There are two main uses to which value added statements can be put.
Shareholders reading the statement can note the trend of distributions to themselves, to the labour force and to reinvestment for growth. Any tendency to an increased labour share at the expense of reinvestment may lead them to reconsider their continued shareholding.
Trade-union officials and employees will find the value added state- ment more helpful than the profit and loss account. The size of value added puts an absolute maximum on employee remuneration even if one could ignore the legal claims for interest and tax. Employees are shown to be the recipients of the lion’s share of wealth in many companies and the debate on conflicting claims is more easily conducted using the value added statement. Perhaps more emphasis needs to be placed on increas- ing the size of the cake (value added) than on squabbling about the size of the four slices which in reality boils down to three, or even only two.
Value added
The other main use of the value added concept is in measuring performance. Chapter 9 introduces the idea of using ratios to measure aspects of cost control and asset utilization aimed at improving the return on capital. In a similar way we can examine the trend of value added per worker, or £ wages per £ value addedto monitor labour productiv- ity. Likewise, we can appraise capital productivity via the ratio £ value added per £ capital employed. Comparisons of these ratios between similar firms can only stimulate a more informed debate on efficiency and productivity.
Consideration should also be given as to whether the value added statement is produced on an historic or current cost basis. The latter would seem more appropriate because only after allowing for the cost of sales, depreciation and monetary working capital adjustments can we talk about the real wealth created at today’s prices.
Employee reports
This topic is introduced here because of its affinity to the value added statement, which is often used to communicate basic financial informa- tion to employees in place of the profit and loss account. Most employ- ees (and many shareholders for that matter) find the annual accounts totally confusing and, increasingly, firms prepare a short, salient finan- cial report just for their employees’ consumption.
The cornerstone of this report is usually a value added approach, describing the wealth created in the year and how it has been distrib- uted. Sometimes an abbreviated profit and loss account is given, but it is perhaps confusing to present both. Balance sheets are rarely given except in a highly summarized manner. The whole purpose of employee reporting is to communicate a few key facts on company performance which can be readily understood, rather than a morass of accounting detail which can thoroughly confuse the untrained reader.
Further reading
Wood, F and Sangster, A (2002) Business Accounting Vol 2,FT Prentice Hall, Harlow.
Self-check questions
1. Define value added.
2. A value added statement is based on the same concepts, and uses the same information, as which statement?
3. How might a firm use the value added to measure changes in productivity and efficiency?
4. Name the four parties to whom value added is distributed.
5. Even when firms do not include a value added statement in their annual reports, they may distribute one to which party?
Value added
Financial ratios
INTRODUCTION
Earlier chapters have examined the two most important financial state- ments of profit and loss account and balance sheet. To recapitulate – the trading performance of a company for a period of time is measured in the profit and loss account by deducting running costs from sales income. A balance sheet sets out the financial position of the company at a particular point in time, namely, the end of the accounting period. It lists the assets owned by the company at that date matched by an equal list of the sources of finance.
A person experienced in reading company accounts can get some insight into a company’s affairs by examining these financial statements.
Changes in some of the key items can be identified by comparing the current year’s figure with the previous year’s figure, but conclusions drawn from this approach can be misleading. Consider the following situation.
Example
Consider a company whose profit increased by 5 per cent over the previous year.
This might appear to be a good performance until one considered that a 4 per cent rate of inflation existed during the year, and that an extra 10 per cent of capital employed was needed to earn that extra profit.
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Analytical approach
Experienced and inexperienced readers of accounts will benefit from a more methodical analysis of the figures. The main analytical approach is to examine the relationship of pairs of figures extracted from the accounts. A pair may be taken from the same statement, or one figure from each of the profit and loss account and balance sheet statements.
When brought together, the two figures are called ratios, although this term is not always used in the normal sense of the word. Some of the ratios are meaningful in themselves, but their value mainly lies in their comparison with the equivalent ratio last year, a target ratio, or a competitor’s ratio.
All too frequently one sees television or newspaper reporting that some leading company made £x million profit last year. As a sum of money the figures sound very large and more naive audiences might be tempted to think of excessive prices being charged. Such reporting is almost meaningless without reference to last year’s figure, the size of the company’s sales, or the amount of capital employed. In other words, the absolute value of profit is not as meaningful as, say, the return on capital employed or the profit margin on sales, both of which are expressed as percentages.
Forms of ratios
Ratios can be expressed in one of three forms although it is mainly convention which determines which form one particular ratio will take.
The three forms are:
ᔢ a percentage – say when profit is expressed as a percentage of sales turnover;
ᔢ a multiple – for example, sales being three times the size of the capital employed;
ᔢ a true ratio – as when the ratio of current assets to current liabilities was 2:1.