Lecture Notes- Financial Statements

Financial Statements

Companies’ are required by law to publish their financial statements annually. This is because financial statements are used by a wide range of users and therefore they need to give accurate information to these users. Financial statements also need to be comparable and provide basic information to users.( FTC Kaplan 2007)

Financial statements on the whole are designed to provide overall picture of the financial position and performance of a business. To provide this overall picture most accounting systems provide 3 main financial statements, each of which deal with answering the following

·         What cash movement took place over a particular period?

·         How much wealth (profit) was generated by the business over a particular period?

·         What is the accumulated wealth of the business at the end of a particular period?

These questions are addressed by the three financial statements, each of which deals with one of them. The financial statements produced are

·         Balance Sheet

·         Profit and Loss account

·         Cash flow statement

Users of Financial Statements

Customer

To assess the ability of the business to continue in business and to supply the needs of customers

Competitors

To assess the threat to sales and profits posed by those business. To provide benchmark against which the competitors’ performance can be measured

Shareholders

The primary concerns of these is with receiving adequate return on their investments

Creditors

They are concerned with the security of the debt or loan

Management:

They are concerned with the trend and level of profit, since this is the main measure of their success

Lenders

To assess the ability of the business to meets its obligations and to pay interest and to repay the amount borrowed

Employees

To assess the ability of the business to continue to provide employment and reward employees for their labour

Suppliers

To assess the ability of the business to pay for the goods and services provided

Government

To assess how much tax

                                                                  

Other potential users include

·         Bank managers

·         Financial institutions

·         Professional advisors to investor

·         Financial journalist and commentator

The Balance Sheet

This set out the financial position of a business at particular point in time. It also reveals the forms in which the wealth of the business is held and how much wealth is held in each form.

The Balance Sheet also sets out the assets of the business on one hand and claims against the business on other hand ( Peter Atrill et al 2002)

In a nut shell the Balance Sheet reveals the financial position, the wealth as well as the assets held by a business.

Parts of Balance sheet

Fixed Assets

This deals with:

Tangible assets- Buildings, fittings and fixtures, machinery

Intangible assets- Patents, Trademarks, Brand names, Goodwill,

Current Assets

This deals with:

·         Cash at hand and at bank

·         Debtors/ receivables

·         Inventories/stocks- raw materials, work in progress, finished goods

Current Liabilities

Long term and short – loans, creditors, overdraft etc

Profit and Loss account (Income Statement)

This measures and reports on the profit (wealth) the business has generated over a period. The measurement of profit requires that the total revenues of the business generated during a particular period be calculated.

Revenue is the measure of inflow of assets that arises as a result of trading operations. Different forms of business enterprises will generate different forms of revenue. Some examples of different forms of revenues are

·         Sales of goods- manufacturer

·         Fees for services- a solicitor

·         Subscription – clubs

·         Interest received- investment funds

Expense- this represents the outflow of assets incurred as a result of generating revenue.

Examples of some common types of expense are:

·         Cost of goods sold/ cost of sale

·         Salaries and wages

·         Rents and rates

·         Insurances

·         Heat and light

The P and L account shows the total revenue generated during a particular period and deducts from this the total expense incurred in generating that revenue. The difference between the total revenue and the total expenses will represent either profit or loss. (Peter Atrill et al 2002)

Format for P & L

Sales

Less cost of sales

Opening stock

Closing stock

Gross profit

Less expense

Salaries & wages

Rents and rates

Insurance

Loan interest

Depreciation

Net profit

Cash flow statement

This is the summary of cash receipts and payment over the period concerned. It shows a business’ source of cash and how that cash is used.

Standard and layout

Net cash flow from operating activities

                                          Returns from investment and servicing finance

      Taxation

                                      

                    

Capital expenditure (asset)

                                                                       

                                                        

Equity dividend paid

                                                

Management of liquid resources

 

              

                                                Increase or decrease in cash over the period

Various parts of Cash flow statements

(1)Net cash flow operating activities

·         This deals with the operating activities

·         And cash sales or cash from debtors

(2) Returns from investment

·         This deals with fixed return finance e.g. interest bearing loans, preference, dividends, interest

(3)Taxation

·         Corporate tax - Companies pay tax in 2parts-50% in current year and 50% at the end of the year.

(4) Capital expenditure

·         Cash payment for additional assets

·         Cash receipts from disposable fixed assets

·         It could be loan made by the business

·         Shares in other companies

(5) Equity dividend paid

·         Payment made to ordinary shareholders

(6) Management of liquid resource

·         Short term cash

(7) Financing long term loan

Additional Financial Data

In addition to the above 3 financial statements businesses also publish the following statements

·         Auditor’s report

·         Director’s report

·         Chairman’s report.

