Accounting for Business: Preparation of Financial Statements and Analysis of Financial Ratios

Level of study: 5

Number of credits: 20 credits

Course the module belongs to: BA (Hons) Business Studies

Faculty: Business

Semester/Trimester of delivery: 3

Start date of the module: July 2024

Location of study: London School of Commerce

Student Name:

Student ID:

Table of Contents

Introduction

There are diverse functions performed in an organisational context amongst which accounting is one of the compulsory functions. Accounting for business is different elements and factors. Preparation of financial statements is one of the most important elements and factors of accounting for business. Similarly, financial ratios are also one of the most important factors. This study discusses both these aspects of accounting for business. It is going to prepare an income statement of an organisation named AC Ltd in addition to the preparation of its statement of financial position. On the other hand, there is going to be an in-depth evaluation of the financial performance of another organisation known as CR plc based on financial ratios. Depending on the financial ratios, the liquidity of the organisation along with its profitability and efficiency is going to be analysed.

Question 1

(a) Prepare an income statement for the year ended 31st December 2023.

Income Statement of AC Ltd

For the year ended 31^st December 2023

Items	Amount (’ 000)	Amount (’ 000)
Sales		£ 1,300
Cost of sales
Opening inventories	£ 110
Purchases	£ 800
Closing inventories	£ 120	£ 790
Gross profit		£ 510
Operating Expenses
Directors’ remuneration	£ 37
Administrative expenses	£ 150
Selling and distribution expenses	£ 75
Audit fees	£ 12
Depreciation of machinery	£ 32	£ 306
Profit before interest and tax (PBIT)		£ 204
Debenture interests	£ 13
Interest on bank loan	0	£ 13
Profit before tax (PBT)		£ 191
Taxation		£ 40
Profit after tax (PAT)		£ 151
Dividends -- Interim	£ 20
-- Final	£ 45	£ 65
Retained profit for the year		£ 86
Retained profit b/d		£ 81
Retained profit c/d		£ 167

Workings:

(1) Cost of Sales

= Opening inventories + Purchases – Closing inventories

= £110 + £800 – £120

= £790

(2) Gross Profit

= Sales – Cost of Sales

= £1300 – £790

= £510

(3) Administrative Expenses

= Administrative Expenses at the end of the year – Administrative Expenses paid in advance

= £160 – £10

= £150

(4) Audit fee

= Total audit fee at the end of the year + Audit fee not yet paid

= £10 + £2

= £12

(5) Depreciation of machinery

= 20% of (Machinery at cost at the end of the year – Accumulated Depreciation at the end of the year)

= 20 / 100 * (£250 – £90)

= £32

(6) Profit before interest and tax (PBIT)

= Gross profit – Operating Expenses

= £510 – (£75 + £150 + £12 + £37 + £32)

= £204

(7) Profit before tax (PBT)

= Profit before interest and tax (PBIT) – Interest Expenses

= £204 – £13

= £191

(8) Profit after tax (PAT)

= Profit before tax (PBT) – Taxation

= £191 – £40

= £151

(9) Dividends -- Final

= 10 pence per share

= 0.10 * 450000 shares

= £45000

(10) Retained profit for the year

= Profit after tax (PAT) – Dividends (interim + final)

= £151 – (£20 + £45)

= £151 – £65

= £86

(b) Prepare a statement of financial position as at 31st December, 2023.

Statement of Financial Position of AC Ltd

As at 31^st December 2023

Items	Cost (’ 000)	Accumulated Depreciation (’ 000)	NBV (’ 000)
Non-current assets
Machinery	£ 250	£ 122	£ 128
Land & buildings	£ 624	0	£ 624
			£ 752
Current assets
Prepayment	£ 10
Receivables	£ 100
Inventory	£ 120
Cash and Bank	£ 16		£ 246
Total assets			£ 998
Share capital
£1 Ordinary shares			£ 450
Reserves
Retained profits			£ 167
Shareholders’ equity			£ 617
Non-current debts
7% Debentures	£ 200
Long-term bank loan	0		£ 200
Current debts
Bank overdraft	£ 24
Accruals	£ 2
Payables	£ 70
Proposed dividends	£ 45
Taxation	£ 40		£ 181
Shareholders’ equity & debts			£ 998

