FINANCIAL ACCOUNTING QUICK REVISION NOTES

INTRODUCTION TO BUSINESS ORGANISATION

legal structures of a business
The legal structure a business chooses is fundamental to the way it operates. This legal framework determines who
shares in the profits and losses, how tax is paid, where legal liabilities rests. It also determines the nature of a business'
relationships with business associates, investors, creditors and employees.
There are three options for a business' legal structure:
(1) Sole Trader
An individual who runs an unincorporated business on his or her own. Sometimes otherwise known as a "sole
proprietor" or (in the case of professional services) a"sole practitioner".
The sole trader structure is the most straight-forward option. The individual is taxed under the Inland Revenue's Self-
Assessment system, with income tax calculated after deduction for legitimate business expenses and personal
allowances. A sole trader is personally liable for the debts of the business, but also owns all the profits.
(2) Partnership
A partnership is an association of two or more people formed for the purpose of carrying on a business. Partnerships are
governed by the Partnership Act (1890). Unlike an incorporated company (see below), a partnership does not have a
"legal personality" of its own. Therefore the Partners are liable for any debts of the business.
Partner liability can take several forms. General Partners (the usual situation) are fully liable for business debts. Limited
Partners are limited to the amount of investment they have made in the Partnership. Nominal Partners also sometimes
exist. These are people who allow their names top be used for the benefit of the partnership, usually for remuneration,
but they do not get a share of the partnership profits.
The operation of a partnership is usually governed by a "Partnership Agreement". The specific terms of this agreement
are determined by the partners themselves, covering issues such as:
- Profit-sharing - normally, partners share equally in the profits;
- Entitlement to receive salaries and other benefits in kind (e.g. cars, health insurance)
- Interest on capital (the amount invested in the partnership)
- Arrangements for the introduction of new partners
- Arrangements for retiring partners
- What happens when the partnership is dissolved
(3) Incorporated Company
Incorporating business activities into a company confers life on the business as a "separate legal person". Profits and
losses are the company's and it has its own debts and obligations. The company continues despite the resignation,
death or bankruptcy of management or shareholders. A company also offers the best vehicle for expansion and the
provision of outside investors.
There are four main types of company:
(1) Private company limited by shares - members' liability is limited to the amount unpaid on shares they hold
(2) Private company limited by guarantee - members' liability is limited to the amount they have agreed to contribute
to the company's assets if it is wound up.
(3) Private unlimited company - there is no limit to the members' liability
(4) Public limited company (PLC) - the company's shares may be offered for sale to the general public and members'
liability is limited to the amount unpaid on shares held by them.
Specific arrangements are required for public limited companies. The company must have a name ending with the
initials "plc" and have an authorised share capital of at least 50,000 of which at least 12,5000 must be paid up. The
company's "Memorandum of Association" must comply with the format in Table F of the Companies Regulations (1985).
The company may offer shares and securities to the public. In return for this right to issue shares publicly, a public
limited company is subject to much stricter regulation, particularly in relation to the publication of financial information.
The vast majority of companies incorporated in the UK and in other major industrialised countries are private
companies limited by shares - "private limited liability companies".
The Office of the Registrar of Companies" (based in Cardiff) maintains a record of all UK private and public companies,
their shareholders, directors and financial information. All this information has to be provided by Companies by law and
is available to any member of the public for a small charge.
Forming a company
Who can form a company?
The Companies Act generally allows one or more persons to form a company for any lawful purpose by subscribing to its
memorandum of association. However, a public company or an unlimited company must have at least two subscribers.
What needs to be done?
Ready-made companies are available from company formation agents whose names and addresses appear in directories
such as Yellow Pages. These are essentially "shell companies" where all the relevant documentation has been
completed and the company assigned a generic name (e.g. "Newco 123345"). Company formation agents charge a fee
(around 200 per company) for providing this service. Individuals can choose to complete the process themselves by
using company formation documents provided by Companies House. These documents are summarised below:
Memorandum of Association
The Memorandum of Association is one of two official documents that describe the company's constitution (the other
being the Articles of Association).
The Memorandum of Association sets out the details of a company's existence. It must be signed by the subscribers and
contain the following information:
- The company's name: the last word of the name must be "limited" or "Ltd"
- Address of the Registered Office - this must be England, Wales or Scotland and means that the company operates
under British law and pays British tax.
- The objects for which the company is formed (the "objects clause") - this sets out the objects for which the company is
incorporated (usually a very general statement such as "to carry on its trade and business").
- A statement that the liability of the company members is limited. This means that if the company is insolvent, the
shareholders are liable to creditors for only the amount of their shares
- The amount of the authorised shares capital and how it is divided. The amount of share capital subscribed in cash or
assets is called the "issued share capital"
- The names of the subscribers
Articles of Association
This document governs the running of the company. For example, it describes the voting rights of shareholders , the
conduct of shareholder and directors' meetings, and the other powers of management.
The articles constitute a contract between a company and its members, but this applies only to rights of the
shareholders in their capacity as members of the company.
The contents of the articles include:
Classes of shares - the share capital can be divided into different types of shares which have different rights (for
example, in relation to voting in meetings, or relating to the sharing of profits and payment of dividends)
Restrictions on the issue of shares - the existing shareholders have a statutory right of "preemption". This means that
they have "first-refusal" over the issue of new shares.
Restrictions on share transfers - in order to retain control, directors of private companies usually want to restrict the
transfer of shares
Purchase by a company of its own shares - subject to strict regulation, companies can now buy their own shares and
assist anyone else to buy them.
Directors - the articles set out how and when directors are appointed. The operation of the Board of Directors is also set
out by the articles
Choosing a Company Name
There are some restrictions on the choice of a company name. Briefly, the restrictions are that:
The name cannot be the same as another company (for obvious reasons!)
The use of certain words is restricted. These include names likely to cause offence, names that imply connections with
the government or a local authority.
Advantages of limited liability for a company
Whilst many businesses prefer to trade as a sole trader or a partnership, nearly all significant businesses operate as an
incorporated company. The main advantages of incorporation via a limited company are summarised below:
Separate Legal Identity
A limited company has a legal existence separate from management and its members (the shareholders)
Members' liability is limited ("limited liability")
The protection given by limited liability is perhaps the most important advantage of incorporation. The members' only
liability is for the amount unpaid on their shares. Since most private companies issue shares as "fully paid", if things go
wrong, a members' only loss is the value of the shares and any loans made to the company. Personal assets are not put
at risk. The protection of limited liability does not, however, apply to fraud. Company directors have a legal duty not to
incur liabilities in their companies which they have reason to believe the company may not be able to pay. If creditors
lose money through director fraud, the directors' personal liability is without limit.
Protection of Company Name
The choice of company names is restricted and, providing a chosen name complies with the rules, no-one else can use it.
The only protection for sole traders and partnerships is trademark legislation.
Continuity
Once formed, a company has everlasting life. Directors, management and employees act as agent of the company. If
they leave, retire, die - the company remains in existence. A company can only be terminated by winding up, liquidation
or other order of the courts or Registrar of Companies.
New Shareholders and Investors can be easily introduced
The issue, transfer or sale of shares is a relatively straightforward process - although existing shareholders are protected
via their "preemption" rights and by company legislation that seeks to protect the interests of minority investors.
The process of lending to a company is also easier than with other business forms. The lending bank may be able to
secure its loan against certain assets of the business (a "floating charge") or against the business as a whole ("fixed
charge".
Better Pension Schemes
Approved company pension schemes usually provide better benefits than those paid under contracts to self-employed
sole trading businesses.
Taxation
Sole traders and partnerships pay income tax. Companies pay Corporation tax on their taxable profits. There is a wider
range of allowances and tax-deductible costs that can be offset against a company's profits. In addition, the current
level of Corporation Tax is lower than income tax rates.
introduction to raising finance
When a company is growing rapidly, for example when contemplating investment in capital equipment or an
acquisition, its current financial resources may be inadequate. Few growing companies are able to finance their
expansion plans from cash flow alone. They will therefore need to consider raising finance from other external
