INTERPRETATION OF ACCOUNTS FOR BEGINNERS
This document is designed to provide an introduction (or refresher) for non-accounting professionals who are involved (maybe as part of a team) in advising businesses that are in financial difficulties.
As with any form of decision making having accurate information on which to base the decisions is vital. However, when a business is in financial difficulties those who are brought in to advise on the options for recovery or whether recovery is likely to be possible are often confronted with information that is out of date. Even where book keeping has been good it is important to remember that some financial events can overwhelm a business very quickly. The most obvious event that impacts dramatically on the financial viability of a business is that a larger debtor of that business defaults.
Nevertheless the accounts of any business provide one of the most reliable bases for assessing the performance of a business. However, it is important to remember that accounts are normally produced for a particular purpose, usually the Inland Revenue, particularly so in the case of a small or medium sized business. If they are to provide a fuller insight as to the health of the business they will need interpretation.
The two main financial statements are the Balance Sheet and the Trading and Profit and Loss Account, but there may also be a Source and Application of Funds
The Balance Sheet shows what funds are employed in the business. It shows how they are employed (these are the ASSETS) and how they were provided (these are the LIABILITIES). The balance sheet shows this state of affairs at a particular moment, usually the last day of the trading year but it can be prepared for any other time that it is required.
Assets can take many forms from buildings or land to machinery or cash and evento money that is owed to the business in the form of debts. Assets are normally grouped into two categories.
The first group is those assets which form the means of production and which are not normally traded these are the Fixed Assets.
The second category is those assets which are intended to be sold in the normal course of business these are the Current Assets.
Land or Machinery would be regarded as Fixed Assets because although they can be sold and in the case of say a car they will eventually be sold the buying and selling is incidental to the main reason for having them which is as a means of production. Raw materials are current assets because they are purchased as an ingredient of production and the finished product is also a Current Asset because it will be sold.
Within the broad groupings of fixed assets and current assets it is possible to see a range of "Fixedness" from land and buildings at one end of the scale to cash at the other end so that it is normal to list the assets in order starting with the most fixed and descending to the most liquid.
The assets in a typical farm balance sheet would be grouped as follows:-
Buildings and Improvements ) Fixed Assets- the means
Machinery ) of production
Raw Materials )
Work in Progress ) Current Assets-
Finished Products ) production in progress
Cash in the Bank )
The second part of the balance sheet shows how the assets employed in the business were provided.
The term "liability" has an slightly ominous meaning in everyday parlance but in the balance sheet this is not necessarily so. Much of the money employed in the business will usually have been provided by the owners, both in the form of the initial capital they invested in the business and profits earned by the business over the years that have been retained , these are “good” but they will still be shown as a liability. So interpreting the liabilities it must be considered to whom there is a liability.
Apart from the owners of the business and retained profits funds will have been supplied by banks or other lending institutions who have made funds available on a formal basis. Another source of funds will be suppliers of goods and services to the business on credit. These do not regard themselves as investors in or lenders to the business and expect to be paid within a short period.
So just as the level of "fixedness " varied with different assets so the long term availability of funds to the business may vary. Long term liabilities represent those investors or owners of the business who do not expect to have their money repaid whilst the business continues. Medium term liabilities are fund provided for an agreed period, such as is the case with a mortgage or bank loan. Current Liabilities are those funds provided without any commitment to the business and due to be paid quite soon, theoretically instantly.
The liabilities of a typical balance sheet for a Small or Medium Sized Business might
look like :-
Owners Capital )Long Term Liability
plus retained profit. )
Bank Loan )Medium Term Liability
Hire Purchase Agreement )
Bank Overdraft )Current Liabilities
Trade Creditors )
Balance Sheet Layout
Traditionally Balance Sheets were arranged with the Assets shown in a vertical column on the right hand side of the page and the Liabilities in a column on the left. The assets and liabilities were normally arranged with the long term assets and liabilities at the top and the current at the bottom.
