Liquidity, Profitability, Efficiency

When running a business it is best to know how the business is performing from year to year. For example, is profit up from last year? Can the firm support the interest from loans? Or does the company have enough cash?

To analyse the performance of the business we accountants must interpret accounts. This is extremely useful to understand financial statements of a business.

“So how do we analyse the business?”

A very good question! We do this by looking at the businesses accounts through 4 aspects. They are as follows:

Liquidity: This highlights if the company has enough liquid resources or in other words cash to pay off bills creditors etc.

Profitability: Highlights the earnings or profit compared to expenses over a certain period of time i.e. usually a year.

Efficiency: Highlights how well a company can perform in regards to use of assets.

 

Liquidity

Current Ratio:                                     Current Assets: Current Liabilities

This ratio determines if a firm can pay its liabilities. A ratio of 2:1 is an average for most industries. This shows that a company has twice as many assets as to liabilities. For example, Mazon Ltd. has current assets worth €1000. They also have current liabilities of €800. If we use the current ratio asset we get.

1000: 800 

                                                                  1.25:1

While it is not the preferred ratio of 2:1, the company still has more assets than liabilities and is in relatively good health.

Quick (Acid Test) Ratio                     Current Assets (-Inventory): Current Liabilities

This ratio determines if a firm can pay its liabilities without the inventory within the other current assets. As stated above an average of 2:1 is highly desired however it will be very difficult to achieve without inventories within the current assets. Lets’ use the example again of Mazon Ltd. They have current assets of €1000 inventories worth €100 and current liabilities of €800. This is what would happen if used the acid test ratio.

                                                1000 (-100): 800

                                                            900:800

                                                            1.125:1

While the company does not have liquidity, it is perilously close to having some problems. The company might have to look at ways to improve this ratio quickly. 

Days Receivables Outstanding           Receivables X 365

                                                                        Sales

This ratio deals with the number of days that a business takes to gather revenue after the sale has been completed. If a company has a high number of days to collect its income it might mean it is giving too much credit to its customers. While if a company has a low number of days to collect its income meaning they collect their income faster. We use the number 365 for the amount of days in one year.

For example our friends at Mazon Ltd have sales of €5000 for year. The company has receivables of €1000.

                                                            1000 X 365     =          73 days

                                                                  5000           

This means that the company will collect its receivables in 73 days.  This might be seen as been too high for some industries where the industry average is 30 days. The answer here might be due to poor management of funds or with a recession on it is more difficult to collect the revenue of customers.

Days Payables Outstanding                Payables X 365

                                                                Purchases

This ratio deals with the number of days that a business takes to pay its creditors after the purchases has been completed. If a company has a high number of days to pay its creditors this might mean the company have problems with liquidity or poor management of funds. While if the company has a low number of days to pay its creditors the company has enough resources and management of funds is very efficient.

For example our friends at Mazon Ltd have purchases of €4000 for year. The company has payables of €2000.

                                                2000 X 365     =          182.5 days       =          183 days

                                                      4000         

This means that the company pays its creditors on average 183 days. This might be seen as been very high for some industries where the industry average is 30 days. The answer here might be due to poor management of funds again or with a recession on it is more difficult to pay the bill of creditors.

Days Holding of Inventory                Inventory X 365

                                                       Cost of Goods Sold

This ratio deals with the number of days it takes to convert inventory into sales. If the number is high it might mean there is a slowdown in trading. Or that the company is holding onto too much inventory.

For example Mazon Ltd. has sales for the year of €5000. The company also has inventory worth €800.

                                                800 X 365       =          58.4 days         =          58 days.

                                                     5000

From this example we see that the company holds onto stock for 58 days. The average will depend on what industry the company is in and its competitors average as well.

