Interpret the contents of a trading and profit and loss account and balance sheet for a selected company explaining how accounting ratios can be used to monitor the financial performance of the organisation
Profit and Loss account.
The P&L will not tell you about the underlying health of the business, such as how much money it owes or is owed and what the value of its assets are. It shows how much money did business made in a year. It records two things sales and cost/turnover.
The trading account shows the income from sales and the direct costs of making those sales. It includes the balance of stocks at the start and end of the year.
There are different sections of P&L which include:
1. Sales- it is the total value of what you’ve sold during the period of time. The formula for it is price time’s quantity.
2. Cost of sales- these are the costs that are directly related to the sales you have made. It includes raw materials or stock you have purchased to resell. It may also include the cost of creating the items that you sold, including the cost of staff time if you are selling service.
3. Gross Profit – This is the sum of sales revenue minus cost of sales. It tells you how much profit you are making directly from your sales.
4. Operating Costs – These are all the other costs associated with running a business, such as the rent and rates on your premises, accountancy and legal fees, and depreciation. These costs cannot be directly linked to your sales and may not change very much even if your sales figures were to change significantly.
5. Net Profit – This is the gross profit minus the operating costs. This is almost the true profit of your business because it’s made up of all the income and all the costs. The net profit is transferred over to balance sheet.
A balance sheet shows the value of a business on a particular date. A balance sheet shows what the business owns and owes. It is also used as a guide for solvency of the company.
Anything in your business that has financial value is included in the balance sheet. Everything is split into four groups.
1. In first group is included everything that can be liquidated (sold for cash) including stock, cash, and money owed by customers, are current assets. These are usually short term.
2. Second group is more long-term; including property, machinery, patents and long-term investments these are called fixed assets, which are long term liquidation.
3. Third part of balance sheet is current liabilities and they are what the business owes in the short-term: money owed to suppliers, taxes due, short-term loans and overdrafts.
4. The last group is long-term liabilities they are what the business owes in the long-term – to be paid after one year, as well as capital and reserves.
Gross Profit Margin
This ratio examines the relation between the gross profit and sales revenue. It also measures the % of gross profit that is made from a given amount of sales. It shows how efficiently a business is using its materials and labours in the production process and gives an indication of the pricing, cost structure, and production efficiency of your business. The higher the gross profit margin ratio the better it is for business. The higher the percentage, the more the business retains of each pound of sales, which means more money is left over for other operating expenses and net profit. A low gross profit margin ratio means that the business generates a low level of revenue to pay for operating expenses and net profit. It indicates that either the business is unable to control production or inventory costs or those prices are set too low.
Acid Test Ratio
This method excludes stock as stock is not a very liquid asset. Acid-Test ratio provides a more rigorous assessment of a company’s ability to pay its current liabilities. A higher acid-test ratio indicates greater short-term financial health. The acid-test ratio is more conservative than the current ratio, which measures much the same thing, because the current ratio excludes the value of inventory.
Net Profit Margin
Net profit margin measures how much of each pound earned from sales of good and service the company is translated into profits. It also provides clues to the company’s pricing, cost structure and production efficiency. Net profit is used to pay for interest, tax and distribution to the owners. The higher the net profit margin ratio the better it is for the business. It indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. A low net profit margin ratio may mean that you are not generating enough sales, the gross profit margin is too low, or that you are not keeping your operating expenses under control to leave an acceptable profit. A business with a low ratio might need to take on debt to pay its expenses.
Return On Capital Employed
It shows the return for money that is spent and it also says how well you do with the money. ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders’ earnings and it indicates that the company is not employing its capital effectively and is not generating shareholder value. For a company, the ROCE trend over the years is also an important indicator of performance. In general, investors tend to favour companies with stable and rising ROCE numbers over companies where ROCE is volatile and bounces around from one year to the next.
It shows how long it takes debtors to pay you money back.
Increases in debtor days may be a sign that the quality of a company’s debtors is decreasing. This could also mean a greater risk of defaults. It could similarly be an indicator that cash flow is likely to weaken or that more working capital will be required. Investors should be aware of why changes in debtor days are happening, especially if there is a very large increase or a clear long term increasing trend. It may reflect a change in how the business operates, or its environment. This is not necessarily bad, but it can be an indication of a potentially serious problem.