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Topic 6.4 – Interested Parties: Owners

Learning objective

Identify owners as interested parties, explain why they are interested, describe the information they need, and show how the four primary financial statements satisfy those needs in line with the Cambridge IGCSE Accounting (0452) syllabus.

6.4.1 Who are the owners?

  • Sole trader – a single individual who owns and runs the business.
  • Partnership – two or more individuals who share ownership and control.
  • Shareholders (stockholders) – individuals or entities that own shares in a limited company.
  • Owners of clubs, societies or other non‑trading organisations – they also require information on profitability, assets and cash flow to decide on funding, membership fees and future activities.

6.4.2 Why owners are interested parties

  1. They have invested capital and expect a return on that investment.
  2. They bear the financial risk of loss.
  3. They decide on future investment, dividend (or drawing) policy and overall business strategy.
  4. They need information for personal tax returns, compliance with lenders or regulatory bodies.

Link to core accounting principles

The business‑entity principle requires that a business’s financial affairs be recorded separately from those of its owners, giving owners the right to receive distinct financial statements. The matching principle ensures that expenses are recognised in the same period as the revenues they help generate, providing owners with a true picture of profitability. Finally, the going‑concern assumption underpins the preparation of a balance sheet that reflects the entity’s ability to continue operating, which is essential for owners when assessing the security of their capital.

6.4.3 Owners’ rights and responsibilities

Rights Responsibilities
Receive a share of profits (dividends for shareholders, drawings for sole traders/partnerships). Provide the initial capital and, when required, additional funding.
Vote on major business decisions (e.g., appointment of directors, changes to partnership agreement). Monitor performance and hold management accountable.
Access to financial information (annual accounts, interim reports). Comply with legal and regulatory requirements (filing accounts, paying corporation tax, etc.).

6.4.4 Information owners need

Owners require information that enables them to assess:

Information need What it tells the owner Financial statement(s) that provide it
Profitability Level of profit and how it is distributed. Income Statement; Statement of Changes in Equity
Capital structure (equity & debt) Amount of equity invested, retained earnings and any borrowings. Statement of Financial Position; Statement of Changes in Equity
Liquidity Ability to generate cash for dividends/drawings. Cash Flow Statement; Statement of Financial Position (cash & current assets)
Overall financial position Net assets (owner’s equity) and the safety margin against creditors. Statement of Financial Position

6.4.5 How the four financial statements meet owners’ needs

Financial statement Primary information for owners
Income Statement (Profit & Loss Account) Revenue, expenses, gross profit and net profit – the basis for profitability analysis and dividend decisions.
Statement of Financial Position (Balance Sheet) Assets, liabilities and owner’s equity – shows net worth and capital structure.
Statement of Changes in Equity (Statement of Owner’s Equity) Opening equity, profit for the period, drawings/dividends and closing equity – tracks how the owner’s stake changes over time.
Cash Flow Statement Cash generated from operating, investing and financing activities – indicates cash available for distribution and future investment.

6.4.6 Key ratios and calculations used by owners

  • Return on Capital Employed (ROCE) $$\text{ROCE} = \frac{\text{Profit before interest and tax (PBIT)}}{\text{Capital Employed}} \times 100\%$$ (Capital Employed = equity + non‑current liabilities)
  • Return on Capital Invested (ROCI) $$\text{ROCI} = \frac{\text{Net profit}}{\text{Total capital invested}} \times 100\%$$
  • Earnings per Share (EPS) – for shareholders $$\text{EPS} = \frac{\text{Net profit} - \text{Preferred dividends}}{\text{Number of ordinary shares outstanding}}$$
  • Dividend (or drawing) payout ratio** $$\text{Payout ratio} = \frac{\text{Dividends paid (or drawings)}}{\text{Net profit}} \times 100\%$$
  • Debt‑to‑Equity ratio** $$\text{Debt‑to‑Equity} = \frac{\text{Total debt}}{\text{Owner’s equity}}$$ Used to gauge financial risk.

These ratios allow owners to:

  • Assess the return on their investment (ROCE, ROCI, EPS).
  • Decide how much profit to retain versus distribute (payout ratio).
  • Monitor financial risk and compare performance with other firms (debt‑to‑equity, inter‑firm comparison).

6.4.7 Limitations of financial statements for owners

  • Prepared on a historic‑cost basis – may not reflect current market values of assets.
  • Do not contain non‑financial information (e.g., market conditions, customer satisfaction, employee morale).
  • Only provide a snapshot at a point in time (balance sheet) or for a specific period (income & cash‑flow statements).
  • Subject to estimation and judgement (e.g., depreciation, bad‑debt provisions).

6.4.8 Numeric example – how owners interpret the statements

Scenario: A sole trader, “Green Gardens Ltd”, provides the following abbreviated accounts for the year ended 31 December 2024.