sources. In addition, managers who are looking to buy-in to a business ("management buy-in" or "MBI") or buy-out
(management buy-out" or "MBO") a business from its owners, may not have the resources to acquire the company.
They will need to raise finance to achieve their objectives.
There are a number of potential sources of finance to meet the needs of a growing business or to finance an MBI or
MBO:
- Existing shareholders and directors funds
- Family and friends
- Business angels
- Clearing banks (overdrafts, short or medium term loans)
- Factoring and invoice discounting
- Hire purchase and leasing
- Merchant banks (medium to longer term loans)
- Venture capital
A key consideration in choosing the source of new business finance is to strike a balance between equity and debt to
ensure the funding structure suits the business.
The main differences between borrowed money (debt) and equity are that bankers request interest payments and
capital repayments, and the borrowed money is usually secured on business assets or the personal assets of
shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it
defaults on debt interest or repayments or its prospects decline.
In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation
in increasing levels of profits and on the eventual sale of their stake. However in most circumstances venture capitalists
will also require more complex investments (such as preference shares or loan stock) in additional to their equity stake.
The overall objective in raising finance for a company is to avoid exposing the business to excessive high borrowings, but
without unnecessarily diluting the share capital. This will ensure that the financial risk of the company is kept at an
optimal level.
Business Plan
Once a need to raise finance has been identified it is then necessary to prepare a business plan. If management intend
to turn around a business or start a new phase of growth, a business plan is an important tool to articulate their ideas
while convincing investors and other people to support it. The business plan should be updated regularly to assist in
forward planning.
There are many potential contents of a business plan. The European Venture Capital Association suggest the following:
- Profiles of company founders directors and other key managers;
- Statistics relating to sales and markets;
- Names of potential customers and anticipated demand;
- Names of, information about and assessment of competitors;
- Financial information required to support specific projects (for example, major capital investment or new product
development);
- Research and development information;
- Production process and sources of supply;
- Information on requirements for factory and plant;
- Magazine and newspaper articles about the business and industry;
- Regulations and laws that could affect the business product and process protection
(patents, copyrights, trademarks).
The challenge for management in preparing a business plan is to communicate their ideas clearly and succinctly. The
very process of researching and writing the business plan should help clarify ideas and identify gaps in management
information about their business, competitors and the market.
Types of Finance - Introduction
A brief description of the key features of the main sources of business finance is provided below.
Venture Capital
Venture capital is a general term to describe a range of ordinary and preference shares where the investing institution
acquires a share in the business. Venture capital is intended for higher risks such as start up situations and development
capital for more mature investments. Replacement capital brings in an institution in place of one of the original
shareholders of a business who wishes to realise their personal equity before the other shareholders. There are over
100 different venture capital funds in the UK and some have geographical or industry preferences. There are also certain
large industrial companies which have funds available to invest in growing businesses and this 'corporate venturing' is
an additional source of equity finance.
Grants and Soft Loans
Government, local authorities, local development agencies and the European Union are the major sources of grants and
soft loans. Grants are normally made to facilitate the purchase of assets and either the generation of jobs or the training
of employees. Soft loans are normally subsidised by a third party so that the terms of interest and security levels are less
than the market rate. There are over 350 initiatives from the Department of Trade and Industry alone so it is a matter of
identifying which sources will be appropriate in each case.
Invoice Discounting and Invoice Factoring
Finance can be raised against debts due from customers via invoice discounting or invoice factoring, thus improving cash
flow. Debtors are used as the prime security for the lender and the borrower may obtain up to about 80 per cent of
approved debts. In addition, a number of these sources of finance will now lend against stock and other assets and may
be more suitable then bank lending. Invoice discounting is normally confidential (the customer is not aware that their
payments are essentially insured) whereas factoring extends the simple discounting principle by also dealing with the
administration of the sales ledger and debtor collection.
Hire Purchase and Leasing
Hire purchase agreements and leasing provide finance for the acquisition of specific assets such as cars, equipment and
machinery involving a deposit and repayments over, typically, three to ten years. Technically, ownership of the asset
remains with the lessor whereas title to the goods is eventually transferred to the hirer in a hire purchase agreement.
Loans
Medium term loans (up to seven years) and long term loans (including commercial mortgages) are provided for specific
purposes such as acquiring an asset, business or shares. The loan is normally secured on the asset or assets and the
interest rate may be variable or fixed. The Small Firms Loan Guarantee Scheme can provide up to 250,000 of borrowing
supported by a government guarantee where all other sources of finance have been exhausted.
Mezzanine Debt
This is a loan finance where there is little or no security left after the senior debt has been secured. To reflect the higher
risk of mezzanine funds, the lender will charge a rate of interest of perhaps four to eight per cent over bank base rate,
may take an option to acquire some equity and may require repayment over a shorter term.
Bank Overdraft
An overdraft is an agreed sum by which a customer can overdraw their current account. It is normally secured on
current assets, repayable on demand and used for short term working capital fluctuations. The interest cost is normally
variable and linked to bank base rate.
Completing the finance-raising
Raising finance is often a complex process. Business management need to assess several alternatives and then negotiate
terms which are acceptable to the finance provider. The main negotiating points are often as follows:
- Whether equity investors take a seat on the board
- Votes ascribed to equity investors
- Level of warranties and indemnities provided by the directors
- Financier's fees and costs
- Who bears costs of due diligence.
During the finance-raising process, accountants are often called to review the financial aspects of the plan. Their report
may be formal or informal, an overview or an extensive review of the company's management information system,
forecasting methods and their accuracy, review of latest management accounts including working capital, pension
funding and employee contracts etc. This due diligence process is used to highlight any fundamental problems that may
exist.
Introduction to accounting
Introduction
It is not easy to provide a concise definition of accounting since the word has a broad application within businesses and
applications.
The American Accounting Association define accounting as follows:
"the process of identifying, measuring and communicating economic information to permit informed judgements and
decisions by users of the information!.
This definition is a good place to start. Let's look at the key words in the above definition:
- It suggests that accounting is about providing information to others. Accounting information is economic
information - it relates to the financial or economic activities of the business or organisation.
- Accounting information needs to be identified and measured. This is done by way of a "set of accounts", based on a
system of accounting known as double-entry bookkeeping. The accounting system identifies and records "accounting
transactions".
- The "measurement" of accounting information is not a straight-forward process. it involves making judgements about
the value of assets owned by a business or liabilities owed by a business. it is also about accurately measuring how
much profit or loss has been made by a business in a particular period. As we will see, the measurement of accounting
information often requires subjective judgement to come to a conclusion
- The definition identifies the need for accounting information to be communicated. The way in which this
communication is achieved may vary. There are several forms of accounting communication (e.g. annual report and
accounts, management accounting reports) each of which serve a slightly different purpose. The communication need is
about understanding who needs the accounting information, and what they need to know!
Accounting information is communicated using "financial statements"
What is the purpose of financial statements?
There are two main purposes of financial statements:
(1) To report on the financial position of an entity (e.g. a business, an organisation);
(2) To show how the entity has performed (financially) over a particularly period of time (an "accounting period").
The most common measurement of "performance" is profit.
It is important to understand that financial statements can be historical or relate to the future.
Accountability
Accounting is about ACCOUNTABILTY
Most organisations are externally accountable in some way for their actions and activities. They will produce reports on
their activities that will reflect their objectives and the people to whom they are accountable.
The table below provides examples of different types of organisations and how accountability is linked to their differing
organisational objectives:
Organisation Objectives Accountable to (examples)
Private or public company
(e.g. BP, Tesco)
- Making of profit
- Creation of wealth
- Shareholders
- Other stakeholders (e.g. employees,
customers, suppliers)
Charities
(e.g. Save the Children)
- Achievement of charitable aims
- Maximise spending on activities
- Charity commissioners
- Donors
Local Authorities
(e.g. Leeds City Council)
- Provision of local services
- Optimal allocation of spending budget
- Local electorate
- Government departments
Public services (e.g. transport,
health)
