Unit Five The Financial Sector Unit Five The Financial Sector AP Macroeconomics MR. Graham.
Unit 3 - 6123 Financial Management
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Transcript of Unit 3 - 6123 Financial Management
Unit 3 - 6123 Financial Management
6123 - Content
Financial Accounts
• Purpose of Account
• Capital & Revenue Expenditure
• Profit & Cash
• Format of Balance Sheet and P&L Account
• Preparation
• Working Capital
• Interpretation of final Accounts
• Limitations of ratio analysis & of Accounting Statements
Budgeting
• The Role,Purpose, process & feature of budgets in financial management
• The Process, purpose and features of budgeting and cash flow forecasting
Classification and Analysis of Costs
• Classification of Costs
• Contribution
• Break-Even & Margin of Safety
• Uses assumptions & Limitations of Break-Even analysis
Chief Examiner Speaks
• Be prepared to work out some ratios & analyse what the results mean or imply about the firm
• If the case study contains accounting info. You will be able to prepare for this, but remember the case study figures could be amended in the stem of the question
• If there are no figures in the case study, expect to see some given to you in the question paper
• You must understand and be able to use and calculate ratios as well as concepts like breakeven and contribution
Topic 1 - What is meant by Accounting
• Identifying Information - this involves capturing all of the financial data within a business related to how it is performing
• Measuring Information - Value of items / No. sold per week
• Recording Information - Hand-written/ Computer packages / Spreadsheet
• Accounts should be - Reliable / Comparable / Relevant/ Understandable
Use of Accounts
• Accounting acts as an information system by processing business data so that those parties either interested in or affected by the business can be provided with the means to find out how well or badly the organisation is performing
Users of Accounts
• Owners / Shareholders
• Managers
• Employees
• Advisors & Brokers
• Customers
• Community
• Competitors
• Suppliers
• Lenders
• Government Agencies
• Why do these different stakeholders use accounts?
Revenue & Capital Spending
• Revenue Spending - is expenditure on current assets and expenses, that is things that are used once. Examples are stock, electricity bills or rent
• Items which will be used only once - paper, printer, toner…..
• Items that will be used in the very near future - stock
• Items that have been used before they are paid for - advertising
• Capital Spending - expenditure on fixed assets, or things that are used repeatedly - machinery, vehicles……
Money spent on the long-term operations of the business
The Difference Between Revenue & Capital Expenditure
Spending Capital/Revenue Explanation
Buying Property Capital A long-term asset forthe business
Extending Premises Capital For the long-term useof the business
Repair to Premises Revenue A one-off payment tomaintain the businessand its premises in auseable state
Wages & Salaries Revenue A one-off payment forthe work done in theprevious week
Buying a delivery Van Capital For repeated use by thebusiness
Petrol For The Van Revenue Petrol can only be usedonce then more must bebought
Profit & Cash• Cash - the money that flows into and out of the business on a
weekly, monthly and annual basis
• Cash - a liquid asset owned by the business which enables it buy goods and services
• Profit - the money made by the business as a result of its trading activities, less all expenses paid plus any non-cash provisions (such as depreciation) which have to be made on an accruals basis (Gross profit / Net profit / Profit after taxation)
• Profit - a surplus arising from trading. Sell goods at a higher price than you pay for them
Total Profit = Total Revenue - Total Costs
The Trading Account
• The Trading Account can be likened to a video giving ongoing pictures of an organisation’s trading activities
• Gross Profit = Value of stock sold (sales) - cost of producing those sales
• Gross Profit = Net Sales - cost of sales
A business that does not trade (a business in the service sector)
will not have a trading account
• The trading account includes only those items in which organisations trades:
• Sales / Turnover
• Sales Returns (returns inwards) = goods returned to the business
• Net Sales = Sales - Returns inwards
• Purchases• Purchase Returns (returns inwards) = goods returned by the business
• Carriage Inwards = Cost of buying goods / transport• Net purchases = Purchases + Carriage inwards - Return Outwards
• Cost of sales - opening stock is effectively a purchase
closing stock must be deducted from purchases
Cost of Sales
Opening stock + Carriage inwards - returns outwards - closing stock
The Trading Account of D.Cork for the year ended 31/12/2000
Sales 21,000
less Returns inwards 1,000
Net sales 20,000
opening stock (1/1/2000) 4,500
Purchases 12,100
Carriage inwards 300
12,400
Less returns outwards 500
Net purchases 11,900
16,400
less closing stock (31/12/2000) 3,700
Cost of sales 12,700
Gross profit 7,300
Question - Trading account
• Prepare trading accounts from each of the following sets of figures:
• M.Atherton on 31/12/2000. His figures are as follows: closing stock £4,100; returns outwards £700; carriage inwards £400; purchases £15,300; returns inwards £500; opening stock £3,900; sales £50,000
• J.Gallian on 31/12/2000. Her figures are as follows: closing stock £3,200; returns outwards £550; carriage inwards £324; purchases £10,125; returns inwards £650; opening stock £4,789; sales £15,000
The Profit & Loss Account
• The P&L a/c may be drawn up beneath the trading account, and covers the same period of trading. The gross profit or loss figure becomes the starting point for the P&L a/c.
