I am writing this report on the contents of the profit and loss account
1.0 TERMS OF REFERENCE
I am writing this report to explain the contents that’s on the profit and loss account and the purpose of each element. I am then going to write examples of different ratios for the business.
First of all I am going to look at all of the contents on a profit and loss account, I am then going to write what they all are and what they do on the account. I am then going to write down all of the ratios that the business needs to think about.
This is how much they sold in the year without anything getting taken off. The sales for the year were ï¿½63,850.
This is the amount paid back to the customers when items are returned. The sales return figure was ï¿½250
Net Sales (Turnover)
This is the receipts for sales for the year. The net sales for the year was ï¿½63600 (63,850 – 250)
This is the value of stocks of finished products, work in progress and raw materials that are held in the business at the beginning of the year. The opening stock that K Han had at the beginning of the year was ï¿½7700.
This is different for different businesses, if it is a manufacturing
business that you are talking about then this is the value of raw
materials purchased, if you
are talking about a service business, then it would be the cost of the things bought to sell to customers or to provide a service to the customers. K Han spent ï¿½37,500 on purchases.
This is receipts to the organisation from the suppliers when it returns
items. There was no purchase returns for the year 2007.
This is the value of finished products, work in progress and raw
materials held in the business at the end of the year. The closing stock
This is the difference between the businesses total revenue and how
much it costs to make the product or to buy the products in. The gross
profit for 2007 was ï¿½27,600 (63600 – 36000)
Cost of Goods Sold
This is found by doing the calculation:
opening stock + purchases – purchase returns – closing stock = cost
of goods sold (7700 +37500 – 0 – 7400 = 36000)
These are what the business has to pay out for. Things that come under expenses are things like:
* Rent & Rates (ï¿½6000)
* Wages & Salaries (ï¿½3920)
* Telephone & Postage (ï¿½190)
* Motor Expenses (ï¿½1500)
* Advertising (ï¿½1500)
* Sundries (ï¿½240)
* Buildings (ï¿½0)
* Equipment (ï¿½2325)
* Motor Vehicles (ï¿½600)
This is the amount of money that the business has made after all the expenses have been taken away. The way to calculate net profit is: gross profit – all other costs. Net profit for the year was ï¿½11,325 (27,600 – 16,275)
This is items that the business has brought and will use for an extended period of time. These are frequently called tangible fixed assets. When fixed assets are on the balance sheet it will show the original prices paid for these assets, the amounts that they have depreciated by and the net current value of each of them. Examples of fixed assets are:
* Buildings (net book value = 0)
* Equipment (net book value = ï¿½13,175 (15,500 – 2325))
* Motor Vehicles (net book value = ï¿½2,400 (3000-600))
Current assets are the second section in the balance and this contains assets that are available in the company for paying debts. Examples of current assets are:
* Stock ï¿½7,400
* Debtors ï¿½150
* Bank ï¿½560
* Cash ï¿½250
Current liabilities are the third section in the balance sheet and this contains the amounts that are owed to suppliers or lenders and need to be paid quite quickly. This usually has to be paid back in one year. Examples of current liabilities are:
* Creditors ï¿½1610
This can also be known as net current assets or current capital. This measures how much a business has available to pay bills. It is usually calculated by deducting current liabilities from current assets. The figure that comes from this calculation should be positive, if not the business may find it hard to pay off its debts. The working capital for 2007 was ï¿½6750 (8360 – 1610) (15,575 – 6750 = ï¿½22,325)
This is the debts that have to be paid for in more than one year’s time, for example:
* Bank Loan ï¿½10,000
Net assets are the difference between the total assets of the business and its total liabilities. It is the figure to which the accounts should be balanced. This is ï¿½12,325 (22,325 – 10,000)
This is the final section of the balance sheet and it shows where the money came from to run the business. The net profit figure from the profit and loss account is moved to this section. This is opening capital plus net profits (16,000 + 11,325 = 27,325 and then less drawings which are 15,000 = ï¿½12,325.
Profitability: There are 3 different ratios that you will use to calculate how much profit your business could make.
Gross profit percentage of sales. The calculation for this is: gross profit for year divided by Sales for year x 100. This shows how much gross profit is being made compared with the sales made in your business. It is common to compare the figures from one year to another and this ideally will show that the business is stable in trading if the figures stay comparatively the same. If the percentages are decreasing then this could mean that purchase costs are increasing or that your sales are falling. GPP = ï¿½27,600/ï¿½63,600*100 = 43%
Net profit percentage of sales. The calculation for this is: net profit for year divided by sales for year x 100. This is similar to the gross profit percentage buy it shows how much net profit is being made compared with sales. This is useful to compare the gross profit percentage with the net profit percentage because this shows how much of the gross profit is being taken up by the expenses of the business. A fall in the net profit percentage may show that expenses were increasing. NPP = ï¿½11,325/ï¿½63,600*100 = 18%
Return on capital employed (ROCE). The calculation for this is net profit for year before interest and tax divided by capital employed x 100. This is a difficult ratio as the term ‘capital employed’ is used by different accountants. For the accounts that have been produced for you capital employed can be defined as: fixed assets plus current assets minus current liabilities. This can change though depending on the accountant so please be aware of this. The ratio shows the percentage return that the investors have received on the capital that they invested. ROCE = ï¿½11,325/ (ï¿½15,575+ï¿½8360-ï¿½1,610)*100= 51%.
