FINANCEFINANCE

The importance of financial management

Aims Aims • Ensure there is adequate

funding at all times• Ensure costs are kept under

control• Ensure cash is coming into and

out of the business effectively• Establish and control

profitability levels

How is this done?How is this done?• Collection of financial data

throughout the year• Preparation of final accounts

– Trading account– Profit and loss account– Balance sheet

• Analysis of final accounts using ratios

Why do firms need finance?

• To operate• Production• Expansion/

growth• Starting up• Wages and

salaries• New product

development

• Cover expenses• Buying goods• Research• Marketing costs• Day-to-day

running costs• Pricing

strategies

2 main sources2 main sources• INTERNAL • EXTERNAL

HANDOUT

CAPITALCAPITAL• LOAN

• Money employed in a company that has been borrowed from external sources for fixed periods of time

• Debentures• Mortgage

• SHARE

• The money employed in a company that has been subscribed by the shareholders in the form of ordinary or preference shares

SHARES:-SHARES:-

• Ordinary – most common type, no guaranteed dividend

• Preference – fixed rate of return – carry less risk but cost more

• Deferred – usually held by the company founders – only receive a dividend after the Ords get theirs.

Who uses financial Who uses financial information?information?

EMPLOYEES

WAGE BARGAINING

MANAGERS

RECORDANALYSECONTROL

OWNERS

PERFORMANCERETURN ON

INVESTMENT

INLAND REVENUE

REGISTRAR OF COMPANIES

AUDITORS

LEGAL REASONS

BANKSUPPLIERS

COMPETITORSCOMMUNITY

MEDIAINVESTORS

PERFORMANCE AND STABILITY

GOVERNMENT

STATISTICAL

HANDOUT

Choosing Sources of fundsChoosing Sources of funds• CONSIDER

• Cost:- interest payments and administration costs must be considered

• Share issues are expensive to administer

Use of FundsUse of Funds• What is the funding for

• Is it long term for capital items – mortgage, loan, hare issue

• Is it short term for raw materials – trade credit or overdraft

Status and SizeStatus and Size• Sole traders are limited in

their choice of finance – take on a partner, small loans

• Public and Private companies can use many different sources

Financial SituationFinancial Situation• Poor – lenders are reluctant

and cost of borrowing rises – business may need collateral (assets as security)

QUESTIONSQUESTIONS1. State the advantages to a

business of a bank overdraft compared to a bank loan

2. What factors affect the choice of sources of funding

3. A sole trader needs to raise £5000 how do you suggest this is done? Explain.

The Financial StatementsThe Financial Statements• Trading, Profit and Loss Account

• Provides a summary of all trading (purchasing and selling) activities along with all costs that have been incurred

• The end result will show whether the firm has made a profit that year or a loss

Ex

The Trading AccountThe Trading Account• Shows the revenue earned from

selling products (TURNOVER) and the cost of manufacturing products (COST OF GOODS SOLD).

• Subtracting one from the other gives

– GROSS PROFIT

Layout:-

Trading Account for period ended 31.12.02

£ £Sales 100,000LESS COST OF GOODS SOLDOpening Stock 5,000Add Purchases 35,000

40,000Less Closing Stock 4,000COST OF GOODS SOLD

36,000

GROSS PROFIT 64,000

COST OF GOODS SOLDCOST OF GOODS SOLD• This figure is calculated by adding the

stock in hand at the start of the year (opening stock) and the purchases made throughout the year together to find out how much was spent on these materials.

• The stock in hand at the end of the year must be deducted as this is still on the shelf and will not be sold in this financial year

COST OF GOODS SOLD = OPENING STOCKADD PURCHASESLESS CLOSING STOCK

Ex

The PROFIT AND LOSS ACCOUNTThe PROFIT AND LOSS ACCOUNT • The P&L account is an extension

to the trading account. Where the trading account ends the profit and loss account begins.

• Once Gross Profit is calculated then expenses can be deducted and Net Profit can be calculated.

