CHAPTER 2 Finance Figure 11 Income Statement for BRSS Pty Ltd For the period ending | For the period ending 30 June 2017 in 000's | 30 June 2018 in 000’s Sales 2000 8200 Less COGS: 800 1440 Gross Profit 1200 1760 Less Operating Expenses Selling Expenses 520 860 General Administration Expenses 80 130 Financial Expenses 400 320 Net Profit 200 450 Points to note: The Income Statement is a financial statement which shows whether the business has. made a profit or a loss during a period of time. = It's also known as a profit & loss statement or revenue statement. = An income statement is completed before the balance sheet. ™ Sales is revenue generated by the business, = Cost of goods sold (COGS) is how much the goods or services have cost the business before sale. (COGS = Opening Stock + Purchases — Closing Stock) = Gross profit = Sales - COGS. = Operating expenses are those expenses (costs) incurred in the normal operations of the business they are divided into 3; a) Seling/distribution e.g. advertising b) Administration/generel e.g. insurance, utlities, office wages ©) Financial e.g. depreciation, interest Net Profit = GP - Expenses ee 56 “This book is xbjet to Cong. No mere than 1036 is pemited tobe photocopied. 1S Get Smart Ecaton 2018 ARDAREAAAAEDAGEDGGGAGGGGAGGEVGAG GYPOSTS STFS FTC T TTS V SST T VTS SVT TVS TTT TTTT TTT TTT TST VG “cuarTer 2 ) Finance Figure 12 Balance Sheet of BRSS Pty Ltd: $ $ As at 30 June 2017 | As at 30 June 2018 in 00's in 00's Current Assets Cash at Benk 200 400 Accounts Receivable (debtors) 400 500 Inventory 900 1400 Non-Current Assets Property, equipment, motor vehicles 1800 1850 Total Assets 3000 3550 Current Liabilities Accounts Payable (creditors) 700 940 Accrued Expenses 50 60 Bank Overdratt 0 400 Non-current Liabilities Bank Loan 250 400 Shareholders Equity Share capital 1900 1900 Retained eamings 100 150 Total Liabilities + Shareholders Equity 3000 3550 Points to note: = The Balance Sheet is a financial statement that shows businesses assets, labilies and owners ecuity at a specific date. = Also known as the Statement of Financial Position, i the owners. how much the business is worth to = It shows the accounting equation A=L+OE = There are 2 ways a balance sheet can be formatted: T-Account OR Statement form. “This bocce eubjct to Copyright. No mere than 1036 la pormtod to be photocoped 87 © Got Smt Eoueaton 2078(CHAPTER 2 Finance = Assets are items of value of the business owns. There are 3 types: 4) Current assets ~ cash and other types of assets that are reasonable expected to be converted into cash, sold or consumed in the next 12 months. These include inventories, debtors and cash. 2) Non-Current assets — (also known as fixed assets) are assets that are expected to be used for a number of years Ie. not held for resale, and except for land/buildings these assets have useful lives and are depreciated. They are not expected to be converted into cash within the next 12 months. This include property, fixtures and fittings, equipment and vehicles. 3) Intangiole assets- assets that usually do not have a physical substance but are expected 10 provide future benefits to the business e.g. goodwill, copyrights, patents and brand names. = Liabilities show what a business owes. They can be classified into 2 categories: 1) Current liabiities- amounts a business owes that is expected to repaid within 12 months. 2) Non-current liabilities ~ (also known as long term lit that are not expected to be repaid within 12 months. ies) amounts a business owes = Owners’ equity ~ This shows the equity of the owner in the assets of the business. If the business is unincorporated (sole trader or partnership), owner's equity looks like: capital + net profit - drawings. If the business is incorporated (company) owners’ equity looks like: shareholder's equity + retained eamings. Analysis of the balance sheet can indicate whether: = the business has enough current assets to cover current liabilities — liquidity the business has enough assets to cover its debts - gearing / solvency = the interest and money borrowed can be paid the assets of the business are being used to maximise profits = the owners of the business are making a good retum on their investment. Figures from previous years BS can be analysed to show changes and trends Thrbt acs Gana he maw ar nh te pou a 7 ‘© Get Smart Education 2018 CORBCCRECEREREEEHEHCHOCHHLE REESE REREEEHHEPECTTHOSTTSSSSTCTCSSESCTCTCTTCTSSKTTSTCSSSSTHHSSKHRGREOESE (CHAPTER 2 Finance Figure 13 Cash Flow Statement for BRSS Pty Ltd For the period ending | For the period ending 30 June 2017 in 30 June 2018 in 00's 00's {$$ Total cash inflows 1800 2300 Total cash outflows 1700 2400 Net Cash Flow 400 -400 Cash at the beginning of the year 400 200 Cash at the end of the year 200 400 Points to note: = The Cash Flow Statemant shows the movement of cash inflows and cash outflows over a period of time. = Only cash transactions are included in the Cash Flow Statement = NGF = TC!~TCO (Net cash flow = total cash infiows - total cash outfiows) = Cash at the end of the month or year = NCF + Cash at the beginning of the month or year = Cash Flows are usually divided into 3 categories: Operating activities, investing activities and Financing activities. Operating activities: these relate to the main activity of the business. Inflows = Sales, Outflows = Payments to suppliers, employees and other expenses Investing activities: these relate to the cash inflows and outflows from the purchase and sale of NCA and investments. Financing activities: these relate to the cash inflows and outflows from borrowing sotivities of the business. Inflows = equity such as issue of shares, Outflows = debt (payments for loans) ‘This beccis aubjot to Cong. No more than 10% fs period to be photocepac. 