1.1. What is Financial Accounting?

Financial accounting could be defined as the process of recording, summarising and reporting financial transactions of a business (ICAEW, 2012). Double entry booking keeping system lies at the heart of the financial accounting.

The objective of this chapter is to understand:

- The double entry accounting techniques to a range of simple transactions

- Preparation of ledger accounts

- Preparation of trial balance

- Income Statement

- Balance Sheets

- Cash Flow Statements

- Ratio Analysis

2. Double entry book keeping system

2.1. Key components of financial accounting

In order to develop a comprehensive understanding of the booking system, it is imperative to understand the key components of financial statements. The five key components of financial accounting are:

  • Assets
  • Liabilities
  • Equity
  • Income
  • Expenses

Assets could be defined as the resources owned by a business entity from which future economic benefits are expected to flow to the entity (IFRS, 2012). Typical examples of assets include inventory, plant and machinery and land.

Liabilities could be defined as an obligation arising from a past event, the settlement of which would lead to an outflow of the future economic benefits from an entity (IFRS, 2012). Typical examples of liabilities include accounts payables and loans.

Equity could be defined as the residual interest of the owners of the business in its assets after deducting the liabilities (IFRS, 2012).

Income could be defined as the increases in the economic benefits during the accounting period in the form of increase in assets or reduction of liabilities (IFRS, 2012). Typical examples of income include revenue generated from sales of products or services and interest income earned on financial investments.

Expenses could be defined as the decreases in the economic benefits during the accounting period in the form of reduction of assets or increase in liabilities (IFRS, 2012). Typical examples of expenses include costs of procuring goods for selling and marketing, selling and administrative expenses.

2.2. Accounting equation

The accounting equation underpins the concept of double entry accounting technique of recording transactions. Mathematically, the accounting equation could be expressed as:

Assets = Liabilities + Equity

The accounting equation reflects the fundamental concept underpinning the double entry accounting system. The double entry accounting system is based on the concept that each accounting transaction will impact at least two accounts. For instance, when an organisation borrows money from a bank, its bank balance as well as the loans payable balance increases.

Print out your bank statement for past six months and classify all the receipts and payments into either of one of the following - income, expense, assets, liabilities or equity.

Now, you can think of using the golden rules and posting the double entries for all your transactions.

2.3. Accounting terminology

In accounting terms, the increase or decrease in the components of the financial accounts are expressed in terms of debits or credits.

Table 1: Golden rules for understanding debits and credits

Debit 

Credit

  • Increase in expenses
  • Decrease in income
  • Increase in assets
  • Decrease in liabilities
  • Decrease in equity
  • Decrease in expenses
  • Increase in income
  • Decrease in assets
  • Increase in liabilities
  • Increase in equity

If you succeed in memorising the rules for debits, the rules for credits are exactly the opposite.

2.4. Accruals concept of accounting

Accruals concept of accounting underpins the accounting technique of double entry system. The accruals concept of accounting states that a transaction is recorded at the time when it takes place, not when the settlement is made.

For example, a business sells a product worth £1,000 on 1st October 2016 and receives the payment on the 31st October 2016. Based on the accruals concept of accounting, the sales would be recoded on the 1st of October, the date when the sales occurred, not on the 31st October, when the cash was received for the sales.

2.5 Recording financial transactions using double entry accounting system

The objective of this section is to demonstrate the double entry accounting techniques for a range of business transactions.

Double entry to record sales, cost of sales transactions and inventory

A business sold an inventory for £1,000 on credit on 1st October 2016. The purchase price of the inventory was £750. The customer paid the amount on 31st October 2016.

The double entries to record the transaction would be:

Table 2

Date

Debit/Credit

Account

Amount

01/10/2016

Debit

Debtors

1,000

Credit

Sales

1,000

Debit

Cost of goods sold

750

Credit

Inventory

750

31/10/2016

Debit

Cash

1,000

Credit

Debtors

1,000

The double entries have been derived by applying the golden rules highlighted in the section 2.3 above.

When a sale is made for £1,000 on credit, debtors’ account, which is an asset, is increasing in value because a debtor owes £1,000 to the business. Based on the golden rules, an increase in the asset is debited.

