make recommendations and suggestions for improving profitability and working capital

Analysis and Interpretation – Cambridge IGCSE Accounting (0452)

1. The Fundamentals of Accounting

• Purpose of accounting – to record, classify and summarise a business’s financial transactions so that reliable information is available for monitoring performance, planning and decision‑making.
• Book‑keeping vs. accounting – book‑keeping is the systematic recording of transactions; accounting adds interpretation, analysis and the preparation of financial statements.
• Accounting equation – Assets = Liabilities + Owner’s Equity
• Double‑entry principle – every transaction affects at least two accounts; one debit and one credit of equal amount.

Example – Purchase of stock on credit for £5 000

2. Sources of Accounting Data & Recording

• Business documents – invoices, receipts, credit notes, bank statements, payroll sheets, electronic payment confirmations, etc.
• Books of prime entry
  • Sales journal, purchases journal, cash book, journal proper.
  • Imprest petty‑cash book for small cash payments.
• Ledger divisions
  • Sales ledger – records each customer’s transactions (trade debtors).
  • Purchases ledger – records each supplier’s transactions (trade creditors).
  • Nominal ledger – contains all income, expense, asset, liability and capital accounts.
• Discounts
  • Trade discount – reduction off the list price, recorded before the invoice is issued and does not appear in the accounts.
  • Cash discount – incentive for early payment (e.g., 2 % if paid within 10 days) and is recorded as a reduction of revenue or expense.
• Journals → Ledgers → Trial Balance – the classic accounting cycle.

Sample journal entry – Cash sale of £2 200 (VAT 20 %)

3. Verification of Records

• Trial Balance – lists all ledger balances to confirm that total debits equal total credits.
• Control accounts – summarise subsidiary ledger activity (e.g., Trade Debtors Control, Trade Creditors Control).
• Bank reconciliation – adjusts the cash‑book balance to match the bank statement.
  • Typical adjustments: unpresented cheques, deposits in transit, bank fees, interest.
• Errors that do NOT affect the trial balance
  • Commission errors (wrong amount recorded on both debit and credit).
  • Compensating errors (two errors that offset each other).
  • Omission of a transaction entirely (both debit and credit omitted).
  • Principle errors (e.g., treating a capital expense as revenue).
• Suspense accounts – temporary accounts used to hold differences when the trial balance does not balance; cleared once the error is identified.
• Error correction – identify the type of error and make the appropriate journal entry to correct it.

Example – Simple trial balance

4. Accounting Procedures (Policies & Adjustments)

• Capital vs. revenue expenditure
  • Capital – creates a future economic benefit (e.g., purchase of machinery).
  • Revenue – consumed within the period (e.g., repairs, salaries).
  • Impact of mis‑classification: treating a capital purchase as revenue inflates expenses and reduces profit for the year, while understating assets on the balance sheet.
• Depreciation
  • Straight‑line: Depreciation = (Cost – Residual value) ÷ Useful life
  • Reducing‑balance: Depreciation = Opening NBV × Depreciation rate
• Disposals of assets – remove the gross cost and accumulated depreciation, record any gain or loss.
• Accruals and pre‑payments – recognise expenses/revenues in the period to which they relate, even if cash has not moved.
• Doubtful debts
  • Create a provision:
    Dr Bad‑debt expense Cr Provision for doubtful debts
  • Adjust the provision at year‑end if the estimated uncollectible amount changes.
• Inventory valuation – weighted‑average cost (default for IGCSE); FIFO is also acceptable. LIFO is not examined.

Depreciation example (straight‑line) – Machine cost £15 000, residual value £3 000, useful life 5 years:

Annual depreciation = (£15 000 – £3 000) ÷ 5 = £2 400.

5. Preparation of Financial Statements

5.1 Sole‑Trader

• Statement of Profit or Loss (Income Statement)
• Statement of Financial Position (Balance Sheet)

5.2 Partnership

• Statement of Profit or Loss – as for a sole trader.
• Appropriation Account – shows how profit is divided between partners (interest on capital, salary, share of profit).
• Capital & Current Accounts – each partner has a capital account (initial investment + share of profit – drawings) and a current account for drawings and interest.