PROFIT AND LOSS ACCOUNT FOR YEAR ENDED   £ £

GROSS PROFIT   100,000

Add Revenues    

Rent Received 1,000  

Tax Rebate Received 2,500 3,500    103,500

Less Expenses    

Advertising 3,000  

Rent and Rates 1,400  

Telephone 750  

Depreciation 640  

Wages 1,500 7,290

Net Profit   96,210

DetailsDetails REVENUES This is money that has been

received by the business BUT NOT FROM SALES

EXPENSES Bills that have been paid

throughout the year Ex

• USES• Owners are keen to see how much

profit they have made• Profit is a guide to performance of the

business• Comparisons can be made with

previous years and competitors• Ratios can be used to give a clear

picture• Can highlight problems with expenses

LIMITATIONSLIMITATIONS

• Cannot show what is going to happen in the future

• Only contains historical information• Can be manipulated and will not

always tell the true story • Does not consider

– Size of business, competition, market/trends, staffing issues, customer loyalty, location, management techniques …….

• Once Net Profit has been calculated certain businesses are required to show exactly what they are doing with this profit.

• This can be done in an Appropriation Account.

• This is just attached to the bottom of the Profit and Loss Account:-

THE BALANCE SHEETTHE BALANCE SHEET• WHAT DOES THE BALANCE

SHEET SHOW?•  • It is like a photograph of a

business at a particular point in time. It contains information about the ASSETS of a business, its LIABILITIES and its CAPITAL.

ASSETSASSETS • Resources that a business owns.

They can be used in production. Can be divided into CURRENT ASSEETS and FIXED ASSETS.

• Current assets are used in production and are constantly changing.

• Fixed assets are kept for more than one year such as machinery, fixtures etc.

LIABILITIESLIABILITIES • These are the debts of the

business ie what it OWES to other businesses, individuals and institutions.

• They might be short term like an overdraft or long term such as a mortgage.

CAPITALCAPITAL • Is the money introduced to the

business by the owners eg when they buy shares. It is a source of funds and can be used to buy assets.

• In all businesses the value of the assets (what a business owns) will equal the value of liabilities and capital (what the business owes).

• ASSETS = CAPITAL + LIABILITES

BALANCE SHEET OF GREEN LTD AS AT 31.12.02FIXED ASSETS £000 £000 £000Premises 200Machinery 40Fixtures 20 260

Add CURRENT ASSETSStock at end 10Debtors 15Bank Balance 5 30

Less CURRENT LIABILITIESCreditors 15Overdraft 3 18 12

272FINANCED BYCapital 150Reserves 80Retained Profit 42 272

Ex

RATIO ANALYSISRATIO ANALYSIS

The analysis of final The analysis of final accounts used to:-accounts used to:-

• Compare performance from year to year

• Compare performance with competition

• Identify problem areas

• There are various types of Ratio that you must learn

Profitability RatiosProfitability RatiosGROSS PROFIT AS A % OF SALES

Gross Profit X 100 = 200,000Sales 1 300,000

 = 66.6%

• For every £1 of sales 66.6pence is Gross Profit• The Higher the GP% the better• To improve GP% production costs must be cut or selling

price must be increased

Profitability RatiosProfitability RatiosNet Profit (before tax) x 100=

106,000 Sales 1 300,000= 35%

• For every £1 of sales 35% is net profit (actual profit)• This indicates the management’s ability to control

costs. If GP% remains constant and NP% falls then rising costs must be investigated. Note the gap between NP% and GP%.

• The Higher the NP% the better

Profitability RatiosProfitability RatiosPROFIT MARK UPGross Profit X 100= 200,000Cost of Goods Sold 1 100,000  

= 200%

• Measures the percentage added to the cost of the goods to calculate the selling price.

• Usually compared with competition to ensure fair/competitive pricing.

EFFICIENCY RATIOEFFICIENCY RATIO RETURN ON CAPITAL EMPLOYED  Net profit before tax 100

106,000 Capital employed(start) 1 126,500= 83.8%

• The higher the rate the better for the investor. ROCE relates profit to the size of the business (the amount invested). Increase in ROCE is favourable. Any decrease must be investigated.

