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food is zero rated, which means that Amanda does not charge VAT on
sales, but VAT is charged on many of the goods and services she buys. In
this case, Revenue and Customs is a debtor and the amount in the Trial
Balance represents the amount of VAT that Amanda has paid, but not yet
recovered at her year end.
Legal costs. Is it something owned? No, then it must be an expense. What
type of expense is it? This is an administrative expense, so it would appear
below the ˜gross profit™ line.
Stock. Is it something owned? Yes, as stocks are the goods we are holding
with a view to sell later on. Will stock be owned for a year or more?
Hopefully not and if it were, it would have to be written off. Accordingly,
stock is a current asset.
Trade debtors. Is it something owned? Yes, as debtors are people or compa-
nies who owe us money and we certainly expect these debtors to pay us
within a year. Trade debtors are classified as current assets.
Cost of sales. Is it something owned? No, because ˜cost of sales™ is the direct
cost associated with the sales Amanda has made in the period. Cost of
sales is always the first item in the Profit and Loss Account after sales.
Rent (office). Is it something owned? No, then it must be an expense. Amanda
does not own her office, but pays the owner to be able to use it.
Fixtures and fittings. Is it something owned? Yes. Will it be owned for a year
or more? Yes. Can fixtures and fittings be seen and touched? Yes, then
they must be a tangible fixed asset. What has happened is that Amanda
has rented an unfurnished office and has had to furnish it. She could take
her fixtures and fittings with her if she moves to another office.
Van. Owned for over a year, can see and touch, so a tangible fixed asset.
Warehouse rent. Like ˜office rent™, but this time the rented space is a store for
Amanda™s finished products. Because this expense is incurred before the
goods are delivered to customers, it would come above the ˜gross profit™
line in the Profit and Loss Account.
Delivery costs. These are the costs associated with delivering the goods to
customers and would come under the heading of ˜distribution™ that fall
below the ˜gross profit™ line.
Stationery. Paper, envelopes, etc. might be something that Amanda owns at
the year end, but the value would be so immaterial that the full cost would
be expensed and being an administrative expense would come below the
˜gross profit™ line.
General insurances. This is another administrative expense.

27
Accounting and Business Valuation Methods

Wages. Here it is related to the warehouse manager who organised the trans-
port and is, therefore, an expense that comes above the ˜gross profit™
line.
National Insurance. It is the employer™s contribution of this tax, relating to
wages paid and accordingly falls into the same category. Employers deduct
income tax and national insurance from their employees and each month
they have to pay the sum of the amount they have deducted, plus their
contribution, to Revenue and Customs. It is the employer™s contribution
that appears in the Profit and Loss Account.
Interest. It is the amount paid to a lender, to compensate the lender for the
money he has loaned the business. In the Profit and Loss Account, interest
is charged after all other expenses, including extraordinary items, with
the exception of tax. But as Amanda is a sole trader, we are not accounting
for tax in the example shown.
Bank charges. It is the amount that the bank has charged for providing
banking services and is treated as an ordinary administrative expense.
Stock losses. It is the amount that has been lost because stock has gone
missing or lost value for whatever reason. It is usually charged above the
˜gross profit™ line.
Goodwill impairment. It is the amount that goodwill has had to be written
down, because its valuation cannot be justified based on the predicted
future earnings. Given ˜goodwill impairment™ is often an unexpected event
that does not regularly happen, it is treated as an extraordinary item in
the Profit and Loss Account.
Depreciation. It is a book entry having no impact on cash, which indi-
cates how much the assets have been written down in the financial year.
Depreciation on assets to do with production would be charged above
the ˜gross profit™ line, while all other depreciation would be regarded as
a distribution or administrative expense and would be charged below
the line.
Prepayments are payments made in advance and are regarded as debtors and
are accordingly classified as current assets.
Accounting and audit expenses are yet another administrative expense com-
ing below the ˜gross profit™ line.

If an item is on the credit side of a Profit and Account, then the question is: is
the item something the business owes? If the answer is yes, it is a liability and
will appear in the Balance Sheet. If the answer is no, then it will be income

28
Telling the story

generating and will appear in the Profit and Loss Account. We can now go
down the Trial Balance on the credit side.

Capital. Is this something the business owes? Yes, capital is what the busi-
ness owes to the owner of the business. Remember that although a sole
trader as a person and his or her own business are treated as the same
entity, the books of the business will not record any transactions that are
for personal use. A sole trader is not paid a wage or a salary, but rather is
taxed on the profits his or her business makes, but will still get the per-
sonal and other allowances given to salaried or waged employees based
on their personal circumstances. However, a sole trader has unlimited
liability, which means that if the business cannot meet all its debts, then
the sole trader will have to sell personal assets to make good. Will the
business owe capital to the owner of the business for a year or more?
Well, the owner of the business will certainly hope to stay in business for
a year or more, so capital is a fixed liability.
Loan. This is the amount that the business owes to the bank and as the
intention is to pay it off over 5 years, it is another fixed liability.
Trade creditors. Is it something the business owes? Yes, so it must be a
liability. Will the business still owe what will appear in the Balance Sheet
in a year™s time? No, because creditors are people the business owes money
to and they will certainly expect to be paid within 12 months. Therefore,
creditors are classified as current liabilities.
Sales. Is it something the business owes? No, so sales must be income
generating and therefore will appear in the Profit and Loss Account.
Accruals. They relate to goods and services received by the Balance Sheet
date, but not put through the books as a permanent entry at the Balance
Sheet date. Accruals are regarded as creditors and are therefore classified
as current liabilities.

So, now we have classified each item in the Trial Balance as either going
to the Profit and Loss Account or Balance Sheet; we can prepare these two
statements.



The Pro¬t and Loss Account
The Profit and Loss Account is simply a statement showing sales or income
over a set period, together with the costs associated with such sales or income
over the same period. Where sales or income exceed costs, a profit has been

29
Accounting and Business Valuation Methods

made and where costs exceed sales or income a loss had been incurred. Sales
relate to goods, while income (fees charged by an accountant or a solicitor, for
example) relates to services.

