Basic Principles of Accounting & Financial Analysis: Roger Claessens, Prof. UBI United Business Institutes

Basic principles of accounting & financial analysis
Roger Claessens, Prof. UBI United Business Institutes
Accounting & Financial analysis
Basic principles of accounting & financial analysis 1 The need for financial reporting
2 The balance sheet

3 The basic rules of accounting
4 The profit and loss account

5 The structure of a balance sheet 6 Financial flows 7 Key financial ratios 8 Different balance sheets
A learning Curve Step by Step

Knowledge in accounting
Step by step
Time
The need for financial reporting
1 Sources of information 2 Management reports 3 Financial and legal requirements
Financial reporting
Financial Reporting
What are indicators that things are going, or not going, as they should?
Sources of financial information
Financial Reporting
Why do we need financial information? What could be the sources of financial information? What might be the difference between management accounts and statutory accounts, and who needs them?
Financial reporting
Financial Reporting
Accelerator
Actual Speed
Gear
Brake
Car
Control actions Desired Speed
Driver
Speedometer
Financial reporting
Financial Reporting
Key
Actual Results
Performance
Indicators
Business
Control actions Budgeted Results
Manager
Reports
Financial Reporting
Performance improvement depends on the use and reliability of financial information:
The speedometer = information that allows for control : daily recording of activities the financial situation the financial activities the situation versus budget
Management reports
Financial Reporting
Management requires control Control requires knowing what is happening Knowing what is happening requires reporting
PERFORMANCE
MANAGEMENT CONTROL REPORTING
Financial and legal requirements
Financial Reporting
Statutory Annual After audit Legally defined Accurate Public record
Management Monthly Promptly after the end of the period Suited to individual needs Estimate / Provisions Internal Use

The four functions of management :
Financial Reporting
1 2
Manage Organise
3
4
Plan
CONTROL
MEMO : MOPC
What type of information do managers need ?

We really need various types of information:
Financial Reporting
Financial : % Gross Margin / Invested capital Commercial : Total credit cards sold Activities : Total calls made
What type of information do managers need ?

The annual accounts do not provide real time information, we need information reports which allow for timely controls and allow for: The comparison of results versus budget Fast actions in order to improve performance
Financial Reporting
The assurance that the company is on the right track!
Basic principles of accounting
The three sources of financial information

There are 3 sources of financial information:
The balance sheet shows what the company has and what it owes
The Profit and Loss Account or Income statement shows what the company earns or looses (results) The cash flow report the source and application of funds
The three sources of financial information

The car dealer as a base for many examples.
Why? Simple process : purchase - show room (stock) sales

No production, we do not take into account the other activities, such as maintenance.

Profit Leaks
Financial Reporting
Profit
A? A? A?
A? A?
A?
The concept of a balance sheet

What I HAVE What I OWE
Exercise 1

Mortgage
Car loan
Exercise 1
House Car Furniture Equipment Savings
Equipment loan
Invoices Overdraft
Petty Cash

Mortgage
Car loan
Exercise 1
House Car Furniture Equipment Savings
100 10 30 20 10
65
5
Equipment loan
Invoices Overdraft
10
5 10
Petty Cash
Adding up
175
Adding up
95

What I HAVE
House 100
What I OWE
Net worth
Mortgage Car loan
80
65 5
Exercise 1
Car
Furniture Equipment Savings Petty Cash Total
10
30 20 10 5 175
Equipment loan
Invoices Overdraft
10
5 10
Total
175

What I HAVE
House at
purchase price 70 Car 10
What I OWE
Net worth Mortgage 50 65
Exercise 1
Car loan
Furniture
Equipment Savings Cash
30
20 10 5 Equipment loan Invoices Overdraft 10 5 10
Total 145 Total 145 The difference is a matter of evaluation of the assets

What I HAVE
House at expected sales price 120 Car 10
What I OWE
Net Worth
Mortgage Car loan
100
65 5
Exercise 1
Furniture
Equipment Savings Cash
30
20 10 5 Equipment loan Invoices 10 5
Overdraft
10
Total 195 Total 195 The difference is a matter of evaluation of the assets

