 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
INTERPRETATION
OF ACCOUNTS FOR BEGINNERS
This document is designed to
provide an introduction (or refresher) for non-accounting professionals who are
involved (maybe as part of a team) in advising businesses that are in financial
difficulties.
Contents –
Interpreting the Balance
Sheet
INTRODUCTION
As with any form of decision making having accurate information on which
to base the decisions is vital. However, when a business is in financial
difficulties those who are brought in to advise on the
options for recovery or whether recovery is likely to be possible are often
confronted with information that is out of date. Even where book keeping has
been good it is important to remember that some financial events can overwhelm
a business very quickly. The most obvious event that impacts dramatically on
the financial viability of a business is that a larger debtor of that business
defaults.
Nevertheless the accounts of any business provide one of the most
reliable bases for assessing the performance of a business. However, it is
important to remember that accounts are normally produced for a particular
purpose, usually the Inland Revenue, particularly so in the case of a small or
medium sized business. If they are to provide a fuller insight as to the health
of the business they will need interpretation.
The two main financial statements are the Balance Sheet and the
Trading and Profit and Loss Account, but there may also be a Source and Application of Funds
Statement.
THE BALANCE SHEET
The Balance Sheet shows what funds are employed in the business. It
shows how they are employed (these are the ASSETS) and how they were provided (these
are the LIABILITIES). The balance sheet shows this state of affairs at a
particular moment, usually the last day of the trading year but it can be
prepared for any other time that it is required.
Assets
Assets
can take many forms from buildings or land to machinery or cash and even to money
that is owed to the business in the form of debts. Assets are normally grouped
into two categories.
The
first group is those assets
which form the means of production and which are not normally traded
these are the Fixed Assets.
The
second category is those assets which are intended to be sold in the normal
course of business these are the Current Assets.
Land or Machinery would be regarded as Fixed Assets because although
they can be sold and in the case of say a car they will eventually be sold
the buying and selling is incidental to the main reason for having them which
is as a means of production. Raw materials are current assets because they are
purchased as an ingredient of production and the finished product is also a
Current Asset because it will be sold.
Within the broad groupings of fixed assets and current assets it is
possible to see a range of "Fixedness" from land and buildings at one end of the scale to cash at the other
end so that it is normal to list the assets in order starting with the most
fixed and descending to the most liquid.
The assets in a typical farm balance sheet would be grouped as follows:-
ASSETS
Land )
Buildings
and Improvements )
Fixed Assets- the means
Machinery )
of production
)
Raw Materials )
Work in Progress )
Current Assets-
Finished
Products )
production in progress
Debtors )
Cash
in the Bank )
Liabilities
The second part of the balance sheet shows how the assets employed in
the business were provided.
The term "liability" has an slightly
ominous meaning in everyday parlance but in the balance sheet this is not
necessarily so. Much of the money employed in the business will usually have
been provided by the owners, both in the form of the initial capital they
invested in the business and profits earned by the business over the years that
have been retained , these are “good” but they will still be shown as a
liability. So interpreting the liabilities it must be considered to whom there
is a liability.
Apart from the owners of the business and retained profits funds will
have been supplied by banks or other lending institutions who
have made funds available on a formal basis. Another source of funds will be
suppliers of goods and services to the business on credit. These do not regard
themselves as investors in or lenders to the business and expect to be paid
within a short period.
So just as the level of "fixedness "
varied with different assets so the long term availability of funds to the
business may vary. Long term liabilities represent those investors or owners of
the business who do not expect to have their money repaid whilst the business
continues. Medium term liabilities are fund provided for an agreed period, such
as is the case with a mortgage or bank loan. Current Liabilities are those
funds provided without any commitment to the business and due to be paid quite
soon, theoretically instantly.
