BAF1013 Finance & Accounting for Decision Making Lecture 3 PDF

BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Lecture 3: Financial Impact of Recorded Business Transactions Learning Objectives At the end of the lecture, you should b...

BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Lecture 3: Financial Impact of Recorded Business Transactions Learning Objectives At the end of the lecture, you should be able to: 1. Explain the significance of key financial statements. 2. Describe the components of key financial statements. 3. Describe the impact business transactions have on the financial statements. 4. Explain the role of financial ratio analysis when making business decisions. 1. Introduction of Key Financial Statements Definition and Purpose of Financial Statements Financial statements are reports that detail a company's financial performance and position. Financial statements provide a summary of the financial health of a business, showing how money flows in and out of the company. They are critical for understanding the financial position, performance, and cash flows of a business. Key Types of Financial Statements: Income Statement (Profit or Loss Statement) shows the company’s revenues, expenses, and profits over a specific period. Balance Sheet shows a snapshot of the company’s assets, liabilities, and owner’s equity at a specific point in time. Cash Flow Statement tracks the cash inflows and outflows over a period, indicating the company’s liquidity. Significance of Financial Statements They help owners and investors understand whether the company is making a profit or a loss. Lenders and creditors use financial statements to assess if the company is creditworthy. Managers use them to make informed decisions to improve the company's financial health. 1 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ 2. Components of Key Financial Statements Profit or Loss Statement Revenue: Money earned from sales or services. Expenses: Costs incurred to generate revenue (e.g., salaries, rent, utilities). Net Profit: The difference between revenue and expenses. If revenues are higher, the company makes a profit. If expenses are higher, it incurs a loss. Example: Mode Enterprise Profit & Loss Statement for the month ended 30 September 2024 $ $ Revenue Service fees revenue 6,000 Less: Expenses Salaries expense 1,200 Office rental expense 800 Vehicle expense 200 2,200 Net Profit 3,800 Balance Sheet Assets: What the business owns (e.g., cash, inventory, equipment). Liabilities: What the business owes (e.g., loans, accounts payable). Owner’s Equity: The owner's investment in the business. 2 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Example: Mode Enterprise Balance Sheet as at 30 September 2024 $ $ Owner’s Equity Capital, Mode 10,000 Add: Net Profit 3,800 13,800 Represented by: Assets Cash at bank 4,800 Accounts receivable 8,000 Inventories 2,000 Furniture 3,500 18,300 Less: Liabilities Loan from bank 4,000 Accounts payable 500 4,500 Net Assets ( A - L ) 13,800 3. The Impact of Business Transactions on Financial Statements Business transactions are the fundamental activities that drive a company's operations and financial performance. You have learned in Business Accounting that each business transaction has a dual effect because it impacts at least two accounts in the financial statements, maintaining the balance of the accounting equation: Assets=Liabilities + Owner’s Equity This session will explore the effects of various business transactions on the Balance Sheet and Profit or Loss Statement. 3 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ 3.1 Types of Business Transactions and Their Impact: Asset Transactions o Purchase of Assets Example 1: Buying equipment for $10,000 cash Impact: a. Increase in Equipment (Asset) by $10,000. b. Decrease in Cash at Bank (Asset) by $10,000. Balance Sheet Effect: Total assets remain unchanged; only the composition changes. Example 2: Buying inventory for $2,000 on credit Impact: a. Increase in Inventory (Asset) by $2,000. b. Increase in Accounts Payable (Liability) by $2,000. Balance Sheet Effect: Total assets increased by $2,000; Total liabilities increased by $2,000. Liabilities Transactions o Borrowing Money (Taking a Loan) Example 1: Taking a loan of $20,000. Impact: a. Increase in Cash at Bank (Asset) by $20,000. b. Increase in Bank Loan (Liability) by $20,000. Balance Sheet Effect: Total assets increased by $2,000; Total liabilities increased by $2,000. o Paying off liabilities Example 2: Pay creditors $2,000. Impact: a. Decrease in Cash (Asset) by $2,000. b. Decrease in Accounts Payable (Liability) by $2,000. Balance Sheet Effect: Total assets decreased by $2,000; Total liabilities decreased by $2,000. 4 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Revenue and Expense Transactions o Earning Revenue Example 1: Earning revenue from services rendered for $8,000 cash. Impact: a. Increase in Cash at Bank (Asset) by $8,000. b. Increase in Service Fees (Revenue) by $8,000. Financial Statements Total assets increased by $8,000; Revenue increased by Effect: $8,000. Example 2: Earning revenue from services rendered for $11,000 on credit. Impact: a. Increase in Accounts Receivable (Asset) by $11,000. b. Increase in Service Fees (Revenue) by $11,000. Financial Statements Total assets increased by $11,000; Revenue increased by Effect: $11,000. o Incurring Expenses Example 1: Paid salary expenses of $3,000. Impact: a. Decrease in Cash at Bank (Asset) by $3,000. b. Increase in Salary Expenses (Expense) by $3,000. Financial Statements Total assets decreased by $3,000; Expenses increased by Effect: $3,000. In summary, business transactions directly influence a company’s financial position and performance. Every transaction modifies some combination of assets, liabilities, equity, revenues, expenses, or cash flows, thus changing the overall financial outlook presented in the financial statements. 