FINANCEBusiness Studies

BS2

Name: _______________________

Outline of Module1. Budgeting

Understand the nature and purpose of budgets and their limitations.

2. Cash Flow Forecast Complete and interpret simple cash flow forecasts. The benefits and limitations of using cash flow forecasts.

3. Profit and Loss Accounts Understand the importance of the main items on a Profit and

Loss Account of sole traders and partnerships. Interpret simple Profit and Loss Accounts

Candidates are not expected to construct accounts or use ratio analysis.

4. Balance Sheets Understand the importance of the main items on a Balance

Sheet of sole traders and partnerships.Candidates are not expected to construct accounts or use ratio analysis.

Interpret simple Balance Sheets.

5. Break Even Analysis Classify costs: fixed, variable and semi-variable. The nature and significance of contribution. Construction and interpretation of break-even charts. The impact of changes in costs and revenue on the gross

and net profit of businesses. What-if analysis.

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Checklist

Revision

1. Budgeting 1.1 Understand the nature and purpose of budgets and their limitations.

DEFINITION: A budget is a target for costs or revenue that a firm or department must aim to reach over a

given period of time. In other words it is a quantitative economic plan prepared and agreed in advance.

BUDGETARY CONTROL/BUDGETING: This is a business system which involves making future plans, comparing the actual results with the planned results and investigating any differences/variances.

A budget forecasts future earnings and future spending,

usually over a 12 month period. Businesses use different

budgets to estimate different things:

o INCOME/SALES REVENUE: Shows the planned income or revenue for a period of time.

o EXPENDITURE/TOTAL COST BUDGET: Shows how much money a business is

expected to spend for a period of time.

o PROFIT BUDGET: Shows the amount of profit a business is expected to make over a

period of time.

o MASTER BUDGET: A summary statement which brings together information from

budgets.

USING BUDGETSBudgets are considered to be a management tool and the way in which they are used can tell you a lot about a firm’s

culture. A tightly controlled budgetary system illustrates a top heavy management system where managers will have

budgets imposed upon them and variances will be closely watched by supervisors. Alternatively, organisations with a

more open culture will use budgeting as an aid for discussion and empowerment.

MAIN REASONS BUDGETS ARE USED

o CONTROL (DELEGATING SPENDING)

o MONITORING PERFORMANCE

o PLANNING

o CO-ORDINATION

o COMMUNICATION

o EFFICIENCY

LIMITATIONS: RESENTMENT: Can cause rivalry between departments if they have to compete for money. RESTRICTIVE: Fixed budgets can stop firms responding to changing market

conditions. TIME-CONSUMING: Managers can get too preoccupied with setting and

reviewing budgets, and forget to focus on the real business issues.

VARIANCE is the amount by which the actual result differs from the budgeted figure – it can be either favourable or adverse.

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2. CASH FLOW FORECAST 2.1 Complete and interpret simple cash flow forecasts.

2.2 The benefits and limitations of using cash flow forecasts.

DEFINTION: Cash flow is money flowing in and out of a business. A Cash Flow Statement is a plan showing all the expected cash receipts and cash payments in a firm over a period of time. It is a business’s estimate of the future timing and source/nature of its income and expenditure.

CASH FLOW IS NOT PROFITPROFIT is calculated by recording all

transactions that will lead to cash going in or out of the business either at that moment or at some point in the future.

CASH FLOW is all the money flowing into and out of the business over a period

of time, calculated at the exact time the cash enters or leaves the bank account/till.

CASH FLOW DEFINITIONS CASH INFLOW (RECEIPTS): A flow of cash into the business CASH OUTFLOW (EXPENSE): A flow of cash out of the business CASH FLOW FORECAST: A future prediction of how cash might flow into and

out of a business. This may be set out in a chart or graph CASH SURPLUS: A situation when the cash inflow is greater than the cash

outflow CASH DEFICIT: A situation when a business finds itself short of cash because

the outflow is greater than the inflowBENEFITS OF CASH FLOWA S B u s i n e s s S t u d i e s – F i n a n c e ( B S 2 ) 4 | M i c h e l l e R y a n

Net Cash Flow isTotal

Receipts– Total

Payments

Closing Cash:

Net Cash Flow +

Opening Cash. Closing Cash

for one month is the opening cash for the

next month…

Negative figures are

show in brackets

A cash flow forecast can help both new and existing businesses in several ways:

It will help a business to plan its financial activities before problems arise and predict when the business might suffer from cash shortages.

