DEPARTMENT OF CIVIL, ENVIRONMENTAL AND GEOMATIC

ENGINEERING, UNIVERSITY COLLEGE LONDON

Companies and Financial Accounting

Week 6 – 14th November 2022

CEGE0016 – Financial Aspects of Project

Engineering
Gemma Cremen
Lecturer in Risk and Resilience Engineering
Infrastructure Systems Institute
g.cremen@ucl.ac.uk
Contents
• Companies

• What is Accounting?

• The Fundamental Accounting Equation

• Balance Sheet

• Income Statement

• Worked Example

• Cash Flow Statement

• Financial Ratios
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Simply Wall St (2022)

3
Companies

4
What is a Company?

• A company is a legal entity (“personality”) that can issue contracts, enter

into agreements or contracts, assume obligations, incur and pay debts, sue
and be sued in its own right, and be held responsible for its own actions.

• There are three main types of companies in the UK:

1. A sole trader
2. A partnership
3. A limited liability company

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Sole Trader

• A sole trader:

➢ Runs their own business as an individual

➢Keeps all of the net profits

➢Is personally responsible for any losses their business makes

(unlimited liability)

6
New York Times (2021)
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Partnership
• A partnership:

➢ Involves two or more partners who share responsibility for the business

➢Keeps all of the net profits (jointly)

➢Is jointly responsible for any losses their business makes

(joint unlimited liability)

• A partner does not have to be an actual person. For example, a limited

company counts as a “legal person” and can also be a partner
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Limited Liability Company
• A limited liability company that is “limited by shares” or “limited by
guarantee”
Limited by Shares Limited by Guarantee
Usually businesses that make a profit Usually businesses that are “not for profit”

• Is legally separate from those who run it • Is legally separate from those who run it
(limited liability) (limited liability)

• Has shares and shareholders • Has gurarantors and a “guaranteed amount”

• Retains net profits • Invests profits it makes back into the company

9
10
Limited Liability Company
• A limited liability company that is “limited by shares” or “limited by
guarantee”
Our focus for the rest of this
Limited by Shares lecture! Limited by Guarantee
Usually businesses that make a profit Usually businesses that are “not for profit”

• Is legally separate from those who run it • Is legally separate from those who run it
(limited liability) (limited liability)

• Has shares and shareholders • Has gurarantors and a “guaranteed amount”

• Retains net profits • Invests profits it makes back into the company

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Structure of a Limited Liability
Company Limited by Shares
Shareholders

Board of Directors

Company Secretary

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What is a Shareholder?
• Shareholders own a limited liability company limited by shares

• They have no day-to-day duties related to the company’s operation

• Each shareholder owns a fraction of the company (and has corresponding

voting power) proportional to their shareholding (investment)

• The liability of shareholders is limited to their original investment

• The company’s profits are paid to shareholders as share dividend

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What is the Board of Directors?
• The Board of Directors is elected by the shareholders at the Annual
General Meeting (AGM) to run the company
➢ Directors may also be shareholders (but not necessarily)
➢ The shareholders can vote to appoint or sack individual Board of Directors members

• The Board of Directors files the company’s audited accounts

Both are legal
• The Board of Directors report to the shareholders at the AGM requirements

• The Board of Directors is controlled by the Chairman of the Board

Responsible
• The Board of Directors can appoint or sack the Chief Executive Officer for day-to-day
(CEO) running
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What is a Company Secretary?
• The Company Secretary ensures the smooth administration of the
company

• The Company Secretary is responsible for:

➢ Making sure the company stays within the law
➢ Making sure the company maintains proper record books and accounts
➢ Providing strategic advice to the Board of Directors (sometimes)

• The Company Secretary may or may not be a member of the Board of

Directors

15
Limited Liability Company
• A limited liability company that is “limited by shares” can be
public or private
Private Limited Company (Ltd.) Public Limited Company (PLC)
Share ownership is controlled Share ownership is NOT controlled
• Is owned privately • Company shares can be bought and sold
publically on the open market (a stock
exchange)

• Only one director is required • Two directors are required

• Have nine months to file their annual accounts • Have six months to file their annual accounts

• A company secretary is not legally required • A company secretary is legally required

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 What is Accounting?

“Creativity is great, but not in Accounting”

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What is Accounting?