• Some organisations receive income from sources other than sales. E.g. rent / commission, and these extra incomes are added to gross profit
• Every organisation incurs expenses and a range of overheads, these are deducted to show the true net profit / loss
The Profit & Loss Account
• Rent of premises• Carriage inwards• Discount allowed• Gas• Electricity• Stationary• Motor expenses
• Cleaning costs• Insurance• Business Rates• Depreciation• Bad Debts• Interest on loans• Sundry expenses
The Profit & Loss Account
Net Profit
Gross Profit + Income from other sources - Expenses
The Trading and Profit and Loss Account of D.Cork for the year ended 31/12/2000
Sales 21,000
less Returns inwards 1,000
Net sales 20,000
opening stock (1/1/2000) 4,500
Purchases 12,100
Carriage inwards 300
12,400
Less returns outwards 500
Net purchases 11,900
16,400
less closing stock (31/12/2000) 3,700
Cost of sales 12,700
Gross profit 7,300
add other income:
Discount received 2,000
9,300
Less expenses:
Electricity 510
Stationary 125
Business rate 756
Interest on loans 159
Total expenses 1550
Net profit 7750
The Trading and Profit & Loss Account
• M.Atherton - using the figures below work out the Net Profit.
Electricity - £500
Rent - £2000
Petrol - £600
Insurance - £100
• J.Gallian - using the figures below work out the Net Profit.
Income received- £2000
Rent - £1000
Insurance - £500
Interest - £800
Trading and Profit and Loss account
• Using the following figures i.construct the trading account and calculate gross profit, ii. Construct the profit and loss account and calculate net profit.
• D.Harris is a newsagent on 31/12/2002 his figures were as follows: closing stock £4,000; returns outwards £500; carriage inwards £500; purchases £15,000; returns inwards £500; opening stock £4,000; sales £45,000 and rental income of £4000, electricity £500, rent £1000, petrol £1000 and insurance £500.
Gross profit & Net Profit
• Company A & B have just produced their end of year figures. Study the figures and explain their differences.
• Company A - Gross Profit 20% & Net profit 15%
• Company B - Gross profit 40% & Net profit 14%
• How could the gross profit and net profit figures for both companies be improved?
Balance Sheet
• A statement of an organisation’s assets and liabilities at a precise point in time, usually the last day of the financial year. Liabilities must equal assets thanks to the accounting convention of double-entry bookkeeping
• Fixed assets - items of a monetary value which have a long-term function and can be used repeatedly. E.g. land, buildings, equipment & machinery (usually more than 1 year).
• Current assets - anything owned by the organisation which is likely to be turned into cash before the next balance sheet date (usually less than 1 year). E.g. stock, debtors & cash
• Current Liabilities - anything owed by the organisation which is likely to be paid in cash before the next balance sheet date (usually less than 1 year). E.g. creditors, overdrafts, dividends and unpaid tax
• Long-term Liabilities - debts falling due after more than 1 year. These include medium and long-term loans, debentures and provisions for tax payments or other long-term debts
• Net assets - Fixed assets + Current assets - Current liabilities
• Working capital - is the day-to-day finance for running a business
= Current assets - Current liabilities
Balance Sheet AFixed assets
Land & Buildings 80,000
Machinery 13,200
Motor Vehicles 8,700
101,900
Current Assets
Stocks 9,700
Debtors 3,750
Bank 2,100
Cash 970
16,520
Less Current Liabilities
Creditors 8,000
Value added tax owing 1,000 9,000
7,520
109,420
less Long-term liabilities
Bank loan 9,000
Mortgage 30,000
39,000
70,420
Net Assets
Finances by:
Capital 70,000
add Net profit 5,286
75,286
less Drawings 4,866
70,420
Balance Sheet BFixed Assets
Land & Building 320,000
Machinery 24,000
Motor Vehicles 12,000
356,000
Current assets
Stocks 12,250
Debtors 7,100
Bank 23,200
Cash 500
43,050
less Current liabilities
Creditors 500
Proposed dividends:
Ordinary Shares 12,000
Preference Shares 10,000
Corporation tax 10,350 32,850
366,200
less Long-term Liabilities
Bank loan 10,000
10% debentures 8,000
18,000
348,200
Issued share capital
200,000 ordinary shares of £1fully paid 200,000
100,000 10% preference shares of £1 fully paid 100,000
300,000
Reserves
General reserve 6,000
Balance of retained profit 42,200
48,200
Shareholders funds 348,200
Ratios
• Using The Trading & Profit Account and The Balance Sheet work out the 6 ratios.
