnover = Sales Accounts Receivable

Financial ratios are one of the main tools used to analyse financial information. Comparative ratio analysis is used for comparing the business performance: –Over time – compare with past performance –Inter-firm, i.e. between similar businesses –Against industry standards

Limitations of financial reports Accounting PracticeLimitation Historical CostTrue value of assets may be understated or overstated. Value of intangibles (licences, trademarks, brand names, intellectual property, goodwill) No uniform method for valuing these, especially goodwill.