What do you think is the objective of companies across the globe? Is it customer service, employee satisfaction, social responsibility? May be yes - may be no. Yes, because they are the means to achieve the primary objective and no, because they are the objectives on their own. Well, what could be the primary objective, if not only objective?
Let me borrow a line from Wikipedia to answer this question: “Businesses are formed to earn profit that will increase the wealth of its owners and grow the business itself” Every action and transaction (and of course inaction) has a financial implication. Ultimately everything boils down and sums up to greenback.
Balance sheet and Operating Margin are believed to be the touchstones – perhaps millstones if not managed properly - of any organization. Trial balance, inventory turnover, top line, bottom line, ROI, sequential growth etc are some of the commonly used terms in our daily life. The extent to which these buzzwords are fathomed is subject to debate. Therefore, we make a small attempt here to give a brief introduction to those terms and Financial Accounting concepts.
Firstly, every transaction and activity that has a financial implication is recorded. Such transactions are entered in two accounts at a time. This practice, known as ‘Double-entry bookkeeping system’, requires a debit entry in one of the accounts and a corresponding credit entry in another account.
For instance, an employee buys raw material with cash. This transaction needs to be recorded in two accounts, namely, cash and raw material accounts. In the cash account you make credit entry and a debit entry in the raw material accounts. This sounds good, but how do we determine what to debit and credit? How do we ensure we don’t debit an account that should indeed be credited? This is where golden rules of accounting come in handy.
Golden Rules of accounting:
- 'Personal Account': Debit the Receiver & Credit the Giver
- 'Real Account': Debit what comes in, Credit what goes out
- 'Nominal Account': Debit all expenses / losses, credit all Incomes / Gains
Personal accounts are accounts maintained for individuals and organization with whom the company does business with
Real accounts are for real things that can either be seen, felt and touched – an exception being goodwill. In other words these represent assets.
Nominal account represents expenses, losses, incomes and gains.
In our case, cash as well as raw material accounts are real accounts. When the company buys raw material by paying cash, cash goes out and raw material comes in and hence they are credited and debited respectively.
As all transactions are equally recorded on debit and credit sides, sum of all debit sides values and credit side values of all the account put together would be equal at any given point in time. Such an exercise is known as Trial Balance which serves as a tool to detect errors, which can result in the totals not being equal.
With accounting entries are maintained for each and every transaction, they are used to arrive at the Final Accounts which comprises of P&L (Profit and Loss) account and Balance sheet at the end of the accounting period, which is normally a quarter.
Balance sheet is a snapshot of company’s assets and liabilities at the end of the period. P&L, on the other hand, is the summary of profit or loss the company has made for the entire period. You might have read items sounding like ‘assets stand at Rs 2,000 crore on 31-03-2009 and profit for the FY 08-09 was Rs 120 crores’. First one reflects balance sheet position on a given day and the latter draws reference from P&L statement for entire financial year.
While preparing Final Accounts at the end of accounting period, all account values should either be transferred to the balance sheet or to the P&L statement. Account that represent assets (such as inventories, investments, receivables etc) and liabilities (such as payables, owner’s equity, earning & surplus - liability from company’s point of view to its owners/share holder) – are transferred to balance sheet.
All others accounts, which can be classified under expenses, losses, incomes and gains, are transferred to P&L statement. Sales volume or revenue or gross profit comes at the top. Expenses, interest and tax are deducted from this to arrive at the net profit or earnings. Revenue, which appears on the top, is referred as top-line and the net profit, which appears at the bottom, is referred as bottom-line.
Lesser the expenses more the profitability or the ability to convert top-line into bottom-line is. Operating Margin is the ratio of the bottom-line (normally it is the operating income excluding other incomes/expenses and tax) to the top-line. A company reporting 30 % OPM saves Rs 30 as a profit by doing business for Rs 100 after meeting an expense of Rs 70.
Operating margin directly affects the profit. After all, it is the bottom-line that finally matters in business.