LIQUIDITY RATIOSLIQUIDITY RATIOSCURRENT RATIO Current Assets = 35,000Current Liabilities 23,000 = 1.5:1

• For every £1 of debt the firm has £1.50 of assets to cover the debt. 

• Current ratio should be between 1.5 and 2 :1. If it is less than this there is a danger of running out of cash. If it is higher too much cash is tied up in stock – not working for the firm.

LIQUIDITY RATIOSLIQUIDITY RATIOSAcid Test Ratio (Quick Ratio) Current Assets – Stock = 35,000 –

15,000Current Liabilities 23,000

= 0.87:1 • Stock is deducted as it is the asset most

difficult to turn into cash. A ratio of around 1:1 is desirable but will depend on the business involved and the type of stock kept.

Ex

Limitations of Ratio Limitations of Ratio AnalysisAnalysis

• Comparing over a period of time

• Inflation• Procedure changes• Business changes• Management changes

Comparing like with likeComparing like with like• Size• Product mix• Objectives• Different accounting methods

and valuation methods• Location• Staff and management

When analysing ratiosWhen analysing ratios

Always mention the things that are not

covered

WHY FIRMS FAILWHY FIRMS FAIL

Lack of SalesInadequate profit

Poor locationPOOR CASH FLOW

In 1998 62,000 business In 1998 62,000 business failures were reportedfailures were reported

Lack of Cash was blamedLack of Cash was blamed

Sources of Cash Flow Sources of Cash Flow ProblemsProblems

• Overtrading• Buying fixed assets• Stockpiling• Too many debtors• Taking too much credit• Overborrowing • Unforeseen expenditure• Seasonal factors • Changes in demand

Cash flow and liquidityCash flow and liquidity• The availability of cash can be

checked using the WORKING CAPITAL RATIO

• Current Assets/Current Liabilities :1

• When this ratio is less than 1:1 there is said to be a Liquidity or Cash Crisis

Resolving a Cash CrisisResolving a Cash Crisis• The following measures can be used

to obtain cash• Stimulate sales• Sell off stocks of raw materials• Sell off fixed assets and lease them back• Mount a rigorous drive on debtors • Sell debts to factoring company• Only make essential purchases• Try to get extended credit• Reduce personal drawings• Negotiate

BUDGETINGBUDGETING• In general, a budget is a

statement that shows future expectation.

• Businesses monitoring and controlling costs for a period of time can be said to “be budgeting”

• They can be in various formats – overtime budget

USES OF BUDGETSUSES OF BUDGETS• Monitor and control the

activity of the business• To gain information –

expectations• Set targets for performance for

specific periods of time• To plan and prepare for the

future.

CASHCASH• To help identify times when cash

will be short we compile

• CASH BUDGETS

• Highlights – periods when a loan may be required and periods when there is excess cash which could be invested.

SIMPLE LAYOUTSIMPLE LAYOUTOpening Balance £1000

Add Cash InSales £2000TOTAL £3000Less Cash OutExpenses £1200Closing Balance £1800

Ex

Uses of a Cash BudgetUses of a Cash Budget• All information in a Cash Budget is

estimated and is used to assist management in decision making

• Helps monitor the progress or performance of the business

• Used to demonstrate the possible implications of a new venture (purchase of a fixed asset)

• As part of a business plan to show possible performance

• To allow comparisons of projected and actual results.

How management use a How management use a Cash BudgetCash Budget

• PLANNING

• Identify where cash is being spent and times where there may be financial issues – too much or too little cash

• ORGANISING

• Making sure that there are suitable resources for all areas of the business

• COMMANDING

• Management must know exactly how much cash is available to be able to tell departments what the budget will be

• CO-ORDINATING

• Surpluses identified in one department may be used to cover short falls in another

• CONTROLLING

• A cash budget allows a manager to identify and keep track of cash

USERS OF FINANCIAL USERS OF FINANCIAL INFORMATIONINFORMATION

• INTERNAL

• Managers• Employees• Owner• Shareholders• Potential

investors

• EXTERNAL

• Trade Unions• Creditors• Bank• Government and

Government bodies

• Community• Pressure Groups

THE END OF FINANCETHE END OF FINANCE