This knowledge should help the business to control its business and financial operations, for example making sure they have enough cash to pay suppliers.

Identifies times of future cash surpluses so that they can be used to their best advantage.

LIMITATIONS OF CASH FLOW Cash flow forecasts can be based on false assumptions about

what’s going to happen. Circumstances can change suddenly after the forecast has been made as costs can rise,

machinery can break down or competitors can affect sales. A false forecast can have disasterous results as a busienss that runs out of cash can go

bankrupt.

ANALYSING CASH FLOW FORECASTS: (QUESTIONS TO ASK YOURSELF)

1. Is it realistic? 2. If there is a surplus (+) there is no problem, if there is a deficit (-) you must be

able to examine the effect of this on the closing cash balance for the month3. Is there too much credit being given to debtors?

(REMEMBER THE ALPHABET FOR THIS ONE!)

BORROW money (short term loan/overdraft) to cover any cash shortageCUT DOWN on planned expenditure (non essential items)DEFER PAYMENTS to creditorsEARN EXTRA INCOME to make up any cash shortfallFIXED ASSSET sale and leaseback of assets

STUDENT QUESTIONS What is a cash flow forecast? Why is it important that a business holds sufficient cash but not too much? How does a cash flow forecast indicate whether a business faces cash flow problems in the

future? What are the benefits of a business preparing a cash flow forecast? How can you work out a company’s opening balance in any given month? What’s the difference between profit and cash flow? Discuss the ways in which a business can improve its cash flow? To what extent can a business successfully and accurately predict future cash flow? Explain your

answer.

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3. Profit and Loss Accounts 3.1 Understand importance of the main items on a P&L Account of Sole Traders/Partnerships.

3.2 Interpret simple Profit and Loss Accounts.

The Profit and Loss Account shows how much money has been coming into the company (revenue) and how much has been going out (expenses).

Revenue is sales income (turnover) from selling goods and services which includes cash payments and sales on credit.

Expenses are all the costs of the business which are divided into direct or indirect and fixed or variable.

Trading, Profit and Loss Account for Company X for year ended 31/12/20-1

£ £Sales XLess Cost of SalesOpening Stock X+ Purchases X

X- Closing Stock (X)Cost of Sales (X)Gross Profit X

Less ExpensesLight & Heat XAdvertising Xdepreciation xWages X (X)Net Profit XTAX X (X)Retained profit X

TRADING ACCOUNT: Works out gross profit. PROFIT AND LOSS ACCOUNT: Subtracts overheads to work out

operating profit and net profit. APPROPRIATION ACCOUNT: Shows what is done with the profits – it is

either distributed to shareholders or kept in the business to invest in future activities (retained profit).

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OPERATING PROFITTakes into account all revenues and costs from regular trading, but not any revenues and costs from one-off events – in other

words it only covers activities that are likely to be repeated year on

year.

4. Balance Sheets 4.1 Understand the importance of main items on a Balance Sheet of Sole Traders/Partnerships.

4.2 Interpret simple Balance Sheets.

Balance Sheets are a snapshot of a firm’s finances at a fixed point in time. They show the value of all the assets and liabilities as well as the value of all the capital.

* Consists of 2 Parts: Part 1: Shows what the company owns, its total net assets

Part 2: Shows how the company has been financed

BALance sheet of Company X LtdAs at 31/12/2009

Fixed assets £ £ £

Land & buildings XMachinery XTotal fixed assets X

Current assetsClosing stock Xdebtors xCash in bank x x

Current liabilitiescreditors Xoverdraft XUnpaid tax x (x)Working capital XNet Current Assets XLong term liabilitiesmortgage Xnet assets xCAPITALReserves XBank loan Xdrawings (x)CLOSING CAPITAL x

* NET ASSETS and CLOSING CAPITAL figures should be the same!!

