Distributable Profit: Interpretation and Limitations

Distributable profit: interpretation and limitations

SSAP 16 considers the relationship between current cost accounting and distribution policy as follows:

'The amounts that can prudently be distributed depend not only on profitability, but also on the availability of funds. This is so with all systems of accounting. When determining distribution policy, consideration must be given to factors not reflected in profit, such as capital expenditure plans, changes in the volume of working capital, the effect on funding requirements of changes in production methods and efficiency, liquidity, and new financing arrangements. The current cost profit attributable to shareholders should not be assumed to measure the amount that can prudently be distributed. Although the impact of price changes on the shareholders' interest in the net operating assets has been allowed for, the other factors still need to be considered. Even if the effect of such factors is neutral, a full distribution of the current cost profit attributable to shareholders may make it necessary to arrange additional finance (equal to the gearing adjustment) to avoid an erosion of the operating capability of the business. However, an increase in the value to the business of the assets may provide increased cover for such financing.'

With regard to interpretation and limitations SSAP 16 states:

'Current cost accounts allow for the impact of specific price changes on the net operating assets, and thus the operating capability, of the business. The same tools of analysis as those applied to historical cost accounts are generally appropriate. The ratios derived from current cost accounts for such items as gearing, asset cover, dividend cover and return on capital employed will often differ substantially from those revealed in historical cost accounts but should be more realistic indicators when assessing an entity or making comparisons between entities.

As with historical cost accounting, CCA is not a substitute for forecasting when such matters as a change in the size or nature of the business are under consideration. It assists cash flow forecasts, but does not replace them. It does not measure the effect of changes in the general value of money or translate the figures into currency of purchasing power at a specific date. Because of this it is not a system of accounting for general inflation. Further, it does not show changes in the value of the business as a whole or the market value of the equity.'

Learn More About Control

Read on: The Gearing Adjustment

We have seen that the capital structure of a company has important implications for financial management purposes. In particular, the gearing is important, since it expresses the relationship between fixed interest (loan capital) and fixed dividend (preference shares) to ordinary shares. A company that has a large proportion of fixed interest and fixed dividend bearing capital to ordinary capital is said to be highly geared.

The purpose of the gearing adjustment is to allocate equitably the current cost adjustments in order that the full burden should not fall on ordinary shareholders,... see: The Gearing Adjustment