UNDERSTANDING CAPITAL AND PROFITInt

UNDERSTANDING CAPITAL AND PROFIT

Introduction

No business will succeed unless it has a sound financial foundation.

This means that the capital invested in the firm must:

be sufficient for its needs,

be organized in the most efficient way.

But what is capital?

Unfortunately, the word capital is used in many ways. Even within the business world, it has various meanings. It is very important that, when you see the word, you ask yourself In what way is this word being used?

Capital, assets and liabilities

To understand the ways in which the word capital is used, it is necessary to appreciate the nature of a firm’s assets and liabilities.

What are assets?

Assets consist of all the thing a firm owns, whether these are paid for or not.

Assets fall into groups. These are:

Fixed assets

These remain in the firm for a relatively long period of time. Examples include land, premises, machinery, equipment, vehicles. ‘Fixed assets’ is sometimes referred to as fixed capital – that is, the amount of capital invested in the fixed assets.

Current assets

These are constantly being used and replaced during everyday business. Examples include stocks (of both raw materials and finished goods), debtors and cash. They are sometimes called current or circulating capital. This is because they circulate (‘go round’ in a circle) in normal trading in the following way.

The raw materials are turned into finished goods.

The finished goods are sold to customers.

The customers pay cash.

The cash is used to buy more raw materials.

What are ‘liabilities’?

Liabilities are the debts the firm owes to others.

Most films purchase their assets, particularly their stocks, on credit. This means that the goods have been purchased and are owned by the firm, but they will not be paid for until later. Debts are liabilities.

They may be:

Long-term liabilities

These are debts not repayable for at least a year. Long-team loans are an example.

Current liabilities

These are debts which are repayable within a year. Trade creditors (that is, firms from whom goods have been bought on credit) are the main example.

Presentation of accounting information

Requirements of an accounting system

The recording and presentation of financial information is the responsibility of the accounting division headed headed by the finance manager.

The first three requirements are met by specific parts of the accounting system. The day-today transactions are first noted in the original documents, such as the invoices, credit notes and receipts. They are then summarized in day books before being fed into the ledger where their full effect is recorded. The ledger is made up of individual accounts – one for each item under which information is required.

From the ledger, the balances of some accounts are transferred to the trading and profit and loss account, which shows the profit for the year (that is, the second requirement above), or are summarized in the balance sheet to show the financial position at a given date (the third requirement above).

There is no simple document which directly gives the answer to the fourth requirement. This demands an intelligent interpretation of the whole accounting system (particularly) of the ratios we considered earlier in this chapter), coupled with a good understanding of such factors as economic trends, possible changes in the law, and statics generally.

The balance sheet

Managers will be primarily concerned with two accounting documents – the balance sheet and the Profit and loss account.

The balance sheet is a summary of the firm’s assets, liabilities and capital as at a given date. There are a number of ways in which it can be set out. The conventional way is to list the assets on the right-hand side of the document, and liabilities and capital on the left. Bear in mind that assets less the liabilities will always give the capital (that is, the ‘capital invested’ using the definitions above). This means that assets equal liabilities plus capital.

However, this old practice is changing and an increasing number of firms are showing the sides reversed. Companies normally present the data in ‘statement’ form showing liabilities as a deduction from assets, to give the capital.

Profit and loss account

The profit and loss account (usually abbreviated to P & L) shows how the profit (or loss) was made. It covers a period, and this is reflected in the title for the document. Notice the different nature of the items listed. They are descriptions of either how the money was earned, or of how the money was spent. The items do not have a continuing material existence of their own. The first part of a P & L, showing the ‘gross’ profit, is sometimes called a trading account (or trading section of the P & L).