General Accounting Part 2
There are a number of terms used in Accounting, which are often not fully understood. Below are some short explanations of basic terms used in Income Statement and Balance Sheet reports.
Income Statement
This report is also referred to as a ‘Statement of Comprehensive Income’ or a ‘Profit and Loss Report’. An Income Statement report is always extracted for a specific period in a financial year and often reflects the year to date values as well. Comparison figures against budgets or previous financial years may also be included.
Revenue or Income
This refers to the income a business derives from selling products and services and also by renting assets. Income such as interest on investments will not form part of the main revenue value, but will be reported as ‘Extraordinary Income’ and will not be used to calculate Gross Profit.
Cost of Sales
This is the direct cost of making sales of products (stock). It is also referred to as Cost of Goods Sold (COSG). The formula for calculating the Cost of Sales is ‘Opening Stock’ plus ‘Purchases’ less ‘Closing Stock’.
Stock (Inventory) is often revalued due to valuation methods such as FIFO (First In First Out) or Average Cost and also, in some cases, by adding in certain costs such as labour to the stock value. All of these adjustments to the value of the stock will impact the Cost of Sales. So it is important to remember that the Cost of Sales is often not just the purchase price of the stock.
To give a simple example. A stock item is purchased for R500.00. This purchase will not be reflected in the Income Statement but will increase the stock value under Current Assets in the Balance Sheet. When the stock is sold for R800.00, the stock value under Current Assets is reduced by R500.00 and posted into Cost of Sales. This the sale of R800.00 less Cost of Sale of R500.00 gives a Gross Profit of R300.00.
Should the stock be revalued to R525.00 due to an Average costing being used, then the Cost of Sale value will be R525.00 and the Gross Profit R275.00
Gross Profit
This value is calculated by subtracting the Cost of Sales from Revenue (sales). It is also called Gross Margin. This revenue can be derived from both stock and services, depending on the type of business. Gross Profit represents the value at which the item was sold (excluding VAT) less the Cost of Sale of the item. The Cost of Sale consists of direct costs incurred in the selling and production of the item. Gross Profit shows the efficiency of the business in making sales. Gross Profit Margin is the ratio of Gross Profit to Revenue. It is a percentage showing how much Gross Profit exceeds the Cost of Sales.
Expenses
These are costs that are incurred by the business that are not directly associated with the products or services which make up the revenue. Some examples are advertising, accounting fees, rental, electricity, bank charges, stationery, etc.
Net Profit
This value is calculated by subtracting the Expenses from the Gross Profit figure and adding any other income. This figure shows the actual profit or loss made by the business. Net Profit Margin is the ratio of Net Profit to Revenue. It is a key ratio of profitability.
Balance Sheet
This report is also referred to as a Statement of Financial Position. A Balance Sheet report is always extracted for a specific point in time and not just for a specific period. The Balance Sheet is one of the core financial reports. Comparison figures against budgets or a previous financial year may also be included. The Balance Sheet has two sections and the totals of each section must be equal to each other. Hence the name Balance Sheet. The sections are one of these formats.
- Equity = Assets – Liability
- Assets = Liability + Equity
Assets
Assets are divided into two sections.
- Fixed or Non-Current Assets.
These are assets that are not expected to be used or sold within the financial year. These assets will usually have depreciation values against them. Some examples of Fixed Assets are:
o Property
o Machinery & Equipment
o Investments
o Goodwill
- Current Assets.
These are assets that fluctuate over the financial year. Some examples are
o Stock (inventory) Holding
o Bank Accounts
o Monies owed by Debtors
Liabilities
Liabilities are divided into two sections:
- Non-Current (Long Term) Liabilities.
These are liabilities that that will not be paid within a financial year. Some examples are
o Long Term Loans to the business
- Current Liabilities.
These are liabilities that fluctuate within a financial year. Some examples are
o Monies due to Creditors (Suppliers)
o VAT, PAYE liabilities
o Bank Overdraft Account
Equity
Equity is the value that the shareholders of a business owner as opposed to what has been borrowed. It is also known as Net Worth. The formula for calculating Equity is Total Assets less Total Liabilities. Equity is comprised of:
- Share Capital
- Retained Income
- Shareholder Loans
Ratios
Below are some common ratios that are used to measure profitability and the health of a business.
- Debt-To-Equity Ratio
This ratio shows the proportion of Equity and Debt (Liabilities) to finance the Assets of the business.
The formula is Total Liabilities / Equity - Current Ratio
This ratio indicates the ability of the business to pay back its Current Liabilities. It is also known as the cash asset ratio, cash ratio, and liquidity ratio.
The formula is Current Assets / Current Liabilities - Quick Ratio
The quick ratio is an indication of the shorty term liquidity of a business. It is also known as the acid test ratio or the quick assets ratio. A higher ratio is positive.
The formula is Current Assets (Stock) / Current Liabilities• - Return on Equity (ROE) Ratio
The return on equity is the Revenue returned as a percentage of Equity. It indicates how profitable a business is using the money invested by its shareholders. The return on equity ratio is also referred to as the return on net worth.
The formula is Net Income / Shareholder’s Equity - Net Profit Margin
This percentage shows how well a business uses its Revenue to make a profit. A higher net profit margin indicates that the business is containing its costs well.
The formula is Net Profit / Net Sales
Bad terminology is the enemy of good thinking. – Warren Buffett
