Accounting – Session 1

TOPICS

Financial accounting
 Accounting terminology
 Main financial statements
 Accounting ratios
Management accounting
 Costs: type and behavior
 Main costing systems
 Contribution analysis
 Short-term decision making

What is ACCOUNTING?
 Accounting is the language of business (a company aims to make a profit/has a
societal goal)
 Definition #2: Accounting = The provision of information to managers and
owners so that they can make business decisions
 It is about recording, preparing and interpreting business transactions (R P I)
 It answers key questions, such as: how much profit have we made?

Types of Accounting
 Distinction between Financial Accounting and Management Accounting

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 FINANCIAL ACCOUNTING
 It provides financial information about the financial performance of a
business
 It is required by law
 It is backward-looking
 Its main purpose is preparation of the major financial statements (3) MFS
 Aimed at external users (shareholders, banks, interest groups)

MANAGEMENT ACCOUNTING
 It provides detailed information about the performance of the internal
activities
 It is backward-looking and forward-looking
 It is NOT required by law
 It is focused on cost accounting and decision making
 Its main purpose is to assist the managers in operating the business
 Aimed at internal users

Internal users External users

- Management - Shareholders and analyst advisors
- Employees - Lenders
Main users
- Suppliers
- Customers
- Government and tax authorities
- Public

Everywhere the same?

Accounting rules and principles – may differ among countries:
- International Accounting Standard Board (IASB) publishes International
Financial Reporting Standards (IFRS)
- Non-listed companies (they don’t have to conform to this, they can use their
own rules)

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 1) Accounting context – factors:
 History
 Country
 Organizational (structure + nature of the business)
 Technological
2) Types of accountancy
 Auditing = checking that the financial statements, prepared by managers, give
a true and fair view of the accounts
 Bookkeeping = entering monetary transactions into the books of account
 Financial Accounting = preparation and interpretation of the financial accounts
 Financial Management = managing the sources of finance of an organization
 Insolvency
 Management Accounting = internal accounting of an organization
 Fraud Detection
 Taxation
 Management Consultancy
3) Types of accountant
 Professionally Qualified Accountants (6 institutions in UK)
o Chartered Accountant (3 institutes operate in the UK)
 Second-Tier Bodies
4) Limitations of Accounting – its historic nature (measures the past
expenditures rather than current) and its failure to measure non-financial transactions
5) Language of accounting
Income = the revenue earned by a business (not equal to cash received!) => even if the
customers haven’t paid yet!
Expenses = the costs incurred in running a business (not equal to cash paid!)
Assets = items owned (or leased) by the business which will bring economic benefits
Liabilities = amounts the business owes to a third party (trucks, equipment, buildings,
inventory)
Equity (Capital) = the assets – liabilities to third parties = the owner’s interest in business
Income – Expenses = PROFIT Assets – Liabilities = EQUITY

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 ANNUAL REPORT

 It is composed by:
 Financial statements
 Additional financial and non-financial information
 Main purpose: evaluation of the performance of the business
 Frequency, purpose and users may differ
 Sensitive information is NOT disclosed (strategic reasons)
 Available in:
 Company website (Investor Relations)
 EDGAR SEC (US listed companies)

Main financial statements:

 Income statement
 Statement of financial position = BALANCE SHEET
 Statement of cash flows = CASH FLOW STATEMENT

INCOME STATEMENT (profit and loss account) = income - expenses

- Shows revenue earned and expenses incurred over a period of time
- The difference leads to net income (profit) or net loss

STATEMENT OF FINANCIAL POSITION = assets – liabilities

- Shows assets, liabilities, and equity at a certain point in time (net assets)

STATEMENT OF CASH FLOWS = cash inflows – cash outflows

- Shows cash received and paid over a period of time (net)

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Exercise #1

***An asset can also be an income when someone OWES smth to the business
***current assets = short-term assets
non-current assets – e.g. property, plant and equipment

The Accounting Equation

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Exercise #2

***An asset can also be an income when someone OWES smth to the business
=> include it in the Income!!!
Loans – always liabilities, NOT income

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!!! [ASSETS = Bank balance from Statement of cash flows (end of the year) + other
assets NOT CASH] – Liabilities = Opening equity (start of the year) – /+ Bank
balance from Income statement
Opening Equity = all assets at the beginning (cash + others)

Cash flows = Bank balance at start of the year + Receipts - Payments

Bank balance at the beginning of the year (CASH) is DIFFERENT than Opening
Equity (CASH + OTHER ASSETS)!!