To learn more about liquidity ratios check out this video:

 

Financial Performance 4 Liquidity Ratios 

Uploaded by SusanCrosson on Nov 26, 2007

Profitability

Operating Profit Percentage                           Operating Profit X 100

                                                                                       Sales

This ratio calculates the amount of sales that end up as operating profit. The ratio shows how efficient the company converts sales into operating profit.

For example Bbay Ltd. had sales for the year were €15,000. The operating profit was €3000. (The operating profit is before interest and taxes).

                                                         3000       X 100             =          20%

                                                        15000          1 

We see the company has a 20% operating profit percentage. The higher the percentage highlights that the company is controlling costs. This can also highlight that the company is making higher sales faster than its costs. Generally the higher the percentage the better the position the company is in.

Gross Profit Percentage                                  Gross Profit X 100

                                                                                   Sales

This ratio calculates the amount of sales that end up as gross profit. The ratio shows how efficient the company converts sales into gross profit.

For example Bbay Ltd. had sales for the year were €15,000. The gross profit was €8000.

         8000       X 100             =          53.33%

                                                       15000            1 

The gross profit percentage is 53.33%. Generally the higher gross profit percentage the better. As we see the company has a high gross profit percentage which indicates that it is converting sales into gross profit very effectively.

Mark Up                                                          Gross Profit X 100

                                                                             Cost of Sales

This ratio is the gross profit i.e. mark-up divided the total cost i.e. cost of sales. It is the total amount added to the cost to determine the sales price.

For example Asons Ltd. costs of sales were €10000 and gross profit was €5000. Calculate the mark up.                                  

                                                5000   X  100  =          50%    

                                               10000         1

Thus he makes an 50% mark up on their cost of goods sold. This type of formula is frequently used in retail industry.

To see more examples of profitability check out this video:

Financial Performance 8 Profitability Ratios 

Uploaded by SusanCrosson on Nov 26, 2007

Efficiency 

Usage of Working Capital                                          Sales               

                                                                           Working Capital

For starters, working capital is the money that is used for the day to day running of the company. It is calculated by current assets less current liabilities. This ratio measures how well working capital is used to generate sales for the company.

For example, Woods plc have current liabilities of €10,000, current assets of € 12,000. Sales for the company were €20,000 for the year. Working capital is €2,000. (Remember the formula for calculating working capital).

                                    20,000             =          10 times

                                      2000

This means that the company uses €2,000 of working capital to generate sales of €20,000 10 times over. Generally the higher the working capital turnover the better because it means the company generates a lot of sales relative to its working capital.

Usage of Non Current Assets                                                 Sales               

                                                                                   Non Current Assets

This ratio determines how a company generates sales from its non-current assets i.e. fixed assets. Examples of fixed assets include plant, machinery, equipment, etc.

Let’s take an example. Boods plc has €50,000 worth of fixed assets. Sales for the year were €20,000.

                                    80000              =          1.6 times

                                    50000

As we see here the company usage of non-current assets has a turnover of 1.6 times. This means that the company has the ability to generate sales for fixed assets by 1.6 times. As stated from the previous formula the higher the turnover the better.

Usage of Assets                                                            Sales             

                                                                         Total Capital Employed

This is a measure of how much sales are generate from total amount of assets employed by the business. Total capital employed is total assets minus total liabilities.

For instance Goods ltd has sales of €40,000 for the year and total capital employed is €20,000. Now for the formula

                                    40,000             =          2 times

                                    20,000

Thus for every 1 euro the company has of total capital employed it generates 2 times of that worth of sales. The higher turnover figures the better.

Inventory Turnover                                            Cost of Goods Sold

                                                                                    Inventory

This ratio deals with what is the relationship of money tied up in stock. Is it too much or too little? In other words how effective can a company convert inventory into sales.

For example Doods Ltd. cost of goods sold for the year was €20,000. Inventory was worth € 12,000.

                                    20,000             =          1.67 times

                                    12,000

This turnover figure here is the number of times that inventory that has been sold for the year. A low turnover means that there are bad sales and there is too much inventory. While a high turnover means that the there could be strong sales or poor management of buying.