Mortgage Buildings &
Loan capital Improvements
Bank Overdraft Machinery
Cash in Bank
Total Capital Employed Total Capital
Modern accounting practice is to arrange Balance Sheets horizontally :-
Breeding Livestock -----------
Total Fixed Assets
Growing Crops & Livestock
Cash in Bank
Total Current Assets
Total Current Liabilities
Net Worth -----------
Total Capital Employed
INTERPRETING THE BALANCE SHEET
The owner's stake in the business is shown as a liability, but this liability is the least likely to have to be repaid so represents little threat to the business, It follows then that the higher the proportion that the owner's stake (called the owner's equity) is of the total assets employed in the business, the less vulnerable is the business to demands for repayment of loans or more normally the payment of the interest charges on them or the payment of creditors. Clearly any organisation being asked to provide funds for a business would prefer that in the event of misfortune there will be sufficient assets in the business to repay them, so a business with a high owner's equity would be
considered a safer lending proposition than one with a low owner's equity.
The Ratio of Owner’s Equity can be expressed by the formula :-
Owner's Capital (Net Worth) X 100 = Owner's Equity
Apart from how much money is employed in the business the balance sheet shows how the funds are employed and how they are provided. It provides further insight by showing relative demand and availability of money in terms of time. The liquidity of a business is the measure of the ability of the business to meet its current liabilities out of its liquid assets. A business that had £50,000 in cash in the bank would easily be able to pay current liabilities of £25,000 without interfering with the smooth running of the business and would be said to have a high level of liquidity. If the business had £25,000 in the bank and current liabilities of £50,000 it would have difficulty in paying its bills as they become due and would be said to be a very low level of liquidity. This could put the business at risk if all the creditors demanded to be paid. The liquidity of a business may vary through the year. Some business have a seasonal pattern of production so an arable farm is typically in a liquid state once the crops are sold, say in winter or early spring but less liquid by harvest time. A small house builder usually becomes less liquid a house nears completion and a large amount of money is tied up in its construction but liquidity improves when the house is sold.
The Liquidity of a Business can be expressed by the formula :-
Liquid Assets X 100 = Liquidity
Current Asset Ratio
Whilst liquidity demonstrates the ability of a business to meet short term liabilities out of cash without the need for forced sales of current or even fixed assets, it is often more reasonable to compare the ratio of current assets to current liabilities on the grounds that in an ongoing business it is unlikely that it would become necessary to pay all the bills at one time without the opportunity to collect debts or sell any product.
Ideally current assets should be twice current liabilities, the lower this ratio becomes the greater the chance that cash will have to be raised under duress such as by the premature sale of produce or unfinished animals.
The Current Asset Ratio can be expressed by the formula :-
Current Assets X 100 = Current Asset Ratio
Fixed Asset Ratio
In the case of some types of business so much of the assets are in the form of very fixed assets, such as property that it can be difficult to raise cash to meet demands from creditors in the short term. Farm businesses are often a good example of this category as, particularly in the case of owner occupiers, most of the assets are in fixed assets of land, building, machinery and breeding stock. This may lead to the situation where a business with a high ratio of owner’s equity may still experience difficulties because the ratio of fixed assets to current assets is too high. This situation can occur when improvements or land purchase is financed out of working capital.
The Fixed Asset Ratio can be expressed by the formula :-
Fixed Assets X 100 = Fixed Asset Ratio
This is a measure of the amount of loan capital employed in the business in relation to the owner's equity. If the amount of loan capital is high relative to the owner's equity the business is said to be highly geared. In a profitable business high gearing is attractive to the owner as it greatly increases the return on their capital. For example if the business is making a return on capital employed of 20% and the loan capital costs only 10% then every extra pound borrowed and invested in the business increases the return to the owner by 10 pence. The effects of gearing at different levels can be seen in the following table:-
|Ratio of Borrowed Capital to Owner's capital||Return on Capital||Interest Rate on Loan Capital|
BUT if income declines :-
|Ratio of Borrowed Capital to Owner's capital||Return on Capital||Interest Rate on Loan Capital|
BUT if income declines and interest rates rise at the same time:-
|Ratio of Borrowed Capital to Owner's capital||Return on Capital||Interest Rate on Loan Capital|
It can be seen that a highly geared business is vulnerable if interest rates rise at the same time as income declines.-
Gearing can be expressed by the formula :-
Long Term Loans X 100 = Gearing
Net Worth (Owner's Capital)
Whilst gearing deals with the ratio of formal loans ( on which interest is being paid) to the owner's capital in the business, it is important not to overlook the total indebtedness of a business. Total indebtedness includes all creditors not just formal loans.