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 Accounting principles

A. Accounting Conventions (4)

 Entity = a business has a distinct and separate identity from its owners
 Monetary measurement = only items which can be measured in financial
terms are included in the accounts (e.g. pollution NOT, but a fine on pollution YES) FT
 Historical cost = the amount recorded in the accounts will be based on the
original amount paid for a good or service OAP
 Periodicity = statements are prepared for a set period of time

B. Accounting Assumptions or Concepts

 Going concern = assumption that the business will continue into the
foreseeable future; important for assets valuation AV
 Accruals (or matching concept) = incomes and expenses are recognized
when they are accrued (i.e., earned or incurred) rather than when the money is received
or paid E/I
o Expenses are incurred for the purpose of producing revenue
o Concept of offsetting expenses against revenues

Exercise #3

 Consistency = similar items will be treated similarly from year to year.

Same accounting policies

 Prudence = income and profits should be only recorded when they are
certain and provisions or liabilities should be recorded as soon as they are recognized

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 Mini-case

Chapter 3 (book) – Double-entry bookkeeping

Definition: A way of systematically recording the financial transactions of a

company so that each transaction is recorded twice.

Step 1: Assets = Liabilities

Step 2: Assets = Liabilities + Equity (distinct type of liability)
Step 3: Assets = Liabilities + Equity + Profit
Step 4: Assets = Liabilities + Equity (+Income – Expenses)
Step 5: Assets + Expenses = Liabilities + Equity + Income

Assets and expenses => debit entries (left-hand side)

Income, liabilities, equity => credit entries (right-hand side)

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 Basic rules of double-entry bookkeeping
1. For every transaction, there must be a debit and a credit entry.
2. These debit and credit entries are equal and opposite.
3. In the cash book all account paid in are recorded on the debt side, whereas
all amounts paid out are recorded on the credit side.

Four major types of items 1. Assets 2. Liabilities and equity 3. Income 4. Expenses

1. Assets
- Essentially items owned or leased by a business which will bring economic
benefits. Two main sorts of tangible assets (i.e., assets with a physical existence):
I. Non-current assets – can be divided into intangible assets such as patents
(goodwill) and tangible assets: property, plant and equipment. These are infrastructure
assets NOT USED in the day-to-day trading!!! They are assets in use usually over a long
period of time.
i. Motor vehicles
ii. Land and buildings
iii. Fixtures and fittings
iv. Plant and machinery
II. Current assets – used in the day-to-day trading
i. Inventory (Stock)
ii. Trade receivables (Debtors)
iii. Cash

2. Liabilities – divided into:

I. Short-term and long-term third-party liabilities
II. Capital = equity which is a liability owed by the business to the owner
(increased by profits, reduced by losses)

Short-term: (i) Trade payables (creditors) (ii) Bank overdraft (iii) Proposed taxation
(companies only)
Long-term: (i) Bank loan repayable after several years (ii) Mortgage loan

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 3. Income – day-to-day revenue earned by the business (e.g. sales)
4. Expenses – day-to-day costs of running a business (e.g. rent and rates, electricity,
wages)
Chapter 4 (book) – Main financial statements:
Income Statement (Profit and Loss Account)

Definition: The statement detailing the income less the expenses of an

organization over a period of time, giving profit.
Overview of Income Statement
Revenue (for credit or cash)
Less
Cost of Sales (expense of directly providing R)
Equals
Gross Profit (R – CoS)
Add
Other Income (activities other than trading)
Less
Other expenses (costs incurred in meeting R)
Equals
Net Profit (left over after cost of sales and
expenses have been deducted from R)

***Revenue – reduced by sales returns (faulty, damaged goods)

***Main Cost of Sales = purchases (purchases returns; carriage inwards; inventory –
Opening + Closing)
***Gross profit = essentially an organization’s profit from trading
***Other income = interest from money in a bank/building society (interest received);
dividends received from an investment or profit in sale of a particular item of plant,
property and equipment.
*Other expenses = light and heat, employees pay etc.
DEPRECIATION = non-cash payment!

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Main factors which complicate profit:
- The accruals/matching concept
- Estimation
- Changing prices
- The wearing out of assets

Impairment = an asset will have lost more value than is accounted for via depreciation.
Capital expenditure = a payment to purchase an asset with a continuing use in the
business (such as an item of property, plant and equipment)
Revenue expenditure = a payment for a current year’s good or services (such as
purchases for resale or telephone expenses)

Chapter 6 (book) – Preparing financial statements

Main financial statements:

In the income statement:
profit = income – expenses paid
In the statement of financial position:
closing equity + drawings – opening equity = profit (horizontal format?)

