Number of days' credit taken

In this case the figure for closing trade creditors is compared with that for the annual purchases.  

Annual costs of sales  $6 million
Trade creditors  $1.0 million
Number of days' credit taken

The calculation is (1.0 / 6.0) x 365 = 61 days

Number of days' credit granted

For example:

Annual turnover including GST  $10 million
Trade debtors $1.5 million
Number of days' credit  55

The calculation is:  (1.5 / 10) x 365 = 55 days

Obviously, the lower the number of days the more efficiently the business is being run.

The figure for trade debtors normally comes from the closing Balance Sheet and care should be taken that it is a figure typical of the whole year.

If $1.5 million of the $10 million turnover came in the final month, the number of days' credit is really 31 instead of 55.

The calculation is:  (1.5 / 1.5 ) x 31 = 31 days

Care should also be taken that the GST-inclusive debtors figure is compared with the GST-inclusive turnover figure.

GST is normally excluded from the Profit and Loss Account.



GST = General Sales Tax
In other countries, it is the VAT or Value Added Tax.

Stock Turn or Inventory Turn

For example:

Annual turnover  $10 million
Annual cost of sales (60%)  $6 million
Stock value $1.5 million
Stock turn 4


This measures the number of times that total stock is used (turned over) in the course of a year.

The higher the stock turn the more efficiently the business is being run, though adequate safety margins must of course be maintained.

It is important that the terms are completely understood and that there are no abnormal factors.

Normally the definition of stock includes all finished goods, work in progress and raw materials.

The stock value will usually be taken from the closing Balance Sheet but you need to consider if it is a typical figure.

If the business is seasonal, such as a manufacturing of fireworks, it may not be.  

A better result may be obtained if the average of several stock figures throughout the year can be used.

Profit Turnover

For example:

Annual turnover $10 million
Annual profit before tax $1 million
Profit before tax to turnover 10%


This uses Profit before tax but it may be more useful to use Profit after tax.

Perhaps you want to define profit as excluding the charge for bank interest (EBIT or Earnings before Interest and Tax).

You should select the definition most relevant to your circumstances.

Return on Capital Employed

For example:

Capital employed $5 million
Annual profit after tax $1 million
Return on capital employed 20%

The profit may be expressed before or after tax.

Capital employed is the net amount invested in the business by the owners and is taken from the Balance Sheet.

Many people (including Warren Buffett) consider this the most important ratio of all.

It is useful to compare the result with a return that can be obtained outside the business.

If a bank is paying a higher rate, perhaps the business should be closed down and the money put in the bank.

Note that there are 2 ways of improving the return.  In the example above:

• the return on capital employed would be 25% if the profit was increased to $1.25 million.
• it would also be 25% if the capital employed was reduced to $4 million.

Reading the content of the Annual Report

The content of the Annual Report and Accounts is governed by the law and accounting standards, though directors do still have some discretion.

Listed companies are required to use international accounting standards.

If you are looking at the Report and Accounts of a listed company you will see the following:

• Independent Auditor's Report
• Balance Sheet (it might be called Statement of Financial Position)
• Statement of Comprehensive Income or it might be called Income Statement (this corresponds with the Profit and Loss Account)
• Statement of Changes in Equity
• Statement of Cash Flows
• Notes to the financial statements
• Chairman's Statement
• Directors' Report
• Business Review
• Directors' Remuneration Report

There is so much detail that there is really no substitute for diving in and having a look at the Report and Accounts of your chosen company.

Try not to get bogged down.  Best of luck.



Additional Notes:

Can you locate the following in the Report and Accounts of the company you are interested?

• the pre-tax profit (Profit and Loss Account)
• details of the fixed assets (Balance Sheet and supporting notes)
• the amount of any exports (the notes)
• is it an unqualified audit report? (the Audit Report)
• details of any political or charitable donation (the Directors' Report)
• was there a cash outflow in the period? (the Cash Flow Statement)
• details of the share capital (Balance Sheet and supporting notes)
• the amount of the capital employed (the Balance Sheet).

Consolidated Accounts

A large group may have a hundred or more companies.

It would obviously give an incomplete picture if each of these companies gave information just about its own activities.

This is especially true when companies in a group trade with each other.

This is why the holding company must include consolidated accounts as well as its own figures.

The effect of inter-group trading is eliminated and the Consolidated Balance Sheet gives the group's position in relation to the outside world.

This does not remove the obligation for every group company to prepare and file its own accounts.

Such accounts must include the name, in the opinion of the directors, of the ultimate holding company.

Cash Flow Statement

There are sometimes disputes about the figures in the Profit and Loss Account and Balance Sheet.

This is one reason why cash is so important.  

Cash is much more a matter of fact rather than of opinion.

It is either there or it is not there.

Whether the cash came from (banks, shareholders, customers) is also a matter of fact.

So too is where the cash went to (dividends, wages, suppliers, etc.).

The Cash Flow Statement gives all this information.

