Managing Finance and Budgets Lecture 2 Financial Statements (1)

Session 2 - Financial Statements (1)  Learning outcomes: Understand the role and limitations of financial statements in relation to SMEs, VCOs and large organisations. Manipulate and use financial statements to inform decision- making in situations typically found in SMEs/VCOs.  Key concepts: » Cash versus Profit »Capital/Revenue expenditure »Depreciation »Profit & Loss Account/Balance Sheet »Accounting conventions

Session 2 – Structure Section  AFinancial Terms  BFinancial Statement  CProfit & Loss Account  DThe Balance Sheet  EAccounting Standards and Conventions

Section A Financial Terms

Some Financial Terms  Turnover - total value of sales over a given period - sometimes called Income or Revenue  Cost - the amount of actual or notional expenditure incurred on or attributable to a specified thing or activity (fixed, variable, direct, indirect )  Creditors - suppliers of goods and services whose invoices are still outstanding for payment  Debtors - customers who owe the organisation money  Assets - items which the organisations OWNS  Liabilities - things which the organisation OWES

Some Financial Terms  Accrued expenses - any amount which the organisation owes for expenses already consumed but for which a bill has not been yet received or paid.  Pre-paid expenses - goods or services which have been paid for in advance  Bad debt - a debt which is unlikely to be paid by the customer  Book-keeping - the recording of monetary transactions in sufficient detail to enable its accuracy to be checked, and so that the relevant summarised information can be extracted.

Section B Financial Statements

Financial Statements  To measure the Cash in and Cash out of the organisation over a given period of time – Cash-Flow Statement  To measure profit generated over a specific period of time - Profit & Loss Account = breakdown of all incoming and outgoing finance for a given period, finishing with overall profit or loss.  To measure the accumulated wealth at a specific point in time - Balance Sheet = a “snapshot” of the financial position of the organisation, balancing Assets against Capital and Liabilities.  Financial Statements usually show at least 2 years to allow comparison

Financial Statements - Example  You decide to run a soft drinks stand at a car boot sale to earn some extra money. You borrow £50 from a friend and you buy 200 cans of lemonade at 20p per can. It costs you £5 entry fee, and on the first day you sell 150 of your cans at 50p each.  Produce a Cash-Flow Statement, Profit & Loss Account and Balance Sheet for the one day of operation.

Cash-Flow Statement - a Challenge Create a ‘back-of-the envelope’ cash-flow Statement for the drinks stall. HINTS You need to document everything that happened in the order that it happened. You start with nothing. What do you end up with?

Example Cash-Flow Statement Opening Balance: £ 0 Loan:£ 50+ Goods purchased:£ 40- (200 x 20p) Entry Fee:£ 5- Cash received:£ 75+ (150 x 50p) Closing Balance:£ 80

Profit & Loss Account - a Challenge Create a ‘back-of-the envelope’ profit & loss account for the drinks stall. HINTS What money has been paid to you? What money have you paid out? Your profit is the first lot of money minus the second.

Example Profit & Loss Account Sales: £ 75 (150 x 50p) Cost of Sales:£ 30 (150 x 20p) Gross Profit: £ 45 Entry Fee:£ 5 Net Profit: £ 40

Balance Sheet - a Challenge Create a ‘back-of-the envelope’ balance sheet for the drinks stall. HINTS What assets have you? (in this case: cash, stock) What liabilities have you? ( in this case: loan, profits*) Do these balance? *NB The owners of the company (i.e. you) are liable to take their money away and spend it!

