Unit 3 - 6123 Financial Management

Unit 3 - 6123 Financial Management

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 6123 - Content

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

Owners / Shareholders Managers Employees Advisors & Brokers Customers Community Competitors Suppliers Lenders Government Agencies Why do these different stakeholders use accounts? Users of 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 onthe long-term operations of the business

The Difference Between Revenue & Capital Expenditure

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

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

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 profit7,300 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 A Fixed 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 B Fixed 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 Employed Net Profit + Interest on Debentures / Ordinary Shares + Reserves + Preference shares + Debentures OR Operating Profit (Net Profit) / Capital employed OR 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 cashoutflow headings are as follows: • Payments for assets • Raw Materials • Expenses • Interest payments / Loan repayments

Sources 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

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

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

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 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 Direct & Indirect 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 Fixed & Variable Costs

Unit 3 - 6123 Financial Management