Asset Valuation What I OWE
Exercise 1
How do we value an asset? The simple answer is the original cost LESS the depreciation BUT the alternative is : realisable value replacement value useable or economic value (i.e. cost,which would be incurred in any event)

Exercise 1
All this does not tell us much about our income or expenses during a given period of time This would be shown in other reports, i.e. The Profit and Loss report or Income statement &
The Cash flow report
2 The balance sheet


1 2 3
The key elements of a balance sheet

Facts of a balance sheet and
management decisions

Assets = Have Liabilities = Owe OWN FUNDS
LONG TERM ASSETS
Assets Liabilities to third parties
The balance sheet
LONG TERM DEBT
SHORT TERM ASSETS
SHORT TERM DEBT

Can we draw a conclusion as to the viability of a company by looking at its balance sheet on any given time?
The balance sheet
Would a balance sheet be sufficient?

Why do we pay so much attention to balance sheets? Are there rules for a balance sheet structure?

answers The balance sheet is a picture at any given moment of the company : The balance sheet is subject to interpretation The balance is only meaningful after analysis: - over various periods - in line with balance sheets of the competition - in function of sector - in function of the economic cycle The balance sheet shows the financial health of a company and its capacity to borrow in order to finance its assets!
The balance sheet

Our car dealer
A bank
Equity & Res Fixed assets LT debt LT debt Current assets Current debt Current assets Current debt
Working capital
Fixed assets
Equity & Reserves
The trend of a balance sheet
The trend of a balance
Fixed Assets Current Assets Equity & Reserves
Year 1
Year 2
Year 3
100
105
115
Ratio
1 .81
LT Debt
100
85
75 Debt
.65
ST Debt
Equity
Facts (F) and decisions (D)

ASSETS LIABILITIES
OWN FUNDS Equity (F) Reserves (D) Revaluations (D) (1) LT DEBT (F) (2)
Facts and decisions
FIXED (D) Intang. Fixed (F/D) - Goodwill, Patents Tang. Fixed (D) - Land - Buildings, equipment - Amortisation (D) - Revaluations (D) (4) CURRENT ASSETS - Stock (D) - Debtors (D) TREASURY (F) (5)
OPERATIONAL DEBT (F) Suppliers (F) Provisions (D) ST BANK DEBT (F) (3)

Balance block 1
Facts and decisions
OWN FUNDS
Equity (F) Reserves (D) Revaluations (D) Advance owners (D)
EQUITY = FACT
The amount invested by the shareholder

RESERVES = DECISION
The retained earnings

REVALUATIONS
Based on expertise F = a fact D = a mgt decision The shareholders can decide to finance their company in current account (or subordinate loans)

Balance block 2
Facts and decisions
LT DEBT
Loans (F) Investment credits (F)
LT DEBT= FACT
Borrowed funds less amounts repaid

Balance block 3
Facts and decisions
OPS DEBT (F) Suppliers (F) Provisions (D) ST Bank debt (F)
Most are facts, others such as provisions are the result of an assessment or future charges (accruals)

Balance block 4
Facts and decisions
INTANGIBLES FIXED Goodwill (D)
The intangible assets are subject to amortisation The amount is a decision

Balance block 4
Facts and decisions
TANGIBLES FIXED
Land (F) Buildings (F & D) Equipment (F &D)
A building is put on the books at a purchase value and is amortised over a period of time in function of the rhythm of annual amortisation. The method of amortisation is a matter of decision

Balance block 5
Facts and decisions
CURRENT ASSETS
Stock (D)
STOCK is based on purchase price or net sales price -When the sales price is deemed lower than the purchase price a stock depreciation needs to be recorded : depreciation for stock with a low rotation - It is a decision

Balance block 5
Facts and decisions
CURRENT ASSETS
Debtors - past due (D)

Cash (F) - investments (D) - banks (F) - cash account (F)
DEBTORS = FACT
However the principle of prudence entails two corrections for: -past due debtors -uncollectable = Management decision
The effect of a management decision
Facts and decisions
The effect of an over-evaluation of current assets (with unchanged liabilities)
The balance sheet
but in fact
The over- or understatement of profits
Facts and decisions
Brand accounting Changes in valuation methods Changes in depreciation policy Off balance sheet finance Capitalisation of R & D
Summary Key points to remember