• Gross Profit
• Net Profit
• Return on capital employed
• Gearing ratio
• Current ratio
• Quick (Acid test) ratio
• Company A
• Sales = £90,000
• Gross Profit = £65,000
• Net Profit = £45,000
• Company B
• Sales = £118,100
• Gross Profit = £74,050
• Net Profit = £41,400
Interpretation of Final Accounts
• Gross Profit
Gross Profit / Sales x 100
• Net Profit
Net Profit / Sales x 100
• Return on Capital EmployedNet Profit + Interest on Debentures / Ordinary Shares + Reserves + Preference shares + Debentures
OR
Operating Profit (Net Profit) / Capital employedOR
Net Profit / Fixed Assets + Net Current Assets
• Gearing Ratio
Long Term Liabilities / Ordinary Shares & Reserves x 100
Low geared = less than 100%
High geared = more than 100%
• Current Ratio
Current assets / Current Liabilities
acceptable ratio = 2:1
• Quick Ratio (Acid test ratio)
Current assets - Stock / Current Liabilities
Similar to current ratio but stock not included with current assets - not all assets are easily turned into cash
Working Capital
• Working Capital =
Current Assets - Current Liabilities
• Working capital Ratio (Current ratio) = Current assets / Current Liabilities
Accountants look for a ratio of 2:1
Much below this and the business may suffer from liquidity problems. Much above this and the business is not making the best use of its financial resources
Using Ratios
• Ratios should not be used in isolation (on their own), use a number of ratios
• Compare ratios with those of other companies in a similar industry
• Compare ratios with those from previous years
• Use ratios alongside other information; what is the present state of the economy; how are competitors performing; at what stage of the life cycle is the market the business is in; what are the businesses plans for the future - new products? change of management? New marketing strategy?
Depreciation
• The measure of the wearing out, consumption or other reduction in the useful life of a fixed asset, whether arising from use, time or obsolescence through technological changes
Two ways of calculating depreciation
• Straight-line method
Charges an equal amount of depreciation to each accounting period for the life of an asset
• Reducing Balance method
Calculates the depreciation charge as a fixed % of net book value from the previous period
Straight Line Method
Cost of Asset - Residual Value
Expected Useful Life of asset
E.g. a machine which is expected to last 5 years costs £20,000 to buy brand new. At the end of that time its residual value will be £5,000.
£20,000 - £5,000/5 = £3,000 p.a
Value of machine after 2 years = £20,000 - £6,000 (2 X £3,000)
Reducing Balance Method
• A machine is purchased by a business for £20,000 and its expected useful life is 3 years. The business anticipates a residual value of £4,320 and thus wishes to depreciate at 40% p.a.
Value at end of year 1 = £20,000 - 40%
Value at end of year 1 = £20,000 - £8,000
Value at end of year 1 = £12,000
Value at end of year 2 = £12,000 - 40%
Value at end of year 2 = £12,000 - £4,800
Value at end of year 2 = £7,200
Straight Line Method
Advantages
• It is simple. Little calculation is needed and the same amount is subtracted from the book value each year.
• It is useful for assets like a lease, where the life of the asset and the residual value is known precisely.
Disadvantages
• It is not realistic - most assets depreciate more when they are new.
Reducing Balance Method
Advantages
• It takes into account that some assets, machinery for example, lose far more value in the first year than they do in the fifth year. So the book value reflects more accurately the real value of the asset in the balance sheet.
• For many assets, maintenance and repair costs grow as the asset ages. Using the RBM results in a more equal total expense each year for fixed assets related to costs.
Topic 2 - Budgeting
• Looking into the future helps all organisations to plan their activities so that what they anticipate and want to happen can actually happen.
