There are three main financial statements created by accounting processes: the cash flow statement, the income statement (also called revenue statement, profit and loss (P&L) , and the balance sheet.
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The income statement is a summary of the income earned and the expenses incurred over a trading period.
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The main classification of items in the income statement are revenues, cost of goods sold (COGS) and expenses.
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Profit is the difference between revenue and expenses.
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The balance sheet shows the overall financial stability of the business.
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The main items in the balance sheet are assets, liabilities and owners’ equity.
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Assets are items of value to the business and can be either current or noncurrent.
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Liabilities are debts or business borrowing and can be either current or noncurrent.
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Owner’s equity items refers to the owners’ claims and is considered a liability from the point of view of the business.
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The balance sheet equation is: Assets = Liabilities + Owner’s equity or A = L + OE.
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Cash flow is the movement of cash in and out of the business over a period of time. Management is required to make sure payments are made and received without creating a cash flow problem.
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A cash flow statement shows the movement of cash receipts (inflows) and cash payments (outflows) over a period of time.
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Cash flow statements are divided into three categories: cash flows from operating activities, those from investing activities and those from financing activities.
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Liquidity is used to describe whether a business has a good or adequate cash flow.
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It is vital for a business to be able to manage its borrowings and to use appropriate types of borrowings.
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Profitability is the earning performance of the business and indicates its capacity to use resources to maximise profit.
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The income statement is used to measure the profitability or earning capacity of the business. Figures from this statement are used to calculate the gross profit and net profit ratios.
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The return on equity ratio shows how effective the funds contributed by the owners have been in generating profit, and hence a return on their investment.
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Liquidity is the extent to which the business can meet its financial obligations in the short term.
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Current assets and current liabilities determine the liquidity or short-term financial stability of a business.
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A current ratio of 2:1 indicates a sound financial position.
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Gearing measures the relationship between debt and equity.
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Gearing is the proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business.
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Financial planning is essential if a business is to achieve its goals. Financial planning determines how a business’s goals will be achieved.
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Planning processes involve the setting of goals and objectives, determining the strategies to achieve those goals.
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Budgets provide information in quantitative terms (facts and figures) about requirements to achieve a particular purpose.
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Budgets are often prepared to predict a range of activities relating to short-term and longer term plans and activities.
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A business can overextend financially by:• – hire purchase or leasing over commitments
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A business can overextend financially by:• – purchasing excess stock
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A business can overextend financially by:• – employing too many staff for the business’s current needs.
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To avoid overextending financially, a business should:• – undertake thorough planning
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To avoid overextending financially, a business should:• – avoid overdependence on debt financing.
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To avoid overextending financially, a business should:• – grow at a sustainable rate.
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Overextension of stock ties up a business’s cash and can lose revenue.
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Overextension of staff results in employing too many staff.
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Overextending expenditure can create a high degree of business risk.
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To increase profitability, a business should decrease Cost of goods sold by finding a new supplier or buying online
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To increase profitability, a business should decrease costs such as admin or wages ( put on a casual, reduce hours, employ younger staff or outsourcing)
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To increase profitability, a business should increase sales by increasing marketing, changing marketing strategies, or by increasing or decreasing the mark up of products sold.
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To increase cash flow, a business could defer buying assets or leasing assets
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To increase cash flow, a business could decrease drawings or increase equity into a business by contributing more capital into the business.
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