Income Statement
Sales revenue£120 000
Cost of sales£70 000
Gross profit£50 000
Operating expenses£30 000
Net profit£20 000
Statement of Financial Position
Cash£30 000
Equipment (cost)£50 000
Total assets£80 000
Bank loan (non‑current)£20 000
Owner’s equity (capital)£60 000
Statement of Changes in Equity
Opening equity (capital introduced)£50 000
Profit for the year£20 000
Drawings£10 000
Closing equity£60 000
Cash Flow Statement (selected)
Cash generated from operations£22 000
Cash used for equipment purchase(£5 000)
Net increase in cash£17 000

Key calculations

  • ROCI Total capital invested = Owner’s equity (£60 000) + Loan (£20 000) = £80 000 $$\text{ROCI} = \frac{£20 000}{£80 000}\times100 = 25\%$$
  • Debt‑to‑Equity ratio** $$\frac{£20 000}{£60 000}=0.33$$ (or 33 %) – indicates a relatively low financial risk.
  • Payout (drawing) ratio** $$\frac{£10 000}{£20 000}\times100 = 50\%$$ – half of the profit is taken out as drawings.

Owner’s interpretation

  1. Profit increased to £20 000 – a positive signal for future dividends/drawings.
  2. Statement of Changes in Equity shows a retained profit of £10 000, raising equity from £50 000 to £60 000.
  3. Balance sheet reveals a debt‑to‑equity ratio of 0.33, well below the typical “danger zone” of 1.0, so the owner feels comfortable borrowing if needed.
  4. Cash flow shows £22 000 of operating cash, confirming that sufficient cash exists to cover the £10 000 drawings and still leave a cash buffer.

6.4.9 Exam‑style analysis task (AO2)

Using the data above, calculate the current ratio and comment on the owner’s short‑term liquidity position. Show all working.

Solution (model answer)

  • Current assets = Cash (£30 000) – (no inventories or receivables shown).
    Current liabilities = none listed as current; the bank loan is non‑current.
    Current ratio = £30 000 ÷ £0 → not applicable (the business has no current liabilities).
    Interpretation: With no short‑term debt, the owner’s liquidity is strong; all cash is available for withdrawals or reinvestment.

6.4.10 Recommendation and critical evaluation (AO3)

Recommendation: Based on a 25 % ROCI, a 0.33 debt‑to‑equity ratio and a 50 % payout ratio, the owner could safely increase the dividend (or drawings) to 60 % of profit (£12 000). This would reward the owner without jeopardising the firm’s ability to fund the next year’s equipment purchase.

Critical discussion of a limitation: The financial statements are prepared on a historic‑cost basis, so the equipment is shown at £50 000 even though its market value may be considerably lower after depreciation. If the owner were to sell the equipment, the realised cash could be far less than the balance‑sheet figure suggests, potentially overstating the firm’s true net assets and misleading the owner’s assessment of financial risk.

6.4.11 Other interested parties (≈ 150 words)

Besides owners, the IGCSE syllabus expects learners to recognise several additional interested parties:

  • Managers – need profitability and cost‑control information to plan operations and evaluate performance (income statement, budget variance reports).
  • Creditors (trade payables, banks) – focus on liquidity and solvency; they examine the cash flow statement and the current ratio from the balance sheet.
  • Investors (potential shareholders) – assess growth prospects and returns using all four statements, especially EPS and ROCE.
  • Government and tax authorities – require data for corporation tax, VAT and statutory reporting; the income statement provides taxable profit.
  • Club members / society participants – look for evidence that the organisation can continue (balance sheet) and that surplus funds are available for activities (statement of changes in equity).
  • Employees – interested in the firm’s ability to pay wages and provide job security; they review cash flow and profitability.

6.4.12 Summary of owners’ information needs

Need Relevant statement(s) Typical use
Profitability assessment Income Statement; Statement of Changes in Equity Decide dividend/drawing amount; evaluate management performance.
Equity & capital structure Statement of Financial Position; Statement of Changes in Equity Assess net assets, plan future capital injections, monitor debt‑to‑equity.
Liquidity & cash availability Cash Flow Statement; Statement of Financial Position (cash & current assets) Determine ability to pay dividends/drawings and fund new projects.
Return on investment / inter‑firm comparison All statements (combined analysis) – used to compute ROCE, ROCI, EPS, etc. Benchmark performance against competitors; justify investment decisions.

6.4.13 Key terms

  • Drawings – cash or assets taken by a sole trader/partner from the business.
  • Dividends – distribution of profit to shareholders.
  • Owner’s equity – residual interest of owners after liabilities are deducted.
  • Capital structure – mix of equity and debt financing.
  • Liquidity – ability to meet short‑term cash needs.
  • ROCE / ROCI – measures of profitability relative to capital employed.
  • Debt‑to‑Equity ratio – indicator of financial risk.
Suggested diagram: Flow of financial information from the business to owners – showing how each of the four financial statements feeds into owners’ decision‑making (profitability → dividend policy, capital structure → financing decisions, liquidity → cash distribution, overall position → strategic planning).

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