Workings:

(1) Non-current assets

= Machinery + Land & buildings

= £128 + £624

= £752

(2) Current assets

= Prepayment + Receivables + Inventory + Cash and Bank

= £10 + £100 + £120 + £16

= £246

(3) Shareholders’ equity

= Share Capital + Reserves

= £450 + £167

= £617

(4) Non-current debts

= Long-term bank loan + 7% Debentures

= £0 + £200

= £200

(5) Current debts

= Bank overdraft + Accruals + Payables + Proposed dividends + Taxation

= £24 + £2 + £70 + £45 + £40

= £181

(6) Shareholders’ equity & debts

= Shareholders’ equity + Non-current debts – Current debts

= £617 + £200 + £181

= £998

(c) Explain, using 3 examples, the Accruals (or Matching) Concept in relation to financial statements of AC Ltd.

Accounting concepts are of various types (Tracy and Tracy, 2021). One can define an accounting concept as the primary ideas, statements and assumptions, which serve as frameworks for performing financial accounting calculations and preparing financial statements (Thomas and Ward, 2019). The accrual concept is a specific concept existing within accounting for business that governs the manner in which business organisations record all their credit and cash transactions (Atrill and McLaney, 2018). It revolves around the idea that business organisations need recognising their income and expenditures as and when they are secured or incurred. No transactions need to be recorded based on the exchange of payment for the transactions. The matching concept or principle is another important concept existing in accounting. As defined by Barker et al. (2020), the matching concept is an important accounting concept, which states the requirement of recording all their expenses in the same accounting period during which revenues from them are secured. Both these accounting concepts are essential to be applied for the preparation of financial statements.

Both these concepts of accounting for business have been applied for the preparation of financial statements done for AC Ltd. For instance, the total sales revenue that has been reported for this organisation in its income statement involves not only cash sales but also credit sales. It shows the amount of sales made in this accounting period irrespective of the cash exchange for the sales of the organisation. Similarly, during the income statement preparation of this organisation, the audit fees accrued have been charged as operational expenses for the year. Moreover, the administrative expenses paid in advance have been reduced from expenses. These examples prove that the accrual concept has been applied for preparing the financial statements of AC Ltd.

However, the matching concept is also identified to be applied from the examples of audit fees accrued being charged as operational expenses and administrative expenses paid in advance reduced from expenses. This is because both these accounting treatments show that the organisation reports only those expenses incurred during an accounting period for which revenues have been secured. As audit fees accrued is an expense for this accounting period, it has been charged as operating expense. However, as administrative expenses paid in advance are an expense for the upcoming year, it has been reduced from the operating expenses of this accounting period. Therefore, in this manner, the accrual concept as well as the matching concept has been applied for preparing the financial statements for AC Ltd for the year ended 31^st December 2023.

Question 2

(a) Calculate profitability, liquidity and efficiency ratios for the 2 years.

One of the most important sources of information based on which the financial performance of business organisations along with their financial position can be evaluated is their financial statements (Wood and Sangster, 2018). In this context, Drury (2017) opined that financial ratios are the fractions that are calculated from the financial statements that are developed and presented by business organisations. These ratios largely benefit in terms of measuring and analysing an organisation’s financial health as well as financial position. The following is a detailed calculation of ratios presented for the organisation CR plc for 2022 and 2023 –