• The problem is that, the further one looks into the future, the more difficult it is to see accurately
Benefits of Budgeting
• It helps to predict what the organisation thinks will happen
• It creates opportunities to appraise alternative courses of action
• Budgets set targets
• Budgets help to monitor and control performance
• Budgets are fundamental to the process of business planning
• Budgets can be used as a source of motivation.
• Budgets are a form of communication
Three Areas of Budgetary Forecasts
• The Capital Budget - capital refers to the buying of fixed assets
• The Cash Budget - looks at the cash coming into the organisation as well as cash going out
• Subsidiary Budgets & The Master Budget - Subsidiary budgets looks at individual balance sheet items. Includes the budgeted P&L a/c, balance sheet and Cash Budget
Cash Flow Forecasting(CFF)
• An organisation must ensure that it has sufficient cash to carry out its plans, and ensure that the cash coming in is sufficient to cover the cash going out. At the same time it must take into account any cash surplus it might have in the bank
• Looking carefully at the availability of liquid funds is essential to the smooth running of any organisation
Purposes of The CFF
• Timing consequences - when does the machine need
replacing
• The CFF is an essential document for the complication of
the business plan
• The CFF will help to boost the lenders’ confidence and the
owners confidence
• The CFF helps with the monitoring of performance
CFF Headings
Some of the more likely cash inflow headings are as follows:
• Start-up capital
• Loan
• Miscellaneous receipts
• Sales
Some of the more likely cash outflow headings are as follows:
• Payments for assets
• Raw Materials
• Expenses
• Interest payments / Loan repayments
CFFSources of Cash Flow Problems:
• Over-trading
• Stockpiling
• Allowing too much credit
• Over borrowing
• Underestimating inflation
• Unforeseen expenditure
• Unexpected changes in demand
• Seasonal factors
• How to solve problems:
• Stimulate cash sales
• Sell off stocks of raw materials
• Sell off any fixed costs that may not be vital
• Sell off any fixed assets and lease them back
• Try and recover overdue accounts
• Sell debt to factoring company
• Only make essential purchases
• Extend some credit with suppliers
CFF - Question 1
• B.Have has £500 in the bank on 1/1/04. The owner anticipates that her receipts over the next 6 months are likely to be:
• Jan - £2,300; Feb - £1,400; March - £5,300; April - £6,100;
May - £4,700; June - £1,400
• She has worked out what her payments are likely to be over the next 6 months:
• Jan - £1,400; Feb - £4,100; March - £5,600; April - £5,000;
May - £3,100; June - £900
• B.Have is concerned about whether she needs an overdraft facility and if so when she is likely to use it. Construct a CFF and advise her on her financial requirements
CFF For Miss B.Have
J F M A M J
Receipts
Sales 2300 1,400 5,300 6,100 4,700 1,400
Payments
Purchases 1400 4,100 5,600 5,000 3,100 900
Total(R-P)
900 (2,700) (300) 1,100 1,600 500
OpeningBalance
500 1400 (1,300) (1,600) (500) 1,100
ClosingBalance
1400 (1,300) (1,600) (500) 1,100 1,600
CFF - Question 2
• Prepare the CFF of S.Todd Ltd. The business has £250 in the bank and the owner anticipates that his receipts over the next 6 months are likely to be:
• Jan - £1,400; Feb - £1,600; March - £1,500; April - £1,000;
May - £900; June - £700
• He has worked out what his payments are likely to be over the next 6 months:
• Jan - £1,100; Feb - £700; March - £900; April - £1,400;
May - £1,000; June - £900
Prepare S.Todd Ltd. CFF for the next 6 months
CFF - S.Todd Ltd
J F M A M J
Receipts
Sales
Payments
Purchases
Total(R-P)
OpeningBalanceClosingBalance
Topic 3 - Classification of Costs
• There are two broad approaches to the classification of
business costs
• Categorise costs by their type and identifies whether they can be
directly related to the final product or service of the business
• Analyse costs according to whether they remain fixed with
changes in output levels (see break-even analysis)
Direct & Indirect Costs
• Direct Costs - these costs can be clearly identified with the product or service being provided
• Direct labour
• Direct materials
• Direct expenses
• Indirect Costs - those costs that cannot be classified as direct costs
• Indirect labour - management / Admin / Marketing
• Indirect materials- lubricating materials / cleaning materials
• Indirect expenses - rent / power / stationary
