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FINANCE
The importance of financial
management
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?
• 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?
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To operate
Production
Expansion/growth
Starting up
Wages and salaries
New product
development
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Cover expenses
Buying goods
Research
Marketing costs
Day-to-day running
costs
• Pricing strategies
2 main sources
• INTERNAL
• EXTERNAL
HANDOUT
CAPITAL
• LOAN
• SHARE
• Money employed in a
company that has
been borrowed from
external sources for
fixed periods of time
• Debentures
• Mortgage
• The money employed
in a company that has
been subscribed by
the shareholders in
the form of ordinary
or preference 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
information?
EMPLOYEES
MANAGERS
OWNERS
WAGE
BARGAINING
RECORD
ANALYSE
CONTROL
PERFORMANCE
RETURN ON
INVESTMENT
INLAND REVENUE
REGISTRAR OF
COMPANIES
AUDITORS
LEGAL REASONS
BANK
SUPPLIERS
COMPETITORS
COMMUNITY
MEDIA
INVESTORS
PERFORMANCE
AND STABILITY
GOVERNMENT
STATISTICAL
HANDOUT
Choosing Sources of
funds
• CONSIDER
• Cost:- interest payments and
administration costs must be considered
• Share issues are expensive to administer
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
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
Financial Situation
• Poor – lenders are reluctant and cost of
borrowing rises – business may need
collateral (assets as security)
QUESTIONS
1. 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 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 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
100,000
LESS COST OF GOODS SOLD
Opening Stock
5,000
Add Purchases
35,000
40,000
Less Closing Stock
4,000
COST OF GOODS SOLD
36,000
GROSS PROFIT
64,000
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
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.
PROFIT AND LOSS ACCOUNT FOR YEAR ENDED
£
£
100,000
GROSS PROFIT
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
Net Profit
1,500
7,290
96,210
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
• 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
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 …….
• 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 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.
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.
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.
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.
• 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 31.12.02
FIXED ASSETS
£000
£000
Premises
£000
200
Machinery
40
Fixtures
20
260
Add CURRENT ASSETS
Stock at end
10
Debtors
15
Bank Balance
5
30
Less CURRENT LIABILITIES
Creditors
15
Overdraft
3
18
12
272
FINANCED BY
Capital
150
Reserves
80
Retained Profit
42
Ex
272
RATIO ANALYSIS
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
Profitability Ratios
GROSS PROFIT AS A % OF SALES
Gross Profit
Sales
X
100
1
=
200,000
300,000
= 66.6%
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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 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
Profitability Ratios
PROFIT MARK UP
Gross Profit X
100
Cost of Goods Sold
1
=
200,000
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 RATIO
RETURN ON CAPITAL EMPLOYED
Net profit before tax
Capital employed(start)
100
1
106,000
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 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.
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
Limitations of Ratio
Analysis
• Comparing over a period of time
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Inflation
Procedure changes
Business changes
Management changes
Comparing like with like
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Size
Product mix
Objectives
Different accounting methods and
valuation methods
• Location
• Staff and management
When analysing ratios
Always mention the things that are
not covered
WHY FIRMS FAIL
Lack of Sales
Inadequate profit
Poor location
POOR CASH FLOW
In 1998 62,000
business failures were
reported
Lack of Cash was
blamed
Sources of Cash Flow
Problems
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Overtrading
Buying fixed assets
Stockpiling
Too many debtors
Taking too much credit
Overborrowing
Unforeseen expenditure
Seasonal factors
Changes in demand
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
Resolving a Cash Crisis
• The following measures can be used to obtain
cash
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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
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
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.
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.
SIMPLE LAYOUT
Opening Balance
£1000
Add Cash In
Sales
£2000
TOTAL
£3000
Less Cash Out
Expenses
£1200
Closing Balance
£1800
Ex
Uses 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
Cash 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
INFORMATION
• INTERNAL
• EXTERNAL
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Managers
Employees
Owner
Shareholders
Potential investors
Trade Unions
Creditors
Bank
Government and
Government bodies
• Community
• Pressure Groups
THE END OF FINANCE