It’s often said in the United States that we run two sets of books: financial accounting books and the tax books.
But there’s another important distinction to be made for small businesses between managerial accounting and financial accounting.
Let’s take a closer look.
What are managerial accounting and financial accounting?
Managerial accounting and financial accounting are two distinct branches of accounting that serve different purposes and have different audiences.
Financial accounting is concerned with the preparation of financial statements for external users, such as shareholders, creditors, and regulators.
The goal of financial accounting is to provide a clear and accurate picture of a company’s financial performance and position. Financial accounting reports are based on Generally Accepted Accounting Principles (GAAP) and are used to determine a company’s compliance with tax laws and regulations.
Managerial accounting, on the other hand, is concerned with providing information to internal decision-makers, such as managers and executives. The goal of managerial accounting is to help a company plan, control, and evaluate its operations.
Managerial accounting provides detailed, relevant, and timely information about a company’s financial and economic activities. This information is used by managers to make informed decisions about the future of the company.
Unlike financial accounting, managerial accounting is not regulated by GAAP, and there is more flexibility in the type of information that can be reported.
In summary, financial accounting focuses on meeting the needs of external stakeholders, while managerial accounting focuses on meeting the needs of internal stakeholders.
Focus on Financial Accounting
Financial accounting is the type of accounting that most people are familiar with. It presents itself in the forms of a profit loss, a balance sheet, and a statement of cash flows.
In both public and private companies, these are the primary financial statements issued to determine the health and activity of the company over the prior period.
Indicators from Financial Accounting
These financial health measures are usually done in the form of ratios. A few of the ratios that are used to determine the health of a company, based on financial accounting reporting, are:
- Current ratio
- Working capital ratio
- Earnings per share ratio
- Debt to assets ratio
- Return on equity ratio
- Interest coverage ratio
- and Debt service ratio
Current Ratio/Working Capital Ratio
The Working Capital Ratio, also known as the Current Ratio, is a financial metric that measures a company’s ability to pay its short-term obligations with its current assets. The formula for the working capital ratio is as follows:
Working Capital Ratio = Current Assets / Current Liabilities
Where “Current Assets” refers to the value of all assets that can be converted into cash within a year, such as cash, accounts receivable, and inventory. “Current Liabilities” refers to the value of all debts and obligations that are due within a year, such as accounts payable, short-term loans, and accruals.
A high working capital ratio indicates that a company has sufficient current assets to cover its short-term obligations, and therefore has a strong financial position.
A low working capital ratio, on the other hand, indicates that a company may have trouble meeting its short-term obligations, and therefore has a weak financial position.
Generally, a working capital ratio of 1.5 or higher is considered healthy, while a ratio below one indicates that a company has more liabilities than assets.
Debt to Assets Ratio
The debt-to-asset ratio is a financial metric that measures the proportion of a company’s financing that comes from debt relative to the total amount of financing (both debt and equity). The ratio is calculated by dividing the company’s total debt by its total assets.
A higher debt-to-asset ratio means that a larger portion of a company’s financing comes from debt, which can indicate a higher level of financial leverage and increased risk. On the other hand, a lower debt-to-asset ratio suggests that a company has a stronger equity position and may be less risky.
It’s important to keep in mind that debt-to-asset ratios can vary widely across different industries and that there is no one “correct” level. For example, a company in a capital-intensive industry like utilities or construction may have a higher debt-to-asset ratio than a company in a less capital-intensive industry, like technology or software.
When evaluating a company’s debt-to-asset ratio, it’s also important to consider other factors, such as its ability to generate cash flow and repay debt, its overall financial performance and stability, and its ability to handle fluctuations in interest rates and other economic conditions.
Return on Equity Ratio
The Return on Equity (ROE) ratio is a financial metric that measures the profitability of a company in relation to the equity held by its shareholders. It is calculated by dividing the net income of a company by its shareholders’ equity. The formula for ROE is:
ROE = Net Income / Shareholders’ Equity
ROE is an important indicator of a company’s financial performance and is widely used by investors, analysts, and credit rating agencies to assess the profitability of a company and its ability to generate returns for its shareholders.
