ECMM119 / ECMM128

COMPANY FINANCE &

ACCOUNTING
Lecture 2

Dr Paul Folan
LECTURE CONTENTS
 Lecture 2:
See encyclopidia
Financial Issues for Managers . . . . . . . . . . . .pg289
Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . .pg27

 Accounting

 The Balance sheet, liabilities and assets

 Profit and loss statements

EXAMS

 As part of your exam paper for ECMM119 / ECMM128

there is the possibility that a question will be asked on
Finance material

 Any of the material covered in the two lectures may

appear in an exam question
RECAP – LAST TIME…
 Companies and the Companies Act

 Why should engineers learn about finance?

 Main users of financial information related to a

business

 The Companies Act

RECAP – LAST TIME…
 Product Costing

 Traditional Costing
 Single parameter costing
 Multi-product costing

 Costing Overheads
 Overhead Absorption…
 Cost Centres
RECAP – LAST TIME…
 Product Costing

 Activity Based Costing

 Cost objects consume activities

 Activities consume resources

 This consumption of resources is what drives cost

 RECAP – LAST TIME…
 Budgeting
 A budget is a plan not a forecast – there is a
commitment/requirement to make it happen
Month 1 Month 2 Month etc.
Incomings
Income from Sales Ʃsales Income Ʃsales Income Ʃsales Income
Credit Interest Calculted if you have a positive total in the bank from last month Calculted if you have a positive total in the bank from last month Calculted if you have a positive total in the bank from last month
Sub Total Ʃsales Income + any credit interest Ʃsales Income + any credit interest Ʃsales Income + any credit interest

Outgoings
Various Costs 1 Often annual costs / 12 Often annual costs / 12 Often annual costs / 12
Various Costs 2 Often annual costs / 12 Often annual costs / 12 Often annual costs / 12
Various Costs 3 Often annual costs / 12 Often annual costs / 12 Often annual costs / 12
Specific items, such as Corporation Tax Often paid in one month lump sum
Duty Payments Often calculated from previous month's sales
Overdraft Interest Calculted if you have a negative total in the bank from last month Calculted if you have a negative total in the bank from last month Calculted if you have a negative total in the bank from last month
Sub Total Ʃall outgoings for month Ʃall outgoings for month Ʃall outgoings for month

Total Movement Incomings sub total - Outgoings sub total Incomings sub total - Outgoings sub total Incomings sub total - Outgoings sub total

Total in Bank Previous month's bank balance + Total Movement Previous month's bank balance + Total Movement Previous month's bank balance + Total Movement
ACCOUNTING
 ACCOUNTING
 Accountancy is the production of financial records about an
organization

 Concerned with collecting, analysing and communicating

financial information

 Aim is to help those who use the information to make more

informed decisions
 ACCOUNTING
 Accounting as a form of service

 It should have the following properties:

 Relevance (ability to influence decisions, and not be useless)

 Reliability (should be as free as possible from error)

 Comparability (should allow the user to be able to assess the

business over a period of time)

 Understandability (should be expressed as clearly as possible and

should be understood by those at whom the information is aimed)
 ACCOUNTING
 Accounting information should only be produced if the costs
of providing it are less than the benefits to be derived from
its use

Benefits of accounting information

eventually decline

Cost of providing information,

however, will rise with each additional
piece of information required

Optimal level = greatest gap between

the value of the information and the
cost of providing it
 ACCOUNTING
 Accounting as an information system

1. Identifying and capturing relevant financial information

2. Recording the financial information collected in a systematic manner

3. Analysing and interpreting the financial information collected

4. Reporting the financial information in a manner that suits the needs of users
THE BALANCE SHEET,
LIABILITIES AND ASSETS
BALANCE SHEET
 The purpose of the balance sheet is simply to set out
the financial position of a business at a particular
moment in time

 It reveals:
 Theforms in which the wealth of the business is held
 How much wealth is held in each form

 It sets out the assets of the business on the one hand,

and the claims (liabilities) against the business on the
other
BALANCE SHEET
 Structure:

 A financial statement , showing:

 Fixed Assets

 Current Assets

 Current Liabilities

 Long-Term Liabilities
ASSETS AND LIABILITIES
 So what are assets and liabilities?