Sales would be classified as an income based on the definitions highlighted in the section 2.1 above. Based on the golden rules, increase in the income is credited.

When a business sells an inventory, the amount of inventory in a business decreases. Since inventory is an asset, decrease in inventory is credited by the value of the inventory. The associated expense, cost of goods sold, is debited by the same amount.

On 31st October 2016, when the customer pays the money to the business, the cash balance is increasing whereas the debtor balance is decreasing, as the customer would no longer owe money to the business. Since both cash and debtors are assets, the asset that is decreasing has been credited whilst the one that is increasing has been debited.

Double entry to record irrecoverable debts and allowances

A business made a sale on credit on 1st November 2016 for £1,000. However, the customer was declared bankrupt on the 15th November 2016, as a result of which only £500 was recoverable from the customer on the 30th November.

The double entries to record the transaction above would be:

Table 3

Date

Debit/Credit

Account

Amount

01/11/2016

Debit

Debtors

1,000

Credit

Sales

1,000

15/11/2016

Debit

Irrecoverable debts and allowances

500

Credit

Debtors

500

30/11/2016

Debit

Cash

500

Credit

Debtors

500

The sales entry is the same as shown in table 2 above. A cost of sales entry would be recorded as well based on the value of the inventory that is sold.

The irrecoverable debts and allowances double entry is based on the accruals concept of accounting. Thus, the allowances for doubtful debt is recognised on the day on which it was ascertained that the debt would not be recovered in full. Since it is an expense, an increase in expense is debited. The reduction in debtors, which is an asset, is credited.

The cash entry on 30th November is underpinned by the same explanation as given for the receipt of cash in table 1.

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Double entry to record non-current assets and depreciation

A business purchased machinery worth £50,000 on 1st December 2016 that has an estimated useful life of 10 years. Thus, the depreciation would be calculated as £5,000 per year.

Table 4

Date

Debit/Credit

Account

Amount

01/12/2016

Debit

Machinery

50,000

Credit

Cash

50,000

31/12/2016

Debit

Depreciation

416.67

Credit

Machinery

416.67

On purchase of machinery, since the machine account, which is an asset account, is increasing and the cash, another asset account, is decreasing as cash is going out of the business, the machinery account is debited and the cash account is credited by £50,000.

Depreciation is a charge recognised in the profit and loss account to reflect the decrease in the value of the asset due to wear and tear. Since an expense account is increasing and an asset account is decreasing because the depreciation reflects the reduction in the value of the machinery, increase in expense is debited and decrease in the value of the asset is credited. The amount £416.67 is derived by dividing £5,000 by 12 to reflect the monthly depreciation charge.

Double entry to record prepayments

A business paid £2,000 for an advertising campaign that would run from 1st April 2017 on 1st January 2017.

Table 5

Date

Debit/Credit

Account

Amount

01/01/2017

Debit

Prepayments

2,000

Credit

Cash

2,000

01/04/2017

Debit

Advertising expenses

2,000

Credit

Prepayments

2,000

Based on the accruals concept of accounting, prepayments entry is recorded on the date the payment for the advertising campaign was made in advance. Since prepayments and cash are both assets, the increase in prepayments is debited and the decrease in cash is credited. At the point of making the advance payment, the expense is not recognised in the profit and lost account because of applying the accruals concept of accounting.

On 1st April 2017, when the advertising campaign begins, the expense is recognised. Increase in the expense is debited and decrease in prepayments is credited. Please note, the prepayments account is credited because the cash for the advertising campaign was already made on 1st January 2017.

Double entry to record accruals

A business receives an electricity bill for £500 on 31st January 2017 and makes the payment on 28th February 2017.

Date

Debit/Credit

Account

Amount

31/01/2017

Debit

Electricity expenses

500

Credit

Accruals

500

28/02/2017

Debit

Accruals

500

Credit

Cash

500

On 31st January 2017, electricity expense is recognised in the account by debiting the electricity expense account since it is increasing. However, as no cash payment is made against the electricity invoice, the liability to the business is increasing. Thus, the accruals account is credited.