Example Balance Sheet Assets: Cash: £ 80 Stock: £ 10 (50 x 20p) Total: £ 90 Liabilities: Loan outstanding:£ 50 Retained profits:£ 40 Total:£ 90

Section C The Profit & Loss Account

The Profit and Loss Account  During the next series of slides we will see an example of a ‘real’ Profit and Loss account, and we will analyse this to see what exactly is happening.  Before we do this, we need to understand:  the difference between cash and profit  the difference between capital and revenue costs  the idea of depreciation

Cash Versus Profit  In accounting terms, to calculate Profit (or Loss) Sales Income must be matched against relevant expenditure for a given period  Some goods may be purchased on credit, some sales may be sold on credit  Some purchases may have a useful life which lasts longer than the given period  Therefore Profit in accounting terms is NOT equivalent to Cash in less cash out during that period

Capital & Revenue Costs  Capital Costs are incurred in purchasing assets  Revenue Costs are incurred in delivering the goods or services and operating the company  Capital Costs are not charged directly to the Profit & Loss Account. They are reflected in a depreciation charge over their useful life.  Accounting profit = Revenue Income less Revenue Expenditure - Capital expenditure is only deducted from Accounting profit through depreciation  To “capitalise” an item means to treat it as capital expenditure

Depreciation  Depreciation is the method used to spread the cost of a purchase over a number of time periods  Two main methods used:  Straight-line depreciation = Cost of item divided by number of years over which it is to be written off  Reducing balance = Current value x Depreciation%  Depreciation is shown in the Profit & Loss Account as an Overhead

Depreciation calculation Purchase of a piece of equipment costing £10,000 Straight-line over 5 years Reducing balance at 30% Written down Written down Depreciation Value Depreciation Value Year 1 £ 2,000 £ 8,000 £ 3,000 £ 7,000 Year 2 £ 2,000 £ 6,000 £ 2,100 £ 4,900 Year 3 £ 2,000 £ 4,000 £ 1,470 £ 3,430 Year 4 £ 2,000 £ 2,000 £ 1,029 £ 2,401 Year 5 £ 2,000 £ 0 £ 720 £ 1,681 Year 6 £ 0 £ 0 £ 504 £ 1,176

Sample Profit & Loss Account The next slide shows a profit and loss account for a company over a one-year period. The format varies according to the type of business, but there is a fairly uniform convention to structure the accounts in the following way: ExpenditureIncome Item 1 Item 2 Item 3 etc

Turnover (Sales) (Income)£ 100,000} Cost of Sales (Direct Costs)} Materials£10,000} Trading Transport£ 5,000} Account Labour£15,000} Total Cost of Sales £ 30,00030%} Gross Profit (Gross Margin)£ 70,00070%} Overheads (Indirect Costs) Administrative salaries£18,000 Advertising£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due£10,000 Profit after tax & interest£ 30,00030% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 8,0008%

Turnover (Sales) (Income)£ 100,000} Cost of Sales (Direct Costs)} Materials£10,000} Trading Transport£ 5,000} Account Labour£15,000} Total Cost of Sales £ 30,00030%} Gross Profit (Gross Margin)£ 70,00070%} Overheads (Indirect Costs) Administrative salaries£18,000 Advertising£ 5,000 Rent & Rates£ 4,000 Total Overheads Operating Profit (Net Margin) Interest on loans£ 3,000 Profit before tax Corporation tax due£10,000 Profit after tax & interest Dividends payable£22,000 Retained Profit (Earned Surplus) £ 8,0008% The first part of the account is usually concerned with the total amount of income and working out the Gross Profit. This is called the Trading Account

Turnover (Sales) (Income) Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030%} Gross Profit (Gross Margin)£ 70,00070%} Overheads (Indirect Costs) Administrative salaries£18,000 Advertising£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due£10,000 Profit after tax & interest£ 30,00030% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 8,0008% The next part of the account is usually concerned with the indirect costs and working out the Net Profit.

Turnover (Sales) (Income)£ 100,000} Cost of Sales (Direct Costs)} Materials£10,000} Trading Transport£ 5,000} Account Labour£15,000} Total Cost of Sales Gross Profit (Gross Margin) Overheads (Indirect Costs) Administrative salaries£18,000 Advertising£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due£10,000 Profit after tax & interest£ 30,00030% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 8,0008% The final part of the account is usually concerned with the interest which needs to paid, dividends to shareholders and tax.