Liquidity. These have two ratios to measure how easily the debts can be paid in the business.
Current ratio. The calculation for this is: current assets divided by current liabilities. This shows the proportion of current assets to current liabilities. It shows how solvent the business to pay debts in the near future. A ratio of 2:1 is a good ratio, even though businesses can do well with lower ratios. If the ratio is 3:1 the business needs to consider whether they are using current assets efficiently. CR = ï¿½8,360/ï¿½1,610 = 5.2: 1
Acid test ratio is similar to current ratio apart from the stock figure is absent. The calculation for this is: current assets minus stock divided by current liabilities. This is because it is difficult to sell stock quickly and for a good price if the money is needed quickly. Because of this it is not a good idea to rely on selling stock to pay debts. It shows how much readily available assets the business could rely on if a creditor insisted on immediate payment. With a result of 1:1 it shows that the business should find it easy to pay the bills as they become due but if it falls below 1:1 the company has fewer liquid assets and this could cause problems with the business. If the business has a healthy current ratio but a poor acid test ratio it may be that the business is holding too much stock. AT = ï¿½8,360-ï¿½7,400/ï¿½1,610 = 0.6: 1
Efficiency. There are three sets of efficiency ratios.
Debtors’ payment period. The calculation for this is: debtors divided by credit sales for year x 365 = debtor collection period in days. This shows how long it takes on average for debtors to pay for brought goods on credit. You should compare this with previous years to make sense of the result. The company’s procedure for chasing debtors should be examined if the number of days is increasing as this can have an unfavourable effect on the company’s cash flow. If this is stable then it suggests that debt collection is under control. DPP = ï¿½150/ï¿½63,600*365 = 0.86 days
Creditors’ payment period. The calculation for this is: creditors divided by credit purchases for year x 365 = creditor payment period in days. This ratio shows how long the business is taking to pay for good that they have brought. If this period is rising then it shows that the business is negotiating better terms from its suppliers or it is having difficulty paying bills. The business is getting better terms for buying on credit than it is giving to its customers if the creditor payment period is greater than the debtor payment period. If the debtor payment period is larger than the creditor payment period then this could mean that the circumstances are not so good as the business is allowing longer periods for the customers buying on credit than it is receiving from its suppliers, This will cause problems as they won’t be able to pay the bills to their creditors as they rely on the customers for the money. CPP = ï¿½1,610/ï¿½35,700*365 = 16 days
Rate of stock turnover is the ratio that that shows how long it takes to sell the item. The calculation for this is: Average stock divided by cost of goods sold x 365 = stock turnover in days. There is no way of saying if the rate of stock turnover might be for the business as all business has different situations. For example, a manufacturer of electrical goods may decide to hold their stock for several weeks before they leave for a retailer but on the other hand supermarkets would have a much shorter turnover as food items will expire quickly. A shorter period than last year shows that the company is becoming more efficient, a longer period shows that the business needs to find out why and correct the trend. ST = (ï¿½35,700+ï¿½7,400/2)/ï¿½36,000*365 =77 days
Assets turnover is the final ratio that can help to work out the performance of a business. It looks at the sales as a percentage of the total assets that a business owns. Sales divided by total assets = asset turnover. 63850/ (15575 + 8360) 23935 = 4 times. This means that for every ï¿½1 of assets the business is able to generate ï¿½4 worth of sales. This is good because they are making 4 times the amount that they spend.
From what I looked at I found out that the companies acid test ratio was 0.6:1 it falls below 1:1 which shows that the company has fewer liquid assets and this could cause problems. Also their current ratio is a lot higher than it should be at 5.2:1. This shows that the company is not using their current assets efficiently. It shows that the creditor payment period is fine at 16 days because it is a lot higher than the debtor’s payment period which is 0.86 days. The debtors payment period is good because it is very steady compared to the last year’s figures. By looking at the stock turnover figures I can see that it has raised a lot compared to previous years and it is above average. As the items that the business sells are not perishable, it doesn’t matter too much but this may also indicate that they have too much stock. The net profit has dropped significantly from 27% to 18%.
This is below the average and a fall in this may show that expenses were increasing. If an investor saw the figures for the previous year’s and then saw the figures for 2007 then they would probably go and invest in another business because they don’t think that they will make any money from Mr Hans’s business because something has gone wrong. The asset turnover is good because they are making 4 times the amount that they spend. The ROCE is 51% this shows the percentage return that the investors have received on the capital that they invested. This percentage is good because it is 14% above the average and it shows that they returning good money. They are getting 6% more than the previous year back.
The rate of stock turnover is very high so I would recommend that they sell some of their stock quickly to get some money and not have so much stock sitting around for a long time. Because their net profit dropped a lot in the year it shows that their expenses may have been quite high, so I would recommend that they try and get their expenses down by putting restrictions on paper, lowering staff hours and wages, turning lights off when leaving the room, shopping around for a better deal on their telephone and internet and also see if their suppliers can lower their prices.