On 28th February 2017, when the payment is made to settle the electricity bill, cash is credited as asset is reducing and accruals account is debited to reflect the decrease in the liability, as the electricity bill is no longer a liability to the business.

3. Preparation of ledger accounts

Ledger accounts reflect all the transaction for a particular account. It is a systematic reflection of the double entries at an account level.

The ledger accounts for all the double entries are reflected below:

                                                       Cash Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

31/10/2016

Debtor

1,000

01/12/2016

Machinery

50,000

30/11/2016

Debtor

500

01/01/2017

Prepayments

2,000

31/03/2017

Balance c/f

51,000

28/02/2017

Accruals

500

Total

52,500

Total

52,500

01/04/2017

Balance b/f

51,000

                                                        Sales Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

01/10/2016

Debtor

1,000

31/03/2017

Income Statement

2,000

01/11/2016

Debtor

1,000

Total

2,000

Total

2,000

                                                        Debtors Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

01/10/2016

Sales

1,000

31/10/2016

Cash

1,000

01/11/2016

Sales

1,000

15/11/2016

Irrecoverable debts and allowances

500

30/11/2016

Cash

500

Total

2,000

Total

2,000

                                                  Cost of goods sold Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

01/10/2016

Inventory

750

31/03/2016

Income Statement

750

Total

750

Total

750

                                                          Inventory Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

31/03/2017

Balance c/f

750

01/10/2016

Cost of goods sold

750

Total

750

Total

750

01/04/2017

Inventory

750

                                            Irrecoverable debts and allowances

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

15/11/2016

Debtors

500

31/03/2017

Income Statement

500

Total

500

Total

500

Machine Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

01/12/2016

Cash

50,000

31/12/2016

Depreciation

416.67

31/01/2017

Depreciation

416.67

31/02/2017

Depreciation

416.67

31/03/2017

Depreciation

416.67

31/03/2017

Balance c/f

48,333.32

Total

50,000

Total

50,000

01/04/2017

Balance b/f

48,333.32

Depreciation Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

31/12/2016

Machinery

416.67

31/03/2017

Income Statement

1,666.68

31/01/2017

Machinery

416.67

31/02/2017

Machinery

416.67

31/03/2017

Machinery

416.67

Total

1,666.68

Total

1,666.68

Prepayments Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

01/01/2017

Cash

2,000

31/03/2017

Balance c/f

2,000

Total

2,000

Total

2,000

01/04/2017

Balance b/f

2,000

Note: Advertising expense ledger account is not reflected because it is outside of the financial year 01/04/2016 - 31/03/2017.

Electricity Expense Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

31/01/2017

Accruals

500

31/03/2017

Income Statement

500

Total

500

Total

500

Accruals Account

Debit                     Credit

Date

Transaction

Amount

Date

Transaction

Amount

28/02/2017

Cash

500

31/01/2017

Electricity Expense

500

Total

500

Total

500

For all the ledger accounts reflected above, the accounts those are of expenses or income nature, the balancing figure between the total of debits and credits is debited or credited to the income statement, whereas the accounts those are of asset or liability nature, the balancing figure is reflected as the opening balance in the next period.

4. Trial Balance

A trial balance is a statement of the total of debits and credits for all the ledger accounts with the total of the debit side always equal to the total of the credit side.

Trial Balance

DebitCredit

Account

Amount

Account

Amount

Cost of goods sold

750

Cash (overdraft)

51,000

Irrecoverable debts and allowances

500

Sales

2,000

Machinery

48,333.32

Inventory

750

Depreciation

1,666.68

Prepayment

2,000

Electricity expense

500

Total

53,750

Total

53,750

5. Income Statement

An income statement or profit and loss account is a component of the financial statements of a business that reports the performance of a company over a period of time (ICAEW, 2012a).

The structure of an income statement is as follows:

Income Statement of ABC Plc for the year ending 31st March 2017

Sales

Cost of Sales

Gross Profit

Selling and Distribution Expenses

Administrative Expenses

Other Expenses

Operating Profit

Finance Income

Finance Cost

Profit before tax


Income Tax

Net Profit

Sales represent the total amount that a business has realised by selling its products and services to the customers.

