2.

1 DATA ANALYSIS & INTERPRETATION:

Interpretation and Analysis of Final Accounts and the Balance Sheet Balance Sheet
Interpretation and Analysis

The Balance Sheet is usually prepared on the last day of an accounting period to show the
financial position of the business on that particular day and not for a period. It is a list of
balances of accounts which are still open after the final accounts have been prepared.

Basically, the Balance Sheet shows what the business owns is equal to what it owes both its
external creditors and its owners. Both sides of the Balance Sheet will always balance since
the sum of its liabilities to its creditors and its owners will be equal to its assets. Thus,

Assets = Liabilities + Owners' Equity Capital Owned

The Capital Owned refers to the total amount that the business owes its owners, i.e. the
value of the business that belongs to the owner of the business. It is referred to as the net
worth of the business. It is therefore the difference between its assets and liabilities. You
will by now realize that it is the same as the balance on the Capital Account. The two basic
formulae for Capital Owned are:

Capital Owned = Assets - Liabilities

or Capital Owned = Capital at Beginning of Period + Net Profit -

Drawings + Additional Capital

Capital Owned may increase due to:

Profits from the year's business operations being retained rather than withdrawn in the
form of drawings (in a sloe proprietorship or partnership) or distributed as dividends (in a
company);

Owner(s) bringing additional capital from outside sources;

Upward revaluation of fixed assets. Capital Owned may decrease due to:
Losses from unprofitable operations of the business;

Withdrawal of cash or other assets by the owners; and

Downward revaluation of fixed assets.

Capital Employed

Capital Employed is the effective amount of money actually being used in a business,
regardless of whom it belongs to. For our purpose, capital employed may be taken to
mean capital owned.

Working Capital

The Working Capital refers to the amount of capital which is used to meet the day-to-day
expenses of running the business such as payment for purchase of stocks, payment to trade
creditors, payment of wages to employees, etc. It is the difference between the business'
current assets and its current liabilities.

Working Capital = Current Assets - Current Liabilities

Sufficient working capital in a business is necessary for it to carry on its business efficiently
and profitably.

If a business does not have sufficient working capital, it may encounter problems such as:

Loss of customer goodwill and consequently, loss of customer patronage and sales, because
it will not be able to stock sufficient variety and amount of inventory to cater to customer
demands.

Insufficient cash to pay for day-to-day expenses such as rent, wages of employees, utility
bills and the like. It may find it difficult to keep the employees.

Unable to take advantage of cash discounts offered by suppliers because it is not able to pay
promptly.

Difficult to get trade credit from its suppliers because it is not able to pay creditors on time.
Trade credit is one of the cheaper and easier means of short-term financing compared to
borrowing on bank overdraft.

Not in a position to take advantage of any good opportunities should they present
themselves during this period because of lack of funds.

While a positive working capital (current assets > current liabilities) indicates that the
business is solvent, i.e. able to pay its debts when they fall due, a negative working capital
(current assets < current liabilities) does not necessarily mean that the business is
insolvent , i.e. unable to pay its debts and fulfill its financial obligations when they fall due.

In the short term, the business can always try to raise its level of current assets by
mortgaging its freehold land and property. Or maybe it could sell off some of its equipment,
and lease others to replace them.
Changes in Working Capital

The amount of working capital normally changes in the course of the accounting year as the
business uses it to finance its operations.

Increases in working capital are due to:

Profit from business operations is one of the most important ways to increase the amount
of working capital;

Cash sale of fixed assets or investments;

Owner(s) bringing in additional funds from outside, or through a successful public issue of
additional shares; and

Long-term borrowing such as a bank loan, or public issue of bonds or debentures.

Decreases in working capital are due to:

Cash purchase of fixed assets;

Redemption of redeemable Preference shares or debentures;
Owner(s) withdrawing cash for personal use;
Payment of dividends to shareholders.

Working Capital Ratio or Current Ratio

The Working Capital Ratio is the ratio of current assets to current liabilities . The basic
formula is:

The Working Capital Ratio is usually regarded as an indication of the business's ability to
pay its bills and therefore, of its liquidity and its stability. Being able to pay one's debts as
they fall due is known as being liquid. The reputation of the business will certainly suffer if
the business cannot meet its liabilities when they fall due for payment.

However, if the business is constantly having a liquidity problem, and if some of the
creditors have no choice but to sue the owner in the court of law for payment, then the
business may be forced to sell off all its assets and go into bankruptcy.
However, the importance of the Working Capital Ratio must not be overestimated. It is
certainly true that a business with a Working Capital Ratio of 3 : 1 is better off in terms of
solvency compared to another business with a Working Capital Ratio of 2 : 1.