(e.g. National Health
Service,Prison Service)
- Provision of public service (often
required by law)
- High quality and reliability of services
- Government ministers
- Consumers
Quasi-governmental agencies
(e.g. Data Protection
- Regulation or instigation of some public
action
- Government ministers
Registrar, Scottish Arts Council) - Coordination of public sector
investments
- Consumers
All of the above organisations have a significant roles to play in society and have multiple stakeholders to whom they
are accountable.
All require systems of financial management to enable them to produce accounting information.
How accounting information helps businesses be accountable
As we have said in our introductory definition, accounting is essentially an "information process" that serves several
purposes:
- Providing a record of assets owned, amounts owed to others and monies invested;
- Providing reports showing the financial position of an organisation and the profitability of its operations
- Helps management actually manage the organisation
- Provides a way of measuring an organisation's effectiveness (and that of its separate parts and management)
- Helps stakeholders monitor an organisations activities and performance
- Enables potential investors or funders to evaluate an organisation and make decisions
There are many potential users of accounting Information, including shareholders, lenders, customers, suppliers,
government departments (e.g. Inland Revenue), employees and their organisations, and society at large. Anyone with
an interest in the performance and activities of an organisation is traditionally called a stakeholder.
For a business or organisation to communicate its results and position to stakeholders, it needs a language that is
understood by all in common. Hence, accounting has come to be known as the "language of business"
There are two broad types of accounting information:
(1) Financial Accounts: geared toward external users of accounting information
(2) Management Accounts: aimed more at internal users of accounting information
Although there is a difference in the type of information presented in financial and management accounts, the
underlying objective is the same - to satisfy the information needs of the user. These needs can be described in terms of
the following overall information objectives:
Collection
Collection in money terms of information relating to transactions that have resulted from
business operations
Recording and Classifying
Recording and classifying data into a permanent and logical form. This is usually referred
to as "Book-keeping"
Summarising
Summarising data to produce statements and reports that will be useful to the various
users of accounting information - both external and internal
Interpreting and
Communicating
Interpreting and communicating the performance of the business to the management
and its owners
Forecasting and Planning
Forecasting and planning for future operation of the business by providing management
with evaluations of the viability of proposed operations. The key forecasting and planning
tool is the "Budget"
The process by which accounting information is collected, reported, interpreted and actioned is called "Financial
Management". Taking a commercial business as the most common organisational structure, the key objectives of
financial management would be to:
(1) Create wealth for the business
(2) Generate cash, and
(3) Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources
invested
In preparing accounting information, care should be taken to ensure that the information presents an accurate and true
view of the business performance and position. To impose some order on what is a subjective task, accounting has
adopted certain conventions and concepts which should be applied in preparing accounts.
For financial accounts, the regulation or control of what kind of information is prepared and presented goes much
further. UK and international companies are required to comply with a wide range of Accounting Standards which
define the way in which business transactions are disclosed and reported. These are applied by businesses through
their Accounting Policies.
The main financial accounting statements
The purpose of financial accounting statements is mainly to show the financial position of a business at a particular
point in time and to show how that business has performed over a specific period.
The three main financial accounting statements that help achieve this aim are:
(1) The profit and loss account for the reporting period
(2) A balance sheet for the business at the end of the reporting period
(3) A cash flow statement for the reporting period
A balance sheet shows at a particular point in time what resources are owned by a business ("assets") and what it owes
to other parties ("liabilities"). It also shows how much has been invested in the business and what the sources of that
investment finance were.
It is often helpful to think of a balance sheet as a "snap-shot" of the business - a picture of the financial position of the
business at a specific point. Whilst this is a useful picture to have, every time an accounting transaction takes place, the
"snap-shot" picture will have changed.
By contrast, the profit and loss account provides a perspective on a longer time-period. If the balance sheet is a "digital
snap-shot" of the business, then think of the profit and loss account as the "DVD" of the business' activities. The story of
what financial transactions took place in a particular period - and (most importantly) what the overall result of those
transactions was.
Not surprisingly, the profit and loss account measures "profit".
What is profit?
Profit is the amount by which sales revenue (also known as "turnover" or "income") exceeds "expenses" (or "costs") for
the period being measured.
Users of accounts
The financial accounts provide a wealth of information that is useful to various users of financial information, as
summarised below:
User Interest in / Use of Accounting Information
Investors Investors are concerned about risk and return in relation to their investments. They
require information to decide whether they should continue to invest in a business.
They also need to be able to assess whether a business will be able to pay
dividends, and to measure the performance of the business' management overall
Lenders Banks and other financial institutions who lend money to a business require
information that helps them determined whether loans and interest will be paid
when due
Creditors Suppliers and trade creditors require information that helps them understand and
assess the short-term liquidity of a business. Is the business able to pay short-term
debt when it falls due?
Customers &
Debtors
Customers and trade debtors require information about the ability of the business
to survive and prosper. As customers of the company's products, they have a long-
term interest in the company's range of products and services. They may even be
dependent on the business for certain products or services
Employees Employees (and organisations that represent them - e.g. trade unions) require
information about the stability and continuing profitability of the business. They are
crucially interested in information about employment prospects and the
maintenance of pension funding and retirement benefits. They are also likely to
interested in the pay and benefits obtained by senior management!
Government There are many government agencies and departments that are interested in
accounting information. For example, the IR&CE needs information on business
profitability in order to levy and collect Corporation Tax. Various regulatory
agencies (e.g. the Competition Commission and the Environment Agency) need
information to support decisions about takeovers and grants, for example.
Analysts Investment analysts are an important user group - specifically for companies
quoted on a stock exchange. They require very detailed financial and other
information in order to analyse the competitive performance of a business and its
sector. Much of this is provided by the detailed accounting disclosures that are
required by the London Stock Exchange. However, additional accounting
information is usually provided to analysts via formal company briefings and
interviews.
General public Interest groups, formed by various groups of individuals who have a specific
interest in the activities and performance of businesses, will also require accounting
information.
Accounting concepts and conventions
In drawing up accounting statements, whether they are external "financial accounts" or internally-focused
"management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of the business
and the results of its operation.
The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is
applied in ensuring and assessing whether accounts do indeed portray accurately the business' activities.
To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which
help to ensure that accounting information is presented accurately and consistently.
Accounting Conventions
The most commonly encountered convention is the "historical cost convention". This requires transactions to be
recorded at the price ruling at the time, and for assets to be valued at their original cost.
Under the "historical cost convention", therefore, no account is taken of changing prices in the economy.
The other conventions you will encounter in a set of accounts can be summarised as follows:
Monetary
measurement
Accountants do not account for items unless they can be quantified in monetary terms. Items
that are not accounted for (unless someone is prepared to pay something for them) include
things like workforce skill, morale, market leadership, brand recognition, quality of management
etc.
Separate Entity This convention seeks to ensure that private transactions and matters relating to the owners of a
business are segregated from transactions that relate to the business.
Realisation With this convention, accounts recognise transactions (and any profits arising from them) at the
point of sale or transfer of legal ownership - rather than just when cash actually changes hands.
For example, a company that makes a sale to a customer can recognise that sale when the
transaction is legal - at the point of contract. The actual payment due from the customer may not
arise until several weeks (or months) later - if the customer has been granted some credit terms.
Materiality An important convention. As we can see from the application of accounting standards and
accounting policies, the preparation of accounts involves a high degree of judgement. Where
decisions are required about the appropriateness of a particular accounting judgement, the
"materiality" convention suggests that this should only be an issue if the judgement is
"significant" or "material" to a user of the accounts. The concept of "materiality" is an important
issue for auditors of financial accounts.