With the exception of certain businesses such as banks, insurance companies
and investment trusts (dealt with in chapter five), the Profit and Loss Account
is usually produced in the standard format:


Manufacturer Retailer Service Provider

Sales Sales Income
Less: direct production costs Purchases Direct cost (time
spent at cost)
= Gross margin Gross margin Gross margin
Less: Indirect production costs Product
modifications --------
= Gross profit Gross profit Gross profit
Less: Distribution costs Distribution costs
Administration costs Administration Administration
costs costs
= Profit before exceptional (as manufacturer) (as manufacturer)
items
Less: exceptional items (if any) (as manufacturer) (as manufacturer)
= Operating profit Operating profit Operating profit
Less: Interest Interest Interest
= Net profit Net profit Net profit



In the case of a sole trader, the net profit will be added to the capital, which
will be reduced by the sole trader™s drawings. The sole trader™s tax will be paid
out of his or her drawings. For a partnership, each partner has a capital account
and a current account and all adjustments are made to the current account. If
there is no partnership agreement, then profits will be shared as determined
by the Partnership Acts of 1890 and 1909.

Suppose there were three partners in the ABC Partnership, A, B and C, and
they put in capital of £20 000, £40 000 and £60 000, respectively. A worked
full time in the business, B worked part-time and C was a sleeping partner.



30
Telling the story

A ˜sleeping partner™ is one who puts capital into a business, but does not work
in it. Under the partnership agreement they have signed, profits/losses are to
be shared on the following basis and in the following order:


(1) The partners shall receive ˜notional™ interest at the rate of 10%.
(2) A shall receive a ˜notional™ salary of £40 000 and B shall receive a
˜notional™ salary of £25 000.
(3) Any remaining profits will be shared equally.
(4) In the event a loss is made, ˜notional™ interest will be paid, but ˜notional™
salaries will not be paid and remaining losses will be shared equally.


The word ˜notional™ means that it is not real in the sense that it is only being
used as a mechanism to divide up the profits. If the partnership does not make
a profit, then there is no share out. If the interest is ˜real™ rather than notional,
then each partner would receive interest in full even if the partnership made
a loss.

Based on the partnership agreement, we can work out the share of the profits if
(say) the partnership made a profit of £89 000, £9000 and £44 500, respectively,
or a loss of (£21 000):


A (£) B (£) C (£) Total (£)

Profit 89 000
Notional interest 2000 4000 6000 (12 000)
77 000
Notional salaries 40 000 25 000 Nil 65 000
12 000
Profit share 4000 4000 4000 12 000
46 000 33 000 10 000 89 000

A (£) B (£) C (£) Total (£)

Profit 9000
Notional interest 1500 3000 4500 (9000)
1500 3000 4500 9000



31
Accounting and Business Valuation Methods


A (£) B (£) C (£) Total (£)

Profit 44 500
Notional interest 2000 4000 6000 (12 000)
32 500
Notional salaries 20 000 12 500 Nil (32 500)
22 000 16 500 6000 44 500

A (£) B (£) C (£) Total (£)

Loss (21 000)
Notional interest 2000 4000 6000 (12 000)
(33 000)
Share of losses (11 000) (11 000) (11 000) 33 000
(9000) (7000) (5000) (21 000)


Partners, like sole traders, have unlimited liability. This means that if the
partnership makes a loss, each partner must make good their share of the loss
out of their own personal assets. Each partner is also responsible for paying
their own income tax. If the partnership pays a particular partner™s income tax,
then it counts as drawings and comes out of their current account.

Partnerships work on the basis that each partner is jointly and severally liable
to meet the partnership™s liabilities. Suppose, for example, the ABC Partnership
had liabilities of £21 000, which equated to the loss of £21 000 they made in
the year, and B was declared bankrupt. He was, therefore, unable to make good
his loss of £7000. In such a case, this loss would be allocated to A and C in
proportion to their own liabilities. So A would have to find an additional £4500
and C™s share would be £2500.




32
Telling the story

However, it is possible, in certain circumstances, to form limited partnerships
where each partner has a limited liability. Such partnerships are governed by
the Limited Liability Partnership Act 2000.

In the case of a partnership, the Profit and Loss Account would be completed
by reducing the net profit down to nil, as shown below:


Manufacturer Retailer Service Provider
Net profit Net profit Net profit

Less: transfer to the Partner™s
current account (as manufacturer) (as manufacturer)
Nil Nil Nil



In the case of a limited company, ˜net profit™ would be replaced by ˜profit before
tax™ and the Profit and Loss Account would carry on as below:


Manufacturer Retailer Service Provider
Profit before tax Profit before tax Profit before tax
Less: Corporation tax Corporation tax Corporation tax
= Earnings Earnings Earnings
Less: (proposed) dividends (proposed) dividends (proposed) dividends
= Retained earnings Retained earnings Retained earnings



The Profit and Loss Account for Amanda is shown in Figure 1.3.




33
Accounting and Business Valuation Methods


Amanda Pro¬t & Loss Account for 12 months ended December 31 2004

£ £

Sales 480,000
Less: cost of sales 384,000

Gross margin 96,000

Warehouse rent 6,000
Wages 10,800
National insurance 1,200
Stock losses 239 18,239
Gross pro¬t 77,761
Samples 2,000
Debtor insurances 10,000
Legal costs 5,000
Rent (of¬ce) 10,000
Delivery costs 16,500
Stationery 600
General insurances 1,500
Bank charges 15,300
Depreciation 6,250
Accounting and audit expenses 1,200 68,350
Pro¬t before exceptional 9,411
items and interest
Setting up costs 12,000
15,000 27,000
Goodwill impairment
Loss before interest (17,589)

Interest 20,000
Net loss (37,589)

Figure 1.3 Case study “ Amanda Pro¬t and Loss Account




The Balance Sheet
The Balance Sheet is a statement showing the assets and liabilities that a
business has on a set day only. The Balance Sheet could look completely
different on the day before the set date or on a day after the set date.