Late filing of financial accounts

Unfortunately, a small minority of companies file their accounts late or even not at all.

This is an offence for which the directors can be punished and the company incur a penalty, but it does happen.

It is often companies with problems that file late.

Why profit is listed with the liabilities in the Balance Sheet?

Assets and Liabilities in the Balance Sheet

• Assets in the Balance Sheet are the debit balances in the bookkeeping system.
• Liabilities in the Balance Sheet are credit balances in the bookkeeping system.

Credit and Debit Balances in the Profit Statement

• In the Profit Statement, sales and income are the credit balances.
• In the Profit Statement, costs are the debit balances.
• The net total of all the balances is the profit or loss.
• This one figure (profit or loss) goes into the Balance Sheet as a single item.
• A profit is a credit which is listed with the liabilities.

Explanation on why profit (a credit balance in the Profit Statement) is listed with liabilities in the Balance Sheet

• The explanation is that the profit belongs to someone outside the business. 
• If the Balance Sheet is for a company, the profit belongs to the shareholders.
• It may one day be paid to them in the form of a dividend or by return of capital on the winding up of the company.

Debit and Credit Balances

The first rule of double-entry bookkeeping is that for every debit there must be a credit.

This means that an accounting entry always involves one account being debited and another account being credited.

Let us consider what happens when a $20,000 car is purchased.

• The Motor Vehicle account (which is an asset) is debited with $20,000.
• The Bank Account is credited with $20,000.

Two accounting rules to Understand Balance Sheets

In order to understand the Balance Sheets, you must be familiar with the following two fundamental accounting rules:

• For every debit there must be a credit.
• Balance Sheet assets are debit balances and Balance Sheet liabilities are credit balances.

Depreciation

Fixed assets are assets that will have a value to the business over a long period, usually understood to be any time longer than a year.

They do usually lose their value:

• either with the passage of time (e.g. a lease),
• with use (e.g. a piece of machinery that wears out) or
• due to obsolescence (e.g. computers).

Therefore, they are written off over a number of years.

Depreciation is a book entry and no cash is involved.

The entry is:

• debit depreciation (thus reducing profit)
• credit the asset (thus reducing the value of the asset).

Fixed assets are grouped together in the Balance Sheet and one total is given for the net value of all of them.

Examples of fixed assets are:

• freehold property
• plant and machinery
• computers
• motor vehicles

Prudent Reserves

When something happens that causes an asset to lose value, it is written off.

• For example, if some stock (asset) is stolen, the value of the stock in the Balance Sheet is reduced.

The same thing must happen if a prudent view is that an asset has lost some of its value.

• For example, if some of the stock is obsolete and unlikely to sell for full value.
• Normally, the Balance Sheet will just show the reduced value, which will be explained with notes.

Stock reserve

The creation of a stock reserve reduces the profit.

• If it is subsequently found that the reserve was not necessary, the asset is restored to its full value and the profit is correspondingly increased in a later period.

Bad debt reserve

It is often necessary to create a bad debt reserve to cover money that may not be collectable from customers.

• This bad debt reserve reduces the profit.
• For example, loan loss reserve or provision by the banks.

Working Capital

This is the difference between current assets and current liabilities.

It is extremely important.

• A business without sufficient working capital cannot pay its debts as they fall due. 
• In this situation it might have to stop trading even if it is profitable.

Possible alternatives might include:

• raising more capital,
• taking out a long-term loan, or
• selling some fixed assets.

Try to get a long-term loan

A bank overdraft is repayable on demand.

A long-term loan is repayable at a future date, or more likely in installments over a period.

If times are hard (or even if they are not), there are obvious advantages to having a long-term loan instead of an overdraft, or as well as an overdraft.

So long as you do not breach the terms of the agreement, you cannot be forced to pay it back quickly.

This gives you peace of mind.

Get your customers to pay on time

Take it seriously and give the task the time and resources necessary.

Tel yourself that you are entitled to be paid on time and that you are being cheated if you are not.

Agree the terms in advance and make it clear that they should be honoured.

A good motto is "ask early and ask often".

If all else fails take legal action.

A tough but fair line will probably not upset your customers, but it might.

Ask yourself if you really want those customers.

Never forget the importance of working capital

Working capital is the difference between assets realizable in the short term and liabilities payable in the short term.

It includes cash held and money owed.

Quickly realizable assets are the next best thing to cash.

If you can get the working capital right, you should be safe.

Try hard to achieve this.

Never forget the importance of cash

"Cash is King"

Losses may eventually force a business to close but in the short term, lack of cash is likely to be the critical factor.

You should hoard cash and you should plan your cash flow very carefully - daily if necessary.

Talk to your bank early and explain your plans.

Cash should be the number one priority.

Keep an eye on the accounting ratios

These are always useful, but are particularly so if a business is in trouble.

You should know what is acceptable and you should monitor trends over a period.

If things are going wrong, this may spotlight the dangers and indicate where remedial action is needed.

Gearing and the number of days' credit given and taken may be especially useful.