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A BRIEF INTRODUCTION TO COMPANY ACCOUNTS Our discussions of applying accounting principles have been limited to sole proprietorship, where

one owner and/or few of his/her close associates manage the whole organisation. As a business institution grows, it becomes increasingly harder for a few individuals to manage the entire enterprise and the necessity for the corporate form of organisation becomes increasingly important. A corporate form of organisation is not owned by one or few individuals. Although a number of individuals have to assume the task of its formation. Once the incorporation of the organisation is complete through registration under the companies act of the country, its ownership is offered to the public for subscription. The subscribers of the company (called the common shareholders) then appoint the governing body (the board of directors). The board then employs the management to look after the day-to-day affairs of the business. Accounting for companies follows the same principles and procedures as for a sole proprietorship, but the structure and composition of its accounts are somewhat different from those of a sole proprietorship. In fact, a service organisation or a merchandising firm can operate under the corporate structure. Global fast-food giants like McDonalds, DHL, and Federal Express are all service organisations operating under the corporate structure. Likewise, Wal-Mart and Marks & Spencer are examples of corporate merchandisers. The major difference in the accounting a company from a sole proprietorship is in its capital formation. The capital of a sole proprietorship comes mainly from the owner of the business. If needed, the owner may borrow some money from some private sources and financial institutions. On the other hand, a company mobilises its capital from selling ownership rights called common stock to the general public. These shares of common stock are then bought and sold in the securities markets. Whoever has bought a share of the company becomes a partial owner of the company. The company can also borrow money from public by selling debt instruments called bonds and debenture. These bonds and debentures are also traded in the securities markets. In addition, companies often sell a special type of equity called preference share to the public. The owners of preference shares generally are not allowed to participate in the voting to elect the board of directors, but they get preference over the common shareholders over sharing the companys profit. The profit of a company that it distributes among its shareholders is called dividend. A company rarely distributes its entire profit as dividend. It keeps a certain portion of the profit for future investment and cash flow need. The portion of the companys profit that is not distributed as dividends are called retained earnings. Common stock and preferred stock have a par value, which represents the amount of equity participation in the company. Similarly, bond have a par value which is the actual amount borrowed by the company. If a company performs well financially the price of its shares bonds increase (said to be selling at a premium). If the companys financial performance deteriorates its share and bond prices fall. If the share prices fall below the par, they are said to be selling at a discount. If the company sells its shares to the public at a price above or below the par value, the

difference between the par value and the sales price is called paid in excess (or short) of par. Companies often buy their own shares of common stock to manage their market prices. Such shares do not represent any voting right and are kept in an equity account called Treasury stock. The company can later from its treasury stock to the public, which then regain their voting rights. Share of common stock that remain in the hands of public are called shares outstanding. Let us now take a quick look at the items of the consolidated BALANCE SHEET of a corporate form of organisation. ASSETS: A: Current Assets: Cash Marketable Securities (investments in government securities. Up to 100% redeemable) Accounts Receivable Inventory (Raw materials, Work-inprocess and Finished goods) Prepaid and advances LIABILITIES: A: Current Liabilities: Accounts Payable Short-term Notes Payable Short-term Loans Accruals SHAREHOLDERS EQUITY Common Stock at Par Paid-In Excess (short) of Par Preferred Stock Retained Earnings Treasury Stock B: Fixed Assets: Property, Plant and Equipment Natural Resources Long-Term Investments (money used in procuring assets that are not used for the companys main operations).

B: Long-Term Liabilities: Long-term Notes Payable Bonds and Debenture Long-term loans Mortgaged Loans.

The Consolidated INCOME STATEMENT of a company looks as follows

Net Sales Less Cost of goods Sold = Gross Profit from Sales Less Fixed Operating Expenses Less Depreciation Expense = Operating Income (EBIT) Less Interest Expense = Pre-tax Income (EBT) Less Taxes = Net Income (EAT) Less = Less = Dividend to Preferred Stockholders Earnings Available to Common Stockholders Dividend to Common Stockholders Addition to Retained Earnings.