34
Telling the story

Before the introduction of UK GAAP, the Balance Sheet was prepared horizon-
tally with assets on the right and liabilities on the left. For Amanda, this is
shown as Figure 1.4(a).
The problem with Balance Sheets prepared this way is that they were very con-
fusing and could easily be used to fool the numerically challenged. A common
trick, when selling a business at that time, was to suggest that the business was
worth its asset value. A finance specialist given the job of selling Amanda™s
business might suggest that a selling price of £250 000 was an absolute unbeat-
able bargain, given that the business had assets of £293 200, as certified by
an auditor. Of course, this finance specialist would not tell the unsuspecting
buyer that Amanda™s Profit and Loss Account was on the debit (asset) side;
this meant that she had made cumulative losses. The Profit and Loss Account
should always be on the credit (liability) side of the Balance Sheet, as this is
where it will be found if a profit has been made. It is a liability as it indicates
what the business owes to its owner. In order to present the Balance Sheet in
a more meaningful way, it was revised to look as in Figure 1.4(b).

Intangible assets are shown net of amortisation to date, or impairment as is
currently the case, and tangible assets are shown net of depreciation. The sum
of intangible assets and tangible assets are ˜net fixed assets™, but will often
be shown in accounts in the abbreviated form as ˜fixed assets™. Next comes
current asset, and from current assets, current liabilities are deducted. The
difference between current assets and current liabilities is known as ˜working
capital™. This is shown in accounts as ˜net current assets™, where current assets



Amanda Balance Sheet as at December 31 2004

Assets
Liabilities

£ £

25,000
Intangible assets
50,000
Capital
13,750
Tangible assets
200,000
Long term loans
95,761
Stock
43,200
Creditors and accruals
118,500
Debtors and prepaymemts
2,380
Other debtors
220
Cash at bank
37,589
Profit and Loss Account

Total liabilities 293,200 Total assets 293,200

Figure 1.4(a) Case study “ Amanda “ Balance Sheet (prior to UK GAAP)

35
Accounting and Business Valuation Methods

Amanda Balance Sheet at December 31 2004

£ £

Intangible assets 25,000
Tangible assets 13,750
38,750
95,761
Stock
118,500
Debtors and Prepayments
2,380
VAT
220
Cash at bank
216,861
Total current assets
43,200
Creditors and accruals
173,661
Net current assets
212,411
Total assets less current liabilities
200,000
Less: long term liabilities “ loan
12,411
Total net assets

50,000
Capital
(37,589)
Less: loss in year
12,411
Closing capital

Figure 1.4(b) Case study “ Amanda “ Balance Sheet




are higher than current liabilities, and as ˜net current liabilities™, where current
liabilities are higher than current assets. Working capital is added to net fixed
assets to give ˜total assets less current liabilities™ and this represents the total
capital employed in the business. Long-term liabilities, such as long-term loans,
are deducted from total capital employed to give ˜net assets™, and this ˜net
assets™ figure is the true (assuming the accounts are accurate) asset value of the
business. As can be seen from Figure 1.4(b), the true asset value of Amanda™s
business at 31 December 2004 is £12 411, and this is a long way from the
£293 200 as it would have been shown in the old format.

The bottom block of a Balance Sheet will be different for a sole trader, partner-
ship and Limited Company. Take three scenarios.




36
Telling the story

Sole trader
A sole trader starts with a capital of £120 000 and in the first year makes a
net profit of £89 000. In the year he takes £50 000 out of the business and the
business pays his tax bill of £28 000. The bottom block of the sole trader™s
Balance Sheet at the end of his first year would be:

£
Net assets 131 000

Capital 131 000
Capital would be calculated: £
Opening capital 120 000
Add: net profit 89 000
209 000
Less: Drawings 78 000
131 000

Partnership
A, B and C start a partnership, bringing in a capital of £20 000, £40 000 and
£60 000, respectively. The partnership makes a profit of £89 000, and the profit
is divided up as shown in the example on previous pages. In the first year of
trading, A has received £30 000 and B has received £20 000 from the partner-
ship. Also, the partnership had paid a tax bill of £13 000 for A, £7000 for B and
£8000 for C.

Now the Balance Sheet would look like:
£
Net Assets 131 000

Capital Accounts £
A 20 000
B 40 000
60 000
C
120 000




37
Accounting and Business Valuation Methods


Current Accounts
A 3000
B 6000
C 2000
11 000

Total Partnership capital 131 000

The partners™ current accounts would be calculated as follows:

£
Current account “ A
Opening Balance 0
Add: share of profits 46 000
46 000
Less: Drawings 43 000
3000

Current account “ B
Opening Balance 0
Add: share of profits 33 000
33 000
Less: Drawings 27 000
6000

Current account “ C
Opening Balance 0
Add: share of profits 10 000
10 000
Less: Drawings 8000
2000




38
Telling the story

Limited company
If A, B and C had decided to set up a limited company, rather than a partner-
ship, then they would have to divide up the net profit after tax, called ˜earnings™
in proportion to the capital they put in. However, those being employed in
the company as well as providing capital would be paid a salary and they
would be taxed on the amount of their salary and not on the profits the com-
pany made. However, in addition to the personal tax borne by the sharehold-
ers, the company would pay corporation tax on profits after the deduction of
salaries.

Had A, B and C formed a company, with a view to achieving a similar share of
the profits that they would have received had they been in a partnership, then
they might have structured the company as below:

Issued share capital “ 120 000 ordinary shares of 25 pence, purchased for £1
each.
A buys 20 000 ordinary shares, B buys 40 000 ordinary shares and C buys
60 000 ordinary shares.
A is to be paid a salary of £27 000 per annum and B is to be paid an annual
salary of £17 000.

Now the bottom part of the Profit and Loss Account might read:



ABC Limited “ Profit and Loss Account for the year ended ¦¦¦¦¦¦¦......

£ £
Profit before salaries, national insurance and pension costs 89 000
Less:
Salaries 44 000
National insurance and pension costs 6729 50 729
Profit before tax 38 271
Corporation tax 7271
Earnings 31 000
Dividends 20 000
Retained Earnings 11 000




39
Accounting and Business Valuation Methods


ABC Limited “ Balance Sheet at¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦¦

£
Net assets 131 000

£
Share capital: 120 000 Ordinary shares of 25 pence 30 000
Share premium account 90 000

Profit and Loss Account 11 000
Equity shareholders™ funds 131 000



The Balance Sheet for limited companies will be dealt with more fully in later
chapters, but with regard to the above Balance Sheet:

(1) The share premium account shows the difference between what shares
were sold for and their par value. A share™s par value is the value shown
on the share certificate.
(2) Share capital and share premium are capital reserves, while the Profit
and Loss Account is a revenue reserve.
(3) Dividends can only be paid out of revenue reserves.
(4) The word ˜equity™ means ordinary shares, as against preference shares.