Assets + Expenses = Liabilities + Equity + Income

=> TRIAL BALANCE
Assets – (Liabilities + Equity) = Income – Expenses
Statement of financial position Income Statement

4 steps:
1. Determine the Cost of sales => opening stock + purchases – closing inventory
(adjust purchases for purchases returns)
2. Sales – Cost of sales = Gross Profit (adjust sales for sales return)
3. List and total all expenses
4. Determine net profit

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 In relation to the steps!
1. All the property, plant and equipment (i.e., tangible non-current assets) are added
together.
2. Total assets (current + non-current) are determined next => total assets
3. Total liabilities are determined
4. Net assets = total assets – total liabilities
5. Closing equity = Opening equity + net profit

Five adjustments to TRIAL BALANCE

A. Inventories (Stock) – To maintain the double-entry, the asset of inventory is

entered twice:
1. First, in the trading part of the income statement
2. Second, in the current assets section of the statement of financial position

B. Accruals – appear in the final accounts in two places:

1. First, the amount owing is included in the income statement under expenses
2. Second, a matching amount us included under current liabilities in the
statement of financial position

C. Prepayments – must be deducted. The amount paid in advance is treated as an

asset which will be used up at a future date.

D. Depreciation:
1. First, a proportion of the original cost is allocated as an expense in the income
statement
2. Second, an equivalent amount is deducted from the property, plant and
equipment in the statement of financial position

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 E. Bad and doubtful debts – some may not be collected, while some other will
almost certainly not be collected
 Bad debts = recorded as an expense in the income statement and written
off trade receivables in the statement of financial position
 Provision for the impairment of receivables = set up by a business for
those debts it is dubious about collecting. It is always deducted from trade receivables in
the statement of financial position. BUT only increases/decreases in the provisions are
entered in the income statement! (an increase – as an expense; a decrease – as an
income)

***Equity (Owner’s capital employed) – The money introduced by the sole trader
into the business. Normally = NET ASSETS

***Drawings = Money taken out of the business by the owner = A reduction of

owner’s equity (e.g., living expenses)

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 Accounting – Session 2
TOPICS
 Annual report, forecasts, and market reactions
 Income statement (profit and loss account)
 Statement of financial position (balance sheet)
 Depreciation policy

Income statement
 Presents income (increase of economic benefit which increase owner’s equity)
and expenses over a period of time
 It is uses to evaluate the performance of business
 Income – Expenses = Profit
 Profit = distribution of dividends to shareholders (profit); payment of taxes
 Revenue = income earned from selling products or services (may be
reduced by sales returns!); sales made for credit or for cash
 Cost of sales = costs attributable to the production of goods; common in
trading companies (i.e., buy and sell goods); less common in service companies
 Gross profit = Revenue – Cost of sales
 Other income/expenses = income from other activities. Activities not related
with the daily business (e.g., interests, disposal of assets); expenses not directly
associated with sales (e.g., selling, general and administrative costs)

Exercise #1

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 Gross Profit
(Gross) Profit = Gross margin x Revenue (GM = % of revenue)
(Gross) Profit = Mark-up x Cost of goods sold (mark-up = % of cost of sales)
Revenue = cost of goods*(1+mark-up)

Gross Profit /
Revenue = Gross
Margin

Exercise #2
Mark-up Gross Margin
Revenue 100.000 100%
Cost of sales 75.000 75%
Gross Profit 25.000 25%

Mark-up Gross Margin

Revenue 200.000 130%
Cost of sales 153.846 100%
Gross Profit 46.154 30%

Mark-up Gross Margin

Revenue 66.667 100%
Cost of sales 50.000 75%
Gross Profit 16.667 25%

Mark-up Gross Margin

Revenue 48.000 120%
Cost of sales 40.0000 100%
Gross Profit 8.000 20%

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 Statement of financial position - components

 Presents (1) assets, (2) liabilities and (3) equity at a certain point in time
 It is used to evaluate the value of a company (net assets)
Assets – Liabilities = Equity or Assets = Equity + Liabilities
 Assets = rights to future economic benefits (e.g., by being sold or used)
 Liabilities = obligations
 Non-current assets = used to run business in the long-term (tangible and
intangible assets)

(1) Property, plant and equipment (non-current assets)

 Different types: land and buildings, plant and machinery, fixtures and fittings,
motor vehicles
 Normally valued at historical cost
 Depreciation: the original purchase cost is allocated as an expense every year
across the asset’s useful life (matching concept)
 Several methods of depreciation: e.g., straight line (most common), reducing
balance
NON-CURRENT ASSETS!