Financial ratios	Formula	2022	2023
Profitability ratios
Gross profit ratio	Gross profit / Net sales revenue x 100	£746.5 – £577.8 / £746.5 x 100 = 22.5987 = 22.6%	£830.4 – £646.2 / £830.4 x 100 = 22.1820 = 22.18%
Net profit ratio	Profit after tax (or net profit) / Net sales revenue x 100	£87.6 / £746.5 x 100 = 11.7347 = 11.73%	£83.4 / £830.4 x 100 = 10.0433 = 10.04%
Efficiency ratios
Inventory turnover days	Inventories / Cost of Goods Sold (COGS) x Total number of working days	£87 / £577.8 x 365 days = 54.9584 = 54.96 days	£102.7 / £646.2 x 365 days = 58.0091 = 58.01 days
Trade receivable days	Debtors (or trade receivables) / Net sales revenue x Total number of working days	£48.4 / £746.5 x 365 days = 23.6651 = 23.67 days	£43.2 / £830.4 x 365 days = 18.9884 = 18.99 days
Trade payable days	Creditors (or trade payables) / Cost of Goods Sold (COGS) x Total number of working days	£234.2 / £577.8 x 365 days = 147.9457 = 147.95 days	£346.2 / £646.2 x 365 days = 195.5478 = 195.55 days
Liquidity ratios
Current ratio	Total current assets / Total current liabilities	£291.6 / £234.2 = 1.2450 = 1.25: 1	£417.5 / £346.2 = 1.2059 = 1.21: 1
Quick ratio	Total current assets – Stock / Total current liabilities	£291.6 – £87 / £234.2 = 0.87361 = 0.87: 1	£417.5 – £102.7 / £346.2 = 0.90930 = 0.91: 1

(b) Analyse the financial performance of CR plc over the 2 years using the ratios calculated in 2(a).

The financial ratios calculated for business organisations reflect their performance and position from diverse angles (Wood and Sangster, 2018). For example, profitability ratios are a specialised group or class of ratios, which help in the evaluation of the profit that it earns during a number of accounting periods (Arsyad et al., 2021). This class of profitability ratios for CR plc helps in determining that there has been a reduction in the gross profit ratio of this organisation from 2022 to 2023. A reduction of similar sort can also be observed in its net profit ratio. However, the reductions are marginal and stable profitability can be identified in the organisation.

As mentioned by Patin, Rahman and Mustafa (2020), efficiency ratios can be categorised as another specialised group of ratios. All these ratios assist in the recognition of how efficiently business organisations are able to handle the assets in addition liabilities. This specific group of ratios considered for CR plc shows that this organisation’s inventory turnovers as well as trade payable days have undergone declined in the two years. The reason is that this increase in the ratios indicates a declining efficiency of the organisation’s inventories and trade payables management. However, a decline within the trade receivable days helps to recognise that there has been an increase within the efficiency in terms of handling trade receivables.

Conversely, according to Atrill and McLaney (2019), liquidity ratios are another specialised group or class of ratios. These ratios help in the derivation of the capacity of business organisations in terms of usage of short-term assets for the payment of short-term debt obligations. This class of liquidity ratios for CR plc helps in determining that there has been only a marginal decline in the current ratio of this organisation from 2022 to 2023. However, a marginal increase can be observed in the organisation’s quick ratio over the two years. On an overall basis, stability can be seen in the profitability of the organisation. However, a declining performance of the organisation can be observed in terms of liquidity and efficiency. Strong and efficient strategies need to be adopted in the organisation for the improvement of its future performance.

Conclusion

Hence, as per the discussions made within the study, it can be identified that accounting has an important role in all business organisations. Accounting not only helps business organisations in terms of financial statement preparation but also helps in financial performance measurement and analysis. The practical preparation of financial statements for AC Ltd assisted in determining the accounting treatments that need to be made for preparing an organisation’s statement of financial position and income statement. Moreover, the importance of the accrual concept and the matching concept in financial statement preparation could be determined. On the contrary, the financial ratios analysed for CR plc assisted in identifying that there has been depletion in the organisation’s liquidity, efficiency as well as profitability. However, emphasising on promotions and marketing along with improvement of pricing are recommended to the organisation for enhancing its performance in the forthcoming years. Other than this, controlling credit availed and managing current obligations is also recommended to the organisation.

Bibliography

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