Financial Forecasts and Budgets

Financial Forecasts

A financial forecast is all about predicting and trying to obtain targets in order for the firm to survive. A financial forecast it must be said is only a forecast. For instance have you ever looked at the weather for tomorrow and get it wrong? This means the art of forecasting can never give 100% accuracy.

The main examples of financial forecast include a cash flow forecast and a sales flow forecast.

To find out more about financial forecasts in Ireland check out this link:

http://www.ey.com/IE/en/Newsroom/News-releases/Economic-Eye-Summer-forecast-2011---Ireland-to-emerge-from-recession-in-2012

This link highlights Irelands Economic forecast for 2012 and also looks back on previous years to see whether the economic situation is getting better or worse:

http://www.oecd.org/document/9/0,3746,en_2649_37443_45269961_1_1_1_37443,00.html

How to Make A Financial Forecast 

Uploaded by businessbuffet on May 28, 2008

Financial Budgets

To begin a budget is a business plan expressed in financial terms. This sets out activities and the cost of them for future periods. Budgets are essential in order to run a functioning profitable business.

For example a company OKEA earns €2000 in one month of sales. They make a budget to purchase stock of €1000 and have rent and heating bills of €500 for the next month. OKEA have €500 left over from the €2000 of sales. Thus the company has come in under budget.

Examples include a cash flow budget purchases budget, sales budget and a master budget.


To learn more about budgets check out this website:

http://tutor2u.net/business/accounts/introduction-to-budgets.htm


Check out this link to read about the European Union affects the Irish Budget for 2012:

http://www.irishtimes.com/newspaper/breaking/2012/0629/breaking1.html


With countries such as Ireland who need to increase revenue to balance the national books, here is a link of what happened in Budget 2012 for Ireland:

http://www.deloitte.com/view/en_IE/ie/insights/budget-2012-ireland/a3f504d85bfe3310VgnVCM3000001c56f00aRCRD.htm

The Role of an Auditor

Not a good idea hiding items from the Auditor...

“I have heard this term auditor before what does it mean and is it relative to accounting?”

An auditor is someone who checks the accounts of a company on a yearly basis. This is called an audit. It is there job to see if the accounts are a true and fair representation of the company’s affairs.

The auditor has to request access financial records such as assets, liabilities, bank balances, expenses and receipts of the business to perform the audit.

An auditor gives their opinion of whether or not the financial statements are an accurate and fair representation of the business.

An Auditor must be:

§  Independent

§  Fully qualified and registered

§  A very good communicator

To learn more about the role of an auditor check out this humorous video link:

Los Bank Auditors- I'm on an Audit 

 

 

Uploaded by jimmyeatWV on Sep 10, 2009


Check out this website from the Irish Auditing and Accounting Supervisory Authority which describes the role of auditor:

https://www.iaasa.ie/about/index.htm

Shareholder, Share Capital, Dividend and Debenture

What is a Shareholder?

 

This is a term you will see and hear in the business world. First there are shares. Shares are the amount of interest a shareholder has in a company. These shares are viewed in financial terms i.e. money.    

                                                                                              

§  Shareholders can come in the form of an individual, a group of individuals or a company.

§  Shareholders rights include the right to vote or nominated the directors of the company.

§  The right to sell their own shares or buy shares when they are issued by the firm.

§  Shareholders are also entitled to dividends if they are declared by the company.

To learn more about shareholders check out this website:

http://www.dceb.ie/Knowledge-Centre/Finance_Taxation/Rights-and-Duties-of-a-Shareholder

Check out these useful videos about shareholders:

Business Laws : What Is a Shareholder?

 

Uploaded by eHow on Nov 1, 2008

The IT Crowd - Jen Brings the Internet to the Shareholders meeting - WIDESCREEN 

 

Uploaded by willfaz07 on Dec 14, 2008

What then is Share Capital?

