Unit 21, 22, 23 – Income Statement, Statement of Financial Position, Analysis of Accounts

Key Objectives

Objectives are to revise:

• the main features of income statement and how profit is calculated
• the importance of profit to private sector businesses
• the usefulness of profit data to stakeholders
Definitions
Terms Definitions
Income statement A financial statement that records the revenue, costs and profits of a
business for a given period of time
Statement of Financial A financial statement that records the assets, liabilities and owner’s
Position equity of a business at a particular date.
Revenue Income generated to the business from the sale of products.
Cost of sale Cost of purchasing the goods used to make the products sold.
Gross Profit The gross profit is made when revenue is greater than the cost of sales.
(Revenue – Cost of sales)
Profit The profit made by the business after all costs have been deducted from
revenue. (Revenue – Total costs)
Assets Resources that are owned and controlled by a business.
Liabilities Debts owed by the business that will have to paid sometime in the future.
Non-current assets Resources that a business owns and expects to use more than one year.
Current assets Resources that a business owns and expects to convert into cash within
one year.
Non-current liabilities Debts of a business which will be payable after more than one year.
Current liabilities Debts of a business which will be payable within one year.
Equity (Capital) Amounts owed by the business to its owners, includes capital and
retained profits.
Capital employed Long-term finance used or invested in the business. (Equity + non-
current liabilities)
Profitability The measurement of the profit made relative to either the value of sales
achieved or the capital invested in the business.
Liquidity The ability of a business to pay its short-term debts.
Illiquid That the assets are not easily convertible into cash.

Difference between profit and cash

Why is profit important? Why is cash important?
- to measure the success of a business - to pay its employee’s wages
- to measure the performance of managers - to pay its suppliers for goods and
- to decide whether or not to continue services
making or selling the product - to pay other day-to-day expenses such as
- to finance the purchase of NCA, electricity, water supply, interest
expansion and so on payments, so on.
- to attract investors who will provide the Note: Without cash, business will fail.
additional funds Cash important for short-term payment
Note: Profit is important in measuring the and business survival.
business long-term success and growth.
Income Statement format
$
Sales revenue xx
(-) Cost of Sale (xx)
Gross Profit xx
(+) Income xx
(-) Expenses (xx)
Net Profit xx
(-) Corporate tax (xx)
Profit after tax xx
(-) Dividend (xx)
Retained profit xx
Summary
- Cost of goods sold = Opening inventory + Net purchase – Closing inventories
- Gross profit = Sales revenue – Cost of goods sold
- Net profit = Gross profit + Income – Expense
- Profit after tax = Net profit – Corporate tax
- Retained Profit = Net profit – Dividend
Uses of income statements (Usefulness of profit data to stakeholders)
Statement of Financial Position format

$
Non-current assets xx
Current assets xx
Total Assets xx
Capital/Equity xx
Non-current liabilities xx
Current liabilities xx
Total Capital/Equity and Liabilities xx
Summary

Uses of statement of financial position data

- Shareholders can if their stake in the business has increased or fallen or value over
the last 12 months by looking at the total equity figures.
- Shareholders can analyze how business finances its activities by looking at the debt
finance or retained profits
- Working capital can be calculated from SOFP data which is important as it is used to
pay short-term debts.
Working capital = current assets – current liabilities
- Capital employed can be calculated from SOFP.
Capital employed = shareholder’s equity + non-current liabilities (or)
total assets – current liabilities
Analysis of accounts (to compare business performance: this year vs last year (or) business
vs other business)

Limitations of using analysis of accounts

Interpretation and Analysis of the accounting ratios

Ratios What does it show? How can you interpret?
Gross Profit - shows the percentage of gross profit If percentage increases,
Margin to every $1 earned as sales revenue - prices have been increased by
- shows how successful a business can more than cost of goods
convert sales into profit (or)
- shows the ability to control the cost - cost of goods bought in have
of goods sold been reduced probably using new
supplier who offer lower prices.
Net Profit - shows the percentage of net profit to If percentage increases,
Margin every $1 earned sales revenue - the more successful the
- shows how successful a business can managers are in making net
convert sales into net profit profits from sales
- shows the ability to control the - the overhead costs are well-
overhead cost such as advertising controlled
and marketing
 Return on - shows how much profit is earned for If percentage increases,
Capital every $1 invested in the business - the managers are running the
Employed - shows the ability of the manager in business more efficiently
earning profit from capital invested (making higher profits from
in the business each dollar invested in business)
Current - shows the ability of the business to If result is below 1,
Ratio pay off its short-term debts from - business could not pay its short-
current assets term debts from current assets
- safe current ratio- between 1.5 and 2 If result is above 2,
- Business has too much working
capital tied in unprofitable
current assets
Acid Test - shows the ability of the business to If result is below 1,
Ratio pay off its short-term debts from - the business has cash problems
liquid assets and the management should take
- a result of 1 would be acceptable steps to improve the business
liquidity. Eg. selling off some
inventories to make cash.

Uses and users of analysis of accounts

Users of accounts What they use for
Shareholders Profitability ratios – they would invest more by buying shares if
results are higher to get higher return.
Liquidity ratios – they wouldn’t want to invest in a company with
serious or liquidity problems.
Managers Profitability ratios and liquidity ratios – to assess their performance,
bonus and promotion opportunities
Employees Profitability ratios – to assess whether the future of the company is
secure or not and whether there would be a pay rise
Suppliers Profitability ratios – to assess whether the business is expanding to
continue to supply goods
Liquidity ratios – to assess whether the business has sufficient cash to
pay its debts when it becomes due
Lenders Profitability ratios and liquidity ratios – to assess whether the loan
approval and the business’s ability to pay for the interest and the
loan borrowed
Government Profitability ratios – the higher the profit, the higher the tax revenues
and whether the business is providing employment which will reduce
government spending on unemployment
Customers Profitability ratios – if business is profitable, it will continue
producing products that customers like and trust. If business
continues making profit, it will benefit from economies of scale and
will reduce selling prices.