Assessing performance Using financial data

What are the key questions? What would you want to find out when you look at a company’s accounts?

Balance Sheet Shows the assets (what the business owns) and liabilities (what the business owes) at a particular point in time

Income Statement Shows the income & expenditure, thus profit or loss, of a firm over a period of time (usually a year)

Who uses the accounts? Internal – management accounting External – financial accounting See page 20, table 3.1

Balance Sheet Assets Liabilities Equity (capital) provided by owners Shares or reserves (retained profit)

Assets Non-current are owned for a period of more than 1 year Current are owned for a period of less than 1 year – they circulate in a business on a daily basis and can be expected to turn into cash within one year Assets may be tangible or intangible

Liabilities Current – debts scheduled for repayment within one year Non-current liabilities – debts due for repayment after more than one year Long-term liabilities

capital Two main forms: Share capital (funds provided by shareholders through the purchase of shares) Reserves & retained earnings (those items that arise from increases in the value of the company that are not distributed to shareholders as dividends but are retained for future use by the business)

Why does the balance sheet always balance? Assets = liabilities + equity Page 26, Practice exercise 2

Why a balance sheet? Helps stakeholders assess financial strength of a company Gives picture of overall worth Helps to gain an understanding of the nature of the firm Identifies the liquidity position Shows sources of capital Can compare to earlier balance sheets – identify areas of change

Formulae Current assets = inventories + receivables + cash & other cash equivalents Working capital = current assets – current liabilities Net assets = non-current assets + current assets – current liabilities – non-current liabilities Assets employed = net current assets + non-current assets Capital employed = total equity + non-current liabilities Assets employed = capital employed

Business Expenditure Revenue expenditure Spending on day-to day items, e.g. raw materials, wages, utilities Capital expenditure Spending on non-current (fixed) assets – those used repeatedly in the production process, e.g. buildings, machinery, vehicles

Why is this important? Matching, or accruals concept When calculating profit, any income should be matched to the expenditure involved in creating that income

Prudence Accounting convention that states that accounts should ensure that the worth of the business is not exaggerated What about ‘window dressing’?

Depreciation The fall in value of an asset over time, reflecting the wear and tear of the asset as it becomes older, the reduction in its economic use or its obsolescence Ensures accounts meet principles of accounting: Spreads cost of an asset over the lifetime which it is helping to generate income - affects profit level (income statement) True & fair valuation of a company’s assets (balance sheet)

Straight-line depreciation (also ‘reducing-balance’ depreciation) Annual provision for depreciation = Initial cost – residual value expected lifetime (in years) Warning – based on subjectivity!

Working capital Net current assets (same thing!) Day-to-day finance used in a business Current assets – current liabilities

Rule of thumb Twice as many current assets as current liabilities Why?

Working capital cycle Length = Length of time that goods are held + Time taken for receivables to be paid - Period of credit received from suppliers

Factors influencing level of Working capital Time taken to sell inventories (stocks) Nature of the product Durability of the product Efficiency of suppliers (JIT) Lead time Customer expectations Competition

Factors influencing level of Working capital Time taken by customers to pay for goods: Nature of the market Type of product Bargaining power

Factors influencing level of Working capital Credit period offered by suppliers

Causes of working capital difficulties Failure to control inventory levels Poor control of receivables (debtors) Poor control of payables (creditors) Cash flow problems Poor internal planning & coordination External factors

Solutions?

Solving working capital problems Maintain inventory at lowest practical level JIT Receivables control, e.g. factoring