Finance and accounting (A Level)

10.1 Financial statements

The income statement (profit and loss account)

The income statement shows revenue, costs and profit over a period (normally a year).

The statement of financial position (balance sheet)

It shows assets, liabilities and equity at a date.

Depreciation

Depreciation spreads the cost of a non-current asset over its useful life. Straight-line: (cost − residual value) ÷ useful life. A machine costing $50,000 with a $5,000 residual value over 5 years loses (50,000 − 5,000) ÷ 5 = $9,000 a year, charged as an expense, and the asset value on the statement falls each year. Reducing balance depreciates a fixed percentage of the remaining value.

Inventory valuation

Inventory is hard to value: items may be damaged, out of date or hard to sell, and the cost may differ from what it can be sold for. Accounts use the net realisable value (NRV) method: inventory is valued at the lower of cost and the amount it could be sold for, minus the costs of selling it (NRV = expected selling price − costs to complete and sell). This avoids overstating assets and profit.

Intangible assets, goodwill and users of accounts

Goodwill is the value of a business above its net assets (brand, customers, reputation). Users of accounts: owners, managers, lenders, employees, suppliers, government and competitors, each looking at different information.

10.2 Analysis of published accounts

Profitability ratios

Liquidity ratios

Low liquidity risks being unable to pay bills; very high liquidity suggests idle cash or too much inventory.

Gearing

Efficiency ratios

Faster inventory turnover and short receivable days improve cash flow; long payable days help cash flow but may strain suppliers. Improving efficiency: tighter credit control, better inventory management (such as JIT) and negotiating longer supplier credit.

Shareholder ratios

Dividend per share = total dividends ÷ number of shares; dividend yield = dividend per share ÷ share price × 100; dividend cover = profit after tax ÷ dividends; earnings per share; price/earnings ratio.

Interpreting ratios

Compare ratios over time, with rivals and with the industry, and consider the context (type of business, economic conditions). Limits: accounts are historic, accounting policies differ, window dressing, ratios ignore non-financial factors (staff, brand) and inflation. Always explain causes and suggest actions.

Investment ratios

A high P/E suggests investors expect growth (or the share is expensive); a high yield gives income but may signal risk. Return to investors can be improved by raising profit, paying more dividends (at the cost of retained funds) or growth that lifts the share price.

10.3 Investment appraisal

Investment appraisal evaluates whether a project is worth its cost by comparing cash flows. Methods:

Example ARR: a machine costs $100,000, has a residual value of $20,000 and brings net returns of $35,000 a year for 4 years (total $140,000). Average annual profit = (140,000 − 100,000) ÷ 4 = $10,000. Average investment = (100,000 + 20,000) ÷ 2 = $60,000. ARR = 10,000 ÷ 60,000 × 100 = 16.7%. Compare it with the target return or the interest rate: if the target is 15%, the project passes.

Example NPV at 10%: cost $100,000, cash flows $50,000 in years 1 to 3. PV = 45,455 + 41,322 + 37,566 = 124,343 (approx.), NPV = +$24,343: the project is worthwhile.

Investment decisions also depend on qualitative factors (risk, strategic fit, environmental and ethical impact, objectives, uncertain forecasts) and use sensitivity analysis.

10.4 Finance and accounting strategy

Sources of finance and strategy

Finance strategy chooses the mix of debt and equity (the capital structure) to balance cost, risk and control. Debt is cheaper but increases gearing and fixed costs. Equity has no fixed repayments but dilutes ownership and expects dividends.

Profit and cash management

Profit improvement: raise revenue (price, volume, mix) or cut costs. Cash flow improvement: manage receivables, payables and inventory. Dividend policy balances shareholders' income against retained profit for growth.

Working capital management

Working capital is controlled by managing inventory, receivables (credit control, invoice factoring), and payables. Too little leads to overtrading; too much is idle.

Window dressing and ethics

Window dressing presents accounts more favourably than the true position (delaying expenses, overvaluing assets). Ethical accounting requires honest reporting. Auditors check accounts.

Budgeting and strategic decisions

Cost and profit centres make managers accountable. Budgets link finance to strategy. In mergers and takeovers, finance is used for appraisal and funding. Finance and accounting information is also used to evaluate strategic options, forecast and monitor performance against corporate objectives.

Using accounts in strategy

An annual report contains the financial statements (profit or loss, financial position, cash flow), directors' and auditors' reports and notes; it is used by investors (returns), lenders (ability to pay), managers (control), employees (job security) and government (tax). Financial statements guide strategy by showing strengths and weaknesses (liquidity, profit, debt) and by letting firms compare performance over time and against competitors. Ratio results shape strategy: a low current ratio points to working capital action; high gearing may stop more borrowing.

Strategic decisions change the ratios: raising debt (instead of equity) raises gearing and ROCE (if returns exceed interest) but adds risk; paying higher dividends cuts retained profit and dividend cover but raises yield; growth may cut liquidity and efficiency at first (more inventory and receivables), and cost-cutting may raise profit margins but harm quality. Limitations of published accounts and ratios: they are historic, use different accounting policies, may be window-dressed, ignore non-financial factors (brand, staff), and comparing firms of different types can mislead.