Cost of sales could be defined as those costs that are directly attributable to selling a product or a service. Mathematically cost of sales could be expressed as: Opening stock + Purchases - Closing Stock

Gross profit could be expressed as the difference between the sales and the cost of sales.

Selling and distribution expenses are those costs that are incurred for selling and distributing products and services. Typical examples of selling and distribution costs are marketing expenses.

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Administrative expenses refer to those expenses that are incurred on day-to-day activities of a business. Typical examples of administrative expenses include salaries paid to the employees.

Other expenses refer to those costs that could neither be classified as the selling or distribution nor as administrative expenses. Typical examples of other expenses include warranty costs.

Operating profit is the profit made by a business after deducting cost of sales and overhead expenses.

Finance income refers to the income earned on the investments made by a business. Typical example of finance income includes interest income earned on bank deposits.

Finance expense refers to expenses incurred on raising finance for a business. Typical examples of finance expense include interest paid on a loan.

Profit before tax is the profit that a business makes after deducting direct and indirect overheads and net finance costs.

Income tax is the amount of corporation tax that a business has to pay on its profits.

Net profit is arrived at after deducting all expenses and income tax. It reflects the net profit that a business makes from its operations.

6. Balance Sheet

Balance sheet is the component of financial statements that reflects the position of assets and liabilities of a business at a specific date.

The structure of a balance sheet is as follows:

Balance Sheet of ABC Plc at 31st March 2017

Non Current assets

Property plant and equipment

Investments

Current Assets

Stock

Debtors

Cash

Total Assets

Non Current Liabilities

Loan

Pension Liabilities

Current Liabilities

Bank overdraft

Creditors

Accruals

Equity

Share Capital

Retained Earnings

Total Liabilities and Equity

The definition of assets, liabilities and equity has been reflected in the section 2.1.

Non current assets are those from which future economic benefits are expected to flow to the entity over a period of time that is greater than 12 months. Typical examples of non current assets include property plant and equipment and investments. When a business invests in a plant and machinery, it expects to benefit from it for a period of time that is significantly greater than one year. Furthermore, investments that mature after 12 months can be classified as non-current assets.

Current assets are those from which future economic benefits are expected to flow to the entity for a period of time that is typically less than 12 months. Typical examples of current assets include debtors and inventory. Although debtors could be classified as long-term assets if the period of credit granted by a business is more than 12 months, but the usual practice with most businesses is to grant credit period of less than 12 months. Inventories are classified as current assets because businesses typically expect to sell their inventories over a period of time that is less than 12 months because unsold inventory for a period of more than 12 months could be indicative of obsolescence. Nonetheless, like debtors, inventory could be classified as non-current assets under exceptional circumstances.

Non-current liabilities are those from which future economic benefits are expected to flow out from the entity after a period of twelve months. Loans are typical examples of non-current liabilities as the principal amount borrowed needs to be repaid after one year.

Current liabilities are those from which future economic benefits are expected to flow out from the entity over a period of time that is less than 12 months. Typical examples of current liabilities include accruals and creditors because usually the credit terms offered by most suppliers is significantly less than 12 months.

Equity reflects the residual interest belonging to the owners of the company after deducting liabilities from the assets. Share capital reflects the amount of money that is repayable to the shareholders of the company upon liquidation and the retained earnings reflects the cumulative profits or losses made by a business till the date of the preparation of the balance sheet.

7. Cash Flow Statements

Cash flow statements are a component of the financial statements that reflects the sources of cash generations and uses of cash in a business. Cash flow statements could be prepared using two methods - direct method and indirect method.

Under the direct method, all the cash outflows are deducted from the cash inflows during a year. The indirect method of cash flow statement is more commonly used by businesses.