Share capital is the money raised from borrowing, grants, selling of shares or funds from shareholders or investors. There are two types of capital, issued and authorised share capital.
Issued share capital is the number of shares that the company has issued. The amount raised is either lower or the equal amount of the authorised share capital. Authorised share capital is the maximum amount of capital that can be raised for the company.

For example Pacebook decides it needs to raise capital for new investing activities. In their company policy i.e. Memorandum of Association the maximum amount of authorised share capital they can raise is €100 million. The company raised €50 million from issuing new shares to the public and investors.

However raising capital can be difficult for risky start up companies. For example a new start up company called Apod ltd. sells only high quality socks. Apod decides to raise capital by selling shares of the company to outside investors. These investors are also called venture capitalists.

However you do not need to be a new start up company to raise capital.

§  Long term financing can be achieved in the long term with share capital.

§  Shareholders are only liable for the amount of money they invested in share capital.

Check out these links to learn more about share capital:

http://www.tutor2u.net/blog/index.php/business-studies/print/qa-what-is-share-capital

http://www.formacompany.ie/en/shareholders/share-capital

Check out this video about share capital:

Share capital Categories of share capital 

Uploaded by arinjayjain1979 on Nov 6, 2011

What is a Dividend?

Dividends are the allocation of profits to shareholders of investments. They are declared i.e. proposed by the company’s board of directors. It must be though approved by the shareholders first before any dividends are given out. One of the main reasons why people and firms buy shares in a company is to earn profit.

§  Dividends are a part of the company’s profits which are generally given out to a company’s shareholders.

§      Dividends come in the form of cash, property or stock.

§   Dividends do not happen all the time depending on the company’s policy and the shareholders  decision.

      For example Ryanair are reluctant to pay out dividends to its shareholders but have seldom done it in the past.

Check out this link to see how dividends work

 http://www.formacompany.ie/en/shareholders/right-to-dividend

The Principles of Double Entry Bookkeeping

 

Deduct This!

Who invented the double entry bookkeeping system?

The best place to begin a journey into accounting is at the start. Double entry bookkeeping was originally devised by the Italians in the fifteenth century.  

What are the principles used for in business?

The principles of double entry bookkeeping are used for recording financial transactions that occur within a company. Financial information accounts are recorded in the book called a nominal ledger or another term is often used is the general ledger. An account is a page in the ledger. These accounts in the ledger are usually called as T accounts. For example a nominal ledger set up for assets where information about machinery or furniture will be recorded. Other ledgers would be for rent, lighting and heat, sales, purchases etc.

Here is an example of a T account that would be recorded in a ledger.

 

What is meaning of the term “double entry” in bookkeeping?

The words “double entry” explains that each transaction that occurs within a business, that transaction must be recorded twice. To do this with a ledger account we must split the page in two where on the left it is called a Debit (DR) and on the right it is called a Credit (CR) as above.

You might be asking yourself why do I need are there two parts of the accounts? The answer to that is each transaction has two parts. In other words each transaction has a debit and credit to it.

To find out more about debits and credits check out this link:

lecture 3:debits and credits

 

Uploaded by bigbeancounter on 19 Jun 2009

Accounting Basics Lesson 3.1: How Does Double-Entry Accounting Work, What are Debits and Credits

Uploaded by danieldickson2 on 18 Feb 2011

 

Here is an example of the double entry book keeping:

Trapattoni Ltd. buys a machine for €1000 cash. Here we have two parts of a transaction. First the company has obtained a machine worth €1000. Also the company has lost cash of €1000. The company records this information in two accounts. The company records an increase in the machinery account and it records a decrease in the cash account.

Which account do I debit and which do I credit?

The answer is we debit the receiving account and credit the giving account. This is also referred to as the Golden Rule of Accounting. The reason why this rule is so is because that’s what the Italians decided back in the fifteenth century.  They for all could have swamped this rule around if they so wished. 