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5. Break Even Analysis 5.1 Classify costs: fixed, variable and semi-variable.

5.2 The nature and significance of contribution.

5.3 Construction and interpretation of break-even charts.

5.4 What-if analysis?

5.5 The impact of changes in costs and revenue on the gross and net profit of businesses.

For a product to break-even, i.e. it to be of benefit to a firm, it must earn enough money from sales to cover all of the costs involved in its production. This method of analysing is called

break-even analysis.

Fixed Costs: These costs do not change when output changes, for example the rent of a premises must

be paid even though the factory may be closed due to strike or other unforeseen circumstances. Similarly

insurance on a firms vehicles must be paid regardless of mileage. Variable Costs: These are costs that change when output changes, for example wages and raw

materials.

Semi-Variable Costs: These consist of a fixed or standing charge plus an extra rate which varies

according to use.

Break Even Point: This is the level of sales at which a firm is breaking even, i.e. neither making a

profit or loss. Total revenue equals total costs.

Margin of Safety: This is the amount by which a firm’s sales can fall before reaching break-even

point.

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CONTRIBUTION: This is the difference between the selling price of a product and the variable costs it takes to produce it. Contribution contributes towards fixed costs and profit.

UNIT CONTRIBUTION: This is the contribution on the sale of one unit. Say for example that Mr. Jones, a second hand car salesman, buys a Mini Cooper at an auction for £3,000 and sells it for £4,000 – in this case his contribution is £4000 - £3000 = £1000.

CONTRIBUTION PER UNIT: Selling Price – Variable Cost Calculating contribution can help a business in decision making as they can quickly anaylse what option will

contribute more to fixed costs and profit.

Some businesses use contribution when setting their price as they base their price at a point that exceeds the

variable cost meaning that each individual product will always make a contribution when sold.

THE BEP is where contribution = fixed costs

DRAWING A BREAK EVEN CHART:

1. Draw and label your graph2. Plot your fixed cost line

(straight line)3. Plot your total cost line

(starting from your fixed cost line)

4. Plot your revenue line (starting from 0)

5. Label the Break-Even point, Profit, Loss and

Margin of Safety

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Contribution per unit

Fixed Costs

EXAMPLE:

PRICES It can show the effect of price change on profits.

COSTS It can show how a change in costs can affect profits

SALES It will show the firm’s profits at the different level of sales

MARGIN OF SAFETY It shows the Margin of Safety at each level and allows risk assessment

NEW PRODUCTS It can help a firm decide whether or not to launch new products

FINANCEBusinesses may use BE Analysis to persuade the bank to give them a loan

DISADVANTAGES OF BREAKEVEN CHARTS It is assumed that the business will sell everything it makes which doesn’t happen in

the real world It is assumed that the selling price is the same regardless of the amount bought by the

consumer – however, in real life customers who buy in bulk receive a discount It is assumed that variable costs remain the same regardless of the amount of output –

however, we know that workers get paid overtime to persuade them to work extra hours in order to increase output

CHANGING COSTS/REVENUE WILL HAVE AN EFFECT ON PROFITS

If faced with a ‘what if’ question, identify if the change affects costs (as then it will affect BEP) or revenue. You then need to establish the new situation and the effect this will have on profits.

STUDENT QUESTIONS

Write down the formula for contribution, and the formula for break-even output. Write down two advantages and two disadvantages of break-even analysis. Bob is deciding whether to set up in business selling fishing equipment. Evaluate the value of

break-even analysis in helping Bob to decide whether or not to go ahead with the business. Mrs. Jones has a small restaurant. The average price per customer per meal is £13. The variable

costs of materials and labour per meal are £5. The fixed costs of the restaurant are £1,000 per month. Calculate the break-even number of customers per month.

What effect will a fall in variable costs have on the break-even level of output? How is break-even price calculated?

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GLOSSA RY OF TERMS – FINANCE (BS2)

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