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  Current assets – used to run business in the short-term. They are needed in
day-to-day operations
(1) Inventories (current assets)

 Raw materials: purchased from a third party and ready for use
 Work-in-progress: intermediate products
 Finished goods: goods ready to be sold
 Valuation: at the lower of cost or net realizable value

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 (1) Other current assets

Trade receivables (A/R)

 Sales for which customers have not yet paid (that’s an asset! But adjustments
needed – people who won’t pay)
 Bad debts and doubtful debts (i.e., impairment of receivables)

Prepayments
 Goods or services paid in advance (e.g., insurance) – not yet incurred costs
(that’s why they are assets)

Cash and cash equivalents

 Actual money held by the business
 Petty cash and money in the bank account

(2) Liabilities

 Non-current = Liabilities that the organizations owes and must repay after more
than one year (long-term)

 Current = Liabilities that the organizations owe and must repay within one year
(short-term)

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 Current liabilities

 Trade payables (A/P) = Purchases for which suppliers have not yet been paid
 Accruals = Amounts owed to suppliers for services received, but not yet paid
 Bank loans = Amounts loaned to a company by a bank
 Working capital (or net current assets) = current assets – current liabilities

(3) Equity

 Amount that the business ‘owes’ to the owner(s)

 Net profit (or loss) is the linking figure with the income statement

Exercise #3

Currents assets: 30.000 (inventory + trade receivables + cash)

Current liabilities: 12.000 (trade payables)
Net current assets: 30.000 – 12.000 = 18.000 (CA – CL)

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 Depreciation policy
Eurobulk Cargo Case

Assumptions

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Year 2026 – Expense = 60 747, Net book value = 242 988 => WRONG! (Net book
value should be 100,000 after 10 years)
=> (we need to increase the last year’s depreciation) => at a certain point we have
to switch back to straight line depreciation

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Double declining balance (DDB) [2]
However, DDB does not result in a net book value equal to salvage value
Two cases:
1. 10th year depreciation leads to net book value < salvage value (e.g. 90 000 < 100 000):
depreciation expense limited to a lower amount (e.g. net book value 140 000 and planned
depreciation for the last year 50 000 => depreciation limited to 40 000)
2. 10th year depreciation leads to net book value > salvage value: the method should be
converted to the SL method after a certain year. In particular, when the SL method leads
to a higher depreciation expense.

Salvage (residual) value = the estimated value that an owner is paid when the
item is sold at the end of its useful life

Double declining: when it is something that has declining value with the economic curve (a car
becomes old at a certain point, which means have higher depreciation in the beginning). 
accelerate depreciation.
Straight line: for very static things – building stands for 10 years, so depreciate straight line.

For Tax income purposes prefer to use double declining balance because it gives the fastest tax
deductions for depreciation.

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Depreciation strategies:
- Straight line: simple and helped wit earnings consistency.
- Double-declining: accelerated method, more writing off in the first years, thus
benefit later.  affects bonus.

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 Case: Disposal of the forklifts

What are the financial implications of the two options?

Option 1: Sell immediately upon acquisition for 8 000 per forklift
Cost: 60 000 (each); accumulated depreciation: 48 000; net book value (12 000) (each)
=> LOSS ON SALE (8 000 – 12 000) x 10 = 40 000
Cash: increases by 80 000

Option 2: refurbish for 6 000 each and sell for 14 000 in the fiscal year 2018
Economically speaking, there’s not much happening.
Net book value after refurbishment: 12 000 + 6 000 = 18 000
Loss on sale: (14 000 – 18 000) x 10 = 40 000
Cash: decreases by 60 000 in 2017 and increases by 140 000 in 2018 => overall increase
by 80 000 DEFER THE SALE? Makes no sense

TABLE FOR DEPRECIATION

YEAR COMPUTATION DEPR_EXPENSE ACCUMULATED_DEPR BOOK VALUE

Both accelerated methods result in a higher depreciation expense than the straight-line method in
the first two years of the asset’s life. This pattern reverses in years the last two years. This has important
implications for taxable income and net profit for the company.

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Question 1

Correct answer: B – to reduce tax increase (not C – you end up with a salvage value)

Question 2

A loss of $15 000

Opening equity + net profit – drawings = Closing equity

Liabilities (e.g. a bank loan) and dividends payed to shareholders (part of

the earnings) are NOT included in the INCOME STATEMENT!