59 1©.Gat Sman Edenton 2018,(CHAPTER 2 Finance ©) Financial Ratios Financial Ratios are mathematical tools which allow managers (& stakeholders) to analyse and interpret financial statements. 1. Profitability ratios — ratios which are used to evaluate a business’ profit performancs. They are expressed as @ % and higher is always better. Figure 14 Profitability Ratios for BRSS Pty Ltd Profitability Ratios Formulae BRSS 2017 BRSS 2018 a) Gross Profit Ratio GP 1200 60% | 1760 55% See Se x100 ——x100 Sales 2000 3200 'b) Net Profit Ratio NP 200 10% 450 14% —— x10 x100 ‘x100 Sales 2000 3200 c) Rate of return on. Net Profit 200 10% 450 22% E ———— x100 x100 —— 100 Owners Equity Owners Eouity 2000 2050 ANALYSIS a) The Gross Profit ratio has decreased from 60% (2017) to 55% (2018). This means that the proportion of GP that contributes to sales has decreased. BRSS is less profitable. b) The Net Profit ratio has increased from 10% (2017) to 14% (2018). This means that the proportion of NP that contributes to sales has increased. BRSS is more profitable. ©) The Rate of Retum on Owners Equity has increased trom 10% (2017) to 22% (2018). This means that the return earned on owners funds by management has increased. BRSS is more profitable. 2. Liquidity ratios - ratios which are used to evaluate a business’ abilty to meet its short term obligations. They are expressed as a ratio and higher is better (but too high may indicate that you are not using current assets effectively ie. idle cash). As a general rule: Less than 1:1 - the business is NOT liquid Between 2:1 and 1:1- the business is liquid but NOT liquid ENOUGH Over 2:1 - The business has excellent liquidity SSS 60 “This book is ubjat wo Gooytoht No more than 1096s pamited tobe photocepad. 1 Get Gmant Educator 2018PETTITTTSTHTIASSESHAFFFSHSITTSISTITIFSSSATTTS TSE (CHAPTER 2 Finance Figure 15 Liquidity Ratios for BRSS Pty Ltd Liquidity Ratios a) Current Ratio (Working Capital Ratio) BRSS 2017 BRSS 2018 Current Assets 1.8: Current Liabilities ANALYSIS: a) The Current Ratio has decreased from 2:1 (2017) to 1.8:1 (2018). This means that BRSS is less able to meet its short-term obligations. 3. Solvency / gearing ratios: ratios which are used to evaluate a business’ solvency (stability) and gearing (fis. It determines the business's ability to operate in the long term (measure of its nancial stabilty). They are expressed as a % or a ratio and iower is always better. A high gearing ratio means that a business is: = Less solvent (stable) = Exposed to greater gearing (risk) = More vuinerable to an economic downtum =| More vulnerable to a rise in interest rates There is no optimal level of gearing but a business should consider: = Retum on investment = Cost of debt = Size and stability of earning capacity = Liquidity = Purposes of short-term debt ‘This books subject to Copyright. No mora than 1036 I ported to be photocopied 61 (©GetSman Exerton 2008CHAPTER 2 Finance Figure 16 Solvency Ratios for BRSS Pty Ltd Total Liabilities 1000 x100 Owners Equity BRSS 2018 Solvency Ratios a) Debt to Equity Ratio ) -auity x100| 73% 2050 ANALYSIS: a) The Debt to Equity ratio has increased from 50% (2017) to 73% (2018). This means BRSS's gearing has increased (less solvent}. BRSS is less financially stable. 4. Efficiency ratios (ratios used to measure a business's ability to use its resources effectively) Figure 17 Efficiency Ratios for BRSS Pty Ltd Ratio Formula BRSS 2017 BRSS 2018 a) Expense Ratio Total Expenses 4000 1310 Se ——— «100 | —— x1oo | 50% x1o0} 41% (The Lower the better) Sales 2000 3200 'b) Accounts Receivable Credit Sales 2000 ae 3200 | gy Turnover Saree oe — |” Accounts Receivables 400 times 500 | times (The higher the ratio the better) Sear ©) Average Collection 365 365 365 ie period in days ————_ pseasy Accounts recelvable 5 days 84 days (The lower the number of aber days the better) NB Assure all sales are made on credit. ANALYSIS a) The Total Expense ratio has decreased from 0% (2017) to 41% (2018). This means that the proportion of expenses that contributes to sales has decreased making BRSS more efficient. 6) & c) The Accounts Receivable turnover has increased from 5 times (2017) to 6.4 times (2018). This means that BASS is more efficient because they are collecting their accounts receivables faster. On average they used to collect every 78 days, now its down to 57 days. ee 62 This books subject to Copyright. No mere than 10% ls permit tobe photocopied. {9 Get Smet Ecteation 2018 anne ARAAAARARATATAAAAATARRTETETRIEGEGSCTHFTHFFSTSTSSFSSSSSSSSHHTHTSHTSCTHSCKESKK KH TTT (Gurren) eee The accounts receivable turnover ratio measures: = the effectiveness of a firm's credit policy and how efficiently it collects its debts. = It gives the number of times a year that the debtors are turned over or collected. = Abusiness would want the ART ratio to be as High as possible. The accounts receivable tumover ratio in days: af the answer from the accounts receivable turnover ratio is divided into 865 days