Accounts over a long period, plus notes to the accounts, are likely to provide the best basis for the analysis of the financial position of a company
The balance sheet
Accounting and financial analysis have their own vocabulary Key elements allow for ratio-analysis
2 The balance sheet


1 2 3 4
Double entry accounting Depreciation versus amortisation Cash and non-cash transactions The four principles of accounting
A balance sheet must balance
HAVE = Assets
OWE = Liabilities
What would the opening balance sheet look like?
A balance sheet must balance

Example :
The balance sheet of a newly founded company
Assets
Current Asset
Liabilities
Equity
Double entry concept
ASSET
LIABILITIES
Increases
= DEBIT
Double entry concept
ASSETS
LIABILITIES
Increase
= CREDIT
The double entry concept

ASSETS LIABILITIES
Petty Cash
Equity
The dual entry concept
ASSET Accounts LIABILITY Accounts

Increase Decrease Increase Decrease
The P & L Account or Revenue Account
P&L
The dual entry concept
ASSET Accounts LIABILITY Accounts

Increase Decrease Increase Decrease
P & L Accounts
Charge Revenue
The company purchases equipment for 50 (without VAT)

ASSETS LIABILITIES
EQUIPMENT
EQUITY
CASH
SUPPLIERS

ASSETS LIABILITIES
EQUIPEMENT
(1)
EQUITY
CASH
SUPPLIERS
(1)

ASSETS LIABILITIES
EQUIPMENT
(1)
EQUITY
CASH
(2)
SUPPLIERS
(2) (1)
The company re-sells the equipment for 60 ! (without VAT)

ASSETS LIABILITIES
EQUIPEMENT
EQUITY
DEBTORS
CASH
PROFIT & LOSS
The company re-sells the equipment for 60 ! (without VAT)

ASSETS LIABILITIES
EQUIPMENT
(3)
EQUITY
DEBTORS
(3)
CASH
PROFIT & LOSS

(3)
The company resells the equipment for 60 ! (without VAT)

ASSETS LIABILITIES
EQUIPMENT
(3)
EQUITY
DEBTORS
(3) (4)
CASH
PROFIT & LOSS

(3)
(4)
The company purchases equipment for 50 (inclusive of VAT at a rate of 25 % )

ASSETS LIABILITIES
EQUIPMENT
EQUITY
CASH
SUPPLIERS
The company purchases equipment for 50 (inclusive of VAT at a rate of 25%)

ASSETS LIABILITIES
EQUIPEMENT
(1)
EQUITY
VAT RECEIVABLE
(1)
SUPPLIERS
(2) (1)
CASH
(2)
The company invoices a customer for a fee in the amount of 50 (inclusive of VAT at a rate of 25%)
ASSETS LIABILITIES
DEBTORS
(1)
EQUITY
VAT PAYABLE
(1)
CASH
SALES
(1)
ASSETS LIABILITIES
DEBTORS
(1) (2)
EQUITY
VAT PAYABLE
(1)
CASH
SALES
(1)
(2)
ASSETS LIABILITIES
DEBTORS
(1) (2)
EQUITY
VAT PAYABLE
(3) (1)
CASH
(3) (2)
SALES
(1)
Cash and non cash entries

We take a depreciation of an asset into account for 10
ASSETS LIABILITIES
EQUIPMENT
EQUITY
CASH
P & L Account
Cash and non cash entries

We take a depreciation of an asset into account for 10
ASSETS LIABILITIES
EQUIPMENT
EQUITY
CASH
P & L Account
Depreciation and Amortisation
Depreciation A decrease in value of current assets stock - spare parts - accessories - debtors Amortisation A decrease in value of fixed assets (long term assets) fixed assets - land and buildings - plant and equipment - renovation costs
The influence of a depreciation is a decrease in current assets & the equity and reserves (debts remain unchanged)
The influence of an amortisation is a decrease in fixed assets AND the equity and reserves (debts remain unchanged)
Methods of amortisation
A fixed asset with a value of 100.000 at 10 % per year A fixed asset with a value of 100.000 at 20% per year
Amortisation
LINEAR
Amortisation Residual Value
10000 90000
10000 80000
10000 70000
10000 60000
10000 50000
10000 40000
10000 30000
10000 20000
10000 10000
10000 0
DIGRESSIVE
Amortisation Residual Value
20000 80000
16000 64000
12800 51200
10240 40960
10000 30960
10000 20960
10000 10960
10000 960
960 0
0 0
Amortisation
Accounting Value
90000 80000 70000 60000
Linear Digressive
50000
40000 30000
20000
10000 0 1 2 3 4 5 6 7 8 9 10
Time
Cash and non cash transactions

