Study Block 3 Readings 21 to 26 before attempting TMA 03

Getting Started with Accounting and Finance

Before you read TMA 03, you should study Block 3 Reading 21:  ‘Getting Started with Accounting and Finance’. This reading will help you appreciate one crucial purpose of accounting and financial information: to understand and improve the finances of any business. TMA 03 will assess your knowledge of how such information is used to understand and improve a particular business’ financial position, the one illustrated in the TMA 03 case study.

Your next step is to complete Block 3 Reading 22, entitled ‘Different Legal Forms of Business’. Pay particular attention to the information on a Private limited company (or ‘Ltd’), because the business case study in this TMA will always take this legal form. It is important, however, to remember that the basic principles of accounting and finance apply to any kind of business.

TMA 03 will assess your understanding of the core material of Block 3:  Readings 23 to 26.  In this material you will study the financial statements of Pipes & Installations Ltd, which are explained in Readings 23 to 25. Reading 26 will introduce you to financial ratios, which are the basis for analysing any business. The challenge of TMA 03 is to apply what you learn from Readings 23 to 26 to a different business, with different challenges.

Reading 23 will help you to understand the income statement and how it can be used to analyse the income and expenses of Pipes & Installations Ltd in their most recent financial year.  A crucial aspect of such an analysis is to compare the latest financial performance of the business with that of the previous financial year.  This involves comparing not just the profit or loss made over both years, but every line of income and expense. This helps to understand where the business is doing well and where it is struggling.    

Reading 24 will help you to understand the balance sheet and how it can be used to analyse the financial position of Pipes & Installations Ltd at a particular moment in time (namely, the last day of their most recent financial period). The balance sheet lists the financial resources, including cash (collectively referred to as assets) that the business owns and provides a breakdown of the financial obligations (usually referred to as liabilities) that the business owes. Whereas some liabilities are current and need to be paid within a year, others are non-current (e.g., bank loans) and are payable over a longer time span.

Different Legal Forms of Business

The difference between the total assets and total liabilities figures in the balance sheet equals the net worth of the business. This net worth is the accounting value of the business, and is also referred to as the capital or equity of the enterprise. When a profit is recorded in the income statement, the capital or equity figure in the balance sheet increases. When a loss is made, instead, the opposite happens (i.e., the net worth of the business decreases).

Reading 25 explains the cash flow statement. This statement gives crucial insight into how cash is generated and used in the financial year leading up to the latest balance sheet. Cash is the only asset that can be used immediately to pay off debts or for sudden emergencies or opportunities, so needs to be managed very carefully. A business may have earned a large profit as shown in the income statement, but still not have enough cash available to stay in business. The accumulated or retained profit of a business (also known as capital reserves) that are invested, for example, in current assets such as inventory, or non-current assets such as machines, may not be easily or quickly converted into cash when it is unexpectedly and urgently needed.  

Reading 26 will introduce you to seven ratios that are the basis for analysing the financial performance and health of any business. While you will study how they apply to a particular situation, that facing Pipes & Installations Ltd, the same knowledge can be applied to any business, including the case study you will encounter in TMA 03.

The first three of these ratios assess financial performance. They address some key questions that stakeholders in a business want answers to.

1.What financial return do the owners of a business currently get for their investment?  

2.How does the current return on investment compare with the previous year?

3.What is the profit or loss figure for the last financial year, and what are the different income and expenditure figures that determine this profit or loss?

4.How do these figures compare to those of the previous year?

The second four of these seven ratios assess financial health. They address other key questions that stakeholders in a business want answers to.

1.Does the business have enough current assets to pay current liabilities, such as bank overdrafts, corporation tax and payables as they fall due in the current financial period?  

2.How is the business managing its inventory and its receivables in order to ensure that these two crucial current assets are used sensibly and efficiently to sustain and grow the business?  

3.How much long-term debt does the business have compared to its net worth, also known as its total capital or equity?

Long-term liabilities, like current liabilities, have to be paid irrespective of the business’ ability to make profit and to generate cash. The greater the business depends on long-term debts such as bank loans, the greater the risk the business takes with respect to its future survival. A limited company, such as Pipes & Installations Ltd and the one you will encounter in the TMA 03 case study, only needs to pay dividends to its owners or shareholders when it chooses to. It will, however, have to pay the bank interest on its loan every year, irrespective of whether it can afford it or not.

For any business situation, such as the one in your TMA 03 case study, the answers to the seven financial ratios might reveal areas of the business that need specific actions to be taken to improve financial performance and health. Such actions should be expressed in specific goals that need to be properly identified and managed. These might include:

·reducing certain significant expenses by a planned amount  because they have got out of control

·investing in advertising by a planned amount  to generate sales revenue

·investing in new software by a planned amount to reduce administrative expenditure

·reducing the amount owed by customers by a planned amount by employing a credit controller