4M BG

He would not include the bus tickets as they have been used and there is

no future benefi t to be derived from them.

To evaluate whether the day has been successful he needs to compare

the assets of the business with the amount originally invested.

Original capital $500

Profi t $130 Analysed in the income statement

Total equity $630

The increase in value is the profi t that has been earned. This can be

analysed in more detail in the income statement.

The income statement – day 1

The profi t has been earned by selling the dusters at more that they cost

to purchase. Money was also spent on an item that has no future benefi t

(the bus fares) and therefore this must be deducted in arriving at the profi t

earned.

Sales $250 50 dusters at $5 each

Less: cost of dusters sold ($100) 50 dusters at $2 each

Less: bus fares ($20)

Total profi t $130

Only the cost of the dusters that were sold is deducted in arriving at

the profi t. The cost of the other 150 dusters originally purchased is shown

as inventory on the balance sheet as it will provide the basis for future

trading.

In financial statements, the convention for showing negative numbers

is to put them in brackets. Hence in calculating the profi t, the cost of the

dusters and the bus fares are deducted from the revenue received.

The cash fl ow – day 1

The cash fl ow is like a bank statement, though in this example it is a

summary of the physical cash payments and receipts. It starts with the

original capital invested and shows all the cash received and paid out.

GUIDE TO FINANCIAL MANAGEMENT

32

Capital invested $500

Add: sales $250 50 dusters at $5 each

Less: dusters bought ($400) 200 dusters at $2 each

Less: holdall ($50)

Less: bus fares ($20)

Closing balance $280

Day 2

On day two the business becomes more successful, but also more complicated.

Travelling further on buses for $30, the salesman sold 60 dusters for

$5 each. He also sold 30 dusters to a part-time offi ce cleaner for $4 each,

but the offi ce cleaner promised to pay for them at the end of the week

when he received his next pay cheque. Running low on dusters for day

three, he went back to the wholesaler, opened an account and purchased

100 more dusters on credit. At the end of the month he will have to pay

the wholesaler.

The balance sheet – day 2

Again adding up the items in his possession at the end of the day that

have future benefi t for the next day and beyond, he would produce the

following:

Holdall $50

Inventory $320 160 dusters at $2 each

Money due from customer $120 30 dusters at $4

Cash $550 Analysed in the cash fl ow

Total assets $1,040

It is valid to include the money due in the balance sheet as the customer

has taken some of the stock on the basis that he will pay for it in the

future. Therefore there is a future benefi t of the cash receipt.

Although this accumulation of assets looks successful, the obligation

to the wholesaler also needs to be included as it is a future claim on the

business.

 

Money due to supplier $200

Original capital $500

Profi t $340 Analysed in the income statement

Total liabilities $1,040

 

The income statement – day 2

The income statement summarises a period of trade and in this example

covers day 2. The profi t for day 1 is added on at the end of the statement

to arrive at the total profi t earned by the business.

Sales: cash $300 60 dusters at $5 each

Sales: credit $120 30 dusters at $4 each

Total sales $420

Less: cost of dusters sold ($180) 90 dusters at $2 each

Less: bus fares ($30)

Profi t: day 2 $210

Profi t: day 1 $130

Total profi t $340

The sale on credit can be included in revenue at this stage as the goods

have been delivered and the business has performed all it needs to do to

fulfi l its part of the transaction. The only matter outstanding is to collect

the cash which, until it is received, puts the business at risk.

The cash fl ow – day 2

The cash fl ow continues where it fi nished the day before with the opening

balance for day two being the closing balance for day one. The new cash

received and that paid out during day two are the only items shown.

Opening balance $280

Add: sales $300 60 dusters at $5 each

Less: bus fares ($30)

Closing balance $550

Having introduced the core elements involved in the three statements,

the next stage is to look at the details of the complete statements.

The balance sheet

The balance sheet provides a snapshot of the business showing the

assets owned, liabilities owed and the money put in by investors at

a particular moment in time, typically the end of a month or year as

follows:

_ An asset is something that is owned by the business and has

a future value either through its conversion to cash (such as

inventory or receivables) or by its use in the business (such as a

piece of property, plant or equipment).

_ A liability is an obligation to pay a business or individual at a

future date. This can be either short term (such as payables due to

suppliers) or long term (such as debt).

Ironically, a business does not create wealth for itself. Any profi t that

is generated belongs to the investors who risked their capital in establishing

the business. Therefore any profi t earned becomes a liability of the

business as it belongs to the investors. Through this principle the assets

in a business will always equal the liabilities and a balance sheet will

indeed balance.

The balance sheet does not value a company as many assets are

recorded at their original cost (known as historic cost) when they were

fi rst acquired. Hence after many years, even allowing for depreciation

(see Chapter 5), items such as property, plant and equipment may on the

balance sheet have a much lower value than what they are worth to the

business or indeed their market value. The value of a company is its future

potential as an earning machine rather than the historic collection of assets

it has amassed.