Accounting Concepts
Four important accounting concepts underpin the preparation of any set of accounts:
Going Concern Accountants assume, unless there is evidence to the contrary, that a company is not going broke.
This has important implications for the valuation of assets and liabilities.
Consistency Transactions and valuation methods are treated the same way from year to year, or period to
period. Users of accounts can, therefore, make more meaningful comparisons of financial
performance from year to year. Where accounting policies are changed, companies are required
to disclose this fact and explain the impact of any change.
Prudence Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for
future problems and costs of the business (the are "provided for" in the accounts" as soon as their
is a reasonable chance that such costs will be incurred in the future.
Matching (or
"Accruals")
Income should be properly "matched" with the expenses of a given accounting period.
Key Characteristics of Accounting Information
There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups,
accounting information should satisfy the following criteria:
Criteria What it means for the preparation of accounting information
Understandability This implies the expression, with clarity, of accounting information in such a way that it will be
understandable to users - who are generally assumed to have a reasonable knowledge of business
and economic activities
Relevance This implies that, to be useful, accounting information must assist a user to form, confirm or maybe
revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money to
this business? Should I work for this business?)
Consistency This implies consistent treatment of similar items and application of accounting policies
Comparability This implies the ability for users to be able to compare similar companies in the same industry group
and to make comparisons of performance over time. Much of the work that goes into setting
accounting standards is based around the need for comparability.
Reliability This implies that the accounting information that is presented is truthful, accurate, complete
(nothing significant missed out) and capable of being verified (e.g. by a potential investor).
Objectivity This implies that accounting information is prepared and reported in a "neutral" way. In other words,
it is not biased towards a particular user group or vested interest
Introduction to stakeholders
Lets start with a definition of stakeholders, which are:
Groups / individuals that are affected by and/or have an interest in the operations and objectives of the business
Most businesses have a variety of stakeholder groups which can be broadly categorised as follows:


Stakeholder groups vary both in terms of their interest in the business activities and also their power to influence
business decisions. Here is a useful summary:

Stakeholder Main Interests Power and influence
Shareholders Profit growth, Share price growth,
dividends
Election of directors
Banks & other
Lenders
Interest and principal to be repaid,
maintain credit rating
Can enforce loan covenants
Can withdraw banking facilities
Directors and
managers
Salary ,share options, job satisfaction,
status
Make decisions, have detailed
information
Employees Salaries & wages, job security, job
satisfaction & motivation
Staff turnover, industrial action, service
quality
Suppliers Long term contracts, prompt payment,
growth of purchasing
Pricing, quality, product availability
Customers Reliable quality, value for money,
product availability, customer service
Revenue / repeat business
Word of mouth recommendation
Community Environment, local jobs, local impact Indirect via local planning and opinion
leaders
Government Operate legally, tax receipts, jobs Regulation, subsidies, taxation, planning

Income statement (overview)
The income statement is a historical record of the trading of a business over a specific period (normally one year). It
shows the profit or loss made by the business which is the difference between the firms total income and its total
costs.
The income statement serves several important purposes:
Allows shareholders/owners to see how the business has performed and whether it has made an acceptable
profit (return)
Helps identify whether the profit earned by the business is sustainable (profit quality)
Enables comparison with other similar businesses (e.g. competitors) and the industry as a whole
Allows providers of finance to see whether the business is able to generate sufficient profits to remain viable
(in conjunction with the cash flow statement)
Allows the directors of a company to satisfy their legal requirements to report on the financial record of the
business
The structure and format of a typical income statement is illustrated below:
Boston Learning Systems plc
Income Statement 2011 2010
Year Ended 31 December '000 '000

Revenue 21,450 19,780
Cost of sales 13,465 12,680
Gross profit 7,985 7,100
Distribution costs 3,210 2,985
Administration expenses 2,180 1,905
Operating profit 2,595 2,210
Finance costs 156 120
Profit before tax 2,439 2,090
Tax expense 746 580
Profit attributable to shareholders 1,693 1,510
The lines in the income statement can be briefly described as follows:
Category Explanation
Revenue The revenues (sales) during the period are recorded here. Sometimes referred
to as the top line revenue shows the total value of sales made to customers
Cost of sales The direct costs of generating the recorded revenues go into cost of
sales. This would include the cost of raw materials, components, goods
bought for resale and the direct labour costs of production.
Gross profit The difference between revenue and cost of sales. A simple but very useful
measure of how much profit is generated from every 1 of revenue before
overheads and other expenses are taken into account. Is used to calculate
thegross profit margin (%)
Distribution &
administration
expenses
Operating costs and expenses that are not directly related to producing the
goods or services are recorded here. These would include distribution costs
(e.g. marketing, transport) and the wide range of administrative expenses or
overheads that a business incurs.
Operating profit A key measure of profit. Operating profit records how much profit has been
made in total from the trading activities of the business before any account is
taken of how the business is financed.
Finance expenses Interest paid on bank and other borrowings, less interest income received on
cash balances, is shown here. A useful figure for shareholders to assess how
much profit is being used up by the funding structure of the business.
Profit before tax Calculated as operating profit less finance expenses
Tax An estimate of the amount of corporation tax that is likely to be payable on the
recorded profit before tax
Profit attributable to
shareholders
The amount of profit that is left after the tax has been accounted for. The
shareholders then decide how much of this is paid out to them in dividends and
how much is left in the business (retained earnings in the equity section of
the balance sheet)
Profit quality
One of the issues to consider when looking at the income statement is to look at whether the reported profit ishigh
quality or low quality. What is the difference?
A high quality profit is one which can be repeated or sustained. In other words the profit does not contain any
unusual one-off items of income or profit which shareholders cannot reasonably expect the business achieve in the
following year.
A low quality profit is one which it is difficult to repeat. The profit is likely to benefit from one or more exceptional
items which will not repeat. Examples of exceptional items include:
One-off profits on selling major items of property, plant and equipment (e.g. selling a piece of land)
Income from a significant insurance claim
Profits from selling business units or brands
Balance Sheet (overview)
A balance sheet is a statement of the total assets and liabilities of an organisation at a particular date - usually the
last date of an accounting period.
The balance sheet is split into two parts:
(1) A statement of fixed assets, current assets and the liabilities (sometimes referred to as "Net Assets")
(2) A statement showing how the Net Assets have been financed, for example through share capital and retained
profits.
The Companies Act requires the balance sheet to be included in the published financial accounts of all limited
companies. In reality, all other organisations that need to prepare accounting information for external users (e.g.
charities, clubs, partnerships) will also product a balance sheet since it is an important statement of the financial
affairs of the organisation.
A balance sheet does not necessary "value" a company, since assets and liabilities are shown at "historical cost"and
some intangible assets (e.g. brands, quality of management, market leadership) are not included.
Example Balance Sheet
The structure of a typical balance sheet is illustrated below:
Boston Learning Systems plc
Balance Sheet at 31 December
2009 2008
'000 '000
ASSETS
Non-current assets
Goodwill and other intangible assets 150 150
Property, plant & equipment 2,450 2,100
2,600 2,250
Current assets
Inventories 1,325 1,475
Trade and other receivables 4,030 3,800
Short-term investments 250 190
Cash and cash equivalents 1,340 780
6,945 6,245
Current liabilities
Trade and other payables 2,310 2,225
Short-term borrowings 350 550
Current tax liabilities 800 650
Provisions 290 255
3,750 3,680

