Accounting concepts and the measurement of financial performance and position

Understanding Accounting Concepts

Accrual Concept: Revenue and expenses are recognized when they are earned and incurred, respectively, rather than when they are received or paid.
Prudence Concept: Also known as conservatism, it involves recording potential losses and obligations when they are probable, but not recording potential gains and assets until they are certain.
Consistency Concept: Accounting methods and practices should remain consistent from one accounting period to another to ensure comparability of financial information.
Going Concern Concept: It assumes that a business entity will continue its operations for the foreseeable future.
Materiality Concept: Financial reports should include all material facts. A fact is material if its omission or misstatement could influence economic decisions of users.
Entity Concept: The business is treated as a separate entity from its owners, managers, employees etc. Any funds from or to these individuals should be treated as investments, withdrawals, etc.

Measuring Financial Performance

Profitability Ratios: Determine the ability of a company to generate profits. Key ratios include Gross Profit Margin, Operating Profit Margin, and Net Profit Margin.
Liquidity Ratios: Measure the ability of a company to meet its short-term obligations. Important ratios are Current Ratio and Quick Ratio (or Acid Test Ratio).
Efficiency Ratios: Analyse how effectively a company is using its assets and managing its liabilities. Key ratios are Inventory Turnover, Receivable Days, Payable Days, and Asset Turnover.
Gearing Ratios: Evaluate the financial risk of a company by looking at the proportion of capital funded by debt. Key ratio is Debt to Equity Ratio.

Measuring Financial Position

Assets: These are resources owned by the company that are expected to provide future economic benefits. There are two key types - current assets (such as cash and inventory) and non-current assets (like property, plant and equipment).
Liabilities: These are obligations of the company that are expected to lead to outflow of resources in future. Liabilities can also be current (payable within one year) or non-current.
Equity: This is the residual interest in the assets of the company after deducting liabilities. In simple terms, equity represents the owners’ claim on the company’s assets. It is also referred to as shareholders’ equity or net assets.
Capital Structure: This refers to the mix of equity and debt used to finance the company’s assets. An optimum capital structure balances risks and returns.
Financial Statements: They depict the financial performance and position of a company. Key financial statements include the income statement, balance sheet and cash flow statement. Each of these provides different but complementary information about the financial health of a company.