 Assets
 A resource held by the business with certain characteristics,
including:

 A probable future benefit exists

 The business has an exclusive right to control the benefit (not shared)

 The benefit must arise from some past transaction/event

 The asset must be capable of being measured in monetary terms

(can a monetary value be put on it?)
ASSETS AND LIABILITIES
 Current Assets
 Cash and other assets expected to be converted to
cash, gold, or consumed either in a year or in the
operating cycle (whichever is longer), without disturbing
the normal operations of a business

 These assets are continually turned over in the course

of a business during normal business activity
 Including trade debtors
ASSETS AND LIABILITIES
 Fixed Assets
 These are purchased for continued and long-term use in
earning profit in a business

 Includes land, buildings, machinery, furniture, tools,

fixtures and fittings

 They are written off against profits over their anticipated

life by charging depreciation expenses
ASSETS AND LIABILITIES
 Liabilities
 Represent the claims of individuals and organizations,
apart from the owner, that have arisen from past
transactions or events such as supplying goods or
lending money to the business

 A claim is an obligation on the part of the business to

provide cash, or some other form of benefit, to an
outside party

 It normally arises as a result of the outside party

providing funds in the form of assets for use by the
business
ASSETS AND LIABILITIES
 Capital is also a claim against the business, but
this time it is made by the owner

 A clear distinction is made in accounting between

the ‘owner’ and the ‘business’
 It is a separate entity

 The claiming of capital from the business by the

owner is sometimes referred-to as owner’s equity
ASSETS AND LIABILITIES
 Current liabilities
 Liabilitiesthat are reasonably expected to be liquidated
within a year

 Include payables such as wages, taxes, and accounts

payables, and short-term obligations (e.g. from
purchase of equipment)
ASSETS AND LIABILITIES
 Long-term liabilities

 Liabilities
that are reasonably expected not to be
liquidated within a year

 Include issued long-term bonds, notes payables, long-

term leases, pension obligations, and long-term product
warranties
BALANCE SHEET
 Structure:
 Differentstructures available, but we shall focus on the most
common, the vertical 3-column balance sheet structure
showing:

 Fixed Assets

 Current Assets

 Current Liabilities

 Long-Term Liabilities
Vertical Structure of Balance Sheet

Equal
EXAMPLE
Fixed Assets
Plant and Machinery £30,000
Motor Vehicles £20,000
Freehold Premises £72,000
Fixture and Fittings £9,000
£131,000
Current Assets
Stock-in-trade £34,000
Trade debtors £44,000
Cash in hand £1,500
£79,500
Current Liabilities
Trade Creditors £12,000
Bank Overdraft £25,000
£37,000
£42,500
Total assets less Current Liabilities £173,500
Less:
Long-term Liabilities
Long term loan £60,000
Net Assets £113,500

Capital
Opening Balance £110,000
Add:
Profit for the year to 30th September 2009 £12,500
£122,500
Less:
Drawings for the year to 30th September 2009 £9,000
£113,500
BALANCE SHEET
 We can see from the balance sheet that the total
claims are the same as the total assets; thus:

Assets – Liabilities = Capital

 This is the ‘Balance Sheet Equation’

 It always holds true

 Whatever changes may occur to the assets of the
business or the claims against it, there will be
compensating changes elsewhere that will ensure that
the balance sheet always ‘balances’
INTERPRETING THE BALANCE
SHEET
 We can use the Current Ratio to measure Liquidity

current assets
Current Ratio 
current liabilitie s

 In the medium term, there should be enough money coming

in to pay the necessary expenses.

 Generally, this ratio should be 2 or more as some of the

current assets (stock, for example) may be harder to realise,
but the current liabilities are nearly all for immediate payment
Fixed Assets
Plant and Machinery £30,000
Motor Vehicles £20,000
Freehold Premises £72,000
Fixture and Fittings £9,000
£131,000
Current Assets
Stock-in-trade £34,000
Trade debtors £44,000
Cash in hand £1,500
£79,500
Current Liabilities
Trade Creditors £12,000
Bank Overdraft £25,000
£37,000
£42,500
Total assets less Current Liabilities £173,500
Less:
Long-term Liabilities
Long term loan £60,000
Net Assets £113,500
Current Ratio = Current assets / Current Liabilities
Capital = £79,500 / £37,000 = 2.15 times
Opening Balance £110,000
Add:
This
Profit for tells
the year usSeptember
to 30th that current
assets covers current liabilities by£12,500
2009 2.15 times, a
healthy metric, as per the ideal number of 2 £122,500
Less:
Drawings for the year to 30th September 2009 £9,000
£113,500
 INTERPRETING THE BALANCE
SHEET
 We can use the Liquidity Ratio to measure Liquidity