Fixed & Variable Costs
• Fixed Costs - costs that do not increase as total output increases - rent / heating
• Variable Costs - costs that increase as total output increases because more of these factors need to be employed as inputs in order to increase output - raw materials
• Semi-variable costs - costs that vary with output but not in direct proportion. E.g. A doubling of customer demand would not lead to a doubling of Telephone costs
Total Costs
• Direct Costs can generally be considered as variable costs
• Indirect Costs can generally be considered as fixed costs
Total Costs = Direct Costs + Indirect Costs
or
Total Costs = Variable Costs + Fixed Costs
Break-even Analysis
• Break-even Point - the point at which sales levels are high enough not to make a loss, but not high enough to make a profit. TR=TC
• Contribution - the difference between an item’s selling price and the variable cost needed to produce that item
• Contribution = Selling price per unit - Variable cost per unit
• By producing and selling enough units to produce a total contribution that is in excess of the fixed costs, an organisation will make a profit
Margin of Safety
• Definition - The difference between the break-even point and the selected level of activity designed to achieve the profit target
• E.g. A company has calculated that it breaks-even when it produces 10,000 units. If the company decides to produce 12,000 units, then its margin of safety will be 2,000 units
Break-even Analysis
• Advantages
• It is possible to show changes in costs, revenue and therefore profit with the aid of a diagram
• The diagram is a very easy way of showing how profit levels change with changes in output
• Disadvantages• Analysis assumes all
output is sold
• Analysis does not take into account economies of scale
• It is a very complicated task to allocate all costs to certain production activities
Break-even - Example (Numerical)Penzance Toys
Predicted Sales = 8,000
Sale Price = £12 per unit
Variable Cost = £5 per unit
Fixed Costs = £9000
Using the formula
Contribution = £12 - £5 = £7 per unit
Therefore for each unit made £7 will go towards paying fixed costs
• Break-even = Fixed Costs / Unit contribution
• Break-even = £9,000 / £7
• Break-even = 1,286 units
• OR
• Break-even = Fixed costs / (Sale Price - Variable cost)
• Break-even = £9,000/£12-£5
• Break-even = £9,000 / £7
• Break-even = 1,286 units
Question - Break-even
• E.Brown opens a new restaurant. Using the figures below calculate the number of meals he needs to sell to break-even
• Fixed Costs = £10,000
• Variable Costs = £3 per meal
• Price per Meal = £8 average per meal
Break-even - E.Brown - Example (graphical)
Sales VariableCost
£3 per meal
Fixed Cost
£10,000
Total Costs
FC + VC
TotalRevenue
£8 per meal
TR-TC
0 0 10,000 10,000 0 (10,000)
500 1,500 10,000 11,500 4,000 (7,500)
1000 3,000 10,000 13,000 8,000 (5,000)
1500 4,500 10,000 14,500 12,000 (2,500)
2000 6,000 10,000 16,000 16,000 0
2500 7,500 10,000 17,500 20,000 2,500
Break-even question - Draw break even diagram
Sales VariableCosts£20
FixedCosts£6000
Total Costs
VC + FC
TotalRevenue
Sales X £40
TR-TC
0 0 6,000
100
200
300
400
500
Example - Break-even
• A Hotel owned by J.Smith has recently changed their accountants. The new accountants would like to know how many customers per year the hotel needs to break-even. Using the figures below work out the level of break-even both numerically and graphically
Fixed Costs = £107,200 per annum
Variable costs = £20 per customer
Total Revenue = £70 per customer
How many guests would the hotel need per year to make a profit of £35,000?
Exam - June 2003• 1.(a) (i)Define the following terms:
gross profit
working capital (4)
• (ii) Using figs. 1 & 2, calculate the gross profit and the working capital for Gap Inc in Feb.2002 (4)
• (b) Using information from figs 1 & 2, evaluate Gap Inc’s
(i) profitability
(ii) liquidity
in Feb 2002 (16)
• (c)Analyse additional financial information needed to make a fuller evaluation of Gap Inc’s performance (6)
30 marks
• 2 (a) Give one example of a fixed cost, and one example of a variable cost. (2)
• (b) Analyse the advantages and disadvantages to Gap Inc of classifying costs as either fixed or variable (10)
• In the 2001/2002 financial year, the number of Gap Inc stores increased by approximately 12% to 4,176.
• (c) Assess the extent to which the use of budgeting might assist Gap Inc’s:
• (i) financial management of these stores;
• (ii) continued survival as a business. (18)
30 marks