Accounting Lecture 7

• Bad/irrecoverable debts


  Bad debts arise when a trade receivable (credit customer) is unable (or unwilling) to pay the amount owed in respect of goods sold on credit
• Reasons a debt may be irrecoverable


  • The credit customer cannot be traced
  • Is not worth taking to Court
  • Has been declared bankrupt (and the 'final dividend' in bankruptcy received)
• Bad Debt


  • When a business sells to a customer on credit it takes a business risk that the customer might not pay the amount owed
  • A business might have to write off the debt as a bad debt
  • Bad debt are an expense and will reduce the profit of the business
• Ledger entries for bad debts

  1. Trade receivables' amount reduces

  2. Expense – bad debt written off: increases
• Doubtful Debt


  Money you predict will be uncollectible and turn into bad debt
• Bad Debt


  Debt you have officially written off as uncollectible
• Provisions for bad/doubtful debts

  Reflect the idea that a debt (trade receivable) may not be worth its book value
• Types of provisions for doubtful debts

  • A specific provision in respect of particular trade receivables (credit customers) that have been identified as unlikely to pay their debts
  • A general provision representing an estimate, usually computed as a percentage, of the trade receivables at the end of the accounting year who are unlikely to pay their debts
• General provision


  The level should reflect past experience of loss on debts where there was insufficient data to indicate the need for a specific provision
• Ledger entries for a provision for doubtful debts

  1. Increase expense: charged to selling and distribution costs

  2. Increase provision for doubtful debts
• We care about the changes in provision level over the year
• Sometimes a different expense account is used instead of 'selling and distribution costs'
• The balance on the provision for doubtful debts account is deducted from trade receivables in the statement of financial position to show net trade receivables
• Financial Ratio


  • Comparisons between entities
  • Comparisons over time
• The Classification of Ratios

  • Measures of an entity's financial performance
  • Measures of liquidity and control of working capital
  • Measures of solvency
• Measures of financial performance

  • Return on capital employed (ROCE)
  • Gross profit margin
  • Net profit margin
• Return on capital employed (ROCE)

  • PBIT (operating expense) as proportion of capital employed
  • How much profits were earned for every £1 of capital invested
  • Related business return on investment
• Gross Profit Margin


  • Shows what percentage of sales revenue is gross profit
  • How much 'gross profit' was earned for every £1 sales
  • Different industries have different gross profit margins. For example, supermarkets have low margins (but high volumes) whereas, jewellers have high margins (but low volumes). Therefore, important to compare within industry
  • Ratio can also be expressed as a mark up (sales/cost of sales – 1, multiplied by 100). For example, if you buy something for £1
• Mark-up


  Profit as a % of COST
• Margin


  Profit as a % of REVENUE
• Operating Profit Margin


  • Shows what percentage of sales revenue is operating profit
  • How much 'operating profit' was earned for every £1 sales
  • Can compare to GPM to see how much revenue is 'lost' to expenses (exclude interest)
• Net Profit Margin


  • Shows what percentage of sales revenue is net profit
  • How much 'net profit' was earned for every £1 sales
  • Can compare to GPM to see how much revenue is 'lost' to expenses (include interest)
• Three types of profit

  • Gross
  • Operating
  • Net – after deducting all expenses
• Liquidity


  Ability of the business to generate cash and satisfy short term liabilities without which the business will fail
• Working capital management


  Working capital is defined as current assets minus current liabilities
• Current ratio


  • Extent to which current liabilities are covered by current assets
  • Conventionally, a current ratio of 2:1 is considered satisfactory
• Acid Test Ratio


  • Similar to current ratio, but excludes inventories because these are not as liquid as other current assets
  • As a generalisation, both ratios should be at least 1
  • However, this depends on the type of industry (e.g. supermarkets receive payments from customers before they pay suppliers; therefore, a ratio less than one can be acceptable)
• Receivable days


  How long it takes to receive payment from credit customers
• Payable days


  How long it takes to pay credit suppliers
• Inventory days


  • Indicator of the number of days inventory is held before it is sold
  • The lower the ratio, the more effective the management of inventory
• Solvency


  A firm's ability to sustain its activity into the long-term
• Measures of gearing/leverage


  • Leverage ratio
  • Gearing ratio
• Gearing or leverage


  • The amount of fixed interest/debt 'capital' relative to the amount of equity share capital
  • Debt capital includes loan stock/debentures, preference shares (potentially, depending on the characteristics), bank loans, mortgages and any other long term borrowing
  • Gearing is advantageous to shareholders if company can make: Return on investment > economic cost of debt
  • But too much makes company risky and less attractive to shareholders (debt holders get paid first)
• • Debt/equity ratio in Western Europe for listed companies in last fiscal year – update January 2018: Average: 52.31%
  • Large variation across industries. For example, Apparel 10.06%, Green and Renewable energy: 121.02%
• Interest cover


  Indicated a company's ability to service its borrowing (i.e. Is it making enough to cover interest costs? How much 'slack' is there?)
• A modification of the interest cover can be obtained by replacing earnings with cash flows from operations
• It is important to examine the schedule of debts in the notes to the financial statements – when are debts falling due for repayment