• Accounting is the collection, analysis, and communication of

financial information that is used by:
• Those who need to make decisions and plans in an
organisation
• Those who need to control an organisation

• Accounting helps companies to plan for the future and evaluate past
performance

• Accounting is often referred to as the language of business

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The Fundamental Accounting Equation

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The Fundamental Accounting
Equation

Assets = Liabilities + Owners’ Equity Rights or claims

against the resources
of the company

Those things of What the company What the company

monetary value that owes to creditors owes to shareholders
a company owns
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Assets, Liabilities, and Owners’ Equity
• Assets are resources that a company owns. They have the capacity to
provide future services or benefits.
• Companies use their assets in carrying out activities like production and
sales

• Liabilities are claims against assets – existing debts and obligations

• They arise from purchasing items on credit or borrowing money from a
bank for purchases

Owners’ Equity is what remains of the assets after all liabilities have been
paid
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Assets, Liabilities, and Owners’ Equity

Assets Liabilities Owners’ Equity

Cash Wages due Owners’ capital
Equipment Bank debt
Buildings Accounts payable
Land
Inventories

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Some Important Definitions
Assets are economic resources that a company expects to help
generate future cash inflows or help reduce future cash outflow

Current Assets are a company’s cash and other assets that are
expected to be converted to cash over the next one year period

Non-current Assets are a company’s assets that are not

expected to be converted to cash over the next one year period

Inventory are goods (current assets) available for sale or raw

materials and components used to produce goods available for sale
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Some Important Definitions
Liabilities are economic obligations of the organisation to
outsiders, or claims against its assets by outsiders

Current Liabilities are a company’s short-term obligations, due

within one year period

Non-current Liabilities are a company’s long-term obligations

listed on the balance sheet

Dividends are money paid regularly to shareholders by the

company
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Balance Sheet

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Balance Sheet

• The balance sheet is one of the two most common accounting statements

• The fundamental accounting equation defines the format of the balance

sheet

• The balance sheet shows the financial position of the company at one
instant in time (e.g., end of the quarter or end of the year)

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Balance Sheet

Assets Liabilities/Owners’ Equity

Cash £2,500 Accounts payable £1,200
Land £1,800 Bank note £900
Accounts receivable £800 Owners’ Equity £3,000

Total assets £5,100 Total liabilities £5,100

and Owners’
equity

Assets = Liabilities + Owners’ Equity = £5,100

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Income Statement

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Income Statement

• The income statement is the second of the two most

common accounting statements

• The income statement summarises the revenue

and expense results of operations over a period
of time (a moving picture)

Increase in money value (not cash) that results

• It is defined by the following equation: from a company’s operations and is available for
distribution to its owners
Profit (or Loss) = Revenues – Expenses 29
Income Statement

Revenue
Sales £3,000
Expenses
Labour £1,200
Material £400
Depreciation £500
Total Expenses £2,100
Net Income £900

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Some Important Definitions

Turnover is the net sales generated by a business

Turnover and profit are the

beginning and end points
of the income statement

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Worked Example

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Worked Example
• John Deere owns and operates a design company called Deere Consulting Ltd. The
financial position of his business is: Cash £1,720
Accounts Receivable £3,240
Land £24,100
Accounts Payable £5,400
John Deere, Capital £23,660
• During May 2021, the following events occurred:
1. Deere received £12,000 as a gift and deposited the cash in the business bank account
2. Deere paid off the beginning balance of accounts payable
For Deere Consulting Ltd.,
3. Deere performed services for a client and received cash of £1,100
4. Deere collected £750 cash from a customer on account
Prepare:
5. Deere purchased £720 of supplies on account
(a) The income statement
6. Deere billed a client £5,000 for services rendered
for the month ended 31
7. Deere invested personal cash of £1,700 in the business May 2021
8. Deere recorded £1,860 of business expenses (b) The balance sheet as at
9. Deere sold supplies to another company for £80 cash (the price of the supplies) 31 May 2021
10. Deere withdrew £4,000 cash for personal use 33
Worked Example
Deere Consulting Ltd.
Income Statement
Month Ended 31 May, 2021
Revenue
Services to Client 1 £5,000
Services to Client 2 £1,100
Total Revenue £6,100
Expenses
Business Expenses £1,860
Net Income £4,240

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Worked Example
Deere Consulting Ltd.
Balance Sheet
31 May, 2021
Assets Liabilities/Owners’ Equity
Cash £6,090 Accounts payable £720
Accounts receivable £7,490
Supplies £640
Land £24,100 J. Deere, Capital £37,600

Total assets £38,320 Total liabilities £38,320

and Owners’
equity
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Cash Flow Statement

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 Cash Flow Statement
• The cash flow statement shows how a company
generated the cash flows it needed to finance its various
opportunities and responsibilities over a period of time
(a moving picture)

• It acts as a bridge between the income statement and the balance sheet by
showing how money moved in and out of the business

• The cash flow statement has three primary sections:

1. Cash flow from operating activities Sum of these
2. Cash flow from investing activities sections = net
3. Cash flow from financing activities cash flow 37
Cash Flow from Operating Activities

• Cash Inflows
➢Generation of funds in normal operations

• Cash Outflows
➢Expenditure of funds in normal operations

38
Cash Flow from Investing Activities

• Cash Inflows
➢Sale of plant and equipment
➢Liquidation of long-term investment

• Cash Outflows
➢Purchase of plant and equipment
➢Long-term investments

39
Cash Flow from Financing Activities

• Cash Inflows
➢Sale of bonds, common stock, and other securities

• Cash Outflows
➢Repurchase of bonds, common stock, and other securities
➢Payment of cash dividend

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Cash Flow Statement Cash flows from operating activities
Cash generated from operations £5,460
Income tax paid -£1,351
Interest paid -£40
Net cash flow from operating activites £4,069
Cash flows from investing activities
Interest received £100
Purchases of property, plant and -£5,894
equipment
Proceeds on disposal of property £41
Capital grants received £1,979
Net cash flow from investing activities -£3,774
Cash flows from financing activities
Repayments of borrowings -£10,991
New loans raised £10,841
Repayment of lease liabilities -£107
Net cash flow from financing activities -£257
Net increase/(decrease) in cash and cash £38
equivalents
Cash and cash equivalents at beginning £430
of the period
Cash and cash equivalents at end of £522
year 41
 Financial Ratios
• Financial ratios are mathematical calculations that a
company can use to evaluate its performance

• They are relative magnitudes of selected numerical values taken from a

company’s financial statements

• Financial ratios may be used by managers, stakeholders, or creditors to:

➢Determine whether key performance trends are improving or not
➢Compare ratios (and therefore company performances) between years
➢Define goals for future performance

• Financial analysts use financial ratios to compare strengths and

weaknesses across various companies 42
 Financial Ratios
• There are 5 different types of Financial Ratios:

Help evaluate a company’s ability to pay its bills on a

1. Liquidity Ratios regular week-to-week or month-to-month basis

Measure how much of a company’s assets belong to the

2. Financial Leverage Ratios shareholders rather than creditors (lenders)

3. Asset Utility Ratios Measure how efficient a company is with using its assets
to generate revenue

Help evaluate how well the firm generates a profit through

4. Profitability Ratios its operations

Help evaluate the economic status of publicly traded

5. Market Value Ratios companies and can play a role in identifying stocks that
may be overvalued, undervalued, or priced fairly 43
Financial Ratios – Liquidity Ratios
• Measure the ability to pay short-term debt
Current Assets
Current Ratio =
Current Liabilities
If Current Ratio < 1, the company has liquidity problems to
cover its short-term liabilities

If Current Ratio = 1, the company is able to cover its short-

term liabilities

The ideal Current Ratio is between 1.2 and 2

44
Financial Ratios – Liquidity Ratios
• Measure the ability to pay short-term debt
Why would
Current Assets − Inventory this ratio be
Quick Ratio = required?
Current Liabilities

If Quick Ratio < 1, the company finds it hard to fully pay its
debt in the short term

If Quick Ratio > 1, the company is able to cover its debt

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Financial Ratios – Liquidity Ratios
• Measure the availability of cash to pay debt
Why would
Cash this ratio be
Cash Ratio = required?
Current Liabilities
If Cash Ratio < 1, there is insufficient cash to pay off short-
term debt

If Cash Ratio = 1, there is sufficient cash to pay off short-term

debt

If Cash Ratio > 1, there is more than sufficient cash to pay

off short-term debt 46
Financial Ratios – Financial Leverage Ratios
• Measure the degree to which a company has used to debt to finance its
assets
Total Assets − Total Equity
Total Debt Ratio = Total Assets
What does this value account for?

Total Debt Ratio quantifies the proportion of company

financing that comes from creditors
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Financial Ratios – Financial Leverage Ratios
• Measure the degree to which shareholder equity covers all outstanding
debts
Would you
Total liabilities prefer a
Debt-Equity Ratio = Total equity lower or a
higher ratio?

Debt-Equity Ratio quantifies the proportion of company

financing that comes from investors
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Financial Ratios – Financial Leverage Ratios
• Measure the degree to which stakeholder equity covers the company’s
assets
Would you
Total Assets prefer a
Equity Multiplier Ratio = Total Equity lower or a
higher ratio?