current assets - stock

Liquid Ratio (acid test) 
current liabilitie s

 Note, stock may be in the form of inventories of raw materials, finished

goods awaiting sale, work-in-progress,
 The ratio indicates how quickly company can get cash, with stock being
considered hard to liquefy quickly
 Compares the current assets which are realisable quickly with the debts
which may need to be paid quickly
Fixed Assets
Plant and Machinery £30,000
Motor Vehicles £20,000
Freehold Premises £72,000
Fixture and Fittings £9,000
£131,000
Current Assets
Stock-in-trade £34,000
Trade debtors £44,000
Cash in hand £1,500
£79,500
Current Liabilities
Trade Creditors £12,000
Bank Overdraft £25,000
£37,000
£42,500
Total assets less Current Liabilities £173,500
Less:
Long-term Liabilities
Long term loan £60,000
Net Assets £113,500
Liquid Ratio = Current assets - Stock / Current Liabilities
Capital = £79,500 - £34,000 / £37,000 = 1.23 times
Opening Balance £110,000
Add:
This
Profit for this
the year a more
to 30th strict
2009 test
of liquidity, as it discounts hard £12,500
September to realise
(instantly) stock flows from current assets. £122,500
Less:
Drawings for the year to 30th September 2009 £9,000
£113,500
PROFIT AND LOSS
STATEMENTS
PROFIT AND LOSS
STATEMENTS
 A profit and loss account measures performance of
a business over a particular period

 At the end of the period it shows what profit (or

loss) has been achieved

 Profit:

 Is the Sales less the Cost of Sales

PROFIT AND LOSS
STATEMENTS
 The profit and loss statement:
 Is a record of the year’s activities

 It shows Turnover
reduced by operating expenses
to give Operating Profit
which is then reduced by taxation
to give Profit after Tax
this, together with retained profit brought
forward (from the previous year)
gives Retained profit to carry forward
PROFIT AND LOSS
STATEMENTS
 The profit and loss statement combines three
accounts:

1. Trading Account: which shows

 How gross profit was derived
 Identifies variable costs

2. The Core Profit and Loss: which shows

 How true earnings are derived from gross profit
 Identifies fixed costs, exceptional expenses and
extraordinary expenses
3. The Appropriation Account: which shows
 How the earnings are apportioned to the company’s
reserves and to its owners, the shareholders
 £ £
Sales 100,000
Opening Stock 24,000
Purchases 60,000
84,000
Less Closing Stock 30,000
Cost of goods sold 54,000
Gross Profit 46,000
Less Wages and Salaries 15,000
Professional fees 5,000
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Depreciation 1,400
Office Expenses 1,300
Bank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
 £ £
Sales 100,000
Opening Stock 24,000
Purchases 60,000
84,000
Less Closing Stock 30,000
Cost of goods sold 54,000
Gross Profit 46,000
How gross profit was derived
Less Wages and Salaries 15,000
Trading Account
Professional fees 5,000
Identifies variable costs
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Depreciation 1,400
Office Expenses 1,300
Bank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
 £ £
Sales How true earnings are derived from
100,000
Opening Stock gross profit 24,000
Purchases 60,000
Identifies fixed costs, exceptional
Core
Less
Profit
Closing Stock
expenses and 84,000
extraordinary
30,000
expenses
& Loss Cost of goods sold 54,000
Gross Profit 46,000
Less Wages and Salaries 15,000
Professional fees 5,000
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Depreciation 1,400
Office Expenses 1,300
Bank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
 £ £
Sales How true earnings are derived from
100,000
Opening Stock gross profit 24,000
Purchases 60,000
Identifies fixed costs, exceptional
Core
Less
Profit
Closing Stock
expenses and 84,000
extraordinary
30,000
expenses
& Loss Cost of goods sold 54,000
Gross Profit 46,000
Less Wages and Salaries 15,000
Professional fees 5,000
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Depreciation 1,400
Office Expenses 1,300
Bank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
 £ £
Sales 100,000
Opening Stock 24,000
Purchases 60,000
84,000
Less Closing Stock 30,000
HowCost
theofearnings
goods soldare apportioned to the 54,000
company’s reserves and to its owners, the46,000
Gross Profit
shareholders
Less Wages and Salaries 15,000
Professional fees 5,000
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Appropriation
Depreciation
Office Expenses
1,400
1,300
AccountBank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
 £ £
Sales 100,000
Opening Stock 24,000
Purchases 60,000
84,000
Less Closing Stock 30,000
HowCost
theofearnings
goods soldare apportioned to the 54,000
company’s reserves and to its owners, the46,000
Gross Profit
shareholders
Less Wages and Salaries 15,000
Professional fees 5,000
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Appropriation
Depreciation
Office Expenses
1,400
1,300
AccountBank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
STRUCTURE
 £ £
Sales 100,000
Opening Stock 24,000
Purchases 60,000
84,000
Less Closing Stock 30,000
Cost of goods sold 54,000
Gross Profit 46,000
Less Wages and Salaries 15,000
Professional fees 5,000
NI and Pension 4,600
Rent, Business tax 7,000
Utilities 2,800
Depreciation 1,400
Office Expenses 1,300
Bank Charges 720 37,820
Net Profit 8,180
Less Corporation tax 1,636
Extraordinary items 250
Dividends 2,728 4,614
Retained profit 3,566
EXAMPLE
 Over to you…

