Finance V4

Financial Management Higher Business Management

Today… • Role of Finance • Annual Accounts • Trading, Profit & Loss Account

Role and importance of Financial Management Efficient management of finance is crucial to an organisation’s success. They have to: • Ensure adequate funds are available for resources needed to help achieve organisational objectives • Ensure costs are controlled • Ensure adequate cash flow • Establish and control profitability levels

Duties of Finance • Maintain financial records • Payment of bills and expenses • Collection of accounts due • Monitoring of funds • Payment of wages and salaries • The main role Finance provides information for managers and decision-makers within business

Annual Accounts • There are four main financial statements used (called Final Accounts): • Trading account • Profit and loss account • Balance sheet • Cash flow statement

Trading, Profit & Loss Account • The trading account records how much money is made from selling goods against how much it costs to make. The gross profit is calculated in the trading account. • The profit and loss account shows the businesses incomes and expenditures. The net profit is calculated in the profit and loss account.

Trading Account Format £

£

• Turnover (or sales) 180,000 • Cost of sales • Opening Stock 40,000 • Purchases 95,000 135,000 • Less: Closing Stock (45,000) 90,000 • GROSS PROFIT 90,000

Profit and Loss Account Format £ £ • Gross Profit • Other income • Interest received • • • •

90,000 11,000 101,000

Expenses Rent and rates 25,000 Wages and salaries 45,000 Insurance 2,000 72,000 • NET PROFIT 29,000

Profit and Loss Account Key Terms • Trading account – provides summary of business’s trading activity during financial year • Sales – monies received through selling goods/services • Cost of sales – cost of sales to a business before a profit margin is added • Opening stock – value of stock at start of the financial period • Closing stock – value of stock at end of the financial period

Profit and Loss Account Key Terms • Purchases – cost of goods business has bought for resale to customers • Purchase returns – value of goods purchased but returned to supplier • Sales returns – value of goods bought by customer but returned to the firm • Expenses – any expenses incurred by the business in the course of normal operation

Interpretation of Trading, Profit & Loss Accounts • Was this year’s trading result good or bad, compared with last year or with a rival company? • Has the Gross Profit improved this year, compared with last year? • Are we making efficient use of our stock? • Does our Net Profit figure compare favourably with those of other

Recap… • Role of Finance • Annual Accounts • Trading, Profit & Loss Account

Today… • Balance Sheet • Assets • Liabilities • Capital • Liquidity • Working Capital

Balance Sheet • The profit and loss account shows the history of the business activity throughout the financial year. • The balance sheet shows a snapshot of a particular date in time. • CAPITAL = ASSETS - LIABILITIES

Balance Sheet Assets

Liabilities & Capital

Balanc e

Assets • Assets – are what a business owns • Fixed assets – have a lifespan of more than one year, eg machinery, motor vehicles • Current Assets – are constantly changing eg stock, debtors, bank, cash

Liabilities • Liabilities – what is owed by the business • Current Liabilities – eg trade creditors (suppliers of goods on credit), bank overdraft, short-term loans (less than 1 year) • Long-term liabilities – normally longer than 1 year – eg mortgage, bank loan

Capital • Capital – provided by the owner of the business and treated as being owned to the owner of the business • Profits – may increase capital • Drawings – may decrease capital • Reserves – monies retained by business

Liquidity • Liquidity shows us whether a business has enough assets to cover its debts. • Turning assets into cash to pay off debts is what normally happens. • Stock is the hardest to turn into cash. Why?

Working Capital • Working Capital is: • Current Assets – Current Liabilities • If a business has too much working capital then they are not using their resources properly. • If too little, then they may not be able to pay off short term debts.

Balance Sheet Format • Fixed Assets • Current Assets

Recap… • Balance Sheet • Assets • Liabilities • Capital • Liquidity • Working Capital

Today… Ratio Analysis • What are ratios? • Uses of ratio analysis • Limitations of ratios • Profitability ratios • Liquidity ratios • Asset usage ratios

What are Ratios? • Ratios are a way of comparing different figures. • Ratios should only be used when comparing like with like (ie same size of business; same industry) • Ratios can compare results with previous years or rival firms • Ratios, however are historic, and do not take into account of other factors such as quality of workers, inflation, economic situation

Uses of Ratio Analysis • Compare current performance with previous years • Compare performance against similar organisations • Identify changes in performance to aid future actions • Identify trends over time

Limitations of Ratio Analysis • Information is historic • Comparisons must only be made with similar organisations (size, industry) • No account of external factors (PEST) • No account of NPD or declining products • No account of human factors (staff morale, staff turnover)

Ratios • Profitability

• Liquidity

• Gross Profit percentage • Net Profit percentage • Return on Capital Employed (ROCE)

• Current Ratio • Acid Test Ratio • Asset Usage • Rate of Stock Turnover

Gross Profit Percentage Gross Profit Sales Revenue

X 100%

• Measures profit made from buying and selling stock • For every £1 of sales, how much profit is made? • Increase = more sales generated or cost of materials have fallen • Decrease = cost of materials may have went up