The structure of the indirect method of cash flow is as follows:

Cash flow statement of ABC Plc for the year ending 31st March 2017

Cash flow from operating activities

Profit before Tax

Add:

Net Finance Expense

Non cash items

Decrease in current assets

Increase in current liabilities

Less:

Decrease in current liabilities

Increase in current assets

Tax paid during the year

Net cash flow from operating activities

Cash flow from investing activities

Add:

Proceeds from sale of fixed assets

Less:

Purchase of fixed assets

Investments

Net cash flow from investing activities

Cash flow from financing activities

Add:

Proceeds from issue of shares

Less:

Redemption of debentures

Interest paid

Dividend Paid

Net Cash flow from financing activities

Change in cash and cash equivalents during the year

Cash and cash equivalents at the beginning of the period

Cash and cash equivalents at the end of the period

The indirect method of cash flow is prepared by taking profit before tax from the income statement and adjusting it for non-cash items such as depreciation or amortisation.

Thereafter, the profit figure is adjusted for the changes in the current assets and current liabilities over a period of time to arrive at the net cash flow from the operations. For example, if the debtors’ balance has increased compared to the previous year, it is indicative of a negative impact on cash, as more items would have been sold on credit. Net cash flow from operations is indicative of the ability of a business to generate cash flows from its operations.

Cash from investing activities reflects the cash performance of the business in the investments. Any investments that result in cash outflow from the business are subtracted and those that result in cash inflow are added to arrive at the net cash flow from investment activities.

Lastly, cash from financing activities reflects the sources and uses of cash flow for financing the business. Like cash flow from investing activities, any activities that result in cash outflow from the business are subtracted and those that result in cash inflow are added to arrive at the net cash flow from financing activities 

The net amount of the cash flow from operating, investing and financing activities should reflect the difference in the cash balance between two consecutive years.

For the purposes of cash flow statements, cash equivalents such as short-term deposits are also considered cash. Cash equivalents could be defined as highly liquid assets that could be readily converted into cash without a significant change in value.

8. Ratio Analysis

Ratio analysis could be defined as expression of one number in terms of another in order to facilitate comparison between the financial performances of different businesses or industries (Adedeji, 2014).

8.1 Advantages of ratio analysis

  • Ratio analysis enables the users of the financial statement to make comparisons between the financial performances of two or more businesses, even if they are of different sizes or from different industries, by converting financial numbers into standardised form using pre defined formulas. Imagine comparing the financial performance of two companies of different sizes. Based on the financial numbers, the business with a higher profit would seem better. However, in reality the business with a higher profit might be operating at very thin margins, making it less attractive to the investors.
  • Ratios are easy to calculate and do not consume significant amount of time
  • Ratio analysis is a useful tool to monitor and control a business organisation’s performance. The users of the financial statements are often interested in assessing the profitability margins, liquidity and solvency position of a business.
  • Lastly, ratio analysis helps to simplify the information contained in the financial statements, thereby making it easier for the users of the financial statements to analyse the performance of a business.

8.2 Disadvantages of ratio analysis

  • One of the primary disadvantages of ratio analysis is that it is underpinned by numbers contained within the financial statements. Thus, if the numbers contained within the financial statements were subject to management bias, ratio analysis would give inaccurate results.
  • Secondly, lack of ideal ratios makes it difficult for the users of the financial statements to assess whether a particular ratio is good or bad. For instance, higher the current ratio, the better it is. Nonetheless, a business with exceptionally high current ratio could be reflective of the inability of a business to use its funds efficiently. Thus, the absence of any definitive guidelines regarding its interpretation limits its utility in the real world.
  • Since different businesses adopt different accounting policies and estimates, the comparison between two businesses would not yield effective results if the accounting policies and estimates adopted by the two businesses are different.
  • Ratio analysis is historical in nature whereas most users of financial statements are interested in acquiring information about the future.
  • Lastly, ratio analysis could misrepresent the data because of ignoring factors, such as seasonality.

9. Types of ratios

Ratios could broadly be calculated under five categories:

  1. Liquidity
  2. Solvency
  3. Profitability
  4. Efficiency
  5. Investor

9.1 Liquidity ratios

Liquidity ratios are indicative of the short-term liquidity position of the business. The two most commonly used liquidity ratios are current ratio and quick ratio.

