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Accounting Equation

Is a useful rule which helps when assembling the balance sheet figures. The rule which is always true is that: Assets - Liabilities =Capital Fixed Assets + Current Assets-Current Liabilities - Long term Liabilities = Capital + profit - drawings This means that when preparing a balance sheet there will always be two figures which are the same and we refer to this state as the the balance sheet balancing

Accounting ratios
Used to help make sense of the figures and include the following categories: Profitability ratios , used to compare the profitability of one company with another or of one company over time. Liquidity ratios, used to compare the liquidity of one company with another or of one company over time. Investment ratios, used by potential investors when making investment decisions. Efficiency ratios, used to compare company efficiency with others or with itself from one year to another. Accounting ratios are only useful when used to compare: one company's results over a period of time. one company's results with another company. It is best to compare with the best ,such as a world class company, or to compare with the industry standard for that type of business. the company's results with those expected. It is useful to use budgets for this purpose.

An amount unaccounted for, yet still owed at the year end. The amount needs to be estimated and then added to the expenses deducted from the profit in the Profit and Loss account. The same amount also needs to be added to Trade Creditors in the Current Liabilities section of the Balance sheet An item of value owned by the business

Balance Sheet A financial statement that shows what the business is worth. This is a very simple definition as the valuation of a business is a very complex topic. It shows the business assets and liabilities at one point in time and is sometimes referred to as the "snap shot". Bank & Cash Amounts held in the bank and in cash. Found in the Current Assets section of the Balance Sheet. If the amounts are in deficit, then the bank account is said to be an overdraft and will not appear in current assets but will be found in the Current Liabilities section of the balance sheet. Capital Items, usually cash or other assets introduced into the business by the owners. Sometimes referred to as Capital Introduced. For companies this is referred to as share capital and Capital Employed is the term given to the total of: Share Capital (which comes in two varieties ordinary and preference)

Loan capital (which is simply a grand name for long term loans) Reserves Cash(or) Money Can be in the petty cash tin in the office or at the bank. Current Asset Assets which are expected to be used up and replaced within one year. Sometimes referred to as short term assets.They can be : stocks of finished goods or raw materials or partially finished good known as work in progress. This amount is also referred to as closing stock and can be found in the Trading account section of the Profit and loss Account. It is important to remember that Closing stock appears both in the Balance sheet and in the Profit and Loss account.amounts owed to the business from its customers and known as Debtors. Customers come in two varieties: Cash customers which pay for goods at the time of sale Credit customers which pay for goods at a later date. It is from these sales that debtors arises i.e. amounts owed from customers. This amount is usually shown net of Doubtful debts(which means having the amount of doubtful debts deducted from the total figure for debtors) The deduction for Doubtful debts is usually an estimate and is known as a Provision (meaning estimate) for doubtful debts. It represents amounts under dispute with customers or amounts which customers are having difficulty in paying because of cash flow problems. Income arising from these amounts is therefore considered doubtful. amounts paid in advance (at the end of the accounting year) of goods and services received and referred to as Prepayments Prepayments are shown as added to debtors. cash and bank Current Liability Amounts owed (within one year) for goods and services purchased on credit terms. This means payment for goods and services is due at a date later than the date of sale. Current liabilities can be: Trade creditors, which is the name we give to amounts owed to suppliers. Accruals, which is the name we give to amounts still owed at the year end and not yet recorded in the books of account. Proposed items such as Dividends proposed, which means amounts the business promises to pay in the coming year. Payable items such as Tax payable which is payable within the coming year. Overdraft, which is amounts owed to the bank. Depreciation Is the measure of wearing out of a fixed asset. All fixed assets are expected to wear out, become less efficient and to get "tired". Depreciation is calculated as the estimate of this measure of wearing out and is a charge in the Profit and loss Account. Accumulated Depreciation is the total depreciation charges to date deducted from the cost of the fixed assets to show Net Book Value in the Balance Sheet learn more about depreciation Watch a car becoming more worn out over time When you have finished you need to press escape and return. Drawings Assets withdrawn from the business by the owners. These assets are usually cash but can be any asset withdrawn. In company accounts the withdrawal of assets by the owners is either called : salaries if it is payment for work done by the owner or dividends if it is for a share of the profits

