Unit 3 - 6123 Financial Management

6123 - Content

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

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

Users of Accounts

• Owners / Shareholders

• Managers

• Employees

• Advisors & Brokers

• Customers

• Community

• Competitors

• Suppliers

• Lenders

• Government Agencies

• Why do these different stakeholders use 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 on the long-term operations of the business

The Difference Between Revenue & Capital Expenditure

Spending Capital/Revenue Explanation

Buying Property Capital A long-term asset forthe business

Extending Premises Capital For the long-term useof the business

Repair to Premises Revenue A one-off payment tomaintain the businessand its premises in auseable state

Wages & Salaries Revenue A one-off payment forthe work done in theprevious week

Buying a delivery Van Capital For repeated use by thebusiness

Petrol For The Van Revenue Petrol can only be usedonce then more must bebought

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

The Profit & Loss Account

• 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

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 profit 7,300

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 AFixed 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 BFixed 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 EmployedNet Profit + Interest on Debentures / Ordinary Shares + Reserves + Preference shares + Debentures

OR

Operating Profit (Net Profit) / Capital employedOR

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 cash outflow headings are as follows:

• Payments for assets

• Raw Materials

• Expenses

• Interest payments / Loan repayments

CFFSources 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 - 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

J F M A M J

Receipts

Sales 2300 1,400 5,300 6,100 4,700 1,400

Payments

Purchases 1400 4,100 5,600 5,000 3,100 900

Total(R-P)

900 (2,700) (300) 1,100 1,600 500

OpeningBalance

500 1400 (1,300) (1,600) (500) 1,100

ClosingBalance

1400 (1,300) (1,600) (500) 1,100 1,600

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

J F M A M J

Receipts

Sales

Payments

Purchases

Total(R-P)

OpeningBalanceClosingBalance

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 & Indirect Costs

• 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

Fixed & Variable 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

Total Costs

• Direct Costs can generally be considered as variable costs

• Indirect Costs can generally be considered as fixed costs

Total Costs = Direct Costs + Indirect Costs

or

Total Costs = Variable Costs + Fixed Costs

Break-even Analysis

• Break-even Point - the point at which sales levels are high enough not to make a loss, but not high enough to make a profit. TR=TC

• Contribution - the difference between an item’s selling price and the variable cost needed to produce that item

• Contribution = Selling price per unit - Variable cost per unit

• By producing and selling enough units to produce a total contribution that is in excess of the fixed costs, an organisation will make a profit

Margin of Safety

• Definition - The difference between the break-even point and the selected level of activity designed to achieve the profit target

• E.g. A company has calculated that it breaks-even when it produces 10,000 units. If the company decides to produce 12,000 units, then its margin of safety will be 2,000 units

Break-even Analysis

• Advantages

• It is possible to show changes in costs, revenue and therefore profit with the aid of a diagram

• The diagram is a very easy way of showing how profit levels change with changes in output

• Disadvantages• Analysis assumes all

output is sold

• Analysis does not take into account economies of scale

• It is a very complicated task to allocate all costs to certain production activities

Break-even - Example (Numerical)Penzance Toys

Predicted Sales = 8,000

Sale Price = £12 per unit

Variable Cost = £5 per unit

Fixed Costs = £9000

Using the formula

Contribution = £12 - £5 = £7 per unit

Therefore for each unit made £7 will go towards paying fixed costs

• Break-even = Fixed Costs / Unit contribution

• Break-even = £9,000 / £7

• Break-even = 1,286 units

• OR

• Break-even = Fixed costs / (Sale Price - Variable cost)

• Break-even = £9,000/£12-£5

• Break-even = £9,000 / £7

• Break-even = 1,286 units

Question - Break-even

• E.Brown opens a new restaurant. Using the figures below calculate the number of meals he needs to sell to break-even

• Fixed Costs = £10,000

• Variable Costs = £3 per meal

• Price per Meal = £8 average per meal

Break-even - E.Brown - Example (graphical)

Sales VariableCost

£3 per meal

Fixed Cost

£10,000

Total Costs

FC + VC

TotalRevenue

£8 per meal

TR-TC

0 0 10,000 10,000 0 (10,000)

500 1,500 10,000 11,500 4,000 (7,500)

1000 3,000 10,000 13,000 8,000 (5,000)

1500 4,500 10,000 14,500 12,000 (2,500)

2000 6,000 10,000 16,000 16,000 0

2500 7,500 10,000 17,500 20,000 2,500

Break-even question - Draw break even diagram

Sales VariableCosts£20

FixedCosts£6000

Total Costs

VC + FC

TotalRevenue

Sales X £40

TR-TC

0 0 6,000

100

200

300

400

500

Example - Break-even

• A Hotel owned by J.Smith has recently changed their accountants. The new accountants would like to know how many customers per year the hotel needs to break-even. Using the figures below work out the level of break-even both numerically and graphically

Fixed Costs = £107,200 per annum

Variable costs = £20 per customer

Total Revenue = £70 per customer

How many guests would the hotel need per year to make a profit of £35,000?

Exam - June 2003• 1.(a) (i)Define the following terms:

gross profit

working capital (4)

• (ii) Using figs. 1 & 2, calculate the gross profit and the working capital for Gap Inc in Feb.2002 (4)

• (b) Using information from figs 1 & 2, evaluate Gap Inc’s

(i) profitability

(ii) liquidity

in Feb 2002 (16)

• (c)Analyse additional financial information needed to make a fuller evaluation of Gap Inc’s performance (6)

30 marks

• 2 (a) Give one example of a fixed cost, and one example of a variable cost. (2)

• (b) Analyse the advantages and disadvantages to Gap Inc of classifying costs as either fixed or variable (10)

• In the 2001/2002 financial year, the number of Gap Inc stores increased by approximately 12% to 4,176.

• (c) Assess the extent to which the use of budgeting might assist Gap Inc’s:

• (i) financial management of these stores;

• (ii) continued survival as a business. (18)

30 marks