References

1.       Atrill, Peter et al, 2002, 2^nd edition - Accounting: An Introduction, Prentice Hall, England

Lecture Notes - Sources of Finance

Sources of Finance

Companies need funds to bridge the gap between paying for the production of finished goods and receiving money from their customers (working capital). They also need money to buy their fixed assets with which they operate, such as machinery, land and building (fixed capital)

The major source of finance for companies is retained earnings, which can be used for both working capital and fixed capital (FTC Foulk Lynch 2005)

Short or medium

Short or medium term finance is obtained from the money market and long term finance is from the capital market

Short term = up to 1 year- e.g.  Trade credit, overdraft

Medium term = up to 7 years- e.g.  Leasing, Hire purchase

Long term = 7 years or more – e.g.  Debentures, preference shares

Internal source of finance

The main type of internal source of finance is

Internally generated funds and this comprises of retained earnings plus non -cash charges against profit (e.g. depreciation) (FTC Foulk Lynch 2005)

External source of finance

This is mainly made up of long term finance. Long term finance can be defined as those that are due for payment after one year. The main forms of long term finance are the following

Equity finance- Equity relates o ordinary shares only and it is the investment in a company by ordinary share holders.

Equity capital is raised through the sale of shares to individuals or groups. Ordinary shares in the equity of a business entitled the holders to all distributed profits.

Share holders expect to be rewarded for their investment in two ways these are

·         Receive a dividend after holders of debentures and preference shares have been paid

·          They may be able to make capital gain on their investment by selling their share holding at a later date when the price increases. ( FTC Foulk Lynch 2005)

Preference shares- These are designed for investors who do not wish to take the degree of risk associated with being an ordinary share holder.

Ordinary share

This is the most valuable form of finance and forms the backbone of the financial structures of businesses. It also represents a risky finance and it also gives shareholders control over the business (Peter Atrill et al 2002)

Issuing of share

New shares can be issue by any of the following

·         Private negotiation

·         Placing or offer for sale

·         Right issues

Loans

Many businesses rely on loan capital to finance their operations. Lenders would enter into a contract with the company in which the rate of interest dates of interest payment and capital payment and the security of the loan are clearly stated (Peter Atrill et al 2002).

Types of loan

Debentures- These are written acknowledgement of a debt by a company. It usually contains a provision of payment of interest and also terms for the repayment of the principal. Debentures are often referred to as bonds or loan stocks

·         Debentures are traded on stock markets just like shares. They may be secured or unsecured, redeemable or irredeemable ( FTC Foulk Lynch 2005)

Characteristics of debentures

·         Debts are regarded as low risk

·         Debts holders do not have voting rights, only when interest is not paid will the holders take control of the company

·         They are cheap because it is less risky for investors. Debentures holders would accept a lower rate of return than share holders ( FTC Foulk Lynch 2005)

Convertible loans

This is a traded debt which gives the holder the right to convert to other securities usually ordinary shares at a given future price date at a given price.

The investor remains a lender to the business and would be paid an interest. The investor is not obliged to convert the loan into ordinary shares.

Mortgages

This is form of a loan that is secured on a freehold property and could be over a period of 20 years

Loan covenants

Accounts - Lender may require access to the financial accounts of the business

Other loans- business may have to ask permission from lender before taking other loans

Dividend payment- lenders may require dividend to be limited during the period of the loan

Liquidity – lender may require business to maintain certain level of liquidity during the period of the loan

Sources of short term loans

Overdraft

Trade creditors

Debt factoring

Invoice discounting

Debt factoring

 This is service provided by financial institutions known as factors. The factor takes over the debt collection of the business. It also makes advance payment to the business to the maximum of 85% of the approved trade debtors and also charges between 2-3% of the business turnover (Peter Atrill et al 2002).

Any advance made to the company attracts an interest rate similar to bank overdraft

The capital market

Capital markets deal in long term finance through the stock exchange. The major types of securities dealt on the capital markets are as follows:

·         Public sector stocks

·         Foreign stocks

·         Company securities

·         Eurobonds

The capital market provides the following sources of long term finance

·         Equity – ordinary shares, preference shares

·         Debentures

Euro bonds

·         Eurobonds are bonds dominated in a currency other than that of the national currency of the issuing company. It has nothing to do with Europe. They are also called international bonds. ( FTC Foulk Lynch 2005)

The money markets

Money markets deals in shorter –term funds which are in the forms of bank bill, trade bills, certificate of deposits, unsecured loans etc. No physical location exists, transactions are conduct by the phone, internet etc.

The money market is not one single market but a number of different markets are closely inter-connected with each other.

The main participants in the money markets are central banks and the commercial banks. Other participants include the financial houses, building society, investment trusts, unit trusts, local authorities, large companies and some private individuals

The money market provides the following source of short and medium term finance

·         Leasing

·         High purchasing

·         Trade credit

·         Overdraft

·         Special (government grants) ( FTC Foulk Lynch 2005)

Stock market

The stock market is a market which issued securities of public companies. Government bonds, loans issued by local authorities and other public owned by institutions and some overseas stocks.

The stock market assists the location of capital to industry. If the market thinks highly of a company, the shares of that company will rise in value and it would be able to raise fresh capital through the new issue market at a very low cost. (FTC Foulk Lynch 2005)

Sample question

Ken Wong Ltd approaches a financial institution for a long term loan. What do you think would be the main factor that financial institution will take into account when considering the application.

References

1.       Atrill, Peter et al, 2002, 2^nd edition - Accounting: An Introduction, Prentice Hall, England

2.       FTC Foulk Lynch 2005- Financial Management and Control.

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