Now that Amanda™s Profit and Loss Account and Balance Sheet for the year
ended 31 December 2004 are complete, her nominal ledger would be adjusted
in preparation for the new financial year. Firstly, all items in the Trial Balance
that were designated to be Profit and Loss Account items would be written
down to zero and replaced by one line reading ˜Profit and Loss Account™. This
is shown in Figure 1.5. Secondly, entries would be made in the nominal ledger
to reverse all the reversible entries from the previous year. This is shown in
Figure 1.6.




40
Telling the story
Trial Balance at December 31 2004
Debit (£) Credit (£)

Capital 50,000
Cash at bank 220
Goodwill 25,000
Samples 0
Loan 200,000
Debtor insurance 0
Setting-up costs 0
VAT 2,380
Legal costs 0
Stock 95,761
Trade creditors 40,000
Sales 0
Trade debtors 102,500
Cost of sales 0
Rent (of¬ce) 0
Fixtures and ¬ttings 3,750
Van 10,000
Warehouse rent 0
Delivery costs 0
Stationery 0
General insurances 0
Wages 0
National insurance 0
Interest 0
Bank charges 0
Stock losses 0
Goodwill impairment 0
Depreciation 0
Accruals 3,200
Prepayments 16,000
Accounting and audit expenses 0
Pro¬t and Loss Account 37,589

293,200 293,200

Figure 1.5 Case study “ Amanda “ Trial Balance (after completion of 2004 accounts)




41
Accounting and Business Valuation Methods




Reversing double entries after year end close

Accurals
Number Debit £ Number Credit £
Opening balance 3,200
23R 2,000
23R 1,200


Prepayments
Number Debit £ Number Credit £
Opening balance 16,000
24R 16,000


Wages
Number Debit £ Number Credit £
23R 1,800


National insurance
Number Debit £ Number Credit £

23R 200


Accounting and audit expenses
Number Debit £ Number Credit £
23R 1,200


Rent (office)
Number Debit £ Number Credit £
24R 10,000


Warehouse Rent
Number Debit £ Number Credit £
24R 6,000

Figure 1.6 Case study “ Amanda “ reversible entries




42
Telling the story


Case study “ Amanda
Her accountant came straight to the point. Her accounts were awful. Sales
volumes were not high enough to justify her contract with Zehin Foods plc
and her gross margin percentage at 20% was too low. Then, she had 91 days of
stock at her year end and could not control this by reducing her orders as she
was committed to buying minimum quantities from her supplier. Debtor days
stood at 78 days and while there was not a bad debt risk because her debtors
were insured, this indicated a complete lack of control.

Why, the accountant asked, were the debtors insured anyway when her sales
were to large supermarkets that were very unlikely to go bust? Amanda
explained that debtor insurance was a condition for getting the bank loan, but
this did not satisfy her accountant. Why were her bank charges, being over
3% of turnover, so high? Amanda™s accountant believed that she could have
negotiated with the bank for a better deal.

It was explained to her that the accounts demonstrated that her business was
being run badly, to the effect that she had lost £37 589 of her original £50 000
capital, leaving her with only £12 411. The accountant explained that if she
had difficulty selling any of her stock, the bank might get nervous and demand
their money back. That would put her out of business; the only saving grace
being that as they would have to write off some of their debt, they would not
rush into such action.

The accountant suggested that Amanda needed to understand the meaning of
the working capital cycle, so that she could work out how much cash she
needed to run her business, to negotiate with her banker to get a fair deal
and finally to understand and implement the concept of asset management.
Otherwise, her business was going to end up like a lot of start-ups “ dead
within 3 years.


The working capital cycle
Current assets appear in the Balance Sheet in the order of least liquidity, stock,
debtors and then cash. Current liabilities are deducted from current assets to
arrive at working capital, and from these two figures, the current ratio, being
simply current assets divided by current liabilities, can be calculated.

If the current ratio is greater than 1, it means the business has sufficient cash
to meet its short-term liabilities, while a current ratio of less than 1 means, in

43
Accounting and Business Valuation Methods

theory at least, that the business will require the support of the banks to meet
such short-term liabilities.

In the real world, the current ratio will differ by industry and by different busi-
nesses within a particular industry. It will, therefore, be a matter of judgement
as to what will be reasonable for a particular business. For Amanda™s business,
she might conclude for her plan that she should always have one month™s
stock, creditors will always give her 30 days credit and she will have to give her
customers 60 days credit. If she did not start with any cash and her plan sug-
gested that she would need £7000 per month for expenses (paid as incurred),
then at the end of her first three months, her working capital would be:

£
Stock 40 000
Debtors 100 000
Current assets 140 000

Creditors 40 000
Bank overdraft 91 000
Current liabilities 131 000

Current ratio 1.069

On this basis, she might conclude that she needed £100 000 to finance her
working capital, in which case her working capital would be:

£
Stock 40 000
Debtors 100 000
Cash 9000
Current assets 149 000

Creditors 40 000
Current liabilities 40 000

Current ratio 3.725

On top of calculating the cash needed to finance working capital, it is also
necessary to compute the amount that will be spent on fixed assets. In Amanda™s
case, she needed £60 000 for fixed assets; add this to her £100 000 working
capital requirement and she would need to have borrowed £160 000. But she
had net borrowings of £200 000 at her year end and yet only managed to have

44
Telling the story

£220 in her bank account. The reason for this difference was that Amanda did
not do as well as she might have expected. What this tells us is that when it
comes to funding, businesses need a contingency. It also tells Amanda that lack
of knowledge of the working capital cycle (raw materials and work-in-progress
if a manufacturer, purchases if not, to stock, then debtors, then cash) was not
the cause for her problems.
Of course, many companies can get away with a working capital ratio of less
than 1. These are usually in service industries where there is little or no stock
and being effectively cash businesses, debtors overall amount to only a few
days. Therefore, they can expand by investing the cash generated in their
business and although in theory a current ratio of less than 1 means they cannot
meet their liabilities, they will be able to do so when they fall due under the
terms they are able to negotiate.


