Financial statements

Key financial statements

Can identify 4 statements

•       balance sheet

•       profit and loss account

•       statement of cash flows

•       budget

First 3 are identified with financial accounting

Budgets more with managerial accounting

Balance sheet

Now termed statement of financial position

A self explanatory concept

Financial position as at a particular date

•       financial year end

•       alternatively more frequently

Permits periodic comparison

•        strengthening (weakening) balance sheet

Composed of a set of year end balances

Extracted from the nominal ledger

•       master ledger

Each ledger has a closing balance

For the accounting year (period)

Serves as opening balance for next year (period)

•       book-keeping

•       double entry

Communicates the balance between

•       assets

•       liabilities (liabilities + equity)

Balances principally take the form of values

Underpinned by money measurement concept

•       cost and value calculus

•       ‘hard’ (financial) numbers

Communicates the balance between

•       assets

•       liabilities (liabilities + equity)

Balances principally take the form of values

Underpinned by money measurement concept

•       cost and value calculus

•       ‘hard’ (financial) numbers

Assets

The resources at the disposal of the business

•       what the business owns

Conventionally a distinction between

•       fixed assets

•       current assets

Fixed assets are long term assets

Current assets are more short term/liquid

Fixed assets

A wide ranging category

Assets with varying lifespans

•       fixtures and fittings vs land and buildings

Understood to wear out over time

Need to reflect this in balance sheet valuations

•       depreciation

•       flow through principle

•       reflects accruals basis of accounting 

Tangible vs intangible assets

Intangible assets have become more important

Goodwill was previously best known

•       extra you might pay to buy a business

•       value beyond tangible assets

Past 25 years we refer to intellectual capital

An open ended category of assets

Accountants uncomfortable with intangibles

•       often ‘home grown’ – no cost

•       difficult to value

•       subject to volatility

•       appreciate in value

Need to include them in balance sheet

Or maybe not – what alternatives

Current assets

Shorter lifespans, liquid assets

Again a wide ranging category

Most common examples

•       stock and work in progress

•       debtors

•       cash and bank balances

•       short term investments

•       prepayments

Stock and work in progress

Finished goods, work in progress, component

Very carefully/accurately valued

•       conservative valuations

Overvaluation can eliminate profit

Risks of loss, obsolescence, damage, etc

Nowadays JIT philosophy is widespread

•       reduces this particular risk

Debtors

Necessitate careful management

Debtors owe business money

Most businesses indebted to other businesses

Allowed to take transactions into account

If debtors disappear, so does revenue

And the profit

Liabilities

Claims against the business

•       what the business owes

Initially distinguish between

•       short term (current) liabilities

•       long term liabilities

Plus liability to those who own the business

•       equity

Short term liabilities

Two are particularly important

Cash – or lack of cash = overdraft

•       may be profitable on paper but no cash

Trade creditors – you are usually a debtor too

•       creditors can always call in the cash

•       reduces liquidity if not profitability

 These reflect accruals basis of preparation

Long term liability

Longer term indebtedness

Various forms of long tem loan

•       bank loan

•       personal loans

•       debentures

Usually carry a short term cost – interest

Also long term commitments

•       company pension provisions

Basic equation

Fixed assets

+ current assets

-          current liabilities

-          long term liabilities

= Equity

Equity

Liability of business to owners/investors

Represented by two basic elements

•       investment by owners

•       accrued profit (loss)

In principle if you sell up and settle liabilities

You should realise initial investment and profit

The value realisation principle

Link to profit and loss account

Profit is transferred from profit and loss account

This provides the link between statements

Profit after distribution of any dividends

Why do you retain profit/earnings?

Two key issues to be concerned with

•       source of investment funds

•       stock and work in progress – prudence