Topic 2 - Measuring & Evaluating Financial Position & Performance

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This article is a topic within the subject Accounting 1A.

Contents

Required Reading

Trotman, K. & Gibbins, M., 2009 Financial Accounting: An Integrated Approach, 4th edition, Melbourne: Thomson Nelson ITP pp. 47-73.

The Balance Sheet

The balance sheet shows a firms assets (resources) and how they are financed through liabilities and equity (sources). 'Current' assets and liabilities refer to items that are expected to be settled within the normal operating cycle of the business or within 12 months. A typical balance sheet make look like this:

  • Assets - future economic benefits that are controlled by the entity as a result of past transactions or events
    • Current Assets
      • Cash - held at bank
      • Accounts Receivable - amounts owed by customers (debtors) (e.g. customers paying on credit)
      • Inventory - amounts of finished or work in progress inventories (e.g. Woolworth's stock held in stores or raw materials)
      • Other Current Assets
    • Non Current Assets
      • Property, Plant and Equipment - machinery etc.
        • Accumulated Depreciation - reduces the asset value of PPE as its benefits are used up, it is a contra asset account (more on this later)
      • Other Non Current Assets
  • Liabilities - Future sacrifices of economic benefits that an organisation is presently obliged to make to others due to past events
    • Current Liabilities
      • Accounts Payable - are amounts owed to suppliers (creditors) for the goods and services they have provided to the firm
      • Wages Payable - amounts owed to employees for completed work
      • Accrued Expenses - amounts owed for various expenses (e.g. electricity, water)
      • Provisions - liabilities that are based on reliable estimations (e.g. warranty provisions - some customers will return the product for repaid which will result in outflows for the company)
      • Other Current Liabilities
    • Non Current Liabilities
      • Long Term Loans - borrowed amounts from a bank or the corporate bond market
      • Other Non Current Liabilities

Balance Sheet Analysis

  1. Debt to Equity Ratio (Debt/Equity) measures a firms solvency - the ability to meet present obligations & long term expenses (survivability)
  2. Current Ratio (Current Assets/Current Liabilities) measures a firms liquidity - the ability to repay short term obligations
  3. Acid/Quick Ratio ((Current Assets - Inventory)/Current Liabilities) also measures liquidity but in comparison to the current ratio it neglects inventory (assumes inventory is hard to liquidate).

More in-depth balance sheet analysis will be undertaken later in the course.

The Accounting Equation

Assets = Liabilities + Equity

Examples of the Accounting Equation And Various Transactions

  1. $120 collected from a customer from a previous sale
    • Causes a $120 increase in cash (asset) and a $120 decrease in accounts receivable (asset)

Comprehensive Example

  1. Initially a company issues shares to investors and receives $600,000.
    • 600,000 Asset(Cash) = 0 Liabilities + 600,000 Equity (Share Capital)
  2. Buys Equipment for $500,000 - cash (asset) drops 500,000 and equipment (asset) rises 500,000
    • 600,000 Assets (100,000 Cash + 500,000 Equipment) = 0 Liabilities + 600,000 Equity (Share Capital)
  3. Borrows $200,000 from a bank, cash rises 200,000 (asset), borrowings (liability) rises 200,000
    • 800,000 Assets (300,000 Cash + 500,000 Equipment) = 200,000 Liabilities (Borrowings) + 600,000 Equity (Share Capital)
  4. Purchases $150,000 of Inventory of Credit - inventory (asset) rises 150,000, accounts payable (liability) rises 150,000
    • 950,000 Assets (300,000 Cash + 500,000 Equipment + 150,000 Inventory) = 350,000 Liabilities (200,000 Borrowings + 150,000 Accounts Payable) + 600,000 Equity (Share Capital)

The Income Statement

The income statement a company’s financial performance/profitability over a specific accounting period. Broadly speaking it covers:

  • Revenues - increases in the firms wealth arising from the provision of goods and services to customers
    • Generally recognised when the goods or services are rendered/delivered
    • Customer either pays with cash or promises to pay (receivable)
  • Expenses - decreases in a company’s wealth that are incurred in order to earn revenue
    • E.g. Cost of goods sold or wage expenses
  • Profit - the net inflow of wealth to the company during the period
    • Revenue - Expenses - Tax = Profit

Connecting the Balance Sheet and Income Statement

The balance sheet and income statement are connected via the equity account 'retained earnings'. Remember that a Change in Assets = Change in Liabilities + Change in Equity so that Assets = Liabilities + Equity holds true.

Generally, a strong profit performance leads to a stronger balance sheet and more opportunities to pay back debt or expand.

  • Revenue - increases assets or decreases liabilities = increase in equity
  • Expense - decrease in assets or increase in liabilities = decrease in equity
  • Net Profit - increase in assets or decrease in liabilities = increase in equity (retained earnings)
  • Net loss - decrease in assets of increase in liabilities = decrease in equity (retained earnings)

End

This is the end of this topic. Click Accounting 1A to go back to the main subject page for Accounting 1A

References

Textbook refers to Trotman, K. & Gibbins, M., 2009 Financial Accounting: An Integrated Approach, 4th edition, Melbourne: Thomson Nelson ITP

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