a business can determine the average length of time it takes to convert accounts receivable into cash. = In this case, ideally the length of time is as few days as possible (ower is better). d) Comparative Ratio Analysis — over different time periods, against standards, with similar businesses For analysis to be meaningful, comparisons and benchmarks are needed. Judgements are made by comparing a firm's analysis against other figures, percentages and ratios: = Over different time periods = Against standards With similar businesses ¢) Limitations of Financial Reports Financial reports are really useful, but they do have limitations (restrictions) and caution needs to be exercised with analysing these reports. Businesses want their reports to look good so often the financial reports can be inaccurate. Misleading information can lead to poor business decisions and therefore higher risk. These limitations include: = Normalised eamings: earnings that have been adjusted for changes in economic cycle and one off events. This is a limitation as business can decide if they would like to adjust eamings in a financial year and normalise them. Some financial managers may decide not to. Therefore it is subjective and stakeholders should note that earings may or may not have been adjusted for one off events. = Capitaising expenses: recording an expense as an asset on the Balance Sheet rather than ‘an expense in the Income Statement ([Link] fees and stamp duty on the purchase of property). Therefore, it would be recorded on the balance sheet instead of the revenue statement and as such impact both financial statements. The expense is not included ‘Tis books cube o Copyrigt. No more than 10% ie permed tobe phetoopled. 63 (© Get Sman Eeaton 2018(charter 2 Franco in the calculation of profit therefore boosting profits and wil inflate the asset base of the business and thus owners’ equity (value) of the business on the balance sheet, Therefore, if businesses decide to “Capitalise Expenses” this may result in financial statements not truly reflecting the state of the business which is a limitation of financial reports. = Valuing assets: Estimating the value of assets particularly non-current ones in the Balance Sheet can be difficult. Often these assets are recorded at historical cost (original price), This may distort the balance sheet because it may not accurately reflect their true worth (00 much different from their market value). Land tends to increase in value and vehicles and machinery tends to depreciate. Accountants do depreciate some assets over time to present a more accurate picture. Intangible assats like goodwill are very difficult to value and caution need to be taken on their estimated value. Accountants are allowed to depreciate assets based on accounting standards due to wear and tear but the amount of depreciation is subjective, This creates ‘grey areas’ that businesses can exploit to create a misleading impression of their financial position, which limits the usefulness of financial reports. Henoe this is a limitation of financial reports. = Timing issues: Accountants may adjust timing of revenues and debt repayments to make the business look more profitable, Timing issues are a limitation of financial reporting as, for example, revenues should be matched on the income statement by the expenses used to generate them, If expenses for example, are held over to the next reporting period, @ profit figure could be misleading. Businesses can exploit timing issues in financial statements to give a misleading impression of the financial position of the business, which limits the usefulness of financial reports. For example: Revenues could be delayed or accelerated to manipulate them into or out of the period covered by the report to give an inaccurate picture of the business's eamings. Debt repayments: Financial reports do not disclose specific information about debt repayments. The issue of debt repayments can limit the usefulness of financial reports as it may not be clear when the repayments have to be made, which can create a misleading impression about the financial position of the business. Businesses can renegotiate (re-finance) \with suppliers and banks to delay debt repayments. The recording of debt repayments on financial reports can be used to distort the ‘reality’ of the business's status and this may be undertaken to provide a more favourable overview of the business at that point in time. = Notes to financial statements. These are adcitionel information that are included at the bottom of the reports. They include information that may be important to explain the financial statements such as accounting methods used to record transactions. Notes to financial statements are attached to primary statements to help readers better understand the financial reports. information contained in these notes can be more subjective in nature and therefore have the potential to be misleading. These notes may add extra information riot included in the main report, explain accounting methods used, or explain the reasons for certain financial outcomes. These notes are not regulated by law as strictly as the financial report itself, so the notes may in fact actually be used to mislead stakeholders. _———— The bok ube angi Nome Dan 1 pte ob phe . ‘© Get Smart Education 2018 WAARAAAAAARAAAAUAAAGAAAGIAVVG GEASS G99 99999999998!