Use the following data to produce a profit and loss

account for the year’s production for Peakston Ales
Ltd.
EXAMPLE
 Answers Debit Credit
Sales £31,680,000
Opening Stock £500,000
Purchases £23,760,000
£24,260,000
Less Closing Stock £2,000,000
Cost of Goods Sold £22,260,000

Gross Profit £9,420,000

Less Wages and Salaries £240,000

Professional Fees £6,000
NI and Pension £55,200
Business Tax £30,000
Utilities £24,000
Depreciation £600,000
Office Expenses £220,000
Bank Charges £3,500 £1,178,700

Net Profit £8,241,300

Less Corporation Tax £2,307,564

Extraordinary Items £900
Dividends £4,800,000  £7,108,464
 Answers Debit Credit
Sales (4,400,000 per £31,680,000
Opening Stock month)*12 £500,000
Purchases months*(£0.60) £23,760,000
£24,260,000
Less Closing Stock (£1,980,000 per £2,000,000
Cost of Goods Sold month)*12 months £22,260,000

Gross Profit £9,420,000

Less Wages and Salaries £240,000

Professional Fees £6,000
NI and Pension £55,200
Business Tax £30,000
Utilities £24,000
Depreciation £600,000
Office Expenses £220,000
Bank Charges £3,500 £1,178,700

Net Profit
28% of Net Profit £8,241,300

Less Corporation Tax 15,000,000*£0.32 £2,307,564

Extraordinary Items £900
Dividends £4,800,000  £7,108,464
 INTREPRETING THE P&L
 Profitability
gross profit
Gross Profit Margin 
sales
 Measures efficiency in production
 Unfortunately, this covers both manufacturing and sales, so it is hard to see
where potential problems lie
 A reasonable norm might be 30 - 40%
net profit
Net Profit Margin 
sales
 Measures overall efficiency, adding the core costs to trading costs
 The central overheads will obviously reduce the profit but the net
profit margin should still comfortably be around 10%
 Answers Debit Credit
Sales £31,680,000
Opening Stock £500,000
Purchases £23,760,000
£24,260,000
Less Closing Stock £2,000,000
Cost of Goods Sold £22,260,000

Gross Profit £9,420,000

Gross Profit Margin = 9,420,000 /

Less Wages and Salaries
31,680,000 = 0.297 = 29.7% £240,000
Professional Fees £6,000
Approaching a reasonable norm
NI and Pension £55,200

Net Business Tax

Profit Margin = 8,241,300 / £30,000
Utilities £24,000
31,680,000 = 0.2601 = 26.01%
Depreciation £600,000
Office Expenses £220,000
Relatively, indicating that our
Bank Charges £3,500 £1,178,700
expenses are relatively low

Net Profit £8,241,300

Less Corporation Tax £2,307,564

Extraordinary Items £900
Dividends £4,800,000  £7,108,464
BALANCE SHEET VS. P&L
STATEMENT
 Perform different functions
 Balance sheet is a snapshot of a business at a particular
moment in time
 P&L statement shows the flow of wealth over a period of time

 They are, however, connected:

1. Begin by creating a Balance Sheet at the start of the period
2. Next, after some time, generate a P&L statement to show
the wealth created in the new time period
3. Finally, create a second Balance Sheet to reveal the new
financial position at the end of the period covered by the
P&L statement
BALANCE SHEET VS. P&L
STATEMENT