Turnover (Sales) (Income)£ 100,000} Cost of Sales (Direct Costs)} Materials£10,000} Trading Transport£ 5,000} Account Labour£15,000} Total Cost of Sales £ 30,00030%} Gross Profit (Gross Margin)£ 70,00070%} Overheads (Indirect Costs) Administrative salaries£18,000 Advertising£ 5,000 Rent & Rates£ 4,000 Total Overheads Operating Profit (Net Margin) Interest on loans£ 3,000 Profit before tax Corporation tax due£10,000 Profit after tax & interest£ 30,00030% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 8,0008% The bottom line here is what the company has actually made as a profit over the year. This is the Surplus.

Some Common Terms  On a sheet such as the one we have seen, the terminology can be very confusing at first.  The next few slides discuss the following terms used:  Turnover  Direct Costs  Stock  Gross Profit (Margin)  Indirect Costs (Overheads)  Net Profit (or Loss)

Turnover  Sale of goods or Fees for services  Subscriptions  Interest earned  Income = Revenue = Sales = Turnover  VAT is excluded from Sales figures (and all other figures)

Direct Costs (Cost of Sales)  Costs which are directly related to the cost of providing the goods or service (Cost of Sales)  For example:Goods purchased for resale Direct Labour costs Raw materials, Packaging, Energy  Direct Costs often vary with sales (though some Direct Costs can be FIXED)

Stock  Opening and Closing Stocks must be taken into account when calculating Direct Costs to in order to keep to the matching convention  Where sales volume is high (or prices are standard) an average price may be used  Lower cost must be taken if price has gone down  Other methods include FIFO and LIFO  Should be considered item by item, or in categories, not as overall figure  Manufacturing Companies may incorporate cost of manufacture into stock value (e.g. materials, power, labour)

Gross Profit or Margin  Gross Profit = Sales (Turnover) less Direct Costs  Sometimes called Gross Margin  Gross Margin% or Gross Profit% = Gross Profit x 100 Sales

Gross Profit% - Example Soft Drinks Stand why £30? Sales= £75 Direct Costs=£30 Gross Profit = £45 Gross Profit% = £45 x 100= 60% £75

Indirect Costs or Overheads  Operating Expenses  Costs which are not directly related to sales.  Costs which are incurred even when an organisation produces no output. Often Fixed Costs  For example:Administrative salaries Advertising, Stationery, Rent & Rates Insurance, Bank charges  Indirect Costs do not (necessarily) vary with sales  Interest usually shown later

Profit or (Loss)  Operating Profit = Sales less Direct Costs less Indirect Costs  Profit before tax = Operating Profit less Interest  Profit after tax = Profit before tax less tax  Retained profit = Profit after tax less dividends  Net Profit% = Net Profit x 100 Sales

Net Profit% - Example Soft Drinks Stand Sales= £75 why £5? Direct Costs=£30 Indirect Costs = £5 Gross Profit = £40 Net Profit% = £40 x 100= 53.3% £75

Activity One Discuss the following:  Why does an increase in cash in the bank during a particular accounting period not necessarily mean that the organisation has made a profit?  Why is it important to distinguish between capital and revenue expenditure?  Why is it important to differentiate between indirect and direct costs?

Activity One – Possible Solution  Increase in cash in the bank could be the result of: a loan, payment of a previous debt, selling off an asset, even selling goods at a loss! None of these incurs profit.  Capital expenditure buys things still owned by the company. Revenue expenditure ‘disappears’.  Indirect costs need to be paid even if you don’t sell anything; in difficult times overheads need to be cut.

Section D T he Balance Sheet

Sample Balance Sheets A Balance Sheet can be produced in two different ways:  Horizontal Format  Vertical Format The next two slides illustrate this.