The
liabilities of a typical balance sheet for a Small or Medium Sized Business
might
look like :-
LIABILITIES
Owners
Capital )Long Term Liability
plus retained profit. )
Mortgage )
Bank
Loan )Medium Term Liability
Hire
Purchase Agreement )
Bank
Overdraft )Current Liabilities
Trade
Creditors )
Balance Sheet Layout
Traditional Layout
Traditionally Balance Sheets were arranged with the Assets shown in a
vertical column on the right hand side of the page and the Liabilities in a
column on the left. The assets and liabilities were normally arranged with the
long term assets and liabilities at the top and the current at the bottom.
LIABILITIES ASSETS
Mortgage Buildings
&
Loan
capital Improvements
Bank
Overdraft Machinery
Trade
Creditors
Finished
Products
Raw
Materials
Debtors
Cash
in Bank
___________________ ___________________
Total
Capital Employed Total
Capital
Employed
Modern Layout
Modern
accounting practice is to arrange Balance Sheets horizontally
:-
FIXED ASSETS
Land
Buildings
Machinery
Breeding
Livestock -----------
Total Fixed Assets
CURRENT ASSETS
Growing
Crops & Livestock
Harvested
Crops
Stores
Debtors
Cash
in Bank
--------------
Total
Current Assets
---------------
Total
Assets
CURRENT LIABILITIES
Bank
Overdraft
Trade
Creditors
-------------
Total Current Liabilities
-------------
Net Assets
FINANCED
BY
Mortgage
Loan -------------
Net Worth -----------
Total Capital Employed
INTERPRETING THE BALANCE SHEET
Owner's Equity
The owner's stake in the business is shown as a liability, but this
liability is the least likely to have to be repaid so represents little threat
to the business, It follows then that the higher the proportion that the
owner's stake (called the owner's equity) is of the total assets employed in the
business, the less vulnerable is the business to demands for repayment of loans
or more normally the payment of the interest charges on them or the payment of
creditors. Clearly any organisation being asked to provide funds for a business
would prefer that in the event of misfortune there will be sufficient assets in
the business to repay them, so a business with a high owner's equity would be
considered a safer lending proposition than one with a low owner's equity.
The
Ratio of Owner’s Equity can be expressed by the formula :-
Owner's
Capital (Net Worth) X 100 = Owner's
Equity
Total Assets
Liquidity
Apart from how much money is employed in the business the balance sheet
shows how the funds are employed and how they are provided. It provides further
insight by showing relative demand and availability of money in terms of time.
The liquidity of a business is the measure of the ability of the business to
meet its current liabilities out of its liquid assets. A business that had
Ł50,000 in cash in the bank would easily be able to pay current liabilities of
Ł25,000 without interfering with the smooth running of the business and would
be said to have a high level of liquidity. If the business had Ł25,000 in the
bank and current liabilities of Ł50,000 it would have difficulty in paying its
bills as they become due and would be said to be a very low level of liquidity.
This could put the business at risk if all the creditors demanded to be paid.
The liquidity of a business may vary through the year. Some business have a
seasonal pattern of production so an arable farm is typically in a liquid state
once the crops are sold, say in winter or early spring but less liquid by
harvest time. A small house builder usually becomes less liquid a house nears
completion and a large amount of money is tied up in its construction but
liquidity improves when the house is sold.
The
Liquidity of a Business can be expressed by the formula :-
Liquid
Assets X 100 = Liquidity
Current
Liabilities
Current Asset Ratio
Whilst liquidity demonstrates the ability of a business to meet short
term liabilities out of cash without the need for forced sales of current or
even fixed assets, it
is often more reasonable to compare the ratio of current assets to current
liabilities on the grounds that in an ongoing business it is unlikely that it
would become necessary to pay all the bills at one time without the opportunity
to collect debts or sell any product.
Ideally current assets should be twice current liabilities, the lower
this ratio becomes the greater the chance that cash will have to be raised
under duress such as by the premature sale of produce or unfinished animals.
