Understanding Final Accounts: A Comprehensive Guide
What Do Final Accounts Contain?
The Trading Account
This account shows how the gross profit of a business is calculated. It uses the following formula:
Gross Profit = Sales Revenue – Cost of Goods Sold
Note that:
- Gross profit does not take into account overheads.
- Only the cost of goods sold is calculated; inventory is not included.
- In a manufacturing business, direct labor and manufacturing costs are also deducted to obtain gross profit.
The Profit and Loss Account
The profit and loss account shows how net profit is calculated. It starts with the gross profit from the trading account and deducts all other costs to arrive at net profit.
Depreciation is the fall in value of a fixed asset over time. It is considered an indirect cost to businesses.
For limited companies, there are a few differences in the profit and loss account:
- Profits tax will be shown.
- It includes an appropriation account at the end. This shows how the company used its net profits, specifically how much retained profit was reinvested.
- Results from the previous year are also included.
Balance Sheet
The balance sheet shows a business’s assets and liabilities at a specific point in time, typically the end of the financial year. It records the value of the business and includes:
- Fixed assets: Land, vehicles, buildings expected to be used for more than one year. They depreciate over time.
- Current assets: Stocks, inventory, cash, and debtors held for a short time.
- Long-term liabilities: Long-term borrowings not due within one year.
- Short-term liabilities: Short-term borrowings due within one year.
If total assets are higher than total liabilities, the business is said to have wealth. In a standard business, this wealth belongs to the owners; in a limited company, it belongs to the shareholders. This is represented by the equation:
Total Assets – Total Liabilities = Owners’/Shareholders’ Wealth
Here are some key terms found in balance sheets:
- Working capital: Used to pay short-term debts and also known as net current assets. Insufficient working capital can threaten a business’s survival. The formula is:
Working Capital = Current Assets – Current Liabilities
- Net assets: Shows the net value of all assets owned by the company. These assets must be financed by shareholders’ funds or long-term liabilities. The formula is:
Net Assets = Fixed Assets + Working Capital
- Shareholders’ funds: The total amount invested in the business by its owners. This investment takes two forms:
– Share capital: Money from newly issued shares.
– Profit and loss reserves: Profits belonging to shareholders but retained within the company rather than distributed.
- Capital employed: The long-term and permanent capital used to acquire the business’s assets. Therefore:
Capital Employed = Net Assets
Capital Employed = Shareholders’ Funds + Long-Term Liabilities
Analysis of Published Accounts
Financial accounts require analysis to provide insights into a company’s performance and financial strength. Ratio analysis, which involves comparing two figures, is used for this purpose.
Ratio Analysis of Accounts
Common ratios assess a business’s performance and liquidity. Here are five frequently used ratios:
Ratios for Analyzing Performance:
- Return on capital employed: Indicates a business’s efficiency. A rising result suggests increasing managerial success.
Return on Capital Employed (%) = Operating Profit / Capital Employed * 100
- Gross profit margin: An increase could indicate higher added value or reduced costs.
Gross Profit Margin = Gross Profit / Sales Revenue * 100
- Net profit margin: A higher result suggests greater managerial success and can be used for comparisons with other businesses.
Net Profit Margin = Net Profit Before Tax / Sales Revenue * 100
Note: Net profit does not include tax.
Ratios for Analyzing Liquidity:
These ratios assess a business’s ability to meet its short-term debt obligations.
- Current ratio: Assumes all current assets can be quickly converted to cash, which may not always be true for stock/inventory. A ratio of 1.5 to 2 is generally preferred, indicating the ability to cover short-term debts with a margin of safety.
Current Ratio = Current Assets / Current Liabilities
- Acid test or liquid ratio: Similar to the current ratio but excludes stocks from the calculation.
Acid Test Ratio = (Current Assets – Stocks) / Current Liabilities
These ratios can be used to:
- Compare performance across different years.
- Compare performance with other businesses.
Ratios are most informative when compared with past data or industry benchmarks.
Disadvantages of Ratio Analysis:
- Focuses on past performance and does not predict future outcomes.
- Comparisons across years can be distorted by inflation.
- Comparisons between businesses can be challenging due to variations in accounting methods.