Debt-Equity Ratio quantifies the proportion of a company’s

assets that is financed by stakeholder equity
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Financial Ratios – Financial Leverage Ratios
• Measure the creditworthiness of a company (the ability of the company to
meet its debts)

Times Interest Earned Ratio = Would you

Earnings before interest and taxes prefer a
lower or a
We will use the
Interest higher ratio?
“EBIT” acronym

Times Interest Earned Ratio quantifies the number of times a

company could pay the interest on its annual debt
50
Financial Ratios – Financial Leverage Ratios
• Measure the ability of a company to service its debt and meet financial
obligations (e.g., interest payments and dividends)

Cash Coverage Ratio = Would you

EBIT + Non − Cash Expenses prefer a
lower or a
Interest higher ratio?

Cash Coverage Ratio quantifies the cash available to a

company as a proportion of the interest on its annual debt
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Financial Ratios – Asset Utility Ratios
• Measure how effectively a company manages its inventory

Inventory Turnover = What does

Cost of goods sold a low value
Average of this ratio
inventory over Inventory indicate?
the course of
the period
Inventory Turnover quantifies the number of times an
inventory is created and sold during the period
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Financial Ratios – Asset Utility Ratios
• Measure how long a company’s current stock of inventory will last

Day Sales in Inventory = What does

365 a high value
of this ratio
Inventory Turnover indicate?

Inventory Turnover quantifies the average time in days that a

company takes to turn its inventory into sales
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Financial Ratios – Asset Utility Ratios
• Measure how quickly a company is collecting its sales that were made on
credit

Receivables Turnover =
What does
Net Annual Credit Sales a low value
of this ratio
Accounts Receivable indicate?

Receivables Turnover quantifies the number of times

“accounts receivable” have been created through the sale of
goods on credit
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Financial Ratios – Asset Utility Ratios
• Measure how quickly a company is collecting cash from its credit sales

Day Sales in Accounts Receivable =

What does
365 a high value
of this ratio
Receivable turnover indicate?

Day Sales in Accounts Receivable quantifies the average time

in days that a company takes to collect cash from its credit
sales
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Financial Ratios – Asset Utility Ratios
• Measures the value of a company’s sales or revenues relative to its assets

• Total Asset Turnover Ratio =

What does
Total Annual Sales a high value
of this ratio
Total Assets indicate?

Total Asset Turnover Ratio quantifies the size of total sales as

a proportion asset investment
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Financial Ratios – Asset Utility Ratios
• Measures the amount of assets required to generate £1 in sales

• Capital Intensity Ratio =

How does this
Total Assets value relate to the
Total Asset
Total Annual Sales Turnover Ratio?

Capital Intensity Ratio quantifies the size of asset investment

as a proportion of total sales
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Financial Ratios – Profitability Ratios
• Measures the degree to which a company makes money

Net Income Would you prefer a

• Profit Margin = higher or lower
Net Sales value for this ratio?

Profit Margin quantifies the proportion sales that has turned

into profit
58
Financial Ratios – Profitability Ratios
• Measures a company’s net income produced from its total assets

• Return on Assets Ratio =

Would you prefer a
Net Income higher or lower
value for this ratio?
Total Assets

Return on Assets Ratio quantifies company income as a

proportion of its total assets
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Financial Ratios – Profitability Ratios
• Measures the return a company makes on its equity

• Return on Equity Ratio =

What does a high
Net Income value of this ratio
indicate?
Total Equity

Return on Assets Ratio quantifies net income as a proportion

of shareholder equity
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Important Definitions – Market Value Ratios
Shares are units of equity ownership in a company

Stocks are the same as shares

A stock exchange is a market that matches buyers of company

shares with sellers of company shares

A financial market is a place where financial assets are issued

and traded

61
Financial Ratios – Market Value Ratios
• Measures whether a company’s stock price is overvalued or undervalued

• Price-Earnings Ratio =
What does a low
Price Per Share value of this ratio
indicate?
Earnings Per Share

Price-Earnings Ratio quantifies current share price as a

proportion of profit per share
62
Financial Ratios – Market Value Ratios
• Measures whether a company is overvalued or undervalued

• Market-to-Book Ratio =
Stock price (worth on Would does ratio
the market) Market Value Per Share less than 1
indicate?
Amount of money left if Book Value Per Share
all assets are sold and
all liabilities are paid
Market-to-Book Ratio quantifies a company’s current market
value relative to its book value
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Summary of Today’s Lecture
• Companies
➢ Definition of a Company
➢ Description of Company Structures

• Accounting
➢ Definition of the Fundamental Accounting Equation
➢ Description of Balance Sheet
➢ Description of Income Statement
➢ Description of Cash Flow Statement
➢ Description of Financial Ratios
❑ Liquidity Ratios
❑ Financial Leverage Ratios
❑ Asset Utility Ratios
❑ Profitability Ratios
❑ Market Value Ratios
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