When Profit and Cash Differ
Financial Reporting
Example Depreciation Payment of Creditor
Difference P&L expense, no cash outflow Cash outflow, no P&L expense
Sale on credit
P&L income, no cash inflow
Debtors settle account Cash inflow, no P&L income
The four principles of accounting

MEMO : ACGP
Accruals: Each change needs to be recorded during the relevant period Consistency: The same logic needs to be followed over the periods of accounting Going Concern: Accounting on the basis of a functioning company, in opposition to a gone basis Prudence The financial situation has to be accurately and factually represented
Financial Reporting
The significance of financial management

Financial management allows for the optimisation of the
Financial management
use of working capital

It is a matter of management of the business cycle!
STOCKS
PURCHASE
SALES
SUPPLIERS
DEBTORS
TREASURY
Activity Ratios
The management of stock of spare parts
One of the management issues is the stock rotation, in this case we use two ratios:
The definition of the two ratios 1. Stock turn Annual sales of spare parts at cost Stock spare parts
2. Stock turn in days
365 Stock turn
The utility of the ratio This ratio indicates how often the stocks rotates on an annual basis or alternatively how many days stock days the company has
Activity Ratios
The utility of the management of the working capital
Turn over parts

Gross margin Stock Stock rotation Stock in days Other computing method
500.000
150.000 70.000 500.000-150.000 70.000 70.000 x 365 350.000 365 5 5 times p.a. 73 days = 73 days
Activity Ratios
The purpose of the spare parts management by means of
Ratios
Factors influencing the stock: - The need to match inventory with customer requests
- The express order surcharge

- Obsolescence - The discounts on spare parts
Activity Ratios
The purpose of the debtors and suppliers management by
means of Ratios
Outstanding debtors in days
Outstanding debtors x 365 Turnover with VAT Outstanding suppliers in days
Outstanding suppliers x 365 Purchases with VAT
Summary & key points
The source of working capital allows for a stable base of financing The management of the working capital allows for the management of the activities cycle
The management of the rotation of stock, debtors and suppliers will lead to improved results
The activity ratios allow for a trend analysis!
2 The balance sheet


Basic principles of accounting Expenses and profits Key elements of a P & L Direct and variable expenses The concept of profit centres
The P & L Account
1 2 3 4
Expenses and profits

A turnover generates expenses:
The P & L Account
Fixed expenses are the result of the activity of the company. For example: Salaries Rental Training Advertising
The benefits of profits

Profits:
The P & L Account
reward shareholders with dividends reward shareholders with capital growth pay interest on loans provide protection for future business provide funding for additional fixed assets provide funding for additional working capital provide customer confidence protect the employment of the employees
The benefits of profits

Profits do not necessarily mean cash!
The P&L Account
There is often a time lag between earnings and cash inflows. Indeed :
Stock may be purchased on payment conditions and may be sold and replaced before paying the supplier
Stock may be sold, the earnings accounted for, but the payment is made at a much later date A spare part has been sold but had been paid to the supplier already a long time ago
Key elements of a P & L

P&L Turnover (1) Purchased goods - Inventory = Cost of goods sold (2) Gross margin (3)=(1)-(2) N-1 EURO N
The P&L Account
Operations
+ Other business related income = Income from operations (4) - Goods and services (5) = Added Value (6)=(4)-(5)
- Personnel expense - Other operational expenses = Gross operating income
Exceptional
+ Financial revenues + Exceptional results = Gross total revenue (EBITDA) - Amort., provisions, depreciations = EBIT - Financial expenses - Taxes = NET PROFIT
Investments
Financing
cash flow
N-1 Net Result + Amortisation and provisions = Cash Flow - Paid dividends (Shareholders) - Repayment LT debt = Net self-financing margin EURO N
The P&L Account
The charges to the P & L

