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Accounting and Financial Statements

Subject: Business Studies
Topic: 6
Cambridge Code: 0264 / 0450 / 7115

Purpose of Accounting​

Accounting - Recording and summarizing financial transactions

Functions​

  1. Record transactions - Journal entries
  2. Classify - Group by account type
  3. Summarize - Prepare statements
  4. Analyze - Calculate ratios
  5. Report - Financial statements to stakeholders

Users​

  • Internal: Management (decision-making)
  • External: Investors, creditors, tax authorities

Profit and Loss Statement (P&L)​

Income Statement - Shows profit/loss over period

Format​

Profit=Revenue−Total Costs\text{Profit} = \text{Revenue} - \text{Total Costs}

Components​

Revenue:

  • Sales × Price
  • Minus returns
  • = Net revenue

Cost of Goods Sold (COGS):

  • Opening inventory
  • Plus purchases
  • Minus closing inventory
  • = Cost of goods sold

Gross Profit: Gross Profit=Revenue−COGS\text{Gross Profit} = \text{Revenue} - \text{COGS}

Expenses:

  • Wages, rent, utilities
  • Marketing, delivery
  • Depreciation

Operating Profit: Operating Profit=Gross Profit−Expenses\text{Operating Profit} = \text{Gross Profit} - \text{Expenses}

Net Profit: Net Profit=Operating Profit−Interest−Tax\text{Net Profit} = \text{Operating Profit} - \text{Interest} - \text{Tax}

Balance Sheet​

Statement of Financial Position - Shows assets, liabilities, equity at point in time

Accounting Equation​

Assets=Liabilities+Equity\text{Assets} = \text{Liabilities} + \text{Equity}

Assets​

Current Assets:

  • Cash (most liquid)
  • Receivables (money owed)
  • Inventory (goods for sale)
  • Investments (short-term)

Non-Current Assets:

  • Property, plant, equipment
  • Long-term investments
  • Intangible assets (patents)

Liabilities​

Current Liabilities:

  • Payables (money owed)
  • Bank overdraft
  • Short-term loans

Non-Current Liabilities:

  • Long-term loans
  • Mortgages
  • Bonds

Equity​

  • Share capital (invested)
  • Retained profit (accumulated earnings)
  • Reserves

Cash Flow Statement​

Cash flow - Movement of actual cash in/out

Three Sections​

Operating Activities:

  • Cash from operations
  • Collections from sales
  • Payments for expenses

Investing Activities:

  • Sale/purchase of assets
  • Capital expenditure

Financing Activities:

  • Loans obtained/repaid
  • Dividends paid
  • Share issues

Format​

Net Cash Flow=Operating+Investing+Financing\text{Net Cash Flow} = \text{Operating} + \text{Investing} + \text{Financing}

Closing Cash = Opening Cash + Net Change

Financial Ratios​

Profitability Ratios​

Gross Profit Margin: Gross ProfitRevenue×100%\frac{\text{Gross Profit}}{\text{Revenue}} \times 100\%

  • Higher = Better efficiency
  • Compare with competitors

Net Profit Margin: Net ProfitRevenue×100%\frac{\text{Net Profit}}{\text{Revenue}} \times 100\%

  • Includes all expenses
  • Measure of overall profitability

Return on Capital: ProfitCapital×100%\frac{\text{Profit}}{\text{Capital}} \times 100\%

  • How much profit per unit capital
  • Higher = Good investment

Liquidity Ratios​

Current Ratio: Current AssetsCurrent Liabilities\frac{\text{Current Assets}}{\text{Current Liabilities}}

  • Above 1.5 = Good (can pay short-term debts)
  • Below 1.0 = Problem (insolvency risk)

Acid Test Ratio: Current Assets−InventoryCurrent Liabilities\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

  • Stricter test (excludes inventory)
  • Above 1.0 = Secure

Efficiency Ratios​

Asset Turnover: RevenueTotal Assets\frac{\text{Revenue}}{\text{Total Assets}}

  • How efficiently assets generate sales
  • Higher = Better

Inventory Turnover: COGSAverage Inventory\frac{\text{COGS}}{\text{Average Inventory}}

  • How quickly inventory sells
  • Higher = Less tied-up capital

Solvency Ratios​

Debt-to-Equity: Total LiabilitiesTotal Equity\frac{\text{Total Liabilities}}{\text{Total Equity}}

  • How leveraged business is
  • Lower = Less risky

Depreciation​

Depreciation - Reduction in asset value over time

Methods​

Straight-line: Annual Depreciation=Cost−Salvage ValueUseful Life\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}

  • Equal amount each year
  • Most common

Declining balance:

  • Fixed percentage of book value
  • Higher early depreciation
  • Matches usage pattern

Impact​

  • Expense in P&L (reduces profit)
  • Non-cash (no actual money out)
  • Tax deduction benefit

Break-even Revisited​

From Finance perspective:

Break-even=Fixed CostsUnit Contribution\text{Break-even} = \frac{\text{Fixed Costs}}{\text{Unit Contribution}}

  • Minimum sales needed
  • Plan capital requirements
  • Risk assessment

Key Points​

  1. P&L: Revenue - Costs = Profit
  2. Balance Sheet: Assets = Liabilities + Equity
  3. Cash flow: Different from profit (timing)
  4. Ratios: Profitability, liquidity, efficiency, solvency
  5. Depreciation: Non-cash expense
  6. Analysis: Compare to benchmarks and history

Practice Questions​

  1. Prepare P&L statement from data
  2. Prepare balance sheet
  3. Analyze cash flow statement
  4. Calculate profitability ratios
  5. Assess liquidity position
  6. Compare businesses using ratios

Revision Tips​

  • Know accounting equation
  • Learn P&L structure
  • Understand balance sheet
  • Practice ratio calculations
  • Know what ratios mean
  • Compare to industry standards
  • Understand cash vs profit