Loan from bank, Investment from shareholders, Purchase of a land and

Payments to long-term creditors – NOT in the income statement

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 Accounting – Session 3
TOPICS
 Analyze a statement of cash flows
 Analyze financial statements using appropriate accounting ratios

Statement of cash flows

 Provides information about cash receipts and cash payments over a period of
time
 Additional information about the performance of the business:
o Ability to generate positive cash flows
o Ability to meet its obligations and to pay dividends
o Need for financing

Main sections:
 Cash flows from operating activities O
o Flows from operating activities (e.g., sales to customers and
purchases from suppliers) and taxation

 Cash flows from investing activities I

o Flows from acquisitions and disposals of property, plant and equipment
o Flows from interest received and dividend received
o Flows from financial investments

 Cash flows from financing activities F

o Flows from the issue of shares and loans
o Flows from interest paid and dividend paid

Free cash flow = cash flow from operations after deducting interest, tax, preference
dividends and ongoing capital expenditure, but excluding capital expenditure associated
with strategic acquisitions and/or disposals and ordinary share dividends.

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!! Cash and profit are different! (it’s easier to ‘manufacture’ profits rather than cash flow)
- Cash flow is based on cash paid and cash received (CF = CP – CR)
- Profit is based on income earned and expenses incurred (P = IE – EI)

- Timing differences
- Expense does not necessarily equal cash outflow => Depreciation (non-flow cash
item) => the related cash flows occur only when property, plant or equipment is
BOUGHT/SOLD

Opening cash + Inflows – Outflows = Closing cash (statement of cash flows)

Preparation of cash flows:

1) Direct method => cash flows are classified by type or function based on the
transactions recorded in the bank account (e.g., receipts from sales)
2) Indirect method (used by most companies) =>
- Computation of operating profit COP
- Reconciliation of operating profit to operating cash flow = adjusting for
movements in working capital and for non-cash items, such as depreciation ROP

*** Large companies – required to provide a statement of cash flows; sole traders,
partnerships and small companies may, but are not required to

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Indirect method – steps:
Step 1: Calculation of operating profit by adjusting profit before taxation
What do we need to calculate?
=> Operating cash flow = NET CASH FLOW FROM OPERATING ACTIVITIES
How? Calculate operating profit by adjusting profit before taxation to operating
profit => add interest paid and deduct interest received

Step 2: Reconciliation of operating profit to operating cash flow – two main types
of adjustments:
(i) Working capital adjustments = short-term timing adjustments between the income
statement and statement of cash flows (inventory, trade receivables, trade payables)
***An increase in inventory, trade receivables or prepayments => less cash flowing =>
When trade receivables increase, there is a delay in receiving the money => there is less
money in the bank.
By contrast, a decrease in inventory, trade receivables or prepayments (or an increase
in trade payables or accruals) => more cash flowing into the business

(ii) Non-cash flow items (included in the income statement, BUT NOT in the statement
of cash flows):
- Depreciation – it needs to be added back to profit to arrive at cash flow
- Profit on sale of property, plant and equipment – must be deducted from profit
to arrive at Operating Cash Flow
***The increases/decreases in working capital items are established by comparing
the individual current assets and current liabilities in the opening and closing statement
of financial position.
By contrast, the non-cash flow items are taken from the income statement.

!!! From assignment – in the cash flow statement divide type of activities –
operating, financing, investing. Result = net change in cash, which is added to
initial bank balance (bank balance at the beginning vs. at the end of the month)
Add both earnings and spendings for different type of activities!

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Cash = cash available, it physically exists
Petty cash = money kept specifically for day-to-day small expenses
Cash at bank = (in a current/deposit account)
Cash & cash equivalents => refer to cash at bank and that held in short-term deposit
accounts
Deposits repayable on demand = very short-term investments which can be repaid within
one working day
Deposits requiring notice = accounts where the customer must give a period of notice for
withdrawal (e.g., 30 days)

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 Opening cash + Inflows – Outflows = Closing cash (statement of cash flows)
NOTE!!
1. Interest expense is added back to net profit and then interest paid is
deducted under either operating activities or financing activities. Interest income
is deducted from net profit and then interest received recorded as an inflow under
either operating activities or investing activities.
2. Taxation paid is recorded under operating activities.