A business's strength lies in its long-term ability to earn profits, and not merely in its ability
to pay bills. Moreover, there is always the conflicting aim of using its funds in profitable
ventures, which usually involves long-term commitments such as the purchase of fixed
assets. Funds which are left idle in the bank do not earn much.

Therefore, the amount of Working Capital held will depend on many factors, firstly, on the
nature of the firm's business; secondly, on how much credit it can obtain from its suppliers.

Take, for example, a sundry shop whose stock turnover is at least once every month must
have a higher Working Capital Ratio compared to a jeweller whose stock turnover may not
even amount to once a year, in order to be able to pay for new stocks.

A firm which can sell for cash (e.g. a restaurant) will need less Working Capital than one
which sells on credit (e.g. car traders). In the former business, stocks turn directly into cash
which can be used to pay off creditors. In the latter, the stocks may turn into debtors which
can only turn into cash one or two months later.

Conversely, a firm which has to pay for all its purchases immediately in cash, will need
more Working Capital than one which can get one or two month's credit before having to
pay for the purchases.

Thus, we will not be surprised to learn that a Working Capital Ratio of 1 : 2 is considered
adequate for a supermarket where all the supplies are bought on credit of four to six
weeks, whilst all sales are paid for in cash. The same Working Capital Ratio of 1 : 2 would
be considered extremely dangerous for a sundry shop where all supplies are bought on
credit of two to three weeks, whilst all sales are credit sales, customers taking about a
month on the average to settle their bills.

Acid Test Ratio

This is a more stringent test of the liquidity of a firm. It is calculated as above but excluding
stock in the calculation of current assets, i.e. Acid test ratio = (Current assets - Stock) :
Current liabilities.

Rate of Return on Capital

The Rate of Return on Capital refers to the net profit for the period expressed as a
percentage of the capital at the beginning of the period.
Interpretation and Analysis of Final Accounts - The Trading Account

The Turnover

The Turnover is the net value of goods sold during the accounting period. It is the
difference between Sales and Returns Inwards for the period.

Turnover = Sales - Returns Inwards

Gross Profit

The Gross Profit is the overall profit from Trading. It is the difference between the
turnover and the cost of goods sold.

Gross Profit = Turnover - Cost of Goods Sold Cost of Goods Sold

The Cost of Goods Sold (or Cost of Sales) is the value paid for the goods that have been
sold, valued at cost. It is the sum of the opening stock and the net purchases, minus the
closing stock.

Cost of Goods Sold = Opening Stock + Net Purchases - Closing Stock

The net purchases is the total amount including purchasing expenses paid in buying the
goods, minus the Returns Outwards. Thus,

Net Purchases = Total Purchases + Purchasing Expenses - Returns Outwards

The Purchasing Expenses will include expenses like: Carriage Inwards, Duties on
Purchases, and Insurance on Purchases.

Cost of Goods Available for Sale

The Cost of Goods Available for Sale is the sum of the total amount of goods that are in
stock in the business during the course of the accounting period. It is the sum of the
opening stock and the total volume of the net purchases during the accounting period.

Cost of Goods Available for Sale = Opening Stock + Net Purchases The Mark Up

The Mark Up is the percentage increase on cost price. It is expressed mathematically as the
percentage of profit to the cost price, or the percentage of gross profit to the Cost of Goods
Sold.
The Margin

The Margin shows the percentage of profit on each article sold. Its basic formula is:

Gross Profit as a Percentage of Turnover

When the Margin shows the percentage of profit on each sale, the gross profit as a
percentage of turnover shows how profitable the turnover for the whole period has been.
The gross profit as a percentage of turnover is therefore a more general term, showing the
relationship of gross profit to turnover for the whole period. The basic formula is as
follows:

The importance of the gross profit as a percentage of turnover is that it can be compared
with that of the previous years. A fall in the gross profit as a percentage of turnover will
indicate a fall in the profitability (ability to make profits) of its turnover. This would call for
an inquiry into the causes of its fall. Have goods been purchased at too high a price, or
goods sold at too low a price? Has the opening stock been overvalued, or has the closing
stock been undervalued? Was there theft or shoplifting by customers, or pilfering by shop
assistants? An investigation by the management would then be necessary to rectify the
cause of the fall.

A mere increase in the figure for sales need not necessarily mean that the gross profit will
increase.