Fixed Assets Assets used within the business and not acquired for the purposes of resale. Examples include: Land and buildings Plant and machinery, such as knitting machines and cup making machinery Fixtures and fittings, such as light fittings and shelving Motor vehicles, such as vans and cars.Fixed assets must be shown at original cost(purchase price) or valuation. Valuation is preferred in the case of assets which have changed significantly in value since original purchase. For example the current value of land and buildings can be quite different from the original cost. Accumulated Depreciation must also be shown, which is deducted from cost (or valuation) to give net book value Goodwill comes in two flavours: Inherent goodwill, which is supposed to reflect the reputation and other positive characteristics of the business which are all difficult to put a value on. This type of goodwill should not appear on the Balance Sheet Purchased goodwill, which is the excess of purchase price over fair value of the net assets of the business acquired by the purchaser. Legal framework The law controls what kinds of books, records and systems of internal controls that must be maintained by companies which are subject to an annual examination by external auditors. You will learn much more about these in your studies. Long term Liability Amounts owed to someone else which are payable after one year. Examples include: Long term loans Debentures , which are long term loans secured on the business assets. This means if the business fails to repay back the loan on time the business assets are at risk. Net current assets Sometimes referred to as working capital, this is the difference between total current assets and total current liabilities and is what finances the business on a day to basis. Net Assets Is the difference between the total assets and total liabilities. Profit There are many types of profit: Cash surplus, which is the difference between receipts and payments. Taxable profit, which is the business profit adjusted for tax purposes. Accounting profit, which is the difference between: Income received or receivable and Expenditure paid or payable within an accounting period Often referred to as NET Profit

Accounting profit is calculated using the accruals or matching concept. Which means that the total income includes not only cash received but also amounts owed by credit customers (debtors) for sales made within the accounting period. The total costs incurred to achieve these sales include not just actual payments made , but also amounts still owing to suppliers. Accounting profit is normally referred to as Net Profit which is Gross profit less Expenses. Reserves Amounts retained in the business and not distributed to owners. Reserves can be: Profits made and not passed on to owners. These are some times known as retained earnings. Capital reserves which can not be passed on to owners and represent the perceived increase in valuation of some fixed assets. Shares Amounts invested in a company by its owners. Owners of companies are called shareholders The profit and loss account words Accounting Period Is the period under examination and usually refers to a year. We therefore refer to a Profit and loss Account for the year ended so and so or a Balance Sheet as at so and so. Accruals or Matching concept Is the reason why net profit made is not the same as the cash surplus generated. This is a critical concept for you to understand. It is a fundamental concept upon which the accounts are prepared. You will learn in your studies that profit is not cash for a number of reasons: because of applying the accruals concept to preparation of accounts. This is where we deduct from sales the amounts we have incurred to achieve those sales - WHETHER WE HAVE PAID FOR THEM OR STILL OWE FOR THEM is irrelevant. In other words we count all costs incurred including those still owing to trade creditors at the end of the year. The costs deducted in the accounts will therefore be greater than the actual cash payments made where amounts are still owed at the end of the year. Similarly the sales figure is not made up of cash received from customers but is made up of cash received together with that still to be received. because of accounting for depreciation which is a deduction against profits for the measure of wearing out of a fixed asset and therefore does not involve a cash payment because of the way we value closing stock which can be by using average unit costs, the last unit costs or the earliest unit costs. None of these methods reflect the actual flow of cash because they are all estimates only. You will learn that this is where we consider FIFO (first in first out) and LIFO (last in first out) valuations of closing stock. Expenses Referred to as expenditure and including examples such as: advertising rent and rates wages and salaries travelling expenses light and heat