FINANCIAL RATIOS Financial ratios are indicators of a companys performance as discernable from the companys Balance Sheet and income Statement. We will discuss some of the simple ratios of a company and talk about their significance. Liquidity Ratios: Show the companys ability to pay of its current liabilities from its current assets.
Current Assets

1. Current Ratio

Current Liabilities

Current assets should be significantly higher than current liabilities so that the current ratio is higher than 2:1. Reduces the numerator of the current ratio formula by deducting Inventory (the least liquid of the current assets). The Numerator should High enough so that the quick ratio is at least 1:1.

Current Assets - Inventory

2. Quick Ratio (Acid Test Ratio)

Current Liabilities

or
Cash + Mktbl. Securities + Acct Receivable Current Liabilities

Asset Management Ratios: Show the companys efficiency in using its assets in generating sales. Generally, high asset management ratios indicate high level of efficiency in utilising assets.
Accounts Receivables

1. Average Period (ACP)

collection

Net Sales/360

Shows the average number of days taken by the company to collect its

receivables. The lower the ACP, the better.


Cost of Goods Sold

2. Inventory Ratio (ITO)

Turnover

Inventory

Tells how quickly inventory is converted to sales. The higher the ITO, the better. Tells how efficiently fixed assets are used to generate sales. The higher the FAT, the better. Tells how efficiently all assets are used to generate sales. The higher the TAT, the better.

Net Sales

3. Fixed Asset Turnover (FAT)

Fixed Assets

Net Sales

4. Total Asset Turnover (TAT)

Total Assets

Debt Management Ratios: Show the optimum amount of the firms Debt compared to its assets and equity. Debt should not be too high to cause inability to repay them or too low to lose the opportunity to avail low interest rate. 1. Debt to Asset Ratio (D/A)
Total Debt Total Assets

Debt should be low enough to be covered by its total asset because if incomes are too low assets may have to be sold off to repay the debt. No need to explain its implication at this level of studies. We will talk about it when we read courses in financial management and Advance level accounting. Tells how much decline in operating income the company can withstand before it is no longer able to pay off its interest expense.

2. Debt to Equity Ratio (D/S)

Total Debt Total Equity

EBIT

3. Times Interest Earned (TIE)

Interest Expense

Profitability Ratios: Show the companys ability to earn different types of profits and return compared to the capital employed. 1. a. Gross Profit Margin a. Gross Margin/Net Sales (GPM) b. EBIT/Net Sales b. Operating Profit c. EAT/Net Sales Margin (OPM) c. Net Profit Margin (NPM)
EAT

A comparative analysis can show where the company should earn more and where the company should cut more spending. Shows how much the company is earning after tax compared to total investment in assets. Shows how much the company is earning after tax compared to total investment made by the owners of the company, the shareholders.

2. Return on Asset (ROA)

Total Assets

EAT

3. Return (ROE)

on

Equity

Total Equity

Market Value Ratios: Shows how the companys share price is appealing the current and potential investors
Earnings to Common Stockholders

1. Earnings Per Share (EPS)

# shares of Common Stock Outstanding

Shows how much of the companys reported profit a common stockholder is receiving per share. Tells how much a potential investor would be willing to pay for a currency unit (e.g. Taka, dollar, etc.) of the companys reported profit.

2. Price Earnings Ratio (P/E)

Market Price of Common Stock EPS

Bases for analysing financial ratios:


1.

Ratios have to be compared with the ratios in the previous years to see improvements in financial performance have been achieved. (Trend Analysis)

2.

Ratios have to be compared with ratios for the same time period of the immediate competitors. (Benchmarking) Ratios have to be compared with the industry norms set up by the business bodies for a specific industry. (Cross sectional analysis)

3.

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