Chapter 8 (book) – The statement of cash flows

Cash Inflows and Outflows – examples

Cash Inflow
Cash from customers for goods
Interest received from bank deposit account
Cash from sale of property, plant and equipment
Cash introduced by owner
Loan received

Cash Outflow
Payments to suppliers for goods
Payments for services, e.g., telephone, light and heat
Repay bank loans
Payments for property, plant and equipment, e.g., motor vehicles
Interest paid on bank loan

IAS = International Accounting Standards

IFRS = International Financial Reporting Standards

!!! From assignment:

Assets – Liabilities – Equity = Retained earnings

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Three cashflow categories:
 Operating = principal-revenue producing activities of the entity
 Investing = acquisition and disposal of long-term assets and other investments
(including subsidiaries)
 Financing = activities that result in changes in the size and composition of equity
and borrowings

Main Heading for the Statement of cash flows using IFRS

Simplified meaning Ex. of Inflows Ex. of Outflows
i. Cash flows from the i. Cash for sale of i. Payment for
Cash flows from normal trading activities goods purchases of goods
operating activities of a business ii. Taxation refunds ii. Expenses paid
ii. Cash paid to iii. Taxation paid
government for taxation iv.
i. Cash flows relating to i. Interest received i. Payments for
the purchase and sale ii. Dividends received property, plant and
of iii. Receipts for sale equipment e.g. motor
a. property, plant and and property, plant and vehicles
equipment equipment e.g. motor ii. Purchase of
Cash flows from
b. investments vehicles investments
investing activities
ii. Payments for the iv. Sale of investments iii. Cash paid to buy
purchase or sale of v. Cash received for another company
other companies sale of another
company
v.
i. Cash received from i. Cash received from i. Cash paid to buy
shareholders the issue of: back shares or to repay
ii. Cash flows relating to a. shares loans
the issuing or buying b. loans ii. Dividends paid
Cash flows from
back of shares or loan iii. Interest paid
financing activities
capital
iii. Dividends
companies pay to
shareholders

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 Transaction In Income Statement In Statement of Cash Flows
i. Sale of goods for cash YES YES

ii. Sale of goods on credit YES NO

iii. Telephone bill for year

YES NO
owing

iv. Telephone bill for year paid YES YES

v. Cash purchase of property, NO YES

plant and equipment

vi. Profit on sale of property,

YES NO
plant and equipment

vii. Cash from sale of

property, plant and equipment NO YES

viii. Money received from a NO YES

loan

ix. Bank interest received for a YES YES

year

***When a business makes a profit, but runs out of cash = OVERTRADING

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Financial statement analysis

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Financial statement analysis – two main techniques:

A. Ratio analysis = interpretation of accounts => after the initial bookkeeping

and preparation of the accounts
 six categories of ratios: profitability, efficiency, liquidity, gearing, cash flow,
investment (market) PELGCI
 3 important profitability ratios are return on capital employed (ROCE),
gross profit ratio and net profit ratio
 4 important efficiency ratios are trade receivables collection period, trade
payables collection period, inventory turnover ratio and asset turnover ratio
 2 important liquidity ratios are the current ratio and the quick ratio
 5 important investment ratios are dividend yield, dividend cover,
earnings per share (EPS), price earnings ratio and interest cover

B. Vertical and horizontal analysis

 Vertical analysis (common-size financial statements): key figures (such as
revenue in the income statement and total net assets) are set to 100% => other items are
then expressed as a percentage of 100%
Sales 80 000 100%
Cost of sales 42 000 52.5%
 Horizontal analysis (common-base financial statements): figures (income
statement and statement of financial position) are compared across years
Sales 2015: 80 000 +35%
Sales 2014: 60 000

Ratio analysis
 The interpretation of ratios involves judgement
o It depends on the nature of the business and on the needs of the users
o Additional information about the context is useful to make comparisons
(i.e., benchmarks)

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  Advantages:
o Quick and easy analysis
o Inter-firm and intra-firm comparisons
o Size is taken into account

Profitability ratios (3) – they seek to establish how profitably a business is operating
a) Return on Capital Employed (measures how effectively a company uses its capital
employed; it compares net profit to capital employed) – ALWAYS ADD LOAN INTEREST
TO NUMERATOR
Profit before tax and loan interest
Long-term capital (ordinary share
capital and reserves, preference share
capital and long-term loans)

b) Gross Profit Ratio (it calculates the profit earned through trading)
Gross profit
Revenue
c) Net Profit Ratio (whereas gross profit is calculated before taking administrative
and distribution expenses into account, the net profit ratio is calculated after such
expenses)
Net profit before taxation Net profit after taxation
Revenue Revenue

Efficiency ratios (4) – how effectively a business is operating (primarily concerned with
the efficient use of assets)
a) Trade Receivables Collection Period (Debtors Collection Period) (seeks to
measure how long customers take to pay their debts)
Average trade receivables
Daily basis =
Credit sales per day