Negotiating with banks
Individuals and small businesses tend to bank with one institution and stay
there. The bank chosen might be the one used by parents, or it might be because
of perceived convenience, such as having a branch at a university campus. It
never occurs to individuals that they may be getting a poor deal or that banks
are in business to make a profit. Banks are very clever in that they market their
products in a way that creates the illusion that they are doing their customers
a favour, whereas they are unveiling their latest money-making schemes.
Examples of such money-making schemes are almost endless, but the type of
marketing to look out for is as the following: The large print might suggest that a
high rate of interest would be paid on the account, while the small print would
tell you about an annual fee. Put the two together and the net result might
be a low rate of interest. The account might offer benefits such as discounts
on selected products, but the small print will not acknowledge that customers
could negotiate many discounts for themselves. The general rule is that if
something is advertised in large print in the shop window, there are likely to
be catches. What is advertised will almost certainly be truthful, but the good
news will be in the large print, while the bad will be found in the ˜conditions™.
Banks do sometimes come up with very reasonable offers, but these are often
found by reading leaflets; it is unlikely that such a gem would be advertised
in large print, nor are bank staff likely to push such a product. Getting a good
deal out of banks takes much research, patience and tenacity.

45
Accounting and Business Valuation Methods

Researching the bank issue with students reveals some awful cases of what
amounts to finance abuse. One foreign student had parents who were well able
to support their offspring but they did not want their money to be frittered
away; so they discussed with the student how much financial support was
needed and it was made clear that the parents would not be best pleased if
more than this amount was spent.

The parents transferred the money on the first day of each month, but the
bank took up to 10 days to clear the funds. Because of the bank™s negligence,
the student was forced to go overdrawn, which resulted in a ˜no authorisation™
penalty. The student visited the bank to agree an overdraft limit, but this was
exceeded when the bank charged interest, which triggered further charges for
˜exceeding credit limit™. Within a few months, the account was £250 overdrawn,
all of which were interest and penalties. The student did not know how to get
out of this downward spiral.

The student was advised to consult the local Yellow Pages and to list on one
side of A4 all the banks operating in the area and armed with this make an
appointment to see the bank manager. The strategy was to point out to the
manager the competition this bank faced, to complain that the overdraft had
only been incurred because of the bank™s negligence and to make it clear that
their customer had suffered hurt because of it. The advice was to insist that
the account be credited with all the charges and interest and a further amount
be credited as compensation for the suffering. Failure to agree this, the bank
manager was advised, would result in the account being moved elsewhere and
fellow students at the university being made aware of the treatment that had
been received. In addition, the bank™s claim to recover their money would
be rigorously defended if the case went to the court. Faced with this, the
bank credited the account with all charges and credited a further £100 as
compensation.

The point is that overdrawn accounts can always be closed. If the amount owed
to the bank is legitimate, then the strategy is to open an account elsewhere,
take out a loan to clear the original debt and move on. If the overdraft has come
about because of unreasonable charges (as in the example), then the strategy is
to simply move on and leave the overdraft unpaid. In such cases, it is important
to pay in full all legitimate charges and write to the bank pointing out why
payment is not being made for the remainder.

It must be remembered that banks sometimes make excessive profits because
their customers are lethargic, and if individuals are to get a fair deal, then they

46
Telling the story

must be prepared to move from one bank to another. People not being prepared
to act because ˜it isn™t worth the hassle of moving for £25™ forget that £25
becomes £35 and so on. Banks adopt what can be described as the ˜children™
strategy™ in that they will ratchet up the charges slowly and surely to find out
how much they can get away with. If the bank knows you will not put up with
any unnecessary charges, there will be a marker put on your account to make
sure it does not happen. It should be the objective of every account holder to
have such a marker put on their account.

Now whereas sensible individuals ensure that they have bank accounts that
incur no bank charges or fees and receive interest on credit balances, for the
business customer it is never that easy. Many believe there is nothing they can
do, but it is never the case that nothing can be done.

Like the individual customer, business customers believe that they are in a
very vulnerable position if they owe their bank money, but they can also clear
any monies due by agreeing a loan with another bank. For many though, it is
simply a case of not being bothered. Small business owners seem prepared to
spend weeks and weeks chasing potential customers, but they will not reserve
a week to visit all the banks in the area. It is a simple matter of preparing a basic
business plan and then visiting each bank in turn. Give them a copy of the
business plan, explain the business and ask the bank for the best deal that can
be offered in the circumstances. Explain that you are looking for a long-term
relationship, but you want a good deal and are prepared to visit every bank to
see who is prepared to offer it.

To open a business account, it is important that negotiations are confined to
large branches in which there are managers of sufficient seniority to be able to
make decisions. Otherwise, it will be like the ˜Little Britain™ sketch in which
˜the computer says no™.

There are three important rules to consider when negotiating a business
account, but they are only relevant in full if the business is a limited com-
pany, rather than a sole trader or partnership. Remember, sole traders and
partnerships (but not certain ˜limited partnerships™) have unlimited liability
and have no protection if the business fails:

• Never give personal guarantees.
• Have the bank™s ˜on demand™ clause eliminated.
• Agree in advance what the bank can charge for and what those charges
will be.

47
Accounting and Business Valuation Methods

Never give personal guarantees
The bank will often ask that you give them a guarantee that if the business
fails, you will make good from your personal finances. This should always be
refused because there is no point in having limited liability (your loss in a
limited company is limited to the amount you paid for your shares) and then
giving it away. Instead, agree that the bank can have a fixed and floating charge
over the assets of the company.



Have the bank™s ˜on demand™ clause eliminated
The bank™s standard ˜on demand™ clause is exactly what it says. The bank can
demand its money back ˜on demand™ and without notice at any time of its
choosing. So the business might have one bad month, the bank manager gets
nervous and the bank calls its money in. For obvious reasons, the business can-
not pay up immediately, so the bank has the business wound up. Admittedly,
this is not very likely but it is certainly possible.

The answer is to insist that the ˜on demand™ clause is deleted. Instead there
would be a clause inserted, which stated that the bank would give the business
˜three months™ notice, if it wanted to recover its money. This notice period
would allow the directors of the company sufficient time to negotiate alternative
facilities.