Net current assets 3,195 2,565

Non-current liabilities
Borrowings 1,200 1,450
Provisions 140 140
1,340 1,590

NET ASSETS 4,455 3,225

EQUITY
Share capital 500 500
Retained earnings 3,955 2,725
TOTAL EQUITY 4,455 3,225
An asset is any right or thing that is owned by a business. Assets include land, buildings, equipment and anything else a
business owns that can be given a value in money terms for the purpose of financial reporting.
Definition of Liabilities
To acquire its assets, a business may have to obtain money from various sources in addition to its owners
(shareholders) or from retained profits. The various amounts of money owed by a business are called its liabilities.
Long-term and Current
To provide additional information to the user, assets and liabilities are usually classified in the balance sheet as:
- Current: those due to be repaid or converted into cash within 12 months of the balance sheet date;
- Long-term: those due to be repaid or converted into cash more than 12 months after the balance sheet date;
Fixed Assets
A further classification other than long-term or current is also used for assets. A "fixed asset" is an asset which is
intended to be of a permanent nature and which is used by the business to provide the capability to conduct its trade.
Examples of "tangible fixed assets" include plant & machinery, land & buildings and motor vehicles."Intangible fixed
assets" may include goodwill, patents, trademarks and brands - although they may only be included if they have been
"acquired". Investments in other companies which are intended to be held for the long-term can also be shown under
the fixed asset heading.
Definition of Capital
As well as borrowing from banks and other sources, all companies receive finance from their owners. This money is
generally available for the life of the business and is normally only repaid when the company is "wound up". To
distinguish between the liabilities owed to third parties and to the business owners, the latter is referred to as
the"capital" or "equity capital" of the company.
In addition, undistributed profits are re-invested in company assets (such as stocks, equipment and the bank balance).
Although these "retained profits" may be available for distribution to shareholders - and may be paid out as dividends
as a future date - they are added to the equity capital of the business in arriving at the total "equity shareholders'
funds".
At any time, therefore, the capital of a business is equal to the assets (usually cash) received from the shareholders
plus any profits made by the company through trading that remain undistributed.
Current assets
This section of the balance sheet shows the assets a business owns which are either cash, cash equivalents, or are
expected to be turned into cash during the next twelve months.
Current assets are, therefore, very important to cash flow management and forecasting, because they are the assets
that a business uses to pay its bills, repay borrowings, pay dividends and so on,
Current assets are listed in order of their liquidity or in other words, how easy it is to turn each category of current
asset into cash.
The main elements of current assets are:
Inventories Inventories (often also called stocks) are the least liquid kind of current asset.
Inventories include holdings of raw materials, components, finished products
ready to sell and also the cost of work-in-progress as it passes through the
production process.
For the balance sheet, a business will value its inventories at cost. A profit is only
earned and recorded once inventories have been sold.
Not all inventories can eventually be sold. A common problem is stock
obsolescence where inventories have to be sold for less than their cost (or
thrown away) perhaps because they are damaged or customers no longer demand
them. For these inventories, the balance sheet value should be the amount that can
be recovered if the stocks can finally be sold.
Trade and other
receivables
Trade debtors are usually the main part of this category. A trade debtor is created
when a customer is allowed to buys goods or services on credit. The sale is
recognised as revenue (income statement) when the transaction takes place and the
amount owed is added to trade debtors in the balance sheet. At some stage in the
future, when the customer settles the invoice, the trade debtor balance converts
into cash!
Most businesses operate with a reasonably significant amount owed by trade
debtors at any one time. It is not unusual for customers to take between 60-90
days to pay amounts owed, although the average payment period varies by
industry. Of course some customer debts are not eventually paid the customer
becomes insolvent, leaving the business with debtor balances that it cannot
recover.
When a business is doubtful whether a customer will settle its debts it needs to
make an allowance for this in the balance sheet. This is done by making a
provision for bad and doubtful debts which effectively reduces the value of
trade debtors to the total amount that the business reasonably expects to receive in
the future.
Short-term
investments
A business with positive cash balances can either hold them in the bank or invest
them for short periods perhaps by placing them on short-term deposit. Such
investments would be shown in this category.
Cash and cash
equivalents
The most liquid form of current assets = the actual cash balances that the business
has! The bank account balance would be the main item in this category.
Current liabilities
Current liabilities represent amounts that are owed by the business and which are due to be paid within the next twelve
months. Current liabilities are normally settled from the amounts available in current assets.
The main elements of current liabilities are:
Trade and other The main element of this is normally trade creditors amounts owed by a
payables business to its suppliers for goods and services supplied. A trade creditor is the
reverse of a trade debtor. A business buys from a supplier and then pays for
those goods and services some time later the period depends on the length
and amount of credit the supplier allows.
Short-term
borrowings
Amounts in this category represent the amounts that need to be repaid on
outstanding borrowings in the next year. For example, a business may have a
bank loan of 2million of which 250,000 is due to be repaid six months after
the balance sheet date. In the balance sheet, the bank loan would be split into
two categories: 250,000 as short-term borrowings and the remainder
(1,750,000) in the borrowings figure in non-current liabilities.
Current tax liabilities This category shows the tax liabilities that the business is still to pay to the
government. This will mainly comprise corporation tax, income tax and VAT.
Provisions This is a category that can contain a variety of amounts due. For example, it
would include any dividends due to be paid to shareholders. More importantly,
it will also include any estimates of potential costs which the business might
incur in relation to known disputes or other issues. For example, if the business
is subject to legal claims or is planning to make redundancies in the near future
then the likely costs of these issues needs to be provided for in the balance
sheet
Non-current liabilities
This category shows the longer-term liabilities that a business has. By longer-term, we mean liabilities that need to be
settled in more than one years time. This would include bank loans which are not yet due for repayment.
Accounting for fixed assets
Introduction
An important distinction is made in accounting between "current assets" and " "fixed assets".
Current assets are those that form part of the circulating capital of a business. They are replaced frequently or
converted into cash during the course of trading. The most common current assets are stocks, trade debtors, and cash.
Compare current assets with fixed assets. A fixed asset is an asset of a business intended for continuing use, rather
than a short-term, temporary asset such as stocks.
Fixed assets must be classified in a company's balance sheet as intangible, tangible, or investments. Examples of
intangible assets include goodwill, patents, and trademarks. Examples of tangible fixed assets include land and buildings,
plant and machinery, fixtures and fittings, motor vehicles and IT equipment.
How should the changing value of a fixed asset be reflected in a company's accounts?
The benefits that a business obtains from a fixed asset extend over several years. For example, a company may use the
same piece of production machinery for many years, whereas a company-owned motor car used by a salesman
probably has a shorter useful life.
By accepting that the life of a fixed asset is limited, the accounts of a business need to recognise the benefits of the fixed
asset as it is "consumed" over several years.
This consumption of a fixed asset is referred to as depreciation.
Definition of depreciation
Financial Reporting Standard 15 (covering the accounting for tangible fixed assets) defines depreciation as follows:
"the wearing out, using up, or other reduction in the useful economic life of a tangible fixed asset whether arising from
use, effluxion of time or obsolescence through either changes in technology or demand for goods and services produced
by the asset.'
A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to
generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn.
In determining the expenses for a period, it is therefore important to include an amount to represent the consumption
of fixed assets during that period (that is, depreciation).
In essence, depreciation involves allocating the cost of the fixed asset (less any residual value) over its useful life. To
calculate the depreciation charge for an accounting period, the following factors are relevant:
- the cost of the fixed asset;
- the (estimated) useful life of the asset;
- the (estimated) residual value of the asset.
What is the relevant cost of a fixed asset?
The cost of a fixed asset includes all amounts incurred to acquire the asset and any amounts that can be directly
attributable to bringing the asset into working condition.
Directly attributable costs may include:
- Delivery costs
- Costs associated with acquiring the asset such as stamp duty and import duties
- Costs of preparing the site for installation of the asset
- Professional fees, such as legal fees and architects' fees
Note that general overhead costs or administration costs would not be included as part of the total
costs of a fixed asset (e.g. the costs of the factory building in which the asset is kept, or the cost of the maintenance
team who keep the asset in good working condition)
The cost of subsequent expenditure on a fixed asset will be added to the cost of the asset provided that this expenditure
enhances the benefits of the fixed asset or restores any benefits consumed.
This means that major improvements or a major overhaul may be capitalised and included as part of the cost of the
asset in the accounts.
However, the costs of repairs or overhauls that are carried out simply to maintain existing performance will be treated
as expenses of the accounting period in which the work is done, and charged in full as an expense in that period.
What is the Useful Life of a fixed asset?
An asset may be seen as having a physical life and an economic life.
Most fixed assets suffer physical deterioration through usage and the passage of time. Although care and maintenance
may succeed in extending the physical life of an asset, typically it will, eventually, reach a condition where the benefits
have been exhausted.
However, a business may not wish to keep an asset until the end of its physical life. There may be a point when it
becomes uneconomic to continue to use the asset even though there is still some physical life left.
The economic life of the asset will be determined by such factors as technological progress and changes in demand. For
purposes of calculating depreciation, it is the estimated economic life rather than the potential physical life of the fixed
asset that is used.
What about the Residual Value of a fixed asset?
At the end of the useful life of a fixed asset the business will dispose of it and any amounts received from the disposal
will represent its residual value. This, again, may be difficult to estimate in practice. However, an estimate has to be
made. If it is unlikely to be a significant amount, a residual value of zero will be assumed.
The cost of a fixed asset less its estimated residual value represents the total amount to be depreciated over its
estimated useful life.
Depreciation of fixed assets
Introduction
In our introduction to accounting for fixed assets, we described how businesses need to account for the consumption of
fixed assets over time in a way that reflects their reducing value. The term given to this consumption is depreciation.
This revision note explains the various methods available to calculate depreciation and highlights how subjective this
calculation can be. Other revision notes provide worked example of each depreciation method.
Depreciation Methods
The total amount to be depreciated over the life of a fixed asset is determined by the following calculation:
Cost of the fixed asset less residual value
The period over which to depreciate a fixed asset is known as the "useful economic life" of the asset
So how much of this depreciable amount is charged against profits in each accounting period?
A depreciation method is required to allocate, in a systematic way, the total amount to be depreciated between each
accounting period of the asset's useful economic life.
There are various methods of depreciation available. However, most businesses appear to adopt one of the two
methods described below.
Method 1 - Straight-line depreciation
The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each
accounting period of the asset's life should bear an equal amount of depreciation.
As a result, the depreciation charge for the asset can be calculated using the following formula:
Dpn = (C- R)/ N
where:
Dpn = Annual straight-line depreciation charge
C = Cost of the asset
R = Residual value of the asset
N = Useful economic life of the asset (years)
Whilst it is simple and popular, Is the straight line depreciation method the most appropriate way of calculating
depreciation?
The answer lies in understanding that depreciation is a process of allocation, not valuation.
The pattern of annual depreciation charges for a fixed asset should attempt to match the pattern of benefits derived
from that asset. Therefore, where the benefits from an asset are likely to be reasonably constant over its life the
straight-line method of depreciation would be appropriate as it results in a constant annual depreciation charge.
In practice it may be difficult to assess the pattern of benefits relating to an asset. In such cases the straight-line method
may often be chosen simply because it is easy to understand and calculate.
Method 2 - Reducing balance method
The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's
life but the annual depreciation charge reduces progressively as the asset ages.
To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of
the asset. Thus, depreciation is calculated as a percentage of the reducing balance.
For certain fixed assets, the benefits derived may be high in the early years, but may decline as the asset ages. For such
assets, the reducing-balance method of depreciation would be appropriate insofar as it matches the depreciation
expense with the pattern of benefits.
Once a particular method of depreciation has been chosen for a fixed asset, the method should be applied consistently
over its life. It is only permissible to switch from one method to another if the new method provides a fairer
presentation of the financial results and financial position.
Total depreciation charged
It should be noted that, whichever method of depreciation is selected, the total depreciation to be charged over the
useful life of a fixed asset will be the same.
It is simply the allocation of the total depreciation charge between accounting periods that is affected by the choice of
method.
Depreciation - straight line example
Introduction
In our introduction to the methods available to calculate depreciation, we suggested that there are two main methods
that can be used:
- Straight- line depreciation
- Reducing balance method
We emphasised the point that these two methods simply provide an alternative way of allocating the total depreciation
charge over several accounting periods. The total depreciation charge using either method will be the same over the
total useful economic life of the asset.
To illustrate the straight line depreciation method, we have calculated the depreciation charge for the following asset:
Data
A business purchases a new machine for 75,000 on 1 January 2003. It is estimated that the machine will have a residual
value of 10,000 and a useful economic life of five years. The business has an accounting year end of 31 December.
Straight line depreciation method
Using the straight line depreciation method, the calculation of the annual depreciation charge is as follows:
Dpn = (C- R)/ N
where:
Dpn = Annual straight-line depreciation charge
C = Cost of the asset
R = Residual value of the asset
N = Useful economic life of the asset (years)
So the calculation is:
Dpn = (75,000 - 10,000) / 5
Dpn = 13,000
in the accounts of the business a depreciation charge of 13,000 will be expensed in the profit and loss account for each
of the five years of the asset's useful economic life.
In the annual balance sheet, the machine would be shown at its original cost less the total accumulated depreciation for
the asset to date.
Example of how this would be disclosed in the accounts
At the end of the third year of ownership of the machine, the financial accounts of the business would include the
following items in relation to the machine:
In the Profit and Loss Account:
Depreciation of Machinery - Charge: 13,000
In the Balance Sheet at 31 December 2005:

Machine at Cost 75,000

less: Accumulated Depreciation 39,000

Machine at net book value

36,000
The figure for accumulated depreciation of 39,000 at 31 December 2005 represents three years' worth of depreciation
at 13,000 per year.
The cost of the machine (75,000) less the accumulated depreciation charged on the machine (39,000) is known as the
"written-down value" ("WDV") or "net book value" ("NBV").
it should be noted that WDV or NBV is simply an accounting value that is the result of a decision about which method is
used to calculate depreciation. It does not necessarily mean that the machine is actually worth more or less than the
WDV or NBV.
Depreciation - reducing balance example
Introduction
In our introduction to the methods available to calculate depreciation, we suggested that there are two main methods
that can be used:
- Straight- line depreciation
- Reducing balance method
We emphasised the point that these two methods simply provide an alternative way of allocating the total depreciation
charge over several accounting periods. The total depreciation charge using either method will be the same over the
total useful economic life of the asset.
To illustrate the reducing balance depreciation method, we have calculated the depreciation charge for the following
asset:
Data
A business purchases a new machine for 75,000 on 1 January 2003. It is estimated that the machine will have a residual
value of 10,000 and a useful economic life of five years. The business decides to calculate annual depreciation at the
rate of 40% of the written-down value. The business has an accounting year end of 31 December.
Reducing balance depreciation method
Using the straight line depreciation method, the calculation of the annual depreciation charge is as follows:
31 December
Original machine cost 75,000
2003 Depreciation in 2003 (40% cost) 30,000
Written down value at 31 December 2003 45,000