Rate of Turnover; or the Stockturn; or the Rate of Stock Turnover

The Rate of Stock Turnover should not be confused with the Turnover. Turnover means
net sales, i.e. sales less returns. When we say that the stock has turned over, we mean that it
has been sold and replaced with a new stock. Diagrammatically, one stockturn can be
shown as follows:

When one revolution has been completed, we say that the stock has turned over once. It is
at this point that the business is able to make a profit. So, if a business wants to double its
profit, it must double its rate of turnover.
The Rate of Stockturn indicates the number of times in a year the average stock can be
sold off. It measures the speed at which stocks are cleared or moved. The basic formula is
as follows:

The average stock at cost price is the average amount of stock held in the period under
consideration. Mathematically,

Average Stock at Cost Price = ½ (Opening Stock + Closing Stock)

Another formula for calculating the Rate of Stockturn based on the selling price of the
goods sold is shown as follows:

The Rate of Stockturn by itself does not indicate very much. Certain lines of business, by
their nature, will have a high Rate of Stockturn, whilst others will have a low Rate of
Stockturn, e.g. a newspaper vending business will have a higher Rate of Stockturn than one
which sells university books. What is significant is that, for a particular line of business, a
falling Rate of Stockturn over many successive periods will call for an inquiry into the
causes, and rectifying actions taken.

Did the business have too high a figure for stock than was necessary? Holding of excessive
stock means more money than necessary is tied up in stocks. Stocks which move very
slowly may become obsolete and may have to be sold at a loss. Or must the buying plans be
changed, in view of changing customers' tastes?

Any increase in the business' Rate of Stockturn will mean that goods are sold off faster and
consequently, warehousing expenses will be lowered. Net profit will increase. In those lines
of business where taste changes very fast like clothes and footwear, an increase in the Rate
of Stockturn will reduce chances

of having to clear off old stocks at very low prices, and hence that of making a reduced
gross profit, or even a gross loss.
Interpretation and Analysis of Final Accounts - The Profit and Loss Account

The Profit and Loss Account shows all gains together with the gross profit on the credit
side and all the running expenses on the debit side. If gains and the gross profit are greater
than the expenses, there is a net profit. If, however, the expenses are greater that the gains
and the gross profit, then there will be a net loss.

The net profit is the actual amount of profit that will accrue to the owner(s). It is this
amount that will interest all parties, such as the bankers of the business, the creditors, the
investors, the owners, the Board of Directors, the workers, etc.

The main test of how well the Board of Directors of a company, or the owner of a sole
proprietorship or the partners of a partnership have managed the business under their
control is the Rate of Return on Capital.

Basically, the analysis of the performance of a business depends on two major factors:

1. How profitable is each dollar of sale?

If the business can generate a large volume of sales, but if it does not control its expenses
well, it is not going to show a good return on capital. One of the main items of expenses is
the cost of goods sold.

Is the profit margin sufficiently high so that the gross profit is high enough to cover the
selling and administrative costs and yet yield a good profit? However, the margin must not
be that high that its goods are no longer competitive compared to those of its rivals. If this
happens, then sales volume may drop.

How well is the business controlling its selling and administrative expenses?

How effectively is the business employing its assets, both fixed and current, to
generate sales?

The business then may have to examine the relationship of sale to each item of assets, say
debtors as a ratio of credit sales, which shows the average period of debt collection and
compare it with that of the previous period.

Could the business do something about the lengthening period of debt collection? The
longer the time period that stocks remain tied up in the form of debtors, the smaller would
be the volume of funds available for use to generate more profits.

Perhaps, the business may have to find alternative sources of finance such as drawing up
negotiable bills of exchange instead of allowing customers trade credit in the form of
debtors. At least the business could discount these bills of exchange at the bank should it
need funds urgently.

Or perhaps, the business should seriously try to seek suppliers who are willing to sell to
them on longer trade credit.

The analyst is therefore very interested in the changes in the factors composing the net
profit. For our purpose, we shall discuss certain relationships.

Percentage of Net Profit to Turnover

The Net Profit as a Percentage of Turnover refers to the percentage of profit per dollar of
sale. Its basic formula is as follows:

If this figure is high, it may be used by customers as proof that the business is overcharging,
but if it is low, it is a sign that the business is not profitable. It shows what the margin is
between selling at a profit and selling at a loss.

Percentage of Expenses to Turnover

The Percentage of Expenses to Turnover refers to the percentage of expenses per dollar of
sale. The basic formula is as follows:

A more than disproportionate increase in this ratio, compared to an increase in sales

between two accounting periods, would indicate that there has been excessive spending. So
management must investigate the causes.

To enable management to pinpoint which particular item of expense is responsible, each

major group of expenses is expressed separately as a percentage of turnover. Thus, one
would speak of a Purchasing Expense as a percentage of turnover, and an Administrative
Expense as a percentage of Turnover, etc. Then a comparison of each of these ratios with
their counterpart for the two accounting periods would reveal the culprit.
As a general guide, expenses can be classified as follows:

Purchasing Expenses such as Carriage Inwards, Duties on goods bought;

Selling and Distributing Expenses such as Carriage Outwards, Advertising;

General and Administrative Expenses such as Salaries, Rent; and

Financial Expenses such as Interest, Discount.

Summary