A higher ROE indicates that a company is more efficient in using its equity to generate profits, while a lower ROE may indicate poor financial performance or inefficiency in using its equity.
It’s important to note that ROE can be influenced by a variety of factors, including a company’s debt level, business model, industry, and economic conditions. As such, it’s essential to compare ROE ratios among companies within the same industry or peer group for a more accurate assessment of performance.
Interest Coverage Ratio
Interest Coverage Ratio (ICR) is a financial metric that measures a company’s ability to pay its interest expenses on its debt. It is calculated as follows:
ICR = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
The higher the interest coverage ratio, the better the company’s ability to meet its interest payments. A ratio of 1.5 or higher is considered healthy, indicating that the company is earning enough to pay its interest obligations 1.5 times over.
A ratio less than one suggests that the company is struggling to meet its interest payments and may be at risk of default.
It is important to note that the interest coverage ratio is only one measure of a company’s financial health and should be considered in conjunction with other financial metrics such as debt-to-equity ratio, cash flow, and solvency ratios.
Debt Service Coverage Ratio
The Debt Service Ratio (DSR) is a financial metric used to assess the ability of a borrower to repay their debt obligations. It is calculated as the ratio of a borrower’s monthly debt payments to their monthly gross income.
The higher the DSR, the more of a borrower’s income is dedicated to debt repayment, and the lower their capacity to take on additional debt or other expenses.
Lenders and credit providers often use the DSR as a way to evaluate the risk associated with lending to a borrower. A high DSR can indicate that a borrower has a high level of debt and may be struggling to make payments, which can increase the risk of default.
On the other hand, a low DSR can indicate that a borrower has a low level of debt relative to their income and is better able to handle additional debt obligations.
The ideal DSR varies depending on the lender and the type of loan, but a general guideline is that a DSR of less than 36% is considered to be healthy and sustainable. Some lenders may require a lower DSR, while others may accept a higher DSR for certain types of loans or for borrowers with strong credit histories.
Earnings Per Share Ratio
Earnings per share (EPS) is a financial ratio that measures the amount of profit earned by a company on a per-share basis. It is calculated by dividing the company’s net earnings by the number of outstanding shares of its common stock.
The EPS ratio is an important metric used by investors and analysts to evaluate a company’s performance and determine its potential for growth.
A higher EPS ratio generally indicates that the company is profitable and has a strong financial position, which can attract more investors and increase the company’s stock price. Conversely, a lower EPS ratio can signal financial problems and reduce investor confidence in the company.
It’s important to note that EPS can be impacted by various factors, such as accounting methods, company size, and stage of growth. Therefore, it is typically used in conjunction with other financial metrics to get a more comprehensive view of a company’s financial performance.
The current ratio is just one of many financial metrics used to evaluate a company’s financial health, and a high current ratio may not always be a positive indicator, as it may indicate that a company is not efficiently using its current assets.
Other Indicators
The financial accounting reports will also reveal other information, like gross profit, net profit, the company’s cash balance, the company’s debt balance, and the total equity in the company.
These are all important financial indicators that allow outside parties to analyze the health of the company and its ability to continue to earn profits.
Managerial Accounting
Managerial accounting, also known as management accounting, is a branch of accounting that provides information and analysis to decision-makers within a company.
The primary aim of managerial accounting is to support managers in making informed business decisions by providing them with relevant, timely, and accurate financial and non-financial information.
Managerial accounting information is used for planning, controlling, and performance evaluation. It provides information about the costs of products or services; the profitability of products, customers, or divisions; and the financial performance of the company as a whole. It also helps managers understand how to allocate resources and make decisions that maximize profits and minimize costs.
Some common tools used in managerial accounting include cost-volume-profit analysis, budgeting, and activity-based costing.
Managerial accountants may also use performance metrics such as return on investment, return on equity, and economic value added to evaluate the financial performance of the company.
Cost-Volume-Profit Analysis
Cost-Volume-Profit (CVP) analysis is a fundamental tool in managerial accounting that helps organizations understand the relationship between their costs, revenue, and volume of production. It enables companies to analyze the impact of changes in their costs and sales volume on their overall profitability.