Other operation Other alincome income Goods & services
The P&L Account
Gross margin
Result of Added Operations Value
Personnel expense Other ops expenses
Financial Amortisa tion Income &

Gross ops exceptional profit Gross Profit
EBIT
Profit before taxes
Financial expenses
Taxes
Net Result
Fixed and variable expenses

There are two types of expenses:
The P&L Account
The fixed expenses these expenses are incurred irrespective of the activities or production process Variable expenses fluctuate in function of the volume of production
The break-even point

There will be a point where production covers both fixed and variable cost
The P&L Account
This crucial point is called break-even and is the point as of which profit is being earned
Break-even
The P&L Account
Variable costs
Fixed costs
VOLUME
Break-even
The P&L Account
BREAK-EVEN
PROFIT
Variable costs
LOSS
Fixed costs
VOLUME
The concept of a profit centre

Sales
Sales Gross Profit Variable Expenses Direct Expenses Department Profit
The P&L Account
Service
Sales Gross Profit Direct Expenses Department Profit
Parts
Sales Gross Profit Direct Expenses Department Profit
Total Departmental Profit Indirect Expenses Operating Profit Other Income (Expenses) Total Company Net Profit
The P & L per profit centre

ADVANTAGES DISADVANTAGES
The P&L Account
Reflects the structure of the organisation Allows for a specific reporting per profit centre Allows for educated decisions
Could inhibit an overall approach Could encourage independence Could encourage internal competition
Adequate measures for performance improvement

Allows for a better allocation of resources
Could encourage the pursuit of department proper goals
The link between the balance sheet and the profit and loss account
BALANCE
P&L
Fixed assets Assets Current assets Reserves LT Debt ST Debt
Amortisation Turn over Depreciation Profit Financial charges Financial charges
2 The balance sheet



Fixed Assets Equity & Reserves
Share Capital Revenue Reserves Capital Reserves Land & Buildings Plant & Equipment Fixtures & Fittings Company Vehicles Intangible assets
The balance sheet
Long Term Liabilities

Long Term Loans Mortgages Current Liabilities Bank Overdraft Creditors (inc Tax & VAT) Accruals Short Term Loans
Current Assets
Stocks Debtors Work in Progress Prepayments Cash
The balance sheet
Norms There are certain basic principles such as: LT Assets > LT Liabilities ST Assets > ST Liabilities LT Liabilities should finance: - 100% LT assets - the permanent ST Assets
ST ASSETS LT ASSET S
N.W.
LT DEBT
Long term
ST DEBT
Assets
The balance sheet
Liquidity Permanent
Fixed assets
Operating Stocks assets Debtors
Treasury
Non Permanent Current
assets
Cash
Liabilities
The balance sheet
Disposal
Share Permanent Permanent capital liabilities LT
debt
Operating Liabilities Treasury Suppliers
Temporary
Current liabilities
ST Bank facilities
Working capital management
(1)Source of Working capital
Fixed assets Source of working capital Stock Debtors
Shares & Reserves LT debt
(2) Use of Working capital
ST debt
Use of working capital

ST Bank debt Treasury
(3) Treasury
Cash
The structure of a balance sheet
Fixed assets
Own funds
LT debt Use of working capital ST Debt
Inventory Debtors
Maximise
Source of Working Capital Treasury
Use of Working Capital
Minimise
The goal is to have a positive treasury
The definition of the working capital
The working capital
The origin of the working capital = the difference between equity & l.t. debt and l.t.assets The use of working capital = is the difference between current assets and current liabilities Treasury = the difference between the origin of working capital and the use of working capital
The Net Worth

The difference between assets and liabilities towards third
The working capital
parties : Ownership interest (permanent capital)
Capital + retained earnings (losses)

The difference between ownership and liabilities is of great practical importance. Normally claims which belong to the
owners will only be paid directly to them if the organisation

ceases trading.
Summary
The structure of a balance sheet
1. Quite a large number of elements of the balance sheet are subject to judgement. 2. The source of working capital and the use of working capital relate to each other and determine the level of the treasury 3. Net worth (equity and reserves) can be over- or undertstated.
Basic principles of accounting 1 The need for financial reporting
2 The balance sheet