The total debt ration can be expressed by the formula :-
External Liabilities X 100 = Total Debt Ratio
Net Worth (Owner's Capital)
This is the situation that is often incurred by a successful and rapidly growing business. As the business expands the need for capital exceeds that which is available. More raw materials have to be purchased, more wages paid before the extra revenue from the higher volume of sales is received.
HIDDEN ASSETS AND LIABILITIES
Accounts are prepared following certain conventions as to how assets and liabilities are to be valued. This may mean that assets are shown as having a value greater or less than could be obtained if they were sold.
Some liabilities will not appear on the balance sheet at all as they will not crystalliseuntil such time as the business ceases to trade e.g. redundancy payments, dilapidations. These uncrystallised liabilities could be a major consideration for some businesses which are in difficulties.
The most common hidden asset in a balance sheet is the value of land and buildings because this is usually shown as the value at which it was purchased. If the premises was purchased many years ago the value shown in the accounts may be much lower than its present realisable value.
This may be especially so if the business ceases trading in an orderly manner rather than being forced to dispose of assets as a distressed sale. In some cases buildings or land may have a high value which can only be achieved if the business is to cease and so release the land and buildings for development or more valuable use. This can often be the situation if an area of a town or city undergoes a change of character.
The value of products in store may be much higher than shown in the accounts where it is shown at the cost of production.
In the case of agriculture Inland Revenue Rules allow for Livestock to be valued at the cost of production rather than their market value, this will also apply to livestock valued on a herd basis.
In the case of agriculture quotas for milk, beef or sheep production will not usually appear in the balance sheet unless they have been purchased. In the case of an owner occupier the value of all the quota is relevant, although the effect of the sale of quota on the value of the remaining land must be considered but in the case of milk quota on a tenanted farm it is only the Tenant's Fraction and any Excess Quota that is available to the tenant.
In the case of agriculture a tenant will be entitled to make a claim for improvements made with the landlord's consent and for any Residual Manurial Values and Unexhausted Manurial Values. There may be a trade off of these against any claim for dilapidations.
A business may own rights which have been developed within the business and do not appear on the Balance Sheet but which could be sold by the business to another. This could be a brand name, the design of a product etc.
If land has been purchased at a time when land price was high and this is the value shown in the balance sheet it may not now be possible to realise the purchase price.
Improvements to land or buildings are shown in the accounts at cost in the year in which they are carried out and this value is written down over a number of years so that the value shown in subsequent accounts does not necessarily represent its realisable value in that year. With most fixed improvements it can be argued that they have no value in their own right and what value they do have is reflected in the overall value of the premises as a whole. In the case of a tenant any improvements will only have value if the provision for obtaining consent under the terms of a lease have been complied with. This value may be more or less than their depreciated value shown in the accounts.
Machinery values will be shown in the accounts at their depreciated values.
The relationship between their realisable value and their "book"value will vary depending on the age of the machine. In the first year or so of the life of a machine, and certainly in the first few months, the drop in value may greatly exceed the depreciation but later in the life of a machine it may be possible to sell it for more than its "book" value. Very specialist machines or machines which have been custom built may realize much less than the depreciated value shown in the accounts.
The quantities of finish product shown in the accounts may only be a rough estimate and some of this product may be unsaleable because it is obsolete or damaged. The value placed on finished products will normally be set at the cost of production and this should usually leave a safety margin provided the product is saleable. If a business has been under financial difficulties for some time there may have tended to use rather high estimates of quantity and value of stock rather than show a deterioration in the balance sheet which might alarm the bank and other long term suppliers of capital.
Very seldom is all the money shown as being due to a business actually collectible. This may be due to customers having gone out of business or disagreements over accounts .Once it is known that a business is in financial difficulties it usually becomes more difficult to collect outstanding debts as debtor will be more likely to dispute outstanding bills.