Of course, there might be legitimate reasons why the bank should be entitled
to ask for its money back, on demand, for example, if the owner of the business
was acting fraudulently. The answer, in discussion with the bank, is to agree
˜bank covenants™. A covenant is something you agree with the bank that you
will do. Examples of covenants might be the following:

• I agree to run my account honestly and advise the bank immediately if I
believe I may have financial problems ahead.
• I will ensure that interest cover never falls below 1.25, on a cumulative
basis.
• I will ensure that I never make a loss for three consecutive months.

The deal would be that if you were in breach of any covenant, the bank would
have the right to revert to their ˜on demand™ clause. In reality, a breach of a
bank covenant must be considered to be a serious matter that would always
require negotiations to immediately commence.

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Telling the story

Eliminating the ˜on demand™ clause does mean that there is one less thing to
worry about, but the real benefit is that it focuses the mind. Having agreed
covenants with the bank, one objective of the owners of a business must be to
review the performance of their company against such covenants. For example,
if a covenant stated that there would never be three consecutive months making
a loss, the combination of making a loss for two consecutive months and the
covenant would focus the mind to ensure that the third month was in profit.


Agree the charging structure
A key part of any negotiation with a bank is what they can charge you for
and how much they can charge you for what. Failure to negotiate and agreeing
a charging structure will result in you signing the bank™s standard contract,
which although going to several pages of small print will amount to: ˜we can
charge you what we want, when we want, for whatever reason we choose.™

The business section of the press is littered with horror stories related to banks,
probably the most famous being the ˜golf jolly™. A company, as part of its
marketing effort, organised a golf day. Recipients were invited to participate in
a round of golf, where generous prizes were on offer including one for winning,
one for ˜a hole in one™, one for the best putting round, etc. After the round,
dinner was served with plenty of drinks, all provided free by the company.
To maintain good relations with its bank, the name of the bank manager was
added to the invitation list. He accepted the invitation and had a great time.
You can imagine, therefore, the fury inside the company when they received
an invoice from the bank for their ˜manager™s time™ and, to add insult to injury,
were told that their account had been debited accordingly.

The bank might propose that the amount charged is based on a fixed charge
per quarter, or a charge per transaction or a combination of the two. It could be
even more complicated with debits carrying a higher charge than credits, for
example. The method of charging might be appropriate in the circumstances,
but again might not be.

A charity was organised to provide a service, with the objective of utilising
all the income it received to get to as many people as possible. One bank
offered a set monthly fee to run the account, while another wanted to charge
90 pence per transaction, with the first seven transactions in any 1 month free.
The problem was that although it was a very small charity, its £10 annual
subscription per member tended to arrive in the same month, so the bank would

49
Accounting and Business Valuation Methods

be effectively taking just under 9% commission on each £10 cheque. Clearly,
the fixed monthly fee was the better deal in this case, but it was bettered by a
third bank who offered free banking for charities.

So the strategy must be to visit all the large branches of the banks in the area
and ask for the best deal each will give you. Then, taking into account the
circumstances of your own business, work out what each bank is likely to
charge over a full year. Pick out the top three and arrange another appointment
with each, at which you ask if they can tweak their quotation.

When the bank is selected, ask the bank to draw up a contract setting out
what has been agreed. It is recommended that when the contract arrives, it
is checked over by the company™s solicitor to make sure that it matches the
expectations. Now, all this has taken time and money, but at the end of the day,
it is likely to be considered as an investment with a relatively quick payback.


Asset management
When ˜asset management™ is referred to, all it means is the process by which the
managers of a company seek to protect the company™s assets and ensure that
the company makes the best use of its capital. What this entails is examining
every asset:


Intangible assets
The objective is to examine every intangible asset to ensure their valuation
in the Balance Sheet is reasonable. It does not matter whether the intangible
assets is brands, research and development or goodwill, the test is the same.
This test is whether or not the intangible asset is capable of generating future
income streams commensurate with its value. Clearly, this decision will be a
matter of judgement and will be discussed fully in later chapters.


Fixed assets
The first thing to do is to find every asset shown in the Plant Register to make
sure they really exist. It is not uncommon for a manager to scrap an asset and
then fail to tell the accountant what has happened. The first the accountant
hears of it is when it cannot be found. The asset should be removed from the
books of account and a figure showing ˜loss on disposal of asset™ will equal

50
Telling the story

the written-down value of the asset at the time it was discovered it no longer
existed.

The second test is to make sure the asset is still being used. If not, it should
be sold, if possible, scrapped, if not. What tends to happen occasionally is that
assets are found in a dusty state and enquiries reveal ˜we haven™t used that
old thing for years and its replacement is getting close to its sell-by date.™ In
this case, the depreciation should be increased so that cumulative depreciation
equals the total cost of the asset, giving a written-down value of zero. When
the asset is disposed of, the total cost of the asset and the total depreciation to
date will be taken out of the Balance Sheet, although the figure for ˜net fixed
assets™ would remain unchanged.

Assuming the asset is being used, an assessment of its likely life needs to be
made on a regular basis to ensure that the depreciation being charged fairly
reflects reality.



Current assets “ stock
Of all assets, stock is the most difficult to control, for it has the nasty habit of
going missing. Retailers, in particular, suffer from what they call ˜shrinkage™ as
stock gets stolen by both customers and employees, despite security measures
such as tags and cameras. It seems rather sad that as an additional security
measure, the store manager will sometimes position a member of staff outside
changing rooms so that they can see what customers are taking in. From an
accounting point of view, it is important that the latest technology is used to
ascertain stock, on a real-time basis. As the goods going through the tills are
scanned, stock records should be automatically updated. Regular stock checks
should then be carried out to see if the physical stock count matches the book
stock.

For manufacturing businesses, stock can also be a problem. In this case, where
stock goes missing the problem is more likely to be faulty record keeping rather
than pilferage, but theft cannot be ruled out. Businesses can no longer afford
not to keep detailed stock records, as the old method of recording purchases
only means that there is no control over stock. Using this method, all purchases
are coded to ˜purchases™ and at the end of each month, the stock is physically
counted. Using this method:

Opening stock plus purchases, less closing stock = cost of sales.