The basic equation for CVP analysis is as follows:
Total Revenue = Total Fixed Costs + Total Variable Costs + Total Profit
Fixed costs are expenses that do not change with the volume of production, such as rent and insurance. Variable costs, on the other hand, change with the volume of production, such as raw materials and direct labor.
With CVP analysis, managers can determine the breakeven point, which is the point where total revenue equals total costs. Beyond the breakeven point, a company will start to realize a profit.
CVP analysis is used for several purposes, including:
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Determining the optimal sales volume needed to achieve a target profit.
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Predicting the effect of changes in variable costs and fixed costs on profitability.
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Assessing the impact of price changes on profitability.
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Identifying the most cost-effective pricing strategy.
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Planning and budgeting for future operations.
Overall, CVP analysis is an important tool for managers in decision-making, as it helps them understand how changes in costs and sales volume will impact their bottom line.
Departmental Budgeting
Departmental budgeting is a process used by organizations to allocate resources to specific departments within the company. It is an important component of overall financial planning and management, as it helps organizations to ensure that resources are being used effectively and efficiently to support the company’s objectives and goals.
The process of departmental budgeting typically involves the following steps:
Establishing budgeting guidelines. The company establishes guidelines for how the budgeting process will be carried out, including the time frame, the departments that will be involved, and the data that will be required.
Setting departmental goals. Each department sets goals for the upcoming period, taking into account the company’s overall objectives and strategies.
Determining departmental expenses. Departments estimate their expected expenses for the upcoming period, including both fixed and variable costs.
Allocating resources. Based on the department’s goals and expected expenses, resources are allocated to each department. This may involve allocating funds for specific projects, personnel, or equipment.
Monitoring and controlling expenditures. Departments monitor their actual expenditures against their budget to ensure that they are staying within the allocated resources and making adjustments as necessary.
The benefits of departmental budgeting include:
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Improved coordination and cooperation between departments.
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Better allocation of resources to support the company’s goals and objectives.
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Improved financial control, as departments are held accountable for their spending.
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Increased transparency in the allocation and use of resources.
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Better decision making, as departments have a clear understanding of the resources available to them.
Overall, departmental budgeting is an essential tool for organizations to effectively allocate resources, improve financial control, and support the company’s overall success.
Activity Based Costing
Activity-Based Costing (ABC) is a costing method that assigns costs to products, services, or activities based on the resources they consume. It is a more accurate and detailed way of costing compared to traditional methods, such as process costing or job-order costing, which often do not accurately reflect the true cost of products or services.
The basic principle of ABC is to identify the specific activities that are performed to produce a product or service, and then allocate the costs of those activities to the products or services that consume them.
This allows for a more precise understanding of the costs associated with each product or service, and helps managers make more informed decisions about pricing, production, and resource allocation.
The process of ABC typically involves the following steps:
- Identify activities. The first step is to identify the specific activities that are performed in the production process, such as design, raw material procurement, and production.
- Assign costs to activities. Next, the costs of each activity are assigned, including direct and indirect costs.
- Determine the cost driver for each activity. The cost driver is the factor that causes the costs of an activity to be incurred, such as the number of times an activity is performed or the amount of materials used.
- Allocate costs to products or services. The costs of each activity are then allocated to the products or services that consume them, based on the cost driver.
- Analyze the results. The final step is to analyze the results of the ABC analysis and make decisions based on the information provided, such as adjusting prices or reallocating resources.
ABC is particularly useful in industries where products or services have significant differences in their cost structures, such as manufacturing or service industries. It can also be useful in identifying cost savings opportunities and improving decision-making processes.
Activity-Based Costing is a powerful tool for organizations to more accurately determine the cost of their products or services, and make informed decisions about pricing, production, and resource allocation.
In conclusion
Managerial accounting plays a crucial role in helping organizations make informed decisions, drive business success, and achieve their financial goals.
Managerial accounting is often reported more often that normal periodic (monthly, quarterly, or annually) financial accounting reporting.
Many managerial accounting reports are provided on a weekly basis, enabling departments to adjust spending to match revenue and productivity.
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