The Current Asset Ratio can be expressed by the formula
:-
Current Assets X 100 = Current Asset
Ratio
Current Liabilities
Fixed Asset Ratio
In the case of some types of business so much of the assets are in the
form of very fixed assets, such as property that it can be difficult to raise
cash to meet demands from creditors in the short term. Farm businesses are
often a good example of this category as, particularly in the case of owner
occupiers, most of the assets are in fixed assets of land, building, machinery
and breeding stock. This may lead to the situation where a business with a high
ratio of owner’s equity may still experience difficulties because the ratio of
fixed assets to current assets is too high. This situation can occur when
improvements or land purchase is financed out of working capital.
The Fixed Asset Ratio can be expressed by the formula
:-
Fixed
Assets X 100 = Fixed Asset Ratio
Total
Assets
Gearing
This is a measure of the amount of loan capital employed in the business
in relation to the owner's equity. If the amount of loan capital is high
relative to the owner's equity the business is said to be highly geared. In a
profitable business high gearing is attractive to the owner as it greatly
increases the return on their capital. For example if the business is making a
return on capital employed of 20% and the loan capital costs only 10% then
every extra pound borrowed and invested in the business increases the return to
the owner by 10 pence. The effects of
gearing at different levels can be seen in the following table:-
|
Ratio of Borrowed Capital to Owner's
capital |
Return on Capital |
Interest Rate on Loan Capital |
Return on Owner's Capital |
|
2:1 |
20% |
10% |
40%
|
|
1:1 |
20% |
10% |
30% |
|
1:2 |
20% |
10% |
25% |
BUT if income declines :-
|
Ratio of Borrowed Capital to Owner's
capital |
Return on Capital |
Interest Rate on Loan Capital |
Return on Owner's Capital |
|
2:1 |
10% |
10% |
10% |
|
1:1 |
10% |
10% |
10% |
|
1:2 |
10% |
10% |
10% |
BUT if income declines and interest
rates rise at the same time:-
|
Ratio of Borrowed Capital to Owner's
capital |
Return on Capital |
Interest Rate on Loan Capital |
Return on Owner's Capital |
|
2:1 |
10% |
12% |
9% |
|
1:1 |
10% |
12% |
8% |
|
1:2 |
10% |
12% |
6% |
It
can be seen that
a highly geared business is vulnerable if interest rates rise at the same time
as income declines.-
Gearing can be expressed by the formula :-
Long
Term Loans X 100 = Gearing
Net
Worth (Owner's Capital)
TOTAL DEBT
Whilst gearing deals with the ratio of formal loans (
on which interest is being paid) to the owner's capital in the business,
it is important not to overlook the total indebtedness of a business. Total
indebtedness includes all creditors not just formal
loans.
The
total debt ration can be expressed by the formula :-
External
Liabilities X 100 = Total Debt Ratio
Net
Worth (Owner's Capital)
OVERTRADING
This
is the situation that is often incurred by a successful and rapidly growing
business. As the business expands the need for capital exceeds that which is
available. More raw materials have to be purchased, more wages paid before the
extra revenue from the higher volume of sales is received.
HIDDEN ASSETS AND
LIABILITIES
Accounts are prepared following certain conventions as to how assets and
liabilities are to be valued. This may mean that assets are shown as having a
value greater or less than could be obtained if they were sold.
Some liabilities will not appear on the balance sheet at all as they
will not crystallise until such time as the business
ceases to trade e.g. redundancy payments, dilapidations. These uncrystallised liabilities could be a major consideration
for some businesses which are in difficulties.
Hidden Assets
Land
The most common hidden asset in a balance sheet is the value of land and
buildings because this is usually shown as the value at which it was purchased.
If the premises was purchased many years ago the value
shown in the accounts may be much lower than its present realisable
value.
This may be especially so if the business ceases trading in an orderly
manner rather than being forced to dispose of assets as a distressed sale. In some cases buildings or land may have a
high value which can only be achieved if the business is to cease and so
release the land and buildings for development or more valuable use. This can often be the situation if an area of a town or
city undergoes a change of character.
Products
The value of products in store may be much higher than shown in the
accounts where it is shown at the cost of production.