5 Financial flows 6 The structure of a balance sheet 7 Key financial ratios 8 Different balance sheets
1
2 3
The financing of assets Liquidity
The financial flows
Business Growth Accounting & Financial analysis
Business growth can take three basic forms: Increased profitability on current volume Increased volume on current profitability Increased profitability on increased volume
The Need For Extra Funding Accounting & Financial analysis
To cover the effects of inflation and/or growth we need extra funds to: Carry more stock Support more debtors Update/add to fixed assets Pay more staff
Growth Will Require More of This...
... but where will it come from?
Sources of Funding Accounting & Financial analysis
Internal Share Capital Reserves
External Long Term Loans Stocking Loans Bank Overdrafts Working Capital Loan Venture Capital
The financial flows

The financial flows underline the significance of the profitability of the operations and the financial management of the company The company should generate enough cash to: Finance the investments : repayment of loans and the financial charges Finance the use of working capital Pay out dividends and taxes : Shareholders State dividends taxes
Financial flows
1 2 3 4 5
The need for financial reporting The balance sheet The basic rules of accounting The profit and loss account The structure of a balance sheet
6
7 8
Financial flows
Key financial ratios Different balance sheets
1 2 3 4
Key ratios The link between the ratios Trend analysis Performance measurement
The analysis of a company financial statements is indertaken for the purpose of extracting information related to:
The companys activities

Profitability Efficiency Degree of risk
This is achieved by using ratios relating to key financial variables
Financial ratios
The concept of a ratio A ratio is a fraction
Numerator
Denominator
Denominator
Financial ratios
The concept of a ratio A ratio is a fraction
The financial ratios

Examples of key performance ratios
Profitability ratios Return on capital Return on sales
Risk ratios Efficiency ratios Stock market Sales / Fixed assets Current ratio Price to earnings Stock / Total assets Debt to equity Asset value per share
Return on capital employed
The definition of the ratio
Key ratios
Operating profit Capital employed

The meaning of the ratio Capital employed is defined as fixed assets plus current assets Gives an indication of the profitability of the company = A high profitability could be the result of a high mark-up on goods sold and/or an efficient usage of assets
Return on sales
Key ratios
Operating profit Sales

The meaning of the ratio Gives an indication of the profitability of the company = A high profitability could be the result of an efficient production or distribution process
Sales on fixed assets
Key ratios
Sales Fixed Assets

The meaning of the ratio Provides an assessment on the efficiency of management in using the companys assets
Stock on total assets
Key ratios
Stock Total Assets

The meaning of the ratio The ratio assess the degree of stability in the stock figure throughout the years.
Current ratio
Key ratios
Current Assets Current Liabilities

The meaning of the ratio Assess short-term liquidity and examines the ability of the company to meet its short-term commitments.
Debt to equity
Key ratios
Long-term debt Shareholders equity

The meaning of the ratio This ratio is used to assess the companys ability to meet both interest and principal repayments on loans as they fall due.
Price to earnings ratio (P/E)
Key ratios
Current market Price Earnings per share

The meaning of the ratio This ratio gives the number of years earnings represented by the current price The P/E ratio is a mixture of current price reflecting expectations about the future and historic profit for the most recent accounting period.
Asset value per share
Key ratios
Net assets attributable to ordinary shareholders Number of shares issued

The meaning of the ratio The result of this fraction is often compared with the market value to see to what extend the current price is supported or backed by assets
The significance of trend analysis
Ratio
Key ratios
TREND PEERS
Time
Summary
A series of key ratios provide us a good indication of the structure of the balance sheet, of the profit and loss account and about the trend of the companys performance Ratios show either positive or negative correlations The trend analysis allows for timely decisions and the comparison of the companys performance versus a peer group Ratios allow for standard deviations and the evaluation of the relative performance of the company
Key ratios

Basic Principles of Accounting & Financial Analysis: Roger Claessens, Prof. UBI United Business Institutes

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Basic Principles of Accounting & Financial Analysis: Roger Claessens, Prof. UBI United Business Institutes

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Basic principles of accounting & financial analysis

Roger Claessens, Prof. UBI United Business Institutes

Accounting & Financial analysis

2 The balance sheet

4 The profit and loss account

A learning Curve Step by Step