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by accounting for it in your profit and loss account。 In this case the cost of
goods sold would be ￡3；120 （￡1；060 ＋ ￡1；040 ＋ ￡1；020）； rather than the ￡3；060
that FIFO produces。
The third popular costing method is the average cost method； which
does what it says on the box。 In the above example this would produce
a cost midway between those obtained by the other two methods； in this
example ￡3；090。
All these methods have their merits； but FIFO usually wins the argument
as it acmodates the realities that prices rise steadily and goods move in
and out of a business in the order in which they are bought。 It would be
a very badly run grocer’s shop that sold its last delivery of cereal before
clearing out its existing stocks。
Methods of depreciation
The depreciation is how we show the asset being ‘consumed’ over its
working life。 It is simply a bookkeeping record to allow us to allocate some
of the cost of an asset to the appropriate time period。 The time period will
be determined by such factors as how long the working life of the asset is。
The principal methods of depreciation used in business are：
。 The straight…line method： This assumes that the asset will be ‘consumed’
evenly throughout its life。 If； for example； an asset is being bought for
￡1；200 and sold at the end of five years for ￡200； the amount of cost we
have to write off is ￡1；000。 Using 20％； so that the whole 100％ of cost is
allocated； we can work out the ‘book value’ for each year。
。 The declining…balance method： This works in a similar way； but instead
of an even depreciation each year we assume the drop will be less。
Some assets； motor vehicles for example； will reduce sharply in their
first year and less so later on。 So at the end of year 1； both these methods
of depreciation will result in a ￡200 fall； but in year 2 the picture starts
to change。 The straight…line method takes a further fall of ￡200； while
the declining…balance method reduces by 20％ （our agreed depreciation
rate） of ￡800 （the balance of ￡1；000 minus the ￡200 depreciation so far）；
which is ￡160。
。 The sum of the digits method： This is more mon in the United
States than in the UK。 While the declining…balance method applies a
constant percentage to a declining figure； this method applies a progressively
smaller percentage to the initial cost。 It involves adding up
the individual numbers in the expected life span of the asset to arrive at
the denominator of a fraction。 The numerator is year number concerned；
but in reverse order。
Accounting 37
For example； if our puter asset bought for ￡1；200 had an expected
useful life of 5 years （unlikely）； then the denominator in our sum would
be 1＋2＋3＋4＋5 which equals 15。 In year 1 we would depreciate by 5/15
times the initial purchase price of ￡1；200； which equals ￡400。 In year 2
we would depreciate by 4/15ths and so on。
These are just three of the most mon of many ways of depreciating
fixed assets。 In choosing which method of depreciation to use； and in practice
you may have to use different methods with different types of asset； it
is useful to remember what you are trying to do。 You are aiming to allocate
the cost of buying the asset as it should apply to each year of its working
life。
Balance sheet and other online tools
SCORE （score 》 Business Tools 》 Template Gallery 》 Balance Sheet
（projected）） is an Excel…based spreadsheet you can use for constructing
your own balance sheet。 You can find guidance on depreciation； on
handling stock and on the layout of the balance sheet and profit and loss
account as required by the panies Act from the Accounting Standards
Board （frc 》 ASB 》 Technical 》 FRSSE）。 Accounting Glossary
（accountingglossary） and Accounting for Everyone （
accountingforeveryone 》 Accounting Glossary） have definitions of all
the accounting terms you are ever likely to e across in the accounting
world。
Package of accounts
The cash…flow statement； the profit and loss account and the balance sheet
between them constitute a set of accounts； but conventionally two balance
sheets； the opening and closing one； are provided to make a ‘package’。
By including these balance sheets we can see the full picture of what has
happened to the owner’s investment in the business。
Table 1。10 shows a simplified package of accounts。 We can see from these；
that over the year the business has made ￡600 of profit a。。er tax； and has
invested that profit in ￡200 of additional fixed assets and ￡400 of working
capital such as stock and debtors； balancing that off with the ￡600 put into
reserves from the year’s profits。
FILING ACCOUNTS
A pany’s financial affairs are in the public domain。 As well as keeping
HM Revenue and Customs （HMCR） informed； panies have to file
Table 1。10 A package of accounts
Balance sheet at 31 Dec 2009 P & L for year to 31 Dec 2010 Balance sheet at 2010
￡’s ￡’s ￡’s
Fixed assets 1；000 Sales 10；000 Fixed assets 1；200
Working capital 1；000 less cost of sales 6；000 Working capital 1；400
2；000 Gross profit 4；000 2；600
less expenses 3；000
Financed by Profit before tax 1；000 Financed by
Owners’ equity 2；000 Tax 400 Owners’ equity 2；000
Profit a。。er tax 600 Reserves 600
2；600
Accounting 39
their accounts with panies House （wwwpanieshouse。gov。uk/
about/gbhtml/gb3。shtml）。 Accounts should be filed within 10 months of
the pany’s financial year…end。 Small businesses （turnover below ￡5。6
million） can file abbreviated accounts that include only very limited balance
sheet and profit and loss account information and these do not need to be
audited。 Businesses can be fined up to ￡1；000 for filing accounts late。
You can find the report and accounts for all panies listed on UK
stock markets at Free pany Report and Accounts （fcreports。
）。 US pany accounts can be obtained from The Securities Exchange
mission （sec。gov）。 The Investor Relations Society （irs。
uk 》 IR Best Practice） makes an award each year to the pany producing
the best set of report and accounts。
FINANCIAL RATIOS