Livestock
In the case of agriculture Inland Revenue Rules allow for Livestock to
be valued at the cost of production rather than their market value, this will
also apply to livestock valued on a herd basis.
Quotas
In the case of agriculture quotas for milk, beef or sheep production will not usually
appear in the balance sheet unless they have been purchased. In the case of an
owner occupier the value of all the quota is relevant,
although the effect of the sale of quota on the value of the remaining land
must be considered but in the case of milk quota on a tenanted farm it is only
the Tenant's Fraction and any Excess Quota that is available to the tenant.
Tenant Right
In the case of agriculture a tenant will be entitled to make a claim for
improvements made with the landlord's consent and for any Residual Manurial Values and Unexhausted Manurial
Values. There may be a trade off of these against any claim for dilapidations.
Intellectual Property
A business may own rights which have been developed within the business
and do not appear on the Balance Sheet but which could be sold by the business
to another. This could be a brand name, the design of a product etc.
Hidden Liabilities
Land
If land has been purchased at a time when land price was high and this
is the value shown in the balance sheet it may not now be possible to realise the purchase price.
Improvements
Improvements to land or buildings are shown in the
accounts at cost in the year in which they are carried out and this value is
written down over a number of years so that the value shown in subsequent
accounts does not necessarily represent its realisable
value in that year. With most fixed improvements it can be argued that they
have no value in their own right and what value they do have is reflected in
the overall value of the premises as a whole. In the case of a tenant any
improvements will only have value if the provision for
obtaining consent under the terms of a lease have been complied with.
This value may be more or less than their depreciated value shown in the
accounts.
Machinery
Machinery
values will be shown in the accounts at their depreciated values.
The
relationship between their realisable value and their
"book"value will vary depending on the age
of the machine. In the first year or so of the life of a machine, and certainly
in the first few months, the drop in value may greatly exceed the depreciation
but later in the life of a machine it may be possible to sell it for more than
its "book" value. Very specialist machines or machines which have
been custom built may realize much less than the depreciated value shown in the
accounts.
Finished
Products
The quantities of finish product shown in the accounts may only be a
rough estimate and some of this product may be unsaleable
because it is obsolete or damaged. The value placed on finished products will
normally be set at the cost of production and this should usually leave a safety margin
provided the product is saleable. If a business has been under financial
difficulties for some time there may have tended to use rather high estimates
of quantity and value of stock rather than show a
deterioration in the balance sheet which might alarm the bank and other
long term suppliers of capital.
Debtors
Very seldom is all the money shown as being due to a business actually collectible.
This may be due to customers having gone out of business or disagreements over
accounts .Once it is known that a business is in financial difficulties it
usually becomes more difficult to collect outstanding debts as debtor will be
more likely to dispute outstanding bills.
Unpaid
Tax
Income Tax or Corporation Tax may be outstanding from previous years.
This can be a particular problem where a bad year follows a particularly good one, although in
some industries , such as agriculture, there is provision for averaging which
may alleviate the problem to a degree
CONTINGENT
LIABILITIES
These are the liabilities that will only be incurred if certain actions
take place such as the business is sold, wound up or some of the assets are
sold. They do not appear in the balance sheet of an ongoing business.
Taxation
Capital Gains Tax may become liable on the disposal of some assets so
that only part of the realised value is available to
the business. This may seem unlikely in the case of land or buildings where the
value is similar or less to the value in 1982 ( The Base Year for CGT values)
but the land could have been purchased with money rolled over from previous
sales which could have carried large amounts of CGT, for example from the sale
of land for development.
Redundancy
Payments
If a business is forced to cease trading or to reduce their work force
they will be liable to pay their redundant workers redundancy pay.
Costs
of Sale
If a business is forced to sell up the costs of the sale will have to be
deducted from the proceeds.
Dilapidations
If the business is a tenant of any or all of their premises the landlord
will be entitled to claim dilapidations for any deterioration in condition of
the property. These claims may be offset in part by any claim by the tenant for
Tenant’s Improvements but this may not be possible if the lease has not reached
its end..