5 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ 4. Financial Ratio Analysis and Decision Making What are Financial Ratios? Financial ratios are tools used to assess the financial health and performance of a company by analyzing relationships between various financial statement components. They are key for decision-making by management, investors, and creditors. We shall cover the ratios in the Appendix in later lessons. For this lesson, we shall cover the horizontal and vertical analysis of financial statements: Horizontal Analysis Horizontal analysis, also known as trend analysis, involves comparing financial data over multiple periods to identify trends and growth patterns. Purpose: To assess changes in financial performance over time, allowing analysts to spot upward or downward trends in revenues, expenses, and other key metrics. Key Features: Compares line items across two or more accounting periods. Expresses changes in absolute values (dollars) and relative values (percentages). How to Perform Horizontal Analysis 1. Gather Financial Information: Collect financial statements for the periods you wish to analyze (e.g., quarterly or annually). 2. Calculate Dollar Change: Subtract the base year value from the comparison year value for each line item. Dollar Change = Current Year − Base Year 3. Calculate Percentage Change: Divide the dollar change by the base year value and multiply by 100. Percentage Change = Dollar Change × 100 Base Year Example of Horizontal Analysis Assume a company’s revenue was $100,000 in Year 1 and $120,000 in Year 2: Dollar Change: $120,000 - $100,000 = $20,000 Percentage Change: ($20,000 / $100,000) × 100 = 20% This indicates a 20% increase in revenue from Year 1 to Year 2. 6 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Vertical Analysis Vertical analysis involves expressing each line item on a financial statement as a percentage of a base figure within that statement. It provides insights into the relative size of various accounts. Purpose: To analyze the structure of financial statements by showing how each item contributes to the whole. Key Features: Typically used on Profit or Loss Statement (expressing items as a percentage of total revenue) and Balance Sheet (expressing items as a percentage of total assets). How to Perform Vertical Analysis 1. Select a Base Figure: Choose an appropriate base figure (e.g., total sales for income statements or total assets for balance sheets). 2. Calculate Each Line Item's Percentage: Divide each line item by the base figure and multiply by 100. Percentage = Line Item × 100 Base Figure Example of Vertical Analysis For a Profit or Loss Statement where total revenue is $200,000 and advertising expense is $20,000. Advertising expense as a percentage of revenue: ($20,000 / $200,000) × 100 = 10%. This indicates that advertising expense accounts for 10% of total revenue. Applications of Horizontal and Vertical Analysis Both analyses serve distinct purposes in financial decision-making: Horizontal Analysis Applications: Identify trends over time (e.g., revenue growth). Evaluate performance against historical benchmarks. Forecast future performance based on historical trends. Vertical Analysis Applications: Assess cost structures relative to sales or asset bases. Compare companies within the same industry regardless of size. Evaluate operational efficiency by examining expense ratios. 7 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Differences Between Horizontal and Vertical Analysis Feature Horizontal Analysis Vertical Analysis Focus Trends over time Structure at a specific point in time Data Comparison Multiple periods Single period Calculation Dollar and percentage Percentages of base figures changes Purpose Identify growth patterns Analyze proportionate relationships Summary Horizontal and vertical analyses are essential tools for financial statement analysis. While horizontal analysis focuses on trends over time, vertical analysis emphasizes the relationship between individual line items within a single period. Together, they provide comprehensive insights into a company's financial health and operational efficiency, aiding stakeholders in making informed business decisions. 8 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Appendix Key Financial Ratios: Profitability Ratios: o Gross Profit Margin: (Gross Profit ÷ Revenue) × 100 Indicates how much profit the company makes after deducting the cost of goods sold. o Net Profit Margin: (Net Profit ÷ Revenue) × 100 Measures how much of each dollar of revenue becomes net income after all expenses. Liquidity Ratios: o Current Ratio: (Current Assets ÷ Current Liabilities) Shows whether the company can pay its short-term obligations with its short- term assets. o Quick Ratio (Acid-Test Ratio): (Current Assets - Inventory) ÷ Current Liabilities Measures the company’s ability to meet short-term obligations without relying on selling inventory. Solvency Ratios: o Debt to Equity Ratio: (Total Liabilities ÷ Owner’s Equity) Indicates how much debt the company is using compared to its equity. Higher ratios mean more reliance on borrowed funds. Efficiency Ratios: o Inventory Turnover: (Cost of Goods Sold ÷ Average Inventory) Shows how efficiently the company manages its inventory. Using Ratios in Decision Making: Profitability Ratios: Help determine if the business is generating sufficient profit to be sustainable. Liquidity Ratios: Assist in evaluating the company’s ability to meet short-term obligations. Solvency Ratios: Indicate the level of financial risk, helping in decisions related to borrowing or issuing shares. Efficiency Ratios: Help managers identify if the company is effectively using its assets to generate income. 9