51
Accounting and Business Valuation Methods

The problem is that in this case ˜cost of sales™ = actual cost of sales + stock
losses, and there is no way of knowing how these two figures might be split.
Accordingly, even manufacturing businesses should record every stock item.
So, the entries would be:

Debit ˜raw materials™ credit ˜creditors™ (or ˜cash™); then
Debit ˜work-in-progress™ (with raw material used), credit ˜raw materials™; then
Debit ˜work-in-progress™ (with labour used), credit ˜production labour™; then
Debit ˜finished stock (with finished products), credit ˜work-in-progress™;
finally
Debit ˜cost of sales™ (cost of goods sent out to customers), credit ˜stock™

As can be seen from the above, it is quite an exercise to track movements
between raw materials, work-in-progress, finished goods and cost of sales and
then have spot physical counts in all these areas. However, the only alternative
to this is to risk huge stock losses and worse, not even know what the stock
losses amount to.


Current assets “ debtors
The first thing to ascertain is whether a particular customer is likely to pay
for the goods and services received. Assuming there is nothing wrong with the
goods and services supplied and therefore no dispute, there are two reasons
why debtors do not pay up. The first is that they are trying to extend their credit
as far as possible, the remedy for which is initiating effective credit control
procedures. The second and far more serious reason is that they cannot pay
due to lack of funds. Companies must, therefore, vet their potential customers
before they offer credit terms.

Companies often vet potential customers by asking for references from the
firm™s suppliers and also asking for a bank reference, but both these vetting
methods are fraught with danger. Many companies have the strategy of ascer-
taining their three most important suppliers. They make sure that these three
suppliers are paid on time, even if all their other suppliers are made to wait.
It does not take a genius to work out which three suppliers will be given for
reference purposes.

The problem with bank references is that the bank has a duty to its customers
as well as an obligation to tell the truth. Accordingly, the reference is usually
coded and unless the code is known, it can be difficult to ascertain what it is
all about. The following examples might help.

52
Telling the story



What the bank reference says What the bank means

Undoubted Absolutely no problem here and should your
customer default, we will make good any losses
˜A™ should prove good for the amount Well, it is up to you to take the risk; we can see
of your enquiry no reason why A would default, but you never
know
˜B™ should prove good for the amount You should realise you are taking one hell of a
of your enquiry, even though it is risk, something we would not do
larger than the usual enquiry
˜C™ should prove good for the amount You must realise that you are taking a big risk
of your enquiry. There is a charge in here. We have got everything covered this end
favour of the bank and if C goes belly up, you will be at the end of
the queue.



So, unless the bank reference says ˜undoubted™ the only way to make an effec-
tive judgement is to review the potential customer™s accounts. This is discussed
in Chapter 4.

Having offered your customer credit, the objective is to ensure that the credit
terms are met. This is achieved by regularly checking the age-debt list and
chasing overdue debtors through telephone and e-mail. If gentle reminders fail
to get payment, the next step is to advise the customer that credit is suspended
and that further orders will be considered on a ˜cash with order™ basis only. If
that fails to achieve the objective, then debt collection agencies and the courts
can be used as a last resort.

The problem about using debt collection agencies and the courts is that you
will incur costs that will not be recoverable if the debtor cannot pay as against
wilfully refuses to pay. As lawyers will tell you: ˜It is pointless suing a man of
straw.™ So again a review of the customer™s accounts is recommended before
committing to additional costs.


Current assets “ cash
Companies never go out of business because their profit and loss account
indicates they have made a loss, rather it is running out of cash without the
necessary facilities in place that causes disaster to strike. Indeed, very profitable
companies expanding rapidly have run out of cash and gone out of business,

53
Accounting and Business Valuation Methods

a phenomenon known as ˜overtrading™. So managing cash is one of the most
important controls a company should have in place.

On a regular basis, the company™s cash book should be reconciled to the bank
statement, but it is vital that a company knows what is going to happen to its
cash balance in the future. So to do this, companies prepare cash budgets, as
shown in the following example.

On 31 December 2006, Reliable Retail Limited™s Balance Sheet was as below:

£™000
Fixed assets at cost 2400
Depreciation to date 960
Net fixed assets 1440

Stocks 160
Debtors 1128
Cash at bank 407
Current assets 1695
Trade creditors 188
Creditors “ VAT 126
Current liabilities 314

Net current assets 1381
Total assets less current liabilities 2821
Less: long term loans 0
Total net assets 2821
Share capital 2000
Retained earnings 821
Shareholders™ funds 2821


For the first six months of 2007, the planned purchases were (excluding VAT):

Jan Feb March April May June
Purchases (£™000) 200 280 240 320 400 360


Purchases made in any one month were expected to be in stock at the end of
that month and sold the following month. The selling price to the customer

54
Telling the story

was calculated by taking the cost price (excluding VAT) and multiplying by
300% as an add-on. To this cost price + 300% of cost price, there was then
added a further 17.5% to cover VAT. Because of the high prices, customers pay
by credit card and Reliable Retail receive payment for their sales two months
after they were made (January sales would be paid in March, etc,). They pay
for services (subject to VAT) and wages in the month they were incurred,
but purchases of goods are paid for in the month following receipt (January
purchases paid in February, etc.).

In May, Reliable Retail planned a major refurbishment costing £800 000, plus
VAT of £140 000, which they would pay at the end of that month. The amounts
owed by debtors at the Balance Sheet date of 31 December 2006 were expected
to be paid in two equal instalments in January and February, while outstanding
creditors at 31 December 2006 would be paid in January. VAT was always
paid quarterly in arrears (VAT for January, February and March was paid in
April, etc.).

The budget for Reliable Retail for the first six months of 2007 was as below:




Jan Feb March April May June Half-year
(£™000)
Sales 640 800 1120 960 1280 1600 6400

Cost of sales 160 200 280 240 320 400 1600

Gross profit 480 600 840 720 960 1200 4800
Services 200 200 200 200 200 200 1200
Wages 250 250 250 250 250 250 1500
Depreciation 40 40 40 40 40 40 240

Net profit (loss) (10) 110 350 230 470 710 1860




Reliable Retail had not negotiated overdraft facilities with its bankers, but the
lender had agreed to provide a loan to cover working capital requirements and
the planned refurbishment. A loan of up to £1 million was agreed to be drawn
down in one lump sum that had to be in whole £100 000 units and taken in
time to prevent the company from being overdrawn.