Income Tax or Corporation Tax may be outstanding from previous years. This can be a particular problem where a bad year follows a particularly good one, although in some industries , such as agriculture, there is provision for averaging which may alleviate the problem to a degree
These are the liabilities that will only be incurred if certain actions take place such as the business is sold, wound up or some of the assets are sold. They do not appear in the balance sheet of an ongoing business.
Capital Gains Tax may become liable on the disposal of some assets so that only part of the realised value is available to the business. This may seem unlikely in the case of land or buildings where the value is similar or less to the value in 1982 ( The Base Year for CGT values) but the land could have been purchased with money rolled over from previous sales which could have carried large amounts of CGT, for example from the sale of land for development.
If a business is forced to cease trading or to reduce their work force they will be liable to pay their redundant workers redundancy pay.
Costs of Sale
If a business is forced to sell up the costs of the sale will have to be deducted from the proceeds.
If the business is a tenant of any or all of their premises the landlord will be entitled to claim dilapidations for any deterioration in condition of the property. These claims may be offset in part by any claim by the tenant for Tenant’s Improvements but this may not be possible if the lease has not reached its end..
Costs of Receivership
If the business was forced into receivership the costs of the receiver will reduce the net value of the assets.
BALANCE SHEETS IN A SERIES
A balance sheet shows the state of the business at one particular moment in time but much more light will be shed on the health of a business if a series of balance sheets can be looked at covering a number of years. Looking at a series of balance sheets will show how the various ratios have changed during the period.
Normally a decline in the ratio of the owner's capital to borrowed capital reflects a run of low profitability or years in which the owner has drawn more money out of the business than it has been generating.
Owner's drawings can be an important issue in a small business. If a period of reduced profitability follows a period of high profits the owner may have become used to high drawings and may be reluctant to adjust to a lower standard of living. The turnover of many businesses allows their owners to draw out more money than they are generating as profit. They may be able to do this without even increasing their overdraft by such means as not replacing machinery at the same rate as their present depreciation charges or by financing new machinery by leasing. This means that they are living off their capital which may be acceptable in certain circumstances but it ought to be acknowledged.
If the business is expanding it may be quite legitimate that the owner's share of the assets employed in the business have declined as long as they have not reduced in real terms as well.
The ratio of current assets to current liabilities may deteriorate due to declining profits or using what profits there are to finance capital investment or personal drawings rather than to pay off creditors. The former is preferable to the latter provided that the investments produces an adequate return and provided it is not done to such an extent that the business comes under pressure from creditors. The ratio will fluctuate slightly from year to year in a healthy business but a steady and prolonged deterioration will make the business increasingly at risk of being forced to realise some of its fixed assets.
A worsening liquidity ratio will reflect either low profitability, excessive drawings or the financing of long term investment out of the cashflow of the business.
THE PROFIT AND LOSS ACCOUNT
Whereas the Balance Sheet shows what assets are employed in the business at a given moment in time and how they were provided, the Profit and Loss shows the trading performance of the business over a period of time, usually one year. This then is a very important source of information about the business. A business cannot generally continue to lose money for long periods as the balance sheet will start to deteriorate but a business that is showing good profits even if the balance sheet is poor may have a better future.
Income and Expenditure
The Profit and Loss Account shows the summary of what expenditure was incurred and what sales were made during the trading period . It does not show what payments or receipts there have been so that there is always a risk that a sale will not be paid for.
Opening and Closing Valuations
Apart from the income and expenditure incurred during the year it is necessary to take account of the fact that some of the expenditure incurred during the trading period may have been for the purchase of goods which were still unused at the end of the year. Conversely some of the receipts may have been derived from the sale of goods produced in a previous year. It is necessary, therefore, to make adjustment to the income and expenditure by looking at the value of goods at the start and end of year as shown in the opening and closing valuations.
This is an area where farmers are tempted to take a "flexible" approach in order to minimise their tax and so these figures may be an over or more likely an
understatement of the true position.
Some expenditure is for items such as new buildings or machinery which are of benefit to the business for a much longer than the trading period. The cost of these items is spread over a number of trading periods with either a percentage of the original cost charged to each trading period (straight line depreciation) or alternatively a fixed percentage of the written down value at the start of the period is charged to that period, (diminishing balance depreciation). It is only this depreciation charge that will appear on the expenditure side of the account.