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 b) Trade Payables Collection Period (Creditors Collection Period) (how long it takes
a business to pay its creditors)

Average trade payables

Daily basis =
Credit purchases per day

*** It is often important to compare the trade receivables and trade payables ratios:
Trade receivables collection period (in days)
Trade payables collection period (in days)

c) Inventory Turnover Ratio (Stock Turnover Ratio) (measures the speed with which
inventory moves through the business)
Cost of sales
Average inventories

d) Asset Turnover Ratio (compares revenues to total assets employed)

Revenue
Average total assets

Liquidity ratios (2) – seek to test how easily a firm can pay its debts

a) Current ratio (test whether the short-term assets cover the short-term liabilities; if
they don’t, then there will be insufficient liquid funds to pay current liabilities as they fall
due)
Current assets
Current liabilities

b) Quick ratio = acid test ratio (it is a measure of short-term liquidity)

Current assets – inventories
Current liabilities

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Gearing = the relationship between the equity and the debt capital of a company
Cash flow ratio = is prepared from the statement of cash flows
Investment ratios (5) = focus specifically on returns to the shareholder or the ability of a
company to sustain its dividend or interest payments
a) Dividend Yield (shows how much dividend the ordinary shares earn as a proportion
of their market price)
Dividend per ordinary share
Share price

b) Dividend Cover (shows how many times profit available to pay ordinary
shareholders’ dividends covers the actual dividends)

Profit after tax and preference dividends

Ordinary dividends

c) Earnings per Share (EPS) (measures the earnings attributable to a particular

ordinary share)
Profit after tax and preference dividends
Number of ordinary shares

d) Price/Earning (P/E) Ratio (relates to the share price; high ratio = high price in
relation to earnings = a fast-growing, popular company in which the market has
confidence; low ratio = slower-growing, more established company)

Share price
Earnings per share
e) Interest Cover (shows the amount of profit available to cover the interest payable
on long-term borrowings; ONLY long-term loans used)

Profit before tax and loan interest

Loan interest

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RETURN ON EQUITY (ROE) = Net profit / Equity (avg) = return on net assets = how
effectively a company is using assets in order to create profit = how much profit a
company generates with each dollar of shareholders’ equity
RETURN ON ASSETS (ROA) = Net profit / Total assets (avg) = the percentage of how
profitable a company’s assets are in generating revenue = how many dollars of earning
the company derives for each dollar of the assets they control
PROFIT MARGIN RATIO (NET PROFIT RATIO) = Net profit (before taxation) / revenue
GROSS MARGIN RATIO = Gross profit / Revenue

ASSET TURNOVER RATIO = Revenue / Total assets (avg)

INVENTORY TURNOVER RATIO = Cost of sales / Inventory (avg)

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TRADE RECEIVABLES COLLECTION PERIOD = Trade receivables (avg) / credit sales
per day (sales revenue)
TRADE PAYABLES COLLECTION PERIOD = Trade payable (avg) / credit purchases
per day

Purchases = cost of sales + closing inventory – opening inventory

CASH CONVERSION CYCLE

(OPERATING CASH CYCLE) = Inventory + Receivables - Payables

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CURRENT RATIO = Current assets / current liabilities (short-term liquidity) = company’s
ability to pay its obligations; if <1 => a company’s debts that need to be paid in a year or
less are greater than its assets
A ratio under 1 indicates that the company’s debts that will need to be paid in a
year or less are greater than its assets (either cash or expected to be converted to
cash within a year or less.) A current ratio less than one would not be concerning
if the company has a much higher receivables turnover than payables turnover.
For example, retail companies collect very quickly from consumers but have a long
time to pay their suppliers. Because of this imbalance, a current ratio below 1 is
normal within the industry group.

In theory, the higher the current ratio, the more capable the company is of paying
its obligations because it has a larger proportion of short-term asset value relative
to the value of its short-term liabilities. However, a high ratio (over 3) could
indicate the company is not using its current assets efficiently, is not
securing financing very well, or is not managing its working capital.

QUICK RATIO (acid test) = (Current assets – inventories) / current liabilities

The quick ratio is more conservative than the current ratio because it excludes inventory and
other current assets, which generally are more difficult to turn into cash. A higher quick ratio
means a more liquid current position.

A low and/or decreasing quick ratio might be delivering several messages about a company.
It could be telling us that the company’s balance sheet is over-leveraged. Or it could be saying
the company’s sales are decreasing, the company is having a hard time collecting its account
receivables or perhaps the company is paying its bills too quickly.

