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
Extending Premises
Capital
Repair to Premises
Revenue
Wages & Salaries
Revenue
Buying a delivery Van
Capital
Petrol For The Van
Revenue
A long-term asset for
the business
For the long-term use
of the business
A one-off payment to
maintain the business
and its premises in a
useable state
A one-off payment for
the work done in the
previous week
For repeated use by the
business
Petrol can only be used
once then more must be
bought
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
less Returns inwards
Net sales
opening stock (1/1/2000)
Purchases
Carriage inwards
Less returns outwards
Net purchases
less closing stock (31/12/2000)
Cost of sales
Gross profit
21,000
1,000
20,000
4,500
12,100
300
12,400
500
11,900
16,400
3,700
12,700
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
less Returns inwards
Net sales
opening stock (1/1/2000)
Purchases
Carriage inwards
Less returns outwards
Net purchases
less closing stock (31/12/2000)
Cost of sales
Gross profit
add other income:
Discount received
Less expenses:
Electricity
Stationary
Business rate
Interest on loans
Total expenses
Net profit
21,000
1,000
20,000
4,500
12,100
300
12,400
500
11,900
16,400
3,700
12,700
7,300
2,000
9,300
510
125
756
159
1550
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 longterm 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
Fixed assets
Land & Buildings
Machinery
Motor Vehicles
80,000
13,200
8,700
101,900
Current Assets
Stocks
Debtors
Bank
Cash
Less Current Liabilities
Creditors
Value added tax owing
A
9,700
3,750
2,100
970
16,520
8,000
1,000
9,000
7,520
109,420
less Long-term liabilities
Bank loan
Mortgage
9,000
30,000
39,000
70,420
Net Assets
Finances by:
Capital
add Net profit
less Drawings
70,000
5,286
75,286
4,866
70,420
Balance Sheet
Fixed Assets
Land & Building
Machinery
Motor Vehicles
320,000
24,000
12,000
356,000
Current assets
Stocks
Debtors
Bank
Cash
less Current liabilities
Creditors
Proposed dividends:
Ordinary Shares
Preference Shares
Corporation tax
B
12,250
7,100
23,200
500
43,050
500
12,000
10,000
10,350
32,850
366,200
less Long-term Liabilities
Bank loan
10% debentures
10,000
8,000
18,000
348,200
Issued share capital
200,000 ordinary shares of £1fully paid
100,000 10% preference shares of £1 fully paid
200,000
100,000
300,000
Reserves
General reserve
Balance of retained profit
Shareholders funds
6,000
42,200
48,200
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 Employed
Net Profit + Interest on Debentures / Ordinary Shares + Reserves + Preference shares + Debentures
OR
Operating Profit (Net Profit) / Capital employed
OR
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
CFF
Sources 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
2300
1,400
5,300
6,100
4,700
1,400
Purchases
1400
4,100
5,600
5,000
3,100
900
Total
(R-P)
Opening
Balance
Closing
Balance
900
(2,700)
(300)
1,100
1,600
500
500
1400
(1,300)
(1,600)
(500)
1,100
1400
(1,300)
(1,600)
(500)
1,100
1,600
Receipts
Sales
Payments
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
Receipts
Sales
Payments
Purchases
Total
(R-P)
Opening
Balance
Closing
Balance
F
M
A
M
J
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 materialslubricating 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
Sale Price
Variable Cost
Fixed Costs
= 8,000
= £12 per unit
= £5 per unit
= £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
• Variable Costs
• Price per Meal
= £10,000
= £3 per meal
= £8 average per meal
Break-even - E.Brown - Example (graphical)
Sales
0
Variable
Fixed Cost Total Costs
Total
TR-TC
Cost
Revenue
£3 per meal
£10,000
FC + VC £8 per meal
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
0
100
200
300
400
500
Variable
Costs
£20
0
Fixed
Costs
£6000
6,000
Total Costs
VC + FC
Total
Revenue
Sales X £40
TR-TC
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