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Financial statements and ratios

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Lesson notes

Income statement over a period

  • A simplified trading income statement starts with revenue, subtracts cost of sales for gross profit, and subtracts other operating expenses for operating profit. Finance costs and tax may then be deducted to reach explicitly labelled later profit measures. Follow the question’s net-profit definition; school specifications differ in terminology.
  • An income statement is also called a profit and loss account. A statement of comprehensive income can include other comprehensive income in addition to profit or loss, so the titles are not exact synonyms in full accounting. This lesson uses a simplified income statement and does not teach those additional accounting items.

Simplified annual income statement

Simplified annual income statementFictional annual itemAmountRevenue£160,000Cost of sales£120,000Gross profit£40,000Other operating expenses£20,000Operating profit£20,000Finance costs£2,000Profit before tax£18,000Tax expense£3,000Profit after tax£15,000

Statement of financial position

  • The statement of financial position reports assets, liabilities and equity at one date. Current assets include cash, ordinary inventory, short-term receivables and suitable prepayments; non-current assets include longer-term machinery or premises. Current classification can follow the operating cycle as well as the usual twelve-month distinction.
  • Current liabilities include ordinary trade payables and amounts due shortly. Split a long-term loan where necessary: the portion due in the coming twelve months is normally current and the remainder non-current in this simplified setting. Equity = total assets − total liabilities; retained profit is not a separate cash pot.
  • In the fictional snapshot, non-current assets £150,000 plus current assets £100,000 give £250,000 assets. Current liabilities £50,000 plus non-current liabilities £20,000 give £70,000 liabilities, leaving £180,000 equity. Capital employed for this example is £180,000 + £20,000 = £200,000.

Financial position at year end

Financial position at year endFictional snapshot itemAmountNon-current assets£150,000Current assets£100,000Total assets£250,000Current liabilities£50,000Non-current liabilities£20,000Total liabilities£70,000Equity£180,000Liabilities + equity£250,000

Ratios

  • Gross margin = gross profit ÷ revenue × 100. Net margin = the specified net-profit figure ÷ revenue × 100. Use consistent definitions and nonzero denominators. A supplied net-profit figure can be used directly without inventing additional deductions.
  • Extension formulas, depending on qualification: ROCE = operating profit ÷ capital employed × 100; current ratio = current assets ÷ current liabilities, stated as x:1. Here £20,000 operating profit ÷ £200,000 capital × 100 = 10%, and £100,000 current assets ÷ £50,000 current liabilities = 2:1. Neither measures a guaranteed investor cash payout.

Calculate from the stated inputs

Calculate from the stated inputsRatioWorkingResultGross margin£40,000 ÷ £160,000 × 10025%Profit-after-tax margin£15,000 ÷ £160,000 × 1009.375%ROCE (extension)£20,000 ÷ £200,000 × 10010%Current ratio (extension)£100,000 ÷ £50,0002:1

Interpreting

  • Compare consistent periods, definitions and similar business models; investigate unusual items and accounting choices. Higher margins mean more profit per pound of revenue, but do not alone establish better overall performance or a better business strategy.
  • Fictional Year 1 gross profit £20,000 ÷ revenue £100,000 = 20%; Year 2 £24,000 ÷ £150,000 = 16%. Absolute gross profit rises despite a four-percentage-point margin fall. Price, cost and sales mix need investigating rather than inferring a unique cause.
  • A current ratio below 1:1 may signal liquidity risk, while a high ratio may contain slow-moving stock or overdue receivables. There is no universal ideal applicable to every sector. Use cash timing, finance availability and asset quality to judge payment capacity.

A lower margin need not mean less profit

A lower margin need not mean less profitFictional measureYear 1Year 2Revenue£100,000£150,000Cost of sales£80,000£126,000Gross profit£20,000£24,000Gross margin20%16%

Limitations

  • Historical accounts describe earlier periods and may not predict future conditions. Ratios can also use forecasts, which add estimation uncertainty. Accounting policies, reporting dates and different business models can limit comparability.
  • Ratios do not capture every non-financial influence, such as staff capability, customer experience or product quality. Window dressing can make reported numbers appear more favourable through timing or presentation. Use other evidence and avoid assuming every unusual figure proves wrongdoing.

Look beyond a 2:1 current ratio

Look beyond a 2:1 current ratioFictional itemAmount or implicationCurrent assets£6,000Current liabilities£3,000Current ratio2:1Inventory withincurrent assetsNeeds selling and collectionReceivables withincurrent assetsNeed timely customer paymentFurther evidencePayment dates, cash forecastand asset quality

Slides

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Practice questions

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  1. 1.What is an asset?

    Easy
    • Aan economic resource controlled by the business
    • Bsomething a business owes
    • Crevenue
    • Da cost

  2. 2.What is a liability?

    Easy
    • Asomething a business owns
    • Brevenue
    • Cprofit
    • Dsomething a business owes

  3. 3.What is a non-current asset?

    Easy
    • Acash
    • Breceivables
    • Ca long-term asset like machinery
    • Dstock

  4. 4.What is a current asset?

    Easy
    • Aequity
    • Bcash or an asset expected to be sold, used or collected in the normal operating cycle or short term
    • Ca building
    • Da long-term loan

  5. 5.What are receivables?

    Easy
    • Amoney owed to the business by customers
    • Bmoney owed to suppliers
    • Ccash
    • Dprofit

  6. 6.What are payables?

    Easy
    • Amoney owed by customers
    • Bcash
    • Cprofit
    • Dmoney the business owes to suppliers

  7. 7.What is equity?

    Easy
    • Atotal costs
    • Bthe bank balance
    • Cthe owners' stake: assets minus liabilities
    • Dtotal revenue

  8. 8.What is retained profit?

    Easy
    • Aa loan
    • Bprofit kept in the business
    • Cprofit paid out
    • Drevenue

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