FINANCE
Financial Management
Higher Business Management
FINANCE
Role and importance of financial
management
Efficient management of finance is crucial to
an organisation’s success. It has to:
ensure adequate funds are available for the
resources needed to help achieve the
organisational objectives
 ensure costs are controlled
 ensure adequate cash flow
 establish and control profitability levels.

FINANCE
Duties of financial management
Maintain financial records
 Pay bills and expenses
 Collect accounts due
 Monitor funds
 Pay wages and salaries
 Provide information for managers and
decision-makers within the business

FINANCE
Annual accounts
There are four main financial
statements used (called Final
Accounts):
trading account
 profit and loss account
 balance sheet
 cash flow statement.

FINANCE
Answer a question

Explain the role of the finance
department in an organisation.
(4 marks) 2010

8 minutes
FINANCE
Peer marking

You are going to swap answers.
Has your partner answered well?
 Does the answer make sense?
 Is it worth a mark?

Solution
FINANCE





Control costs – the finance department will help control
costs of an organisation, which should help it be more
profitable.
Monitor cash flow – will closely monitor cash flow and
take corrective action if any problems arise to ensure
proper liquidity.
Plan for the future – by analysing past and future trends
the department will hopefully make decisions that will
improve the organisation’s efficiency.
Monitor performance – use the final accounts to analyse
how the organisation has performed and help improve
any areas of weakness identified.
Make decisions – the department will make use of the
information it has to plan budgets and make financial
decisions; this should help an organisation’s performance
and profitability.
FINANCE
Trading, profit and loss account

The trading account records how much
money is made from selling goods against
how much they cost to make. The gross
profit is calculated in the trading account.

The profit and loss account shows the
business income and expenditure. The net
profit is calculated in the profit and loss
account.
FINANCE
Trading account format
£
Turnover (or sales)
Cost of sales
Opening stock
Purchases
60,000
105,000
165,000
Less: Closing stock (35,000)
Gross profit
£
350,000
130,000
220,000
Profit and loss account format
FINANCE
£
Gross profit
Other income
Interest received
£
220,000
7,000
227,000
Expenses
Rent
Wages
Insurance
Net profit
18,000
75,000
5,000
98,000
129,000
FINANCE
Profit and loss account key terms





Trading account – summary of trading
where gross profit is calculated.
Sales – income received through selling
goods/services.
Cost of sales – cost of items sold.
Opening stock – value of stock at the
beginning of the financial period.
Closing stock – value of stock at the end of
the financial period.
FINANCE
Profit and loss account key terms
Purchases – cost of goods bought to sell on
to customers.
 Purchase returns – total value of goods
purchased by business but returned to
suppliers.
 Sales returns – total value of goods
purchased by customer but returned to the
business.
 Expenses – outgoings such as overheads,
rent, wages.

FINANCE
Interpretation of trading, profit and
loss accounts

Was this year’s trading result good or bad, compared with
last year?

Was this year’s trading result good or bad, compared with a
competitor?

Has our gross profit improved this year?

Are we utilising our stock effectively and efficiently?

Has our net profit improved this year?

Does our net profit compare favourably with that of other
organisations in the same industry?
FINANCE
Balance sheet

The balance sheet shows a snapshot
of a precise point/date in time.

It is a record of assets and liabilities.

Capital = assets – liabilities
FINANCE
Balance sheet
Assets
Liabilities and capital
Balance
FINANCE
Assets

Assets – what a business owns.

Fixed assets – have a lifespan of more
than 1 year, eg machinery, motor
vehicles.

Current assets – constantly changing,
eg stock, debtors, bank, cash.
FINANCE
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.
FINANCE
Capital

Capital – provided by the owner of the
business and treated as being owed to
the owner of the business.
Profits – may increase capital.
 Drawings – may decrease capital.
 Reserves – monies retained by the
business.