Net Profit Percentage Net Profit Sales Revenue

X 100%

• For every £1 of sales, how much profit after expenses is made? • Increase = handling expenses better • Decrease = expenses may have went up

Return on Capital Employed (ROCE) Net Profit X Capital Employed

100%

• If you invest £100 in a firm how much will you get back? • ROCE should be measured against interest rates. Since your savings can make money in a high interest bank account

Current Ratio Current Ratio = Current Assets:Current Liabilities Looks at how business can pay off its debts A ratio of 2:1 is considered prudent, but does not take into account stock being held. Higher than 2:1 means money may not being invested in the business properly Having less than 2:1 may mean the firm is in danger of not being able to pay off debts (too much money tied up in stock?)

Acid Test Ratio • Acid Test = • Current assets – stock: current liabilities This is a tougher ratio than the current ratio because it excludes stock, since stock is the hardest asset to transform into cash. This ratio should be around 1:1.

Rate of Stock Turnover • Stock turnover =

Cost of Sales

Average Stock Stock hanging around is bad for the firm. Stock’s can go off, out of fashion or out of date. This ratio works out how many times stock is used up. Note: Average Stock is calculated by adding

Recap… Ratio Analysis • What are ratios? • Uses of ratio analysis • Limitations of ratios • Profitability ratios • Liquidity ratios • Asset usage ratios

Today… • Cash Flow Statements • Cash Budgets • Cash Flow Problems

Budgets • Budgets are statements of anticipated future expenditure covering a specific time period • Cash Budgets – show expected receipts & payments on a monthly basis to help assess potential cash flow problems

Uses of Budgets • To monitor & control • Gain information • To set targets • To delegate authority

How budgets help managers • Make them accountable for decisions • Help check income & expenditure • Can highlight need for corrective action • Help develop long term plans • Assists with decision making • A means of comparison with actual results

Cash Flow Statements • Cash Budgets/Cash Flow Statements contain estimated figures of cash position of an organisation over a period of time. • Remember the closing balance is cash and not profit! • Cash Budgets are used to highlight potential shortages or surpluses of cash resources

Cash Budget

Cash Budgets and Role of Manager Plan

Borrow or not?

Organise

Bulk buying? Trade discounts?

Command

Departmental budgets

Coordinat e Control

Departmental reports

Delegate

Budgets spent by Dept. Mgrs.

Motivate

Giving financial control may empower individuals

Measure performance

Cash Flow Management • Liquidity – as mentioned, to check either shortages or surpluses of cash resources. • Decision-making – the role of the manager can be aided by cash budgets. • Projection – different variables and scenarios can be used (on a spreadsheet) to see what can affect the cash position of the organisation.

Recap… • Cash Flow Statements • Cash Budgets • Cash Flow Problems

Today… • Users of Financial Information • Internal Sources of Finance • External Sources of Finance • Additional Sources of Finance

Users of Financial Information

• Shareholders – can assess Board’s performance and decide about investment or disinvestment • Potential Shareholders – decide whether firm is a worthwhile risk • Short term creditors – should credit be granted to the firm? • Long term creditors – should money be lended to the firm? Will it be paid back?

Users of Financial Information

• Government and local authorities – look to directors’ report and business plan. Do these plans affect local area? • Competitors – compare themselves with rivals to work out market share and if plans conflict with their own • Employees – can the firm pay better wages? Is the future sound? • Management – use info to evaluate past performance and used to plan for future • Customers – is firm likely to still be around? Other concerns, eg environment

Sources of Finance

Internal Sources of Finance • Retained Profits – profit kept by company for future activities • Selling Assets – money raised by selling off an asset no longer needed • Both are Short-term

External Sources of Finance • Long Term (10 years +) • Issuing Shares – capital raised by selling shares • Debentures – a fixed interest long term loan • Loans – borrowing money, repaid over a time period with interest • Mortgages – a loan secured for property

External Sources of Finance • Medium Term (1-10 years) • Leasing – renting equipment or premises • Hire Purchase – acquiring an asset on credit followed by fixed payments. After last instalment purchaser owns asset. • Loans

External Sources of Finance • Short Term (up to 1 year) • Overdraft – borrowing more money than is available in bank account • Trade Credit – businesses receive goods first, then pay later • Factoring – a specialist business collecting unpaid debts for a fee

Additional Sources of Finance • LEC – Scottish Enterprise Renfrewshire • Local authorities – East Renfrewshire Council • Government Partnerships – Business Gateway

• Grants and allowances – Repayable Grants, Soft Loans, Subsidies • EU grants – Regional Development Fund & Social Fund

Recap… • Users of Financial Information • Internal Sources of Finance • External Sources of Finance • Additional Sources of Finance

a) What four main areas does financial information cover? b) For what purposes might a manager use financial information? c) List at least four characteristics of useful financial information. d) List at least five users of financial information. e) Taking the users of financial information that you have made, suggest a reason for each of them to be using the information.