Costs
of Receivership
If the business was forced into receivership the costs of the receiver
will reduce the net value of the assets.
BALANCE SHEETS IN
A SERIES
A balance sheet shows the state of the business at one particular moment
in time but much more light will be shed on the health of a business if a
series of balance sheets can be looked at covering a number of years. Looking
at a series of balance sheets will show how the various ratios have changed
during the period.
Owner's
Equity
Normally a decline in the ratio of the owner's capital to borrowed
capital reflects a run of low profitability or years in which the owner has
drawn more money out of the business than it has been generating.
Owner's
Drawings
Owner's drawings can be an important issue in a small business. If a
period of reduced profitability follows a period of high profits the owner may have become used to high
drawings and may be reluctant to adjust to a lower standard of living. The
turnover of many businesses allows their owners to draw out more money than
they are generating as profit. They may be able to do this without even
increasing their overdraft by such means as not replacing machinery at the same
rate as their present depreciation charges or by financing new machinery by leasing.
This means that they are living off their capital which may be acceptable in
certain circumstances but it ought to be acknowledged.
Gearing
If the business is expanding it may be quite legitimate that the owner's
share of the assets employed in the business have
declined as long as they have not reduced in real terms as well.
Current
Ratio
The ratio of current assets to current liabilities may deteriorate
due to declining profits or using what profits there are to finance capital
investment or personal drawings rather than to pay off creditors. The former is
preferable to the latter provided that the investments produces an adequate
return and provided it is not done to such an extent that the business comes
under pressure from creditors. The ratio will fluctuate slightly from year to
year in a healthy business but a steady and prolonged deterioration will make
the business increasingly at risk of being forced to realise
some of its fixed assets.
Liquidity
A worsening liquidity ratio will reflect either low
profitability, excessive drawings or the financing of long term investment out
of the cashflow of the business.
THE PROFIT AND
LOSS ACCOUNT
Whereas the Balance Sheet shows what assets are employed in the business
at a given moment in time and how they were provided, the Profit and Loss shows
the trading performance of the business over a period of time, usually one
year. This then is a very important source of information about the
business. A business cannot generally
continue to lose money for long periods as the balance sheet will start to
deteriorate but a business that is showing good profits even if the balance
sheet is poor may have a better future.
Income
and Expenditure
The
Profit and Loss Account shows the summary of what expenditure was incurred and
what sales were made during the trading period . It
does not show what payments or receipts there have been so that there is always
a risk that a sale will not be paid for.
Opening
and Closing Valuations
Apart from the income and expenditure incurred during the year it is
necessary to take account of the fact that some of the expenditure incurred
during the trading period may have been for the purchase of goods which were
still unused at the end of the year. Conversely some of the receipts may have
been derived from the sale of goods produced in a previous year. It is
necessary, therefore, to make adjustment to the income and expenditure by
looking at the value of goods at the start and end of year as shown in the
opening and closing valuations.
This is an area where farmers are tempted to take a "flexible"
approach in order to minimise their tax and so these
figures may be an over or more likely an
understatement of the true position.
Depreciation
Some expenditure is for items such as new buildings or machinery which
are of benefit to the business for a much longer than the trading period. The
cost of these items is spread over a number of trading periods with either a
percentage of the original cost charged to each trading period (straight line depreciation) or alternatively
a fixed percentage of the written down value at the start of the period is
charged to that period, (diminishing balance depreciation). It is only this
depreciation charge that will appear on the expenditure side of the
account.
The Layout
of the Profit and Loss Account
Opening Valuation Sales
Expenditure Closing
Depreciation Valuation
_________________ _____________________
Profit (Loss)
INTERPRETATION OF
THE PROFIT AND LOSS ACCOUNT
Shortcomings
in the Profit and Loss Account
The most common reason for preparing accounts is to satisfy the
requirements of the Inland Revenue. This means that items of income and
expenditure are frequently grouped together so that it is more difficult to get
a clear picture of how different parts of the business are performing.