Sample Balance Sheet (Horizontal format) Fixed AssetsCapital & Reserves Land£ 120,000Share capital £ 100,000 Buildings£ 150,000Retained profit£ 120,000 Fix & Fit£ 75,000 Total£ 220,000 Total£ 345,000L/T Liabilities Loan£ 250,000 Current AssetsTotal£ 250,000 Stock£ 55,000Current Liabilities Debtors£ 75,000Creditors£ 22,000 Bank£ 25,000Tax & VAT£ 8,000 Total£ 155,000Total£ 30,000________£ 500,000

Sample Balance Sheet (Horizontal format) Fixed AssetsCapital & Reserves Land£ 120,000Share capital £ 100,000 Buildings£ 150,000Retained profit£ 120,000 Fix & Fit£ 75,000 Total£ 220,000 Total£ 345,000L/T Liabilities Loan£ 250,000 Current AssetsTotal£ 250,000 Stock£ 55,000Current Liabilities Debtors£ 75,000Creditors£ 22,000 Bank£ 25,000Tax & VAT£ 8,000 Total£ 155,000Total£ 30,000________£ 500,000 This column describes the Assets (owned) This column describes the Liabilities (owed)

SAMPLE BALANCE SHEET (VERTICAL FORMAT) Fixed AssetsLand£ 120,000 Buildings£ 150,000 Fix & Fit£ 75,000 Total£ 345,000 Current AssetsStock£ 55,000 Debtors£ 75,000 Bank£ 25,000 Total£ 155,000 Current Liabilities Creditors£ 22,000 Tax & VAT£ 8,000 Total£ (30,000) Net Current Assets£ 125,000 Total Assets£ 470,000 Less Long term liabilities (Loan)£(250,000) £ 220,000 Capital & Reserves Share capital£ 100,000 Retained profit£ 120,000 £ 220,000

SAMPLE BALANCE SHEET (VERTICAL FORMAT) Fixed AssetsLand£ 120,000 Buildings£ 150,000 Fix & Fit£ 75,000 Total£ 345,000 Current AssetsStock£ 55,000 Debtors£ 75,000 Bank£ 25,000 Total£ 155,000 Current Liabilities Creditors£ 22,000 Tax & VAT£ 8,000 Total£ (30,000) Net Current Assets Total Assets Less Long term liabilities (Loan) Capital & Reserves Share capital£ 100,000 Retained profit£ 120,000 £ 220,000 Firstly come Fixed Assets These are the long-term investments made by the company

SAMPLE BALANCE SHEET (VERTICAL FORMAT) Fixed AssetsLand£ 120,000 Buildings£ 150,000 Fix & Fit£ 75,000 Total Current AssetsStock£ 55,000 Debtors£ 75,000 Bank£ 25,000 Total£ 155,000 Current Liabilities Creditors£ 22,000 Tax & VAT£ 8,000 Total£ (30,000) Net Current Assets Total Assets Less Long term liabilities (Loan) Capital & Reserves Share capital Retained profit £ 220,000 Then: Current Assets The short-term investments which can easily be turned into cash. Current Liabilities This is money to be paid out to creditors, tax, share-holders as dividends, etc.

SAMPLE BALANCE SHEET (VERTICAL FORMAT) Fixed AssetsLand£ 120,000 Buildings£ 150,000 Fix & Fit£ 75,000 Total Current AssetsStock£ 55,000 Debtors£ 75,000 Bank£ 25,000 Total£ 155,000 Current Liabilities Creditors£ 22,000 Tax & VAT£ 8,000 Total£ (30,000) Net Current Assets£ 125,000 Total Assets£ 470,000 Less Long term liabilities (Loan)£(250,000) £ 220,000 Capital & Reserves Share capital£ 100,000 Retained profit£ 120,000 £ 220,000 This gives the Net Current Assets (current assets – current liabilities)

SAMPLE BALANCE SHEET (VERTICAL FORMAT) Fixed AssetsLand£ 120,000 Buildings£ 150,000 Fix & Fit£ 75,000 Total£ 345,000 Current AssetsStock£ 55,000 £ 75,000 £ 25,000 £ 155,000 Current Liabilities Creditors£ 22,000 Tax & VAT£ 8,000 Total£ (30,000) Net Current Assets£ 125,000 Total Assets£ 470,000 Less Long term liabilities (Loan)£(250,000) £ 220,000 Capital & Reserves Share capital£ 100,000 Retained profit£ 120,000 £ 220,000 Then we subtract the Long Term Liabilities e.g. loans of money, goods, buildings etc.

