Working capital - Assignment Example

LIFO vs. FIFO LIFO (last in, first out) and FIFO (first in, first out) are two different ways of accounting for the value of unsold inventory. The FIFO method considers unsold inventory to be that which has been acquired most recently, and the LIFO method uses the goods bought earliest as the unsold inventory. The controller of this company may benefit from moving to the FIFO method as this is an approved accounting method, whereas LIFO is not accepted by IFRS. The effect of inflation on the two processes is different.

In inflation, the FIFO method is based upon the fact that the goods acquired earlier were cheaper to buy, which increases profit, decreases cost of goods sold, and the value of the unsold inventory is higher. The LIFO method works around the principle that goods acquired more recently are more expensive, meaning income tax is lower, COGS is increased and decreases net profit. Record keeping may also be easier using LIFO, because goods are sold from the earliest piece of inventory there will be less unsold goods to keep a record of.

In FIFO, the earliest goods may stay in the inventory for many years and therefore increases the need for record keeping from an early date. Goods from a number of years ago (as found in FIFO) may also cause the need to record strange fluctuations in cost of goods because their purchasing price may be radically different from the present day. 2. Depreciation Depreciation is the decrease in cost of assets. To properly provide an accurate net income for a company, it is important to also include the cost of this depreciation into income reports.

It is important to account for depreciation in value of an important asset because this reflects a cost to the business, despite the fact that the original purchase has already been made. It is a method of allocation. Calculations for depreciation are usually made using a variety of different values: cost of asset, expected salvage value, estimated useful life of the asset and a way of apportioning the costs over this life span. I would recommend using the straight line depreciation method as it is simple and usually fairly accurate.

The annual cost of depreciation is the cost of the asset minus the salvage value, divided by the lifespan of the asset in years. This has benefits over the double-declining balance method, which doesn’t always depreciate an asset fully by its end of life. 3. Current Liability Current liabilities are obligations for the company to fulfil which are based upon previous transactions. This can be a debt or a duty which will have an economic effect on the company. The term “current” refers to the current fiscal year or the operating life of the company.

Current liabilities are separated from long-term liabilities because they do not require payment or interest payment during the year, meaning that they should not be included in the financial year balance sheet. One example of a current liability could be a subscription, where the company has a liability to provide either the product (e.g. a magazine) or give a refund for the entire year, but no additional income will be gained. Another example could be a shop that provides a gift card option, as they have received payment but have a liability to provide the money or items to the customer. 4. Client Recommendations Sole proprietorship (as with a partnership) has the advantage of being easy to form, with no fees and no certificate of formation.

However, a sole proprietor has sole liability for debts and liabilities of the business, meaning that it can be high-risk. Sole proprietors and partnerships have the benefit of being reported for taxation purposes on an individual’s income tax form with no need to report business taxes. Partnerships and sole proprietorship have the benefit of being more informal in structure and formalities. Corporations require a lot more paperwork and are subject to double taxation (business tax and shareholder tax).

However, they do offer a limited amount of liability protection. For this reason, I would suggest that the potential new business owner should go into a partnership as it offers all the benefits of sole proprietorship but liability is shared between partners. 5. Ratios Ratios like the liquidity ratio are useful measures of viability but do leave some information out that may be useful for potential investors. For example, a company may have a good current liquidity ratio because it has a large amount in Accounts Receivable and a small amount in Accounts Payable, but if the Accounts Receivable figure is not receivable until after the payable figure it would run out of money in the short-term.

Liquidity ratios can be used to decide whether or not to invest in a company by allowing potential investors to see the overall state of quick assets to determine health, but must bear in mind the problem outlined above. 6. Profit Margin 7. Year Ending December 2012 Year Ending December 2011 Year Ending December 2010 Revenues 40,000 35,000 33,000 Operating Expenses Salaries 15,000 10,000 9,000 Maintenance and Repairs 6,000 9,000 10,000 Rental Expense 2,500 2,500 2,500 Depreciation 2,000 2,000 2,000 Fuel 4,000 3,500 2,500 Total Operating Expenses 29,500 27,000 26,000 Operating Income 10,500 8,000 7,000 Sales and Administrative Expenses 6,000 4,000 3,000 Interest Expense 2,500 2,000 1,000 Net Income 2,000 2,000 3,000 Profit Margin 5% 5.71% 9.09% It is interesting to see that the profit margin for each year shows a decrease.

The decrease in profit margin between 2010 and 2011 is quite large, and the change between 2011 and 2012 is small but still decreasing. This is interesting to see as the revenue for each year is showing a steady increase. We would assume from this that the costs for the company are increasing, which the figures show they are: salaries were growing (perhaps due to increased staffing needs because of the increased revenue) as were fuel costs. These two increases could also be due to inflation. The profit margin is an interesting figure as it shows that increased revenue is not the only important factor in operating a business.