Similarly the rates of depreciation used for buildings and machinery are the
maximum rates that the Inland Revenue will allow rather than a true
representation of the life of the building or machine.
Accounts are often out of date and this is frequently the case with a
business that is performing poorly. Accounts may not provide all the answers
but they frequently provide the best starting point for looking at the business
and provide clues as to what further information should be sought about
physical performance. It must always be remembered that in most cases it is the
standards of performance of the business which will determine the success or
failure of the business and the accounts can only reflect this.
Overheads
Expenditure can be divided into two main categories Fixed Costs or
Overheads and Variable Cost. Frequently these items of expenditure will be
poorly itemised and simply lumped together in broad
categories such as raw materials. It is usual, though, to be able to separate
out the Fixed Costs into four main categories:-
Labour
Plant and Machinery
Rent/Mortgage and Finance Charges
General Administration Costs
Labour/Machinery
These should be looked at together as these can easily be substituted
for each other. It may be possible to justify expensive machinery and high
operating costs because it enables the work to be carried out by fewer
employees.
It is sometimes possible to separate out the machinery repair costs and
these must be viewed against the machinery depreciation. A business may incur
high repair costs because they maintains older
machines but this may be set off by lower machinery depreciation. Conversely high
depreciation charges may be off set by very low repair bills.
Rent
Equivalent
This figure will include any actual rent paid for premises together with
mortgage interest on owned buildings plus building repairs and depreciation.
Administration
Costs
These will include the costs of running an office such as telephone and
postage but also general insurance, accountants and other professional fees.
Output
Where a business is composed of a number of different enterprises the
variable costs
attributable to that enterprise should be compared to the output from that
enterprise but the information contained in most accounts prepared for taxation
purposes is insufficient to allow this. It is useful to be able to look at the
output relative to the costs. A low cost/low output business may be as
profitable as a high cost/high output business but a high cost/low output
business is doomed to failure.
Sufficiency
of Profit
The profit from the business not only has to provide an income for the
owners but it also has to provide funds to repay capital that has been borrowed
in the past and to fund future investment. It is possible to have a business
which has always made a profit but has had a deteriorating balance sheet and is
experiencing difficulties because the income has not been sufficient to meet
the drawings of the owner and the need for investment in the business. This is
why the third financial document that is sometimes included in a set of
accounts, the Source and Application of Funds, is so useful.
THE STATEMENT OF
SOURCE AND APPLICATION OF FUNDS
As the title implies, this document shows the sources of all funds
flowing into the business, how they have been utilised
and how any differences between the two are reflected in the working capital.
A typical layout would be:-
SOURCES OF FUNDS
Profit before tax
Capital receipts from sales of land etc.
Depreciation on Machinery
Depreciation on Buildings and Improvements
TOTAL FUNDS GENERATED BY THE BUSINESS
Funds introduced from personal sources
TOTAL FUNDS AVAILABLE
APPLICATION OF FUNDS
Taxation
Personal Drawings
Investment in Machinery
Investment in Buildings and Improvements
Investment in Land
Repayment of Loans
TOTAL APPLICATION OF FUNDS
CHANGES IN WORKING CAPITAL
Increase/Decrease in Stores
Increase/Decrease in Debtors
Increase/Decrease in Creditors
Increase/Decrease in Cash
The statement is particularly relevant in highlighting the problems of a
business where the owner is drawing more out of the business than the profit
being generated, resulting in increases of creditors or a reduction in the
valuation.
It also illustrates the difficulties of a business that is obliged to
invest more money than is available from retained profits in new machinery.
One important criteria for assessing the sufficiency of funds being
generated by the business is that they should be sufficient to meet the needs of :-
1. Tax - first claim
2. Repayment of loans as they fall due
3. Private drawings
4. Re-investment
in
that order.
Level
of Profit Required
A good starting point when appraising a small or medium size business is
to decide how much profit does this business need. This will vary widely from
one case to another depending on their circumstances and personal aspirations.
Consider what is a realistic level of private drawings
Consider what is a realistic level of debt repayment