55
Accounting and Business Valuation Methods

The objective, therefore, is to prepare a cash budget for the first six months
of June with a view to calculating the amount of loan required and when it
would be required. Looking at the above Profit and Loss Account, it might seem
that Reliable Retail would not need a loan to finance its refurbishment as it is
starting the year (2007) with £407 000 in the bank and is planning to make a
profit of £1 860 000 in the first six months of 2007. Note that corporation tax
can be ignored for this exercise.

So, guess now to see how much should be borrowed and when. List the months
and take in all possible borrowing from £nil to £1 million, and the odds of
getting both the month and the amount right by sticking a pin in (i.e. a random
selection) are 65/1.

The first step in calculating the cash budget is to work out debtors, creditors
and VAT.

Jan Feb March April May June Half-year

(£™000)
Sales 640 800 1120 960 1280 1600 6400
VAT on sales 112 140 196 168 224 280 1120
Debtors 752 940 1316 1128 1504 1880 7520
Purchases 200 280 240 320 400 360 1800
VAT on 35 49 42 56 70 63 315
purchases
Creditors 235 329 282 376 470 423 2115

Services/other 200 200 200 200 1000 200 2000
VAT on services 35 35 35 35 175 35 350
Payments for 235 235 235 235 1175 235 2350
services
Output VAT 112 140 196 168 224 280 1120
Input VAT 70 84 77 91 245 98 665
Due to Revenue 42 56 119 77 (21) 182 455
and Customs




56
Telling the story

Armed with this information, we can now compute the cash budget

Jan Feb March April May June Half-year
(£™000)
Opening cash 407 172 16 (46) (90) (575) 407

Receipts from 564 564 752 940 1316 1128 5264
debtors
Payments 188 235 329 282 376 470 1880
(goods)
Payments 235 235 235 235 235 235 1410
(services)
Payments 250 250 250 250 250 250 1500
(wages)
Refurbishment 940 940
Payments “ 126 217 343
(VAT)
Closing cash 172 16 (46) (90) (575) (402) (402)


This cash budget may come as quite a surprise, for despite starting with a
healthy bank balance and generated a high level of profitability, we need
our loan as early as March and given the highest computed overdraft is
£575 000, we will need to borrow £600 000. So the correct answer is March and
£600 000. Of course, what causes the cash problem and therefore the require-
ment for funds is the working capital cycle. In this case, it takes 3 months to




57
Accounting and Business Valuation Methods

convert purchases into cash. Given the loan requirement, the final cash budget
would look:


Reliable Retail Limited “ Cash Budget for the first half of 2007

Jan Feb March April May June Half-year
(£™000)
Opening cash 407 172 16 554 510 25 407

Receipts from 564 564 752 940 1316 1128 5264
debtors
Loan from bank 600 600

Payments 188 235 329 282 376 470 1880
(goods)
Payments 235 235 235 235 235 235 1410
(services)
Payments 250 250 250 250 250 250 1500
(wages)
Refurbishment 940 940
Payments “ 126 217 343
(VAT)
Closing cash 172 16 554 510 25 198 198




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Telling the story

Now that a cash budget has been prepared, the final step in the process is to
prepare the forecast Balance Sheet at 30 June 2007. We know from our cash
budget what remains outstanding at this date and given that we have the Profit
and Loss Account, we can complete our Balance Sheet, as shown below:

Reliable Retail Limited Balance Sheet Actual 31/12/06 Budget 30/7/07
£™000 £™000
Fixed assets at cost 2400 3200
Depreciation to date 960 1200
Net fixed assets 1440 2000

Stocks 160 360
Debtors 1128 3384
Cash at bank 407 198
Current assets 1695 3942

Trade creditors 188 423
Creditors “ VAT 126 238
Current liabilities 314 661

Net current assets 1381 3281

Total assets less 2821 5281
current liabilities
Less: long-term 0 600
loans
Total net assets 2821 4681
Share capital 2000 2000
Retained earnings 821 2681
Shareholders™ funds 2821 4681




59
Accounting and Business Valuation Methods

Regarding the computation of the Cash Budget for the 6 months ended 30 June
2007 and the Budget Balance Sheet at that date, the following should be noted:
• Depreciation in the Profit and Loss Account is only a book entry (debit
depreciation in the Profit and Loss Account and credit cumulative depre-
ciation in the Balance Sheet) and therefore has no impact on cash.
Accordingly, depreciation never appears in a cash budget.
• Retained earning in the Balance Sheet is the cumulative retained earnings
since the business started.


Current liabilities “ creditors
On ethical grounds, creditors should be paid as they fall due, but for many
businesses this is not always possible due to cash flow problems. In such cases,
any delay-paying trade creditors should be kept to a minimum, as undue delay
will result in loss of reputation and suppliers demanding cash with order.
It is simply not worthwhile delaying paying Revenue and Customs as this
organisation is not renowned for having a sense of humour in such cases.
Pretending that the problem will go away is really the worst option to take.
Revenue and Customs may be sympathetic if they are kept fully informed
about temporary inability to pay, but they will show absolutely no mercy if
they believe they are being strung along. Hence comes the need for good cash
management that ensures that funds are always available when they are really
needed.


Amanda™s meetings
Amanda wanted to find out how she could review her accounts so that she
could judge for herself how well she was doing or not as the case may be.
She contacted her accountant who told her various ratios, which in Amanda™s
view were difficult to remember. She asked him how he remembered all these
ratios; the accountant told her that he used an acronym “ Pam Sir.
P stood for ˜Performance™;
AM stood for Asset Management;
S stood for Structure; and
IR stood for Investor Ratios.
Once you know what you are assessing, he had told her that it was relatively
easy to remember the ratios themselves.

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Telling the story

To get a second opinion as to how she should proceed with her business,
she arranged to meet a friend. The friend worked at a firm of solicitors and
suggested that she meet a specialist in mergers and acquisitions who also ran
an investment club, financed by several business angels. This specialist also
dealt with several venture capital companies.




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