The Layout of the Profit and Loss Account
Opening Valuation Sales
INTERPRETATION OF THE PROFIT AND LOSS ACCOUNT
Shortcomings in the Profit and Loss Account
The most common reason for preparing accounts is to satisfy the requirements of the Inland Revenue. This means that items of income and expenditure are frequently grouped together so that it is more difficult to get a clear picture of how different parts of the business are performing. Similarly the rates of depreciation used for buildings and machinery are the maximum rates that the Inland Revenue will allow rather than a true representation of the life of the building or machine.
Accounts are often out of date and this is frequently the case with a business that is performing poorly. Accounts may not provide all the answers but they frequently provide the best starting point for looking at the business and provide clues as to what further information should be sought about physical performance. It must always be remembered that in most cases it is the standards of performance of the business which will determine the success or failure of the business and the accounts can only reflect this.
Expenditure can be divided into two main categories Fixed Costs or Overheads and Variable Cost. Frequently these items of expenditure will be poorly itemised and simply lumped together in broad categories such as raw materials. It is usual, though, to be able to separate out the Fixed Costs into four main categories:-
Plant and Machinery
Rent/Mortgage and Finance Charges
General Administration Costs
These should be looked at together as these can easily be substituted for each other. It may be possible to justify expensive machinery and high operating costs because it enables the work to be carried out by fewer employees.
It is sometimes possible to separate out the machinery repair costs and these must be viewed against the machinery depreciation. A business may incur high repair costs because they maintains older machines but this may be set off by lower machinery depreciation. Conversely high depreciation charges may be off set by very low repair bills.
This figure will include any actual rent paid for premises together with mortgage interest on owned buildings plus building repairs and depreciation.
These will include the costs of running an office such as telephone and postage but also general insurance, accountants and other professional fees.
Where a business is composed of a number of different enterprises the variable costs
attributable to that enterprise should be compared to the output from that enterprise but the information contained in most accounts prepared for taxation purposes is insufficient to allow this. It is useful to be able to look at the output relative to the costs. A low cost/low output business may be as profitable as a high cost/high output business but a high cost/low output business is doomed to failure.
Sufficiency of Profit
The profit from the business not only has to provide an income for the owners but it also has to provide funds to repay capital that has been borrowed in the past and to fund future investment. It is possible to have a business which has always made a profit but has had a deteriorating balance sheet and is experiencing difficulties because the income has not been sufficient to meet the drawings of the owner and the need for investment in the business. This is why the third financial document that is sometimes included in a set of accounts, the Source and Application of Funds, is so useful.
THE STATEMENT OF SOURCE AND APPLICATION OF FUNDS
As the title implies, this document shows the sources of all funds flowing into the business, how they have been utilised and how any differences between the two are reflected in the working capital.
A typical layout would be:-
SOURCES OF FUNDS
Profit before tax
Capital receipts from sales of land etc.
Depreciation on Machinery
Depreciation on Buildings and Improvements
TOTAL FUNDS GENERATED BY THE BUSINESS
Funds introduced from personal sources
TOTAL FUNDS AVAILABLE
APPLICATION OF FUNDS
Investment in Machinery
Investment in Buildings and Improvements
Investment in Land
Repayment of Loans
TOTAL APPLICATION OF FUNDS
CHANGES IN WORKING CAPITAL
Increase/Decrease in Stores
Increase/Decrease in Debtors
Increase/Decrease in Creditors
Increase/Decrease in Cash
The statement is particularly relevant in highlighting the problems of a business where the owner is drawing more out of the business than the profit being generated, resulting in increases of creditors or a reduction in the valuation.
It also illustrates the difficulties of a business that is obliged to invest more money than is available from retained profits in new machinery.
One important criteria for assessing the sufficiency of funds being generated by the business is that they should be sufficient to meet the needs of :-
- Tax - first claim
- Repayment of loans as they fall due
- Private drawings
in that order.
Level of Profit Required
A good starting point when appraising a small or medium size business is to decide how much profit does this business need. This will vary widely from one case to another depending on their circumstances and personal aspirations.
Consider what is a realistic level of private drawings
Consider what is a realistic level of debt repayment