FINANCE
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?
FINANCE
Working capital

Working capital is:
current assets – current liabilities
If a business has too much working
capital then it is not using its
resources properly.
 If a business has too little working
capital, then it may not be able to pay
off short-term debts.

FINANCE
Interpretation of balance sheet

Have we enough working capital to
avoid cash flow problems?

Can we improve our trade credit?

Is our debt level serviceable?
FINANCE
Answer a question

Distinguish between:
a)
gross profit and net profit
fixed assets and current assets
debentures and shares
(6 marks) 2007
b)
c)
10 minutes
FINANCE
Peer marking

You are going to swap answers.
Has your partner answered well?
 Does the answer make sense?
 Is it worth a mark?

FINANCE
Solution

Gross profit is turnover less cost of sales – the money made on
buying and selling goods.

Net profit is the profit after all the firm’s expenses have been
deducted from the gross profit.

Fixed assets are items which the business owns and will be
kept for longer than 1 year.

Current assets are items which the business owns and will be
kept for less than 1 year.

Debentures is a loan where there fixed interest is paid over the
stated period of the loan and then the full amount is paid back.

Shares are investment in a company that receives a dividend
each year if profits allow.
What are ratios?
FINANCE
Click for clip
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 other factors such as quality of
workers, inflation, economic situation.

FINANCE
Uses of ratio analysis
Compare current performance with
firm’s previous years.
 Compare firm’s performance against
similar organisations.
 Identify changes in performance to aid
future actions.
 Identify trends over time.

FINANCE
Limitations of ratio analysis
Information is historic.
 Comparisons must only be made with
similar organisations (size, industry).
 Does not take external factors
(PESTEC) into account.
 Does not take NPD or declining
products into account.
 Does not take people issues (staff
morale, staff turnover) into account.

FINANCE
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
FINANCE
Gross profit percentage
Gross profit
× 100%
Sales revenue
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
gone up.

FINANCE
Net profit percentage
Net profit
× 100%
Sales revenue

For every £1 of sales, how much profit
after expenses is made?

Increase = handling expenses better.

Decrease = expenses may have gone
up.
FINANCE
Return on capital employed
(ROCE)
Net profit
× 100%
Capital employed

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.
FINANCE
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 be
invested in the business properly.
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?).
FINANCE
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.
FINANCE
Rate of stock turnover
cost of sales
Stock turnover =
average stock
Stock hanging around is bad for the firm. Stocks 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 closing
and opening stock and then dividing by 2.
FINANCE
Answer a question
a)
Describe ratios to ensure profitability
and liquidity.
(5 marks) 2008
a)
Explain the limitations of using
accounting ratios.
(5 marks) 2010

12 minutes
FINANCE
Peer marking

You are going to swap answers.
Has your partner answered well?
 Does the answer make sense?
 Is it worth a mark?

Solution to a)
FINANCE






Gross profit % measures the gross profit on each
sale.
Net profit % measures the profit after expenses on
each sale.
Mark-up – measures how much has been added to
the cost of the goods as profit.
Return on capital employed – measures the return
on investment in the business.
Current ratio – shows how able a business is to pay
its short-term debts.
Acid test ratio – ability to pay short-term debts after
stock is deducted.
Solution to b)
FINANCE







Information is historical, which means it could lead to bad
decisions being made.
Does not take into account external factors, eg the
business may have performed well during a recession.
Does not show staff morale, which may be poor and the
business has therefore performed well.
Recent investments are not shown, which could result in
future increase in performance/profits.
New products could just have been launched and again
these may improve performance although ratios will not
show this.
Can only be used to compare against similar
organisations, which may not be of great use in certain
situations.
Different accounting process used from one year to the
next can alter ratios, which could result in the wrong
decisions being made.
FINANCE
Budgets

Budgets are statements of anticipated
future expenditure covering a specific
time period.

