FINANCE

1. FINANCE The importance of financial management

2. 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

3. 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

4. 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 Why do firms need finance? Where do they get it from?

5. INTERNAL EXTERNAL 2 main sources HANDOUT

6. 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 CAPITAL

7. 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.

8. Who uses financial information? Internal Needs EMPLOYEES WAGE BARGAINING MANAGERS RECORD ANALYSE CONTROL OWNERS PERFORMANCE RETURN ON INVESTMENT

9. External Needs INLAND REVENUE REGISTRAR OF COMPANIES AUDITORS LEGAL REASONS BANK SUPPLIERS COMPETITORS COMMUNITY MEDIA INVESTORS PERFORMANCE AND STABILITY GOVERNMENT STATISTICAL HANDOUT

10. Choosing Sources of funds • CONSIDER • Cost:- interest payments and administration costs must be considered • Share issues are expensive to administer

11. Use 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

12. Status 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

13. Financial Situation • Poor – lenders are reluctant and cost of borrowing rises – business may need collateral (assets as security)

14. QUESTIONS • State the advantages to a business of a bank overdraft compared to a bank loan • What factors affect the choice of sources of funding • A sole trader needs to raise £5000 how do you suggest this is done? Explain.

15. The 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

16. The 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:-

18. COST 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 STOCK ADD PURCHASES LESS CLOSING STOCK Ex

19. The 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.

20. 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 LessExpenses Advertising 3,000 Rent and Rates 1,400 Telephone 750 Depreciation 640 Wages 1,500 7,290 Net Profit 96,210

21. Details • 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

22. Uses and Limitations of P&L • 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

23. LIMITATIONS • 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 …….

24. The Appropriation Account • 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:-

25. THE 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.

26. ASSETS • 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.

27. LIABILITIES • 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.

28. CAPITAL • 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.

29. 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

30. What does the Balance Sheet look like? Ex

31. RATIO ANALYSIS

32. The analysis of final 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

33. Profitability Ratios GROSS PROFIT AS A % OF SALES Gross Profit X 100 = 200,000 Sales 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

34. Profitability Ratios Net 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

35. Profitability Ratios PROFIT MARK UP Gross Profit X 100 = 200,000 Cost 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.

36. EFFICIENCY RATIO RETURN ON CAPITAL EMPLOYED Net profit before tax100106,000 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.

37. LIQUIDITY RATIOS CURRENT RATIO Current Assets = 35,000 Current 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.

38. LIQUIDITY RATIOS Acid Test Ratio (Quick Ratio) Current Assets – Stock = 35,000 – 15,000 Current 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

39. Limitations of Ratio Analysis • Comparing over a period of time • Inflation • Procedure changes • Business changes • Management changes

40. Comparing like with like • Size • Product mix • Objectives • Different accounting methods and valuation methods • Location • Staff and management

41. When analysing ratios Always mention the things that are not covered

42. WHY FIRMS FAIL Lack of Sales Inadequate profit Poor location POOR CASH FLOW

43. In 1998 62,000 business failures were reportedLack of Cash was blamed

44. Sources of Cash Flow Problems • Overtrading • Buying fixed assets • Stockpiling • Too many debtors • Taking too much credit • Overborrowing • Unforeseen expenditure • Seasonal factors • Changes in demand

45. Cash 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

46. Resolving 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

47. BUDGETING • 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

48. USES 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.

49. CASH • 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.

50. SIMPLE LAYOUT Ex