Office Expenses Miscellaneous Expenses bank interest loan interest depreciation Provision for doubtful debts . This represents an estimate of amounts customers have difficulty paying due to their cash flow problems. This figure will be deducted from the profit in the Profit and loss Account and will also be deducted from the Debtors figure in the Balance Sheet. bad debts written off Amounts owed by customers that cannot afford to pay because they have gone into liquidation. These amounts need to be deducted from the profit in the Profit and Loss Account and also from the Debtors figure which is found in the Current Assets section of the Balance Sheet. accruals and prepayments. Accruals are amounts unaccounted for yet still owing at the year end . Estimates need to be made and then added to the expenses deducted in the Profit and Lossaccount. This amount also needs to be added to Trade Creditors in the Current liabilities section of the Balance Sheet . Prepayments are amounts paid for by the business in advance of goods and services received. These amounts need to be deducted from expenses in the Profit and Loss account and will also appear in theCurrent Asset section of the Balance Sheet along with Debtors. Gross Profit Is calculated by deducting Cost of Sales(sometimes referred to as Cost of goods sold) from sales. Cost Of Sales is calculated by taking: Opening stock, which is the value of stock which exists at the beginning of the accounting period Plus Purchases of goods for resale, made during the accounting period. One common mistake made by students is to confuse purchases with stocks. Purchases of stocks are dealt with through the purchases account and not through the Opening and closing stocks. Less Closing stock, which is the value of stock which exists at the end of the accounting period In other words, it is the value of goods purchased during the year and in stock at the beginning of the year, less those items sold during the year. This is the figure which also appears in the balance sheet as stocks and can be found in the current assets section. Historic cost The method used for preparing accounts which estimates the actual purchase price of all items purchased. This is as opposed to the alternatives which could be to use instead the: cost of replacing items when they are sold or disposed of .Known as the Replacement cost or net realizable value income expected if items were sold. Known as the Realization cost Net Profit Sales less cost of sales less expenses = net profit. Sales less cost of sales = gross profit. Therefore Net Profit = gross profit less expenses.

In other words Net Profit represents the surplus of sales made over expenditure during the accounting period. If a deficit is made(i.e if expenditure is greater than sales) then this results in a net loss and not a net profit. Profit and Loss Account Shows what net profit or loss the business has made within an accounting period after deducting all expenditure from the income. A net profit is earned if total expenditure is less than the sales figure. A net loss is made if it is greater. Comes underneath the Trading Account Sales Income received or receivable for the accounting period. Sometimes referred to as Turnover.It represents the sales value of goods and services made to customers during the year. Trading account Shows what Gross Profit the business has made within an accounting period It comes on top of the Profit and Loss Account By using Ratio Analysis the words in the Balance Sheet and Profit and Loss Account can tell us something about how well the business has performed. Net profit is used in the Net Profit ratio (Ratio 3 below) and can therefore tell us something about the profitability of the business. The higher the figure the better the business is able to control its expenses. In other words the bigger the ratio the better. This means that more profit is made on the goods sold. Other common ratios are also listed below . Profitability 1 Return on Capital Employed = Profit x 100 = % Capital 2 Gross Profit Ratio 3 Net Profit Ratio Efficiency Ratios 4 Stock Turnover Ratio = Gross Profit x 100 = % Sales = Net Profit Sales x 100 = %

= Cost of Goods Sold = No of times Average Stock

5 Fixed Assets Turnover Ratio = Sales = No of times Fixed Assets at NBV 6 Debtor Collection Period = Average debtors x 365 = No of days Sales x 52 = No of weeks x 12 = No of months = Creditors Purchases = Sales Capital Employed x 365 = No of days x 52 = No of weeks x 12 = No of months = No of Times

7 Suppliers Payment Period

8 Asset Turnover

Liquidity Ratios 9 Current Ratio 10 Quick or Acid Test Investment Ratios 11. Gearing

= Current Assets Current Liabilities

= Expressed as a Factor

= Current Assets - Stock [Also expressed as a Factor] Current Liabilities = Preference Shares + Long Term Loans X 100% Shareholders funds + Long Term Loans

A Note of caution: Ratio Analysis is all about comparing one set of ratios with another. This can mean comparing one year with another, or comparing the performance of one company with another or with its budgets. To achieve greater confidence in the conclusions you draw, you really need to compare more values than just two. You also need to bear in mind that there is some flexibility in the accounting treatments adopted by accountants when preparing the financial statements and so differences observed in performance might in part be due to differences in the way items have been treated in the accounts rather than differences in performance. Now test your understanding by attempting to calculate the net profit % from our own figures. First you need to know whether to examine the trading, profit and loss account or the balance sheet. If you make a mistake you may return here, for another try, by pressing your internet return button. You must return to this point in any event if you wish to take a peep at the answer The answers to the net profit ratio Net profit ratio = net profit x 100% = 200 = 10% sales 2000 This means that the business makes a net profit of 10% on it's sales. In other words it makes a profit of 10p for every 1 of sales. These figures can be found on the profit and loss account.