Earlier in this chapter the two important financial statements of profit
and loss account and balance sheet were examined。 To recap – the trading
performance of a pany for a period of time is measured in the profit and
loss account by deducting running costs from sales ine。 A balance sheet
sets out the financial position of the pany at a particular point in time；
usually the end of the accounting period。 It lists the assets owned by the
pany at that date matched by an equal list of the sources of finance。
Reading pany accounts； with practice； you can get some insight into
a pany’s affairs。 paring the current year’s figure with the previous
year’s figure can identify changes in some of the key items； but conclusions
drawn from this approach can be misleading。 Consider the situation shown
in Table 1。11。
You can see that the table is nothing more than a simplified profit and
loss account on the le。。 and the assets section of the balance sheet on the
right。 Any change that increases net profit （more sales； lower expenses；
less tax etc）； but does not increase the amount of assets employed （lower
Table 1。11 Factors that affect profit performance
￡ ￡ ￡
Sales 100；000 Fixed assets 12；500
– Cost of sales 50；000
= Gross profit 50；000 Working capital
– Expenses 33；000 Current assets 23；100
= Operating profit 17；000 – Current liabilities 6；690 = 16；410
– Finance charges 8；090 Total net assets 28；910
= Net profit 8；910
40 The Thirty…Day MBA
stocks； fewer debtors etc）； will increase the return on assets。 Conversely；
any change that increases capital employed without increasing profits in
proportion will reduce the return on assets。
Now let us suppose that events occur to increase sales by ￡25；000 and
profits by ￡1；000 to ￡8。910。 Superficially that would look like an improved
position。 But if we then discover that in order to achieve that extra profit
new equipment costing ￡5；000 had to be bought and a further ￡2；500 had
to be tied up in working capital （stock and debtors）； the picture might not
look so a。。ractive。 The return being made on assets employed has dropped
from 31 per cent （8；910 / 28；910 × 100） to 27 per cent （9；910 / ＇28；910 ＋ 5；000 ＋
2；500＇ × 100）。
ANALYSING ACCOUNTS
The main analytical approach is to examine the relationship of pairs of
figures extracted from the accounts。 A pair may be taken from the same
statement； or one figure from each of the profit and loss account and
balance sheet statements。 When brought together； the two figures are called
ratios。 Miles per gallon； for example； is a useful ratio for drivers checking
one aspect of a vehicle’s performance。 Some financial ratios are meaningful
in themselves； but their value mainly lies in their parison with the
equivalent ratio last year； a target ratio； or a petitor’s ratio。
Before we can measure and analyse anything about a business’s accounts
we need some idea of what level or type of performance a business wants
to achieve。 All businesses have three fundamental objectives in mon；
which allow us to see how well （or otherwise） they are doing。
Making a satisfactory return on investment
The first of these objectives is to make a satisfactory return （profit） on the
money invested in the business。
It is hard to think of a sound argument against this aim。 To be satisfactory
the return must meet four criteria：
1。 It must give a fair return to shareholders； bearing in mind the risk they
are taking。 If the venture is highly speculative and the profits are less
than bank interest rates； your shareholders （yourself included） will not
be happy。
2。 You must make enough profit to allow the pany to grow。 If a business
wants to expand sales it will need more working capital and eventually
more space or equipment。 The safest and surest source of new money
for this is internally generated profits； retained in the business： reserves。
（A business has three sources of new money： share capital or the owner’s
Accounting 41
money； loan capital； put up by banks etc； retained profits； generated by
the business）。
3。 The return must be good enough to a。。ract new investors or lenders。
If investors can get a greater return on their money in some other
parable business； then that is where they will put it。
4。 The return must provide enough reserves to keep the real capital intact。
This means that you must recognize the impact inflation has on the
business。 A business retaining enough profits each year to meet a 3％
growth is actually contracting by 1％ if inflation is running at 4％。
Maintaining a sound financial position
As well as making a satisfactory return； investors； creditors and employees
expect the business to be protected from unnecessary risks。 Clearly； all
businesses are exposed to market risks： petitors； new products and
price changes are all part of a healthy mercial environment。 The sorts
of unnecessary risk that investors and lenders are particularly concerned
about are high financial risks； such as overtrading。
Cash…flow problems are not the only threat to a business’s financial position。
Heavy borrowing can bring a big interest burden to a small business；
especially when interest rates rise unexpectedly。 This may be acceptable
when sales and profits are good； however； when times are bad； bankers；
unlike shareholders； cannot be asked to tighten their belts – they expect to
be paid all the time。 So the position audit is not just about profitability； but
about survival capabilities and the practice of sound financial disciplines。
Achieving growth
Making profit and surviving are insufficient achievements in themselves to
satisfy either shareholders or directors or ambitious MBAs – they want the
business to grow too。 But they do not just want the number of people they
employ to get larger； or the sales turnover to rise； however nice they may
be。 They want the firm to bee more efficient； to gain economies of scale
and to improve the quality of profits。
ACCOUNTING RATIOS
Ratios used in analysing pany accounts are clustered under five