Lecture Notes Flashcards

Final Accounts and Stakeholders

• Final accounts are published financial statements used by stakeholders (managers, employees, shareholders, etc.).
• They differ from management accounting, which is for internal, confidential use.
• Final accounts include:
  • Profit and Loss account (Income Statement).
  • Balance Sheet.

Profit Calculation

• Profit is typically a primary business objective.
• Basic Formula: profit = revenue - cost\ of\ making\ the\ products
• Profit is the surplus after subtracting business costs from revenue.
• A loss occurs if costs exceed revenue.
• Ways to increase profit:
  1. Increase revenue more than costs.
  2. Reduce production costs.
  3. Combine both strategies.

Profit vs. Cash

• Profit and cash are distinct.

• A business can report a profit but have limited cash due to sales on credit where cash is yet to be received.

• The timing of cash flows is crucial; money from profitable sales might arrive months later, causing cash flow issues.

• Causes of cash shortfalls:

  • Over-trading: Rapid expansion that ties up funds in inventory or new assets.
  • Credit Policies: Extended credit periods delay incoming cash.
  • Large Asset Purchases: Buying expensive assets (machinery, property) can deplete cash reserves.

• Insolvency: A business is insolvent if it cannot meet short-term debts, even with reported profits.

• Managing cash flow is as vital as making a profit.

Profit & Loss Account (Income Statement)

• Summarizes revenues, costs, and expenses over a specific period (quarterly/annually).

Key Components of an Income Statement

• Sales Revenue (Sales Turnover): Income from selling goods/services.

• Cost of Goods Sold (COGS): Direct production costs (raw materials, labor).

• Gross Profit: Revenue minus COGS. Gross\ profit = revenue - COGS

• It's profit before fixed costs.

• Expenses: Indirect production costs (rent, salaries, marketing, etc.).

• Net Profit Before Interest & Tax: Profit (or loss) before deducting interest payments and taxes.

• Tax: Compulsory deduction paid to the government from a business’s profit.

• Net Profit After Interest & Tax: Actual profit after all costs are accounted for.

• Belongs to the owners and can be distributed as dividends or retained for internal financing.

• Dividends: Payments to shareholders from net profit after interest and tax.

• Retained Profit: Net profit (after interest, tax, and dividends) kept within the business for its own use and serves as an internal source of finance.

Income Statement Structure

• Sales Turnover
• (-) Cost of Goods Sold (COGS)
• Gross Profit
• (-) Expenses
• (-) Depreciation
• Net Profit Before Interest & Tax
• (-) Interest
• (-) Tax
• Net Profit After Interest & Tax
• (-) Dividends
• Retained Profit

Worked example: Chan’s Bike Hire Co.

• Given:

  • Sales Revenue: 400
  • Rent: 40
  • Interest: 20
  • Cost of Goods Sold: 150
  • Expenses: 30
  • Tax: 25

• Profit and Loss Account:

  • Sales Revenue: 400
  • Cost of Goods Sold: 150
  • Gross Profit: 250
  • Expenses: 30
  • Rent: 40
  • Net Profit Before Interest and Tax (NPBIT): 180
  • Interest: 20
  • Tax: 25
  • Net Profit After Interest and Tax: 135

Practice problems and solutions

• Multiple practice problems building income statements from provided data (Newtown Garden Nursery Ltd, Samba Ltd, Aurelie).
• Problem involving BGR Ltd and a decision on whether the company could open a new cinema based on retained profit.
• Problem for Township plc to determine costs of goods sold and administrative expenses, and to determine if the company can distribute dividends to shareholders.

Genesis Corporation Analysis

• Scenario: Genesis Corporation wants to expand but isn't sure if retained profit is sufficient or whether to take a bank loan. Internal expansion cost: 50,000.

• Income Statement (Year Ending December 31, 2020):

  • Sales Revenue: 275,000
  • Cost of Goods Sold: 170,000
  • Gross Profit: 105,000
  • Wages: 50,500
  • Selling Expenses: 15,650
  • Bills: 10,700
  • Depreciation: 6,000
  • Rent: 7,000
  • Profit Before Interest and Tax: 15,150
  • Interest: 8,750
  • Tax: 6,000
  • Net Profit: 400

• Advice: The company cannot expand using retained profit alone, which is only 400. A bank loan is necessary. However, given existing interest costs, the company should also consider issuing new shares to finance the expansion.