The company receives a machine for €1000 so it is recorded on the debit side and the company spent €1000 so it is recorded on the credit side.

Basic principles of double entry bookkeeping

Uploaded by 3minstermsandcondit on 31 May 2011

Types of Transactions

I can hear you asking “Wait, aren’t there different types of transactions, how will I know where to put them in the accountants?”

A wonderful question to ask! To answer it there are four types of transactions: Assets, Liabilities, Expenses and Incomes.

You must remember your double entry. On the Debit side there will be assets and expenses. This will always be the case.

On the Credit side it will be liabilities and incomes. As same as above they will always be credits. The Liabilities and Assets will only appear in the balance sheet and Incomes and Expenses will appear in the income statement. The balance sheet and income statement will be explained later on in your studies.

 

Hmm I think I get it, do you have an example I can examine?

Of course, Keano Inc. has transactions that have occurred within the month of June 2011. They need an accountant to record these transactions within the accounts. They are as follows:

Shareholders invest €10,000 into the business on June 2^nd.

The company purchases €2000 worth of equipment on June 5^th.

Purchases were made costing €5000 on June 8^th.

The company pays wages of €1000 on June 10^th.

Rent of the building comes to €1000 on June 25^th.

Keano sales for June were €5000.

Here we have a nominal ledger which contains several accounts of a firm. As you can see some of the figures of the accounts are on either the left or right side of the T account.  As we mentioned before, there are four types of transactions. Can you name them above?

We can also see the figures being double entered. Where rent €1000 appears on the debit side of the rent account it appears on the credit side in the cash at bank account. This goes back to what was mentioned earlier, there is two sides to every transaction!

As seen in the cash at bank account the company has a debit balance. This means that the company has brought in more money than spent over June. If we had a credit balance it would be a Liability in which the firm would have to get a loan.

                                                                                     

Why should I learn this double entry bookkeeping, can’t I get a computer to do this?

I hear you asking “Why can’t I do this on a computer, would it be faster and easier” It is true a computer can do this but a person has to know how to input the data into the system. This means they must understand where each transaction or a group of transactions should go. If a shareholder of a company asks you the Accountant, “Why did you put machinery in to accounts of the books, should it not be in only one account?” It would make you look very silly and your job in danger if you could not explain to the shareholder the basic concept of double entry!

Why should I be an accountant?

There are so many reasons to pursue a career in accountancy it can be best summed up with these videos.

Monty Python Accountancy Shanty 07 

Uploaded by czajka18 on 12 Nov 2010

Accountant Man

Uploaded by HHHonoth on 27 Nov 2009

The Accountant

Uploaded by Riggs91 on 3 Sep 2006

The Books of Prime Entry

The books of prime entry record individual transactions that occur within the day to day running of a company.

These are as follows:

§  Sales day book

This book records transactions that are associated with non cash sales i.e. credit sales that include information of customers, the amount, date of sale and description of the sale.

§  Purchase day book

These book records transactions that are associated with non cash purchases i.e. credit purchases. The book includes information of the supplier, the amount, date of purchase and the description of the purchase.

§  Sales returns day book

 

This book is used to record goods that are returned by the firm’s customers.

§  Purchases returns day book

 

This book is used to record goods that are returned by the firm to the supplier.

§  Bank Book

This book is used for recording bank transactions such as deposits and withdrawals. This can be also known as a pass book.

§  Cash Receipts Book

This book is used for recording cash only transactions coming into the business.

§  Cash Payments Book

This book is used for recording cash only transactions going out of the business.

 

So are you saying that we should disregard double entry altogether?

Most certainly not, never! If we used double entry to record every transaction that happened. A company would need an extremely large ledger which would be very difficult to manage every single transaction! These books sum up the totals for example 1 month. These figures are then put into the nominal ledger.

To further explain here is a useful link:

http://accountingstudy.org/day-books-of-prime-entry/