Why Net Assets and the Capital Section on the Balance Sheet are Equal - Lab Report Example

TABLE OF CONTENTS Trial Balance.................................................................................................... 2 Trading Account.............................................................................................. 3 Profit and Loss Account................................................................................... 3 Balance Sheet................................................................................................... 4 Defining the Final Account.............................................................................. 5 Trial Balance............................................................................................. 5 Trading Account........................................................................................ 5 Profit and Loss........................................................................................... 5 Balance Sheet............................................................................................ 6 Why Net Assets and the Capital Section on the Balance Sheet are Equal...... 6 Analyzing Company’s Performance................................................................ 7 Gross Profit Margin................................................................................... 7 Net Profit Margin...................................................................................... 7 Current Ratio............................................................................................. 7 Acid Test Ratio.......................................................................................... 7 Return on Capital Employed..................................................................... 8 References........................................................................................................ 9 The Works Co. Trial Balance January 1, 2011 Account Description Debit Credit Cash 1,700 Debtors 8,500 Allowance for bad debts 850 Stocks on hand 10,000 Prepaid rent 1,500 Premises 216,000 Equipment 22,000 Accumulated depreciation – equipment 2,200 Vehicles 15,750 Bank overdraft 2,100 Accrued expenses 1,500 Creditors 3,600 Long term loan 27,000 Capital 50,000 Drawings 1,500 Sales 375,000 Sales returns 9,100 Discount allowed 6,000 Opening stock 12,000 Purchases 96,150 Purchase returns 6,300 Discount received 5,200 Closing stock 10,000 Salaries 63,000 Electricity and gas 8,700 Rent and rates 4,500 Depreciation 2,200 Provision for bad debts 850 Sundry expenses 4,300 483,750 483,750 The Works Co. Trading Account As at Year Ending January 1, 2011 £ £ Sales 375,000 Sales returns (9,100) Discount allowed (6,000) Net Sales 359,900 Cost of Goods Sold Opening stock 12,000 Purchases 96,150 Cost of goods available for sale 108,150 Purchase returns (6,300) Discount received (5,200) Closing stock (10,000) Cost of Goods Sold 86,650 Gross Profit 273,250 The Works Co. Profit and Loss Account As at Year Ending January 1, 2011 £ £ Gross Profit 273,250 Operating Expenses Salaries 63,000 Electricity and gas 8,700 Rent and rates 4,500 Depreciation 2,200 Provision for bad debts 850 Sundry expenses 4,300 Total Operating Expenses 83,550 Net Profit for the Year 189,700 The Works Co. Balance Sheet January 1, 2011 £ £ ASSETS Non-Current Assets Property, plant and equipment Premises 216,000 Equipment 22,000 Less: Accumulated depreciation 2,200 19,800 Vehicles 15,750 Property and equipment – net 251,550 Current Assets Cash 1,700 Debtors 8,500 Allowance for bad debts (850) 7,650 Stocks on hand 10,000 Prepaid rent 1,500 1,500 Total Current Assets 20,850 Current Liabilities Bank overdraft 2,100 Accrued expenses 1,500 Creditors 3,600 Total Current Liabilities 7,200 Working Capital 13,650 Non-Current Liabilities Long – term loan 27,000 Net Assets 238,200 Equity Capital 50,000 Net profit during the year 189,700 239,700 Drawings (1,500) Total Equity 238,200 Report on the Final Accounts Trial Balance Purpose The trial balance is used to list the accounts and their respective balances. It provides assurance that the debits and credits are mathematically equal after posting. It can also be used to prepare the company’s financial statements such as the balance sheet and profit and loss. Content The trial balance includes all of the accounts of a company in the same order that they appear in the company’s general ledger. The balances are placed either on the debit side (the left column) or the credit side (the right column). Totals for the debit and credit columns are also shown in the trial balance. Lay – out and How Significant Values are Calculated Using a table format, all the account names are written on the left – most side of the trial balance. Two columns are then prepared on the right side of the account names. The left column is the debit side. The right column is the credit side. The balance of each account is then written either on the debit side or the credit side. The totals of the debit and credit balances are then calculated and compared to ensure that both amounts are equal. Trading Account Purpose The trading account shows the company’s gross profit or gross loss during the period. It shows how profitable the company is if one just takes into consideration the company’s direct expenses. It also enables the financial statement user to calculate the gross profit rate for any given period of time. Content The trading account shows two major accounts: the cost of goods sold on the debit side and the sales on the credit side. The cost of goods sold shows the total direct cost incurred by the company. It includes the amounts of the opening stock, the purchases during the period, returned purchases, discounts received on purchases and the closing stock. The sales include the amounts of the sales and the sales returns and allowances. Lay – out and How Significant Values are Calculated The two major categories of the trading account are the sales (the credit side) and the cost of goods sold (the debit side). The net sales amount is calculated by deducting the sales returns and the sales discount from the sales amount. The cost of goods sold amount is calculated by adding total purchases during the period to the opening stock amount and then deducting the amounts of the returned purchases, the discounts received and the closing stock. Gross profit or gross loss is then calculated by deducting cost of goods sold from the net sales. Profit and Loss Account Purpose The profit and loss account shows the over – all profit or loss of the company for a given period. It shows gross profit or loss during the period and all indirect expenses during the same period. The profit and loss account is used to assess the over – all profitability of the company. Content This account shows the gross profit for the period and all the indirect cash