Cash budgets – show expected
receipts and payments on a monthly
basis to help assess potential cash
flow problems.
FINANCE
Uses of budgets
To plan for the future (forecasting).
 Financial or goal-oriented target setting.
 Evaluation and analysis of performance.
 Delegation of financial responsibility (eg
departmental budgets).
 Data and information collection.

FINANCE
How budgets help managers
Make managers decisions accountable.
 Help check income and expenditure
levels.
 Used in long-term planning.
 An aid to decision making.
 An aid for comparing projections with
actual results.
 Used as a tool to act on problems.

FINANCE
Cash flow statements

Cash budgets/cash flow statements contain
estimated figures of the cash position of an
organisation over a specific time period.

Remember the closing balance is cash and
not profit!

Cash budgets are used to identify shortages
or surpluses of cash resources.
Click for clip
FINANCE
Cash budget
FINANCE
Cash budgets and the role of the
manager
Plan
Borrow or not?
Organise
Bulk buying? Trade discounts?
Command
Departmental budgets
Coordinate Departmental reports
Control
Measure performance
Delegate
Budgets spent by department
managers
Giving financial control may
empower individuals
Motivate
FINANCE
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.
FINANCE
Answer a question

Explain why managers use cash
budgets.
(5 marks) 2009

10 minutes
FINANCE
Peer marking

You are going to swap answers.
Has your partner answered well?
 Does the answer make sense?
 Is it worth a mark?

Solution
FINANCE






Managers can compare actual figures with planned
budgets and, if there are any deviations, take
corrective action where required.
Highlights periods where a negative cash flow is
expected and allows for appropriate finance to be
arranged for that period.
Allows for investment to be made in times of excess
cash flow to best utilise surplus profit.
Corrective action can be planned in advance of cash
deficits, for example a loan may be arranged.
Allows managers to control expenditure and ensure
they don’t go over the set budget.
Used to set targets for workers and managers, which
can be a motivational tool.
FINANCE
Users of financial information
Shareholders – can determine if current
performance is worthy of more investment or
if other action required (sell shares or remove
board at AGM).
 Potential shareholders – decide whether or
not firm offers a good investment.
 Short-term creditors – should credit be
granted to the firm?
 Long-term creditors – should money be
loaned to the firm? Will it be paid back?

FINANCE
Users of financial information
Government and local government – will
analyse firm’s reports and business plans. Will
the firm’s future plans impact on community
(voters!)?
 Competitors – compare themselves with rivals
to work out market share and how future plans
may affect their own operations.
 Employees – can the firm pay better wages? Is
the future sound (are their jobs safe)?
 Management – use information to analyse,
compare and evaluate performance and plan
for the future.

FINANCE
Sources of finance
Click for clip
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 sources.
FINANCE
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 on
property.
FINANCE
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.
FINANCE
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.
FINANCE
Additional sources of finance
LEC, eg Scottish
Enterprise
 Local authorities,
eg South
Lanarkshire
Council
 Government
partnerships, eg
Business Gateway

Grants and
allowances, eg
repayable grants,
soft loans,
subsidies
 EU grants, eg
Regional
Development Fund
and Social Fund

FINANCE
Answer a question

Describe four different sources of
long-term finance available to a
private limited company.
(4 marks) 2010

8 minutes
FINANCE
Peer marking

You are going to swap answers.
Has your partner answered well?
 Does the answer make sense?
 Is it worth a mark?

Solution
FINANCE








Bank loan – paid back over a number of years with
interest.
Commercial mortgage – a loan on property paid back
over a long period with interest.
Venture capitalists – invest in an organisation if a more
risky venture is undertaken, but they may request a share
in the organisation in return.
Invite new shareholders to invest in the organisation.
Local/national government grants, which do not have to
be paid back but must meet certain criteria.
Sell off unwanted assets to raise finance quickly.
Debentures – issued to investors and interest payments
are made yearly, with the lump sum paid back at an
agreed time.
Retained profits of the organisation reinvested into the
business.