SAMPLE BALANCE SHEET (VERTICAL FORMAT) Fixed AssetsLand£ 120,000 Buildings£ 150,000 Fix & Fit£ 75,000 Total£ 345,000 Current Assets Current Liabilities Creditors Tax & VAT Total Net Current Assets£ 125,000 Total Assets£ 470,000 Less Long term liabilities (Loan)£(250,000) £ 220,000 Capital & Reserves Share capital£ 100,000 Retained profit£ 120,000 £ 220,000 The final section which shows the balance gives the initial money used to ‘start’ the company (share capital), and the profit retained this year (surplus), and any money held in reserve for ‘emergencies’

Balance Sheet Formats Horizontal Format Fixed Assets Capital & Reserves + + Current Assets = Long-term Liabilities + Current Liabilities Vertical Format Fixed Assets + Current Assets = Capital & Reserves - Current Liabilities - Long term Liabilities

Fixed Assets  Items owned and used by the organisation on a long- term basis  Tangible Assets = equipment, buildings, land  Intangible Assets = brands, logos, patents, goodwill  Goodwill - quality of workforce, reputation, management, location, relationship with customers  Goodwill only tends to be included when purchased at an agreed price  Assets are valued at Cost less Depreciation or Revalued Cost (less depreciation)

Current Assets  Items which can easily be converted into cash (e.g. cash, stock, debtors)  Generally listed in the order in which they can be converted into cash  Valued at cost or market price (whichever is the lower)  Include “Provision for loss” (safeguard against unsold goods or bad debts) and Prepayments (items which have been paid for in advance)

Current liabilities  Current Liabilities (claims) - debts which the organisation is likely to have to pay within one year  Examples include creditors, bank overdraft, loan interest due in next 12 months, VAT, PAYE, accruals

Long-term liabilities  Long-term Liabilities (Fixed Liabilities) - debts which the organisation will not have have to pay within one year  Examples include hire purchase loans, mortgage, long-term bank loans

Shareholders Funds  Most permanent form of funding. Classed as “Liability”  Issued Share Capital - value of shares actually issued  Authorised Share Capital - value of shares company may legally issue  Retained Profit (or Earned Surplus) - profit left after all deductions have been made  Capital Surplus - money earned on disposal of Fixed Assets  Capital employed - all the capital put into the business (share capital, long-term loans, retained profit)

Interpreting the Balance Sheet  Liquidity  Mix of Assets  Financial Structure

Activity Two Discuss the following:  How far does the balance sheet tell us about how much an organisation is worth?  What is the main difference between Fixed and Current Assets?  Why is money input into the organisation by shareholders shown as a liability?

Activity Two - Solutions  The final amount on either side of the balance tells us how much a company is currently valued at.  Current Assets – we could get the money almost immediately with minimum fuss. Fixed assets would take some time and be very disruptive.  The share capital is an amount invested in the company by shareholders, and so is owed to them.

Section E Accounting Standards and Conventions

Accounting standards & conventions  Company Law requires that accounting statements provide a “true and fair view”  Accounting Standards (established by UK accounting professions) try to define what a “true and fair view” is in different situations

Accounting standards & conventions  The final section of this presentation examines the ‘rules for accounting’ laid down by the industry and by convention.  You should study these on your own, making sure that you understand the definition of each of the items on the next slide:

Accounting standards and conventions Boundary rules Definition of an asset Money measurement and stable monetary unit Historic cost convention Realisation Matching or Accruals principle Materiality Prudence Consistency, Objectivity, Substance over form

Boundary rules  Information is restricted to the entity being examined.  Information is restricted to a given period of time (“periodicity”)  Information is restricted to data which can be measured easily (“quantitative”)  Assumption is made that the organisation is a “Going concern” - it will continue indefinitely Financially viable in the short term Competitive Well-structured financially for long term

Definition of an asset  Must be likely to produce future economic benefits  Must have arisen from some past transaction or event  Must have restricted right of access  For example, a piece of equipment, a building, a patent ARE assets, but the workforce is NOT an asset!