expenses (i.e., salaries, rent and electricity). It also includes indirect non – cash expenses such as depreciation and provision for bad debts, expenses accrued but not yet paid (i.e., unpaid electricity) and expenses that were incurred but already paid in advance by the company (i.e, prepaid rent). It also shows the net profit or net loss for the period. Lay – out and How Significant Values are Calculated All the indirect or operating expenses (as enumerated above) are added up. The total amount of these expenses is then deducted from gross profit. The difference is the net profit for the period. Balance Sheet Purpose The balance sheet shows the financial position of the company at any given point in time. It shows the company’s assets, liabilities and equity. The balance sheet is used for various purposes. Creditors analyze the balance sheet to determine if the company can pay them. The owners analyze the balance sheet to determine if their investments are earning and if they can declare dividends for the stocks they own. Content The balance sheet contains the current assets such as cash, receivables, stocks on hand, prepayments; non – current assets such as property and equipment and intangible assets; current liabilities such as payables, accrued expenses and short – term loans; non – current liabilities such as long – term bank loans and equity or the owner’s capital. Lay – out and How Significant Values are Calculated The balance sheet is divided into the assets and liabilities and equity. Assets are then sub – divided into two major categories: current assets and non – current assets. The balances of the property and equipment such as land, buildings, machineries, equipment, etc. are added, less accumulated depreciation plus other non – current assets such as intangible assets to arrive at the total non – current assets. The balances of cash, receivables (net of the allowance for bad debts), stocks on hand and prepayments are added to calculate total current assets. Similar to assets, liabilities are also divided into current and non – current liabilities. The total amount of current liabilities is calculated by adding the payables, accrued expenses and short – term loans. Total current liabilities are then deducted from total current assets to arrive at the working capital. The working capital amount is then added to total non – current assets, less the total amount of non – current liabilities, such as long – term loans and other non – current liabilities, to arrive at the net assets. The equity is calculated by adding up the beginning capital plus any profits or less any net loss for the period and less capital drawings for the same period. The equity should be equal to the net assets. Why Net Assets and the Capital Section on the Balance Sheet are Equal The balance sheet is premised around the concept of the accounting equation. The company has a collection of assets and these assets were obtained from two sources: debts from the company’s creditors and suppliers and equity from the company’s owners. If the debts are deducted from the total assets, this equation will result to the net assets, which is basically the amount of assets remaining for the owners of the company after all debts are paid. Thus, the net assets should always be equal to the capital section. Analyzing Company’s Performance Gross Profit Margin Formula: Gross Profit / Net Sales Calculation: 273,250 / 359,900 Gross Profit Margin = 75.92% Gross profit margin shows the profit the company earned for every unit of goods sold. It also shows how well management is controlling the direct costs of the company. Based on the analysis above, our company is earning £0.75 for every £1 sold. By itself, this is a very good profit margin; however, this margin needs to be analyzed with other companies within the same industry before we can say for certain if it is well within the industry average and if it is, therefore, a good margin. Net Profit Margin Formula: Net Profit / Net Sales Calculation: 189,700 / 359,900 Net Profit Margin = 52.71% Net profit margin measures the net profit generated for each £1 sale. This margin takes into account not only the direct costs and expenses but all the other expenses as well. Our company’s net profit margin is at about 50% which means that for every £1 sale, half of this is retained as our net profit. Again, this seems to be a very good net profit margin but there is still the need to compare this against those of other companies within the same industry. Such comparison will give us an assurance that the net profits earned are well within or even above the industry average. Current Ratio Formula: Current Assets / Current Liabilities Calculation: 20,850 / 7,200 Current Ratio = 2.9:1.00 The current ratio indicates the ability of the company to pay off its short – term debts. In this case, our company has a current ratio of 2.9 to 1 which indicates that the short – term liabilities of the company are more than covered by its short – term assets. Even though this is a positive indication, we should ensure that the current ratio is comparable with the current ratio of the other companies in the same industry. Acid Test Ratio Formula: (Current Assets – Stocks on Hand) / Current Liabilities Calculation: (20,850 – 10,000) / 7,200 Acid Test Ratio: 1.51:1.00 Acid test ratio also measures the ability of the company to pay off its short – term debts. However, the numerator in this ratio takes into account only the most liquid assets of the company, hence, it needs to exclude the stocks on hand, which are not very liquid as compared to the other current assets. In our company’s case, even though we excluded the stocks on hand in the calculation, the remaining current assets are still enough to pay off our short – term debts. Return on Capital Employed (ROCE) Formula: Net profit / Working Capital Calculation: 189,700 / 13,650 ROCE = 138.97% ROCE measures how efficient our company’s management is in utilizing its capital to generate profits for the company. In the above case, we are generating more than 100% of the capital employed. This is a good percentage, however, we must analyze this return every year to see if this is really the trend and to ensure that we are maintaining such a trend. References Books 1. Alexander, D., Britton, A. and Jorissen, A. 2007. International Financial Reporting and Analysis. 3rd ed. London: Thomson Learning. Page 64. 2. Gibson, C. H. 2011. Financial Reporting and Analysis: Using Financial Accounting Information. 12th ed. Ohio: Cengage Learning. Pages 229 – 230, 306, 317, 3. Gowthorpe, C. 2008. CIMA Official Learning Center: Financial Analysis. 1st ed. Oxford: Elsevier Ltd. Page 698. 4. Weyngandt, J. J., Kimmel, P. D., Kieso, Donald E. 2011. Financial Accounting: Tools for Business Decision Making. New Jersey: John Wiley & Sons, Inc. Pages 13 and 129. Read More