2004 Depreciation in 2004 (40% of WDV @ 31 December 2003) 18,000
Written down value at 31 December 2004 27,000


2005 Depreciation in 2005 (40% of WDV @ 31 December 2004) 10,800
Written down value at 31 December 2005 16,200


2006 Depreciation in 2006 (40% of WDV @ 31 December 2005) 6,480
Written down value at 31 December 2006 9,720


2007 Depreciation in 2007 (40% of WDV @ 31 December 2006) 3,888
Written down value at 31 December 2007 5,832
The reducing balance method can result in significant differences in the annual depreciation charge, depending on the
"percentage" of written-down value that is used to calculate the charge.
In the example above, the total amount charged to depreciation in the first three years of owning the machine (2003-
2005) was 58,800 (compared with 39,000 if a straight line depreciation method has been used).


Main ratios (introduction)
In our introduction to interpreting financial information we identified five main areas for investigation of accounting
information. The use of ratio analysis in each of these areas is introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an acceptable rate. The key ratios are:
Ratio Calculation Comments
Gross Profit
Margin
[Gross Profit / Revenue] x
100 (expressed as a
percentage
This ratio tells us something about the business's ability consistently to
control its production costs or to manage the margins its makes on products
its buys and sells. Whilst sales value and volumes may move up and down
significantly, the gross profit margin is usually quite stable (in percentage
terms). However, a small increase (or decrease) in profit margin, however
caused can produce a substantial change in overall profits.
Operating
Profit Margin
[Operating Profit / Revenue]
x 100 (expressed as a
percentage)
Assuming a constant gross profit margin, the operating profit margin tells us
something about a company's ability to control its other operating costs or
overheads.
Return on
capital
employed
("ROCE")
Net profit before tax,
interest and dividends
("EBIT") / total assets (or
total assets less current
liabilities
ROCE is sometimes referred to as the "primary ratio"; it tells us what returns
management has made on the resources made available to them before
making any distribution of those returns.
Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those resources invested in fixed assets and
working capital.
Ratio Calculation Comments
Sales /Capital
Employed
Sales / Capital employed A measure of total asset utilisation. Helps to answer the question - what
sales are being generated by each pound's worth of assets invested in the
business. Note, when combined with the return on sales (see above) it
generates the primary ratio - ROCE.
Sales or Profit
/ Fixed Assets
Sales or profit / Fixed
Assets
This ratio is about fixed asset capacity. A reducing sales or profit being
generated from each pound invested in fixed assets may indicate
overcapacity or poorer-performing equipment.
Stock Turnover Cost of Sales / Average
Stock Value
Stock turnover helps answer questions such as "have we got too much
money tied up in inventory"?. An increasing stock turnover figure or one
which is much larger than the "average" for an industry, may indicate poor
stock management.
Credit Given /
"Debtor Days"
(Trade debtors (average, if
possible) / (Sales)) x 365
The "debtor days" ratio indicates whether debtors are being allowed
excessive credit. A high figure (more than the industry average) may suggest
general problems with debt collection or the financial position of major
customers.
Credit taken /
"Creditor
Days"
((Trade creditors +
accruals) / (cost of sales +
other purchases)) x 365
A similar calculation to that for debtors, giving an insight into whether a
business is taking full advantage of trade credit available to it.
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due:
Ratio Calculation Comments
Current Ratio Current Assets / Current
Liabilities
A simple measure that estimates whether the business can pay debts due
within one year from assets that it expects to turn into cash within that year.
A ratio of less than one is often a cause for concern, particularly if it persists
for any length of time.
Quick Ratio (or
"Acid Test"
Cash and near cash (short-
term investments + trade
debtors)
Not all assets can be turned into cash quickly or easily. Some - notably raw
materials and other stocks - must first be turned into final product, then sold
and the cash collected from debtors. The Quick Ratio therefore adjusts the
Current Ratio to eliminate all assets that are not already in cash (or "near-
cash") form. Once again, a ratio of less than one would start to send out
danger signals.
Stability Ratios
These ratios concentrate on the long-term health of a business - particularly the effect of the capital/finance structure
on the business:
Ratio Calculation Comments
Gearing Borrowing (all long-term
debts + normal overdraft) /
Net Assets (or
Shareholders' Funds)
Gearing (otherwise known as "leverage") measures the proportion of assets
invested in a business that are financed by borrowing. In theory, the higher
the level of borrowing (gearing) the higher are the risks to a business, since
the payment of interest and repayment of debts are not "optional" in the
same way as dividends. However, gearing can be a financially sound part of
a business's capital structure particularly if the business has strong,
predictable cash flows.
Interest cover Operating profit before
interest / Interest
This measures the ability of the business to "service" its debt. Are profits
sufficient to be able to pay interest and other finance costs?
Investor Ratios
There are several ratios commonly used by investors to assess the performance of a business as an investment:
Ratio Calculation Comments
Earnings per
share ("EPS")
Earnings (profits)
attributable to ordinary
shareholders / Weighted
average ordinary shares in
issue during the year
A requirement of the London Stock Exchange - an important ratio. EPS
measures the overall profit generated for each share in existence over a
particular period.
Price-Earnings
Ratio ("P/E
Market price of share /
Earnings per Share
At any time, the P/E ratio is an indication of how highly the market "rates"
or "values" a business. A P/E ratio is best viewed in the context of a sector
Ratio") or market average to get a feel for relative value and stock market pricing.
Dividend Yield (Latest dividend per
ordinary share / current
market price of share) x
100
This is known as the "payout ratio". It provides a guide as to the ability of a
business to maintain a dividend payment. It also measures the proportion of
earnings that are being retained by the business rather than distributed as
dividends.