Current ratio  = Current assets / Current liabilities

Current ratio measures the ability of a business to meet its short-term obligations out of its current assets. Ideal level of current ratio in most industries is deemed to be 2:1. A business with low current ratio often struggles to get short-term credit because the suppliers are skeptical about the ability of the business to meet its obligations.

Quick ratio = (Current assets - Inventory)/ Current Liabilities

Quick ratio is a more stringent measure of liquidity compared to the current ratio. Quick ratio does not include inventory as a part of the current assets because inventories are deemed to be the least liquid assets and it is often not possible to convert them into cash as and when needed.

9.2 Solvency Ratios

Solvency ratios are indicative of the long-term solvency position of a business. The two most commonly used solvency ratios are debt to equity ratio and the interest cover ratio.

Debt to equity ratio = Long-term debt/equity

Debt to equity ratio is indicative of the riskiness of the capital structure of a business. A low debt to equity ratio is indicative of lower risk and vice versa. A business should inject debt into its capital structure till the point its weighted average cost of capital is decreasing. Beyond that point, it is deemed to be inefficient to include more debt in the capital structure. Lenders often assess debt to equity ratio before lending money. Thus, it is important for businesses to manage their capital structure efficiently.

Interest cover ratio = Operating profit + Finance income/ Finance cost

Interest cover ratio measures the ability of a business to meet its interest obligations out of its operating profits. The higher the interest cover ratio, better the ability of a business to meet its interest obligation. Interest cover ratio is another important ratio assessed by the lenders before making decision about lending money.

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9.3. Profitability ratios

Profitability ratios are indicative of the business organisations’ ability to earn profit per unit of revenue generated. The higher the profit margin, the better it is because a high profit margin reflects a business organisation’s ability to earn higher profits per unit of revenue. Four commonly used profitability ratios are gross profit margin ratio, operating profit margin ratio, net profit margin ratio and the return on capital employed.

Gross profit margin ratio = Gross profit / net sales * 100

Gross profit margin indicates the profits earned by a business after accounting for the direct costs of selling the goods.

Operating profit margin ratio = operating profit / net sales * 100

Operating profit margin is reflective of the profits earned by a business after accounting for direct and indirect overheads. Thus, ability of the businesses to keep their operating costs under control could significantly impact this ratio.

Net profit margin ratio = net profit/ net sales * 100

Net profit margin reflects the profits earned by a business after making all the deductions.

9.4 Efficiency ratios

The efficiency ratios are indicative of the ability of a business to utilise its resources efficiently in order to maximise the returns for the shareholders. The commonly used efficiency ratios are receivables days, payable days and inventory days.

Receivable days: Debtors/Sales * 365

The receivables days is reflective of the number of days required by a business to collect money owed by the debtors. The lower the receivable days, the better it is for a business. The receivable days should approximately reflect the credit days offered by a business to its customers. If the receivable days is particularly high compared to the average credit days offered by a business, it could be indicative of potential bad debt.

Payable days: Creditors/ Purchases * 365

The payables days is reflective of the number of days required by a business to pay money owed to the creditors. Although a higher payable days positively impacts the working capital requirement of a business, a business should try to negotiate longer credit days rather than delaying payments to increase the payables days because the latter could have a detrimental impact on the supplier relationship and impact the ability of a business to procure supplies.

Inventory days = Average Inventory / Purchases * 365

Average Inventory = (Opening stock + Closing Stock)/2

The inventory days are reflective of the number of days taken by a business to sell its inventory from the day of procurement. The lower the inventory days of a business, the better it is from a working capital perspective. A higher than industry’s average inventory days is deemed to be risky because it reflects that a business is holding stock for a longer period of time than most competitors and that its inventory might lose value because of risk of obsolescence. Obsolescence is deemed to be major risk in many industries such as fashion and technology.

9.5 Investor ratios

Investor ratios help to assess the attractiveness of a company from an investors’ perspective. The two commonly calculated investor ratios are price earnings ratio and the dividend yield ratio.

Price earning ratio = Market price of share / earnings per share

Price earning ratio is indicative of the growth prospects of a company. Higher the price earning ratio, better the growth prospect of a business. Thus, shares of companies with high price earning ratios are particularly attractive to investors who prefer long-term capital gains rather than regular dividend payments because companies with high price earning ratio often need to invest the funds to finance the high growth projects and have little liquidity left to payout dividends to the shareholders.