5.3 Limited Company

• Statement of Comprehensive Income (or Profit & Loss).
• Statement of Changes in Equity – shows issue of share capital, retained earnings, dividends.
• Statement of Financial Position – classifies equity as share capital, share premium, retained earnings, and reserves.

5.4 Clubs / Societies (non‑profit)

• Receipts & Payments Account – records cash inflows and outflows (similar to a cash flow statement).
• Income & Expenditure Account – accruals are added, giving a profit‑or‑loss for the period.
• Statement of Financial Position – assets, liabilities and accumulated fund (equity).

5.5 Manufacturing Accounts (when required)

• Calculate cost of production:
  1. Opening stock of raw material
  2. + Purchases of raw material
  3. – Closing stock of raw material
  4. = Raw material used
  5. + Direct wages
  6. + Direct expenses
  7. = Direct costs
  8. + Production overheads (applied)
  9. = Prime cost
  10. + Opening work‑in‑process
  11. – Closing work‑in‑process
  12. = Cost of goods manufactured
  13. + Opening finished‑goods stock
  14. – Closing finished‑goods stock
  15. = Cost of goods sold

5.6 Incomplete Records (single‑entry system)

• Reconstruct the missing information using the adjusted trial balance method, the gross profit method, or the bank‑statement method.
• Prepare a Statement of Profit or Loss and a Statement of Financial Position from the reconstructed data.

Example – Simplified Income Statement (sole trader)

Example – Simplified Statement of Financial Position (sole trader)

6. Analysis and Interpretation

6.1 Profitability Ratios

6.2 Working‑Capital Ratios

6.3 Interpretation Guidelines

• Compare each ratio with (a) the business’s own historical figures and (b) industry benchmarks.
• Analyse trends over at least three periods – a steady rise/fall is more informative than a single outlier.
• Consider inter‑relationships: a high GPM but low NPM often points to excessive operating expenses.
• Adjust for one‑off items (e.g., extraordinary gains) before drawing conclusions.
• Identify the interested parties who use the information (owners, lenders, suppliers, customers, management).
• Remember limitations – ratios are based on historical data, may be affected by accounting policies, and do not capture qualitative factors.

6.4 Recommendations for Improving Profitability

1. Increase Sales Revenue
   • Develop new product lines or services that meet identified market demand.
   • Run targeted marketing campaigns (social media, local advertising, loyalty schemes).
   • Review pricing strategy – consider value‑based pricing where the brand permits.
2. Control Direct Costs
   • Negotiate better terms with suppliers; explore alternative sources.
   • Use bulk‑buying where storage capacity allows.
   • Introduce waste‑reduction programmes on the shop‑floor.
3. Reduce Operating Expenses
   • Analyse overheads (rent, utilities, admin salaries) and cut non‑essential items.
   • Outsource non‑core activities (payroll, IT support).
   • Implement energy‑saving measures to lower utility bills.
4. Improve Asset Utilisation
   • Increase capacity utilisation by better production scheduling.
   • Sell or lease under‑used equipment to generate extra income.
5. Optimise Financial Structure
   • Review interest‑bearing debt; refinance at lower rates where possible.
   • Maintain an appropriate mix of debt and equity to maximise ROCE.

6.5 Recommendations for Improving Working Capital

1. Accelerate Receivables
   • Offer modest early‑payment discounts (e.g., 2 % if paid within 10 days).
   • Strengthen credit control – perform credit checks, set clear limits.
   • Send regular statements and follow up promptly on overdue accounts.
2. Manage Inventory Efficiently
   • Adopt a Just‑In‑Time (JIT) ordering system to cut holding costs.
   • Classify stock using ABC analysis; focus tight control on high‑value items.
   • Review slow‑moving items regularly and consider clearance sales.
3. Extend Payables Sensibly
   • Negotiate longer credit periods (e.g., 60 days) where suppliers agree.
   • Take full advantage of agreed terms; avoid early payment unless the discount exceeds the cost of capital.
4. Maintain Adequate Cash Reserves
   • Prepare short‑term cash forecasts (weekly or monthly) to anticipate shortfalls.
   • Keep a minimum cash balance in an interest‑bearing account.
   • Consider a revolving credit facility as a safety net.