A company with a high and/or increasing quick ratio is likely experiencing revenue growth,
collecting its accounts receivable and turning them into cash quickly and likely turning over
its inventories quickly.

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GEARING RATIO (LEVERAGE) = Long-term borrowings (non-current liabilities) / long-
term capital (non-current liabilities + equity)
DEBT-TO-EQUITY RATIO = Total liabilities / equity

EARNINGS PER SHARE (EPS) = Profit after tax and preference dividends / number of
ordinary shares
PRICE/EARNINGS (P/E) RATIO = Share price / EPS

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DIVIDEND YIELD = Dividend per ordinary share / share price
Dividend per ordinary share = Ordinary dividends / Number of ordinary dividends
DIVIDEND COVER = Profit after tax and preference dividends / ordinary dividends

BOOK-TO-MARKET RATIO = Book value / market value

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Limitations of ratio analysis: context, absolute size, like with like, international
comparison and validity of data

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 Accounting – Session 4
TOPICS
 Different types of cost and overview of the main costing techniques
 Traditional total absorption costing
 Activity-based costing (ABC)
Management Accounting
 The provision of financial and non-financial information to managers for costing,
for planning, control and performance of the decision making CPCP
 Cost accounting = the determination of actual and standard costs, budgeting and
standard costing
o Costing (cost recovery: pricing and inventory valuation)
o Planning, control and performance (budgeting, standard costing)
 Decision making
o Short-term decision making (break-even analysis, contribution analysis)
o Long-term decision making (strategic decisions)

Financial accounting and management accounting

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Some Key Cost Accounting Terms
Cost = an item of expenditure (planned or actually incurred)
Total absorption costing = form of costing that is used to recover all the costs (direct +
indirect) incurred by a company into the price of the final product/service
Direct costs = costs that can be directly identified and attributed to a product/service
(e.g., the amount of direct labour that is incurred making a product; sometimes they are
called product costs)
Indirect costs (overheads, period costs) = costs that cannot be directly identified and
attributed to a product/service (e.g., administrative, selling and distribution costs). These
costs are totalled and then recovered into the product or service in an indirect way.
Absorption costing = the form of costing used for valuing inventory for external financial
reporting. It recovers the costs of all the overheads that can be directly attributed to a
product/service (it includes both fixed and variable production overheads)
Marginal costing = excludes fixed costs from the costing process. It focuses on sales,
variable costs and contribution.
Controllable costs = costs that a manager can influence and that the manager can be
held responsible for (opposite from uncontrollable costs)
Standard costs = individual cost elements (direct materials, direct labour and variable
overheads) which are estimated in advance. Normally, the quantity and the price of each
cost element are estimated separately. Actual costs are then compared with standard
costs to determine variances.
Variances = the difference between the budgeted costs and the actual costs in both
budgeting and standard costing
Fixed costs = costs that will NOT vary with production or revenue (e.g., insurance) in an
accounting period => they will not be affected by short-term decisions (e.g., if the
production is increased or not)
=> the more units produced, the less fixed costs per unit => variable cost per unit stays
the same => finally, total cost DECLINES over the quantity
Variable costs = costs that vary with the production and revenue (e.g., the metered cost
of electricity)
Semi-variable costs = e.g. fixed charge for electricity and then payment is per unit

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 Accuracy: direct versus indirect costs

Direct costs = items that are easily traced to the product or service (direct material, direct
labor => ‘prime costs’) = materials, manufacturing labour, royalties = PRIME COSTS
Indirect costs (or overhead) = costs related to the particular cost object but cannot be
traced to it in an economically feasible (cost effective) way because:
- Cost element is shared among cost objects (common costs)
- Physically impossible to trace
- Not cost effective to trace
= supervisors’ wages, staff costs, office expenses, advertising

Exercise #1

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Exercise #2

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Exercise #3

Costing techniques

 Purpose: recover (absorb) the costs into an identifiable product or service

 Pricing: all overhead costs are recovered
 Inventory valuation: only those overheads directly related to the production of
inventory
 Techniques:
o Traditional total absorption costing
o Activity-based costing

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 Traditional total absorption costing

Exercise #4

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ABSORPTION COSTING: CRITICISMS
 Arbitrary allocation of costs to production departments. A change of the allocation
basis would affect product costs
 It is important to avoid the use of a single overall absorption rate x
 The use of broad averages to spread costs over products can lead to product
under-costing or over-costing

Activity-based costing (ABC)

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