Dividend yield = Annual dividend per share / Market price per share

The dividend yield ratio reflects the returns that investors earn in the form of dividends. Investors with a preference of receiving regular dividend payments should invest in companies with high dividend yields.

Download the financial statements of a listed company and put your thoughts on a piece of paper regarding the performance of the company.

Now, calculate each of the ratios discussed above and again put your thoughts on another piece of paper.

Compare your initial analysis with the latter one. This exercise will help you appreciate the importance of ratio analysis as a tool of financial analysis.

10. Horizontal, Vertical and trend analysis

Horizontal analysis could be defined as comparing financial information over a number of years. An example of horizontal analysis is illustrated below:

Horizontal analysis

‘000

2016

2015

2014

% Change between 2015 and 2016

% Change between 2014 and 2015

Sales

2,000

1,500

1,000

33%

50%

Carrying out horizontal analysis helps to identify key trends in a business and make informed business decisions. In the example above, it is evident that between 2014 and 2015 the business grew by 50% compared to an only 33% growth between 2015 and 2016. Thus, carrying out horizontal analysis could enable management to identify the strong and the weak performing areas of a business and formulate appropriate business strategies.

Vertical analysis is a process of financial analysis as a part of which all numbers of an income statement or a balance sheet are expressed in terms of a common denominator.

When performing a vertical analysis for an income statement, all numbers in the income statement are usually expressed in terms of revenue, whereas in a balance sheet, all numbers are usually expressed in terms of total assets. It is at the discretion of the business to choose the most appropriate denominator. An example of vertical analysis is illustrated below:

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Vertical analysis

‘000

2016

2015

2016

2015

Sales

1,000

2,000

100%

100%

Cost of Sales

500

1,500

50%

75%

Gross Profit

500

500

50%

25%

Vertical analysis is a useful tool to monitor and control a business organisation’s performance. In the example above, the gross profits for both the years are £500,000, however, vertical analysis indicates that the gross profit margin of business has declined from 50% to 25% between 2016 and 2015. Thus, it highlights changes in the key metrics of businesses prompting business managers to identify the causes of change and take remedial action to improve the organisation’s performance.

Trend analysis could be defined as the process of conducting ratio, horizontal or vertical analysis over a number of years with the intention of predicting future trends.

11. Summary

This chapter has looked at the basics to double entry technique, explained the key components of financial statements and assessed various tools of analysing financial information. The key lessons are summarised below:

  • The key to understanding the double entry is classification of items into one of the five categories: assets, liabilities, equity, income or expense.
  • Debit the increase in expenses, assets or decrease in liability, income or equity
  • Credit the increase in liabilities, equity or income and the decrease in assets or expenses.
  • Ledger accounts are a systematic refection of all transactions in a particular account
  • Income statement represents the financial performance of a business over a period of time
  • Balance sheet reflects the position of a company’s assets and liabilities at a particular point of time
  • Ratio, vertical and horizontal analysis are useful tools for planning, controlling and monitoring an organisational performance.
  • The effectiveness of the ratio analysis is underpinned by the accuracy of the underlying data.


Recommended Textbooks

Gracia, L., 2013, Introduction to Financial Accounting, Custom Edition, London, McGraw Hill.

Grewal, T., 2014, Analysis of Financial Statements, New Delhi: Sultan Chand.

Robertson, J., 2007, Financial Ratio Analysis, 3rd edition. Lancaster: John Robertson.

References

Adedeji, E., 2014, A tool for measuring organisation performance using ratio analysis, Research Journal of Finance and Accounting, vol. 5 (no. 19), pp. 16-22.

ICAEW, 2012, Financial Accounting Study Manual, 6th Edition, Exeter, Polestar Wheatons.

ICAEW, 2012a, Financial Reporting Study Manual, 6th Edition, Exeter, Polestar Wheatons.

IFRS, 2012, International Financial Reporting Standards, Part A, London, International Accounting Standards Board


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