Money measurement & stable monetary unit  Information that cannot be expressed in monetary terms cannot be included in accounting statements  Accounting tends to assume that the value of money remains constant - i.e.. there is no inflation

Historic cost convention  Assets are shown at a value based on their cost when acquired, NOT current market value or potential value to the organisation  Can mean that the Balance Sheet does not represent the true value of the organisation  Specialised assets may have higher value than is shown  Revaluation of assets can bring the valuation of assets closer to true market value

Realisation  Revenue (Income) should be included in the accounts (“realised”) at the point when: The amount can be measured accurately The work is substantially completed It is reasonably certain that cash will be received  Generally taken to be the point when a client takes delivery of service or goods  Revenue (Income) is unlikely therefore to be the same as cash received

Matching or Accruals principle  Revenue (Income) and Expenses (Costs) must be included together in the same period’s accounts wherever possible  This should enable the assessment of the net effect on profit which a particular activity produces  Accruals may therefore be incorporated into the accounts to allow for costs which have been incurred in producing income, but which have not yet been paid, or for which invoices have not yet been received.

Materiality  Unimportant items are considered not to be “material” and need not be disclosed.  Other accounting rules may be ignored when dealing with immaterial items  Level of materiality varies from one organisation to another

Prudence  Figures should always err on the side of caution  “Anticipate no profit and provide for all future losses”  For example, stock value is shown at cost or market value - whichever is the lower  Where an asset has increased in value, the increase may not be shown until the asset is disposed of  The value of a sale should not be credited to the accounts until it has been delivered to the client

Consistency, Objectivity, & “Substance over form”  Accounts should be consistent in the methods and values used. Changes of policy must be made openly, and in order to improve “true & fair view”  Values should be arrived at objectively and supported by evidence  The strict legal nature of a transaction may be ignored if it distorts a true and fair view - accounts should show the substance rather than the form.

Dual Aspect  Every entry has two aspects, both affecting the Balance Sheet  e.g. Purchase of a piece of equipment - increases Fixed Assets and decreases Current Assets (Bank Balance) or increases Liabilities (Loan)  Saving on costs increases Bank Balance and increases Retained Profits  Slow paying customers decrease Bank Balance and increase Debtors

Deficiencies of financial accounts  Historical (and often out of date)  Cross-company  Incorporate subjective judgements  Do not highlight trends and plans  Do not recognise organisational objectives  Focus on accounting profit (or loss) not cash  Do not include value of organisation’s staff or other unquantifiable assets

Activity Three Discuss the following:  “Accounting is a science - given a single organisation over the same period two accountants will always come up with exactly the same profit or loss results unless they make a factual mistake”  Give reasons why you agree or disagree?

Activity Three - Solutions  “ Accounting is a science - given a single organisation over the same period two accountants will always come up with exactly the same profit or loss results unless they make a factual mistake” I would disagree.  At a simplistic level, the figures for Gross profit and Net profit depend on how you classify direct and indirect costs. Some items could be in either category  At a wider level, recent events (ENRON, Xerox) have shown that some previously well-thought of accountants have been ‘creative’ in the way that they produce accounts, and that there is disagreement and disquiet with the way that the figures have been presented.

Seminar Two - Activities  Preparation: read Chapters 2 and 3  Describe key concepts: Cash versus Profit Capital expenditure v Revenue expenditure Depreciation Profit & Loss Account/ Balance Sheet Accounting conventions  Exercises 2.6 (page 55) and 3.6 (page 93-94)