Essential Standard 4.00
Understanding the role of finance in business.
1
Objective 4.01
Understand financial management.
2
Topics
Financial planning
 Business budgets
 Financial records and statements
 Financial performance ratios

3
Financial planning
4
Financial Planning
Why should a business do financial
planning?
◦
◦
◦
◦
Reduces financial uncertainties
Increases control of financial activities
Provides a ‘map of finances’ for business
Makes it easier to ‘stick’ to financial processes
and goals.
5
Financial Planning continued
Phases of business
◦ Start-up
 Financial planning includes determining the amount of money
needed to start and operate the business until a profit is
made. Also the major sales and expenses are determined.
◦ Operation
 Financial planning includes determining whether they are
making enough money to operate. The basic formula used is
Revenue – Expenses = Profit or Loss.
◦ Expansion
 Financial planning includes determining whether enough
money is made to cover growth opportunities.
6
Business budgets
7
Business Budgets
Types of business budgets:
◦ Start-up budget used by a new business or
during expansion of a business until profits
are made.
◦ Operating budget used for ongoing business
operations for a specific period.
◦ Cash budget used to estimate cash flow in
and out of a business.
8
Business Budgets continued
Steps for preparing a business budget:
 Prepare a list of income and expense
items.
 Gather accurate information from
business records.
 Create the budget.
 Clearly communicate the budget to key
employees in order to make sound
business decisions.
9
What is income?
 Money
received for goods or services
Net Sales
 Revenue
 Receipts
 Earnings
 Interest

10
What is expense?
 Cost
or charge incurred; a payment of
money
Salaries
 Utilities
 Rent
 Insurance

Advertising
Telephone
Repairs/Maintenance
Taxes
11
Sample Company
Budget
January 1, xxxx to December 31, xxxx
Category
Inflows
Net Sales
Cost of Goods
Merchandise Inventory, January 1
Purchases
Freight Charges
Total Merchandise Handled
Actual
Budget
Difference
385,400
300,000
85,400
160,000
120,000
2,500
282,500
160,000
90,000
2,000
252,000
0
30,000
500
30,500
Less Inventory, December 31
100,000
120,000
(20,000)
Cost of Goods Sold
Gross Profit
Interest Income
Total Income
182,500
202,900
500
202,500
132,000
168,000
700
168,700
50,500
34,900
(200)
33,800
Expenses
Salaries
Utilities
Rent
Office Supplies
Insurance
Advertising
Telephone
Travel and Entertainment
Dues & Subscriptions
Interest Paid
Repairs & Maintenance
Taxes & Licenses
Total Expenses
Net Income
68,250
5,800
23,000
2,250
3,900
8,650
2,700
2,550
1,100
2,140
1,250
11,700
133,290
$69,210
45,000
4,500
23,000
3,000
3,900
9,000
2,300
2,000
1,000
2,500
1,000
10,000
106,850
$61,850
23,250
1,300
0
(750)
0
(350)
400
550
100
(360)
250
1,700
26,440
$7,360 12
Startup Budget
March 17, 2011
Cash Needed
to Start
% of
Total
Actual Cash
Spent
% of
Total
% of
Variance
Total
Monthly Costs
Salary of owner-manager
All other salaries and wages
Rent
Advertising
Delivery expense
Supplies
Telephone
Other utilities
Insurance
Taxes, including social security
Interest
Maintenance
Legal and other professional fees
Miscellaneous
Subtotal
$6,000
7,000
1,000
2,000
400
500
500
500
600
1,000
500
300
3,000
500
$23,800
13.7%
16.0%
2.3%
4.6%
0.9%
1.1%
1.1%
1.1%
1.4%
2.3%
1.1%
0.7%
6.9%
1.1%
54.4%
$6,500
7,100
900
2,000
1,000
1,500
500
760
600
1,000
500
300
3,300
500
$26,460
13.9%
15.1%
1.9%
4.3%
2.1%
3.2%
1.1%
1.6%
1.3%
2.1%
1.1%
0.6%
7.0%
1.1%
56.4%
($500)
(100)
100
0
(600)
(1,000)
0
(260)
0
0
0
0
(300)
0
($2,660)
15.8%
3.2%
-3.2%
One-Time Costs
Fixtures and Equipment
Decorating and remodeling
Installation charges
Starting inventory
Deposits with public utilities
Legal and other professional fees
Licenses and permits
$10,000
1,000
500
5,000
1,000
500
500
22.9%
2.3%
1.1%
11.4%
2.3%
1.1%
1.1%
$11,000
1,200
600
4,000
1,200
500
500
23.4%
2.6%
1.3%
8.5%
2.6%
1.1%
1.1%
($1,000)
(200)
(100)
1,000
(200)
0
0
31.6%
6.3%
3.2%
-31.6%
6.3%
Advertising and promotion for opening
Cash
Other
Subtotal
500
750
200
$19,950
1.1%
1.7%
0.5%
45.6%
500
750
200
$20,450
1.1%
1.6%
0.4%
43.6%
0
0
0
($500)
15.8%
Totals
$43,750
100%
$46,910
100%
($3,160)
100%
19.0%
31.6%
8.2%
9.5%
84.2%
13
SAMPLE Operating Budget
July 1, 2004 to June 30, 2005
Income
Membership dues - 35 @ $25.00
Fund-raiser
Contest entry award
Aluminum can sales
T-shirt sales
Parties
Total Income
$875.00
$100.00
$25.00
$27.00
$468.00
$200.00
$1,695.00
Expenses
Parties
Intramurals
Gifts
Refreshments
National/regional dues -35 @$5.00
Fund-raiser
T-shirts
Picnic
Office supplies/duplicating
State & County sales tax
Total Expenses
AVAILABLE FUNDS
$710.00
$15.00
$55.00
$100.00
$175.00
$44.00
$450.00
$99.00
$28.00
$19.00
$1,695.00
-0-
14
Financial
records and statements
15
Financial Records and Statements

What is the purpose of financial records?
Financial records provide specific
information about business activities that
is used to analyze the financial
performance of a business.
16
Financial Records and Statements

Financial records used by businesses:
◦ Asset records – buildings and equipment
owned by the business, their original and
current value, and the amount owed if money
is borrowed to purchase the assets
◦ Depreciation records – identify the
amount assets have decreased in value due to
their age and use
◦ Inventory records – identify the type and
number of products on hand for sale; help
determine # products sold, damaged or lost
and the current value of that inventory
17
Financial Records and Statements
◦ Records of accounts – identify all purchases
and sales made using credit
 Accounts payable record identifies the
companies from which credit purchases were made
and the amount purchased, paid and owed.
 Accounts receivable record identifies
customers that made purchases using credit and the
status of each account
◦ Cash records – list all cash received and
spent by the business
18
Financial Records and Statements
◦ Payroll records – contain information on all
employees of the company, their
compensation and benefits.
◦ Tax records – show all taxes collected, owed
and paid. As a part of payroll, employers must
withhold a certain percentage of employees’
salaries and wages for federal income tax. The
company also makes payments for Social
Security and Medicare and, in some cases, for
unemployment compensation insurance.
Businesses may have to pay several types of
taxes on their income and value of their
assets.
19
What are assets?

Assets are things that a business (or
person) owns

Examples: cash, inventory, real estate,
equipment, accounts receivable
20
What are liabilities?

Liabilities are things that a business (or
person) owes

Examples: debt, accounts payable, loans
21
What is owner’s equity?

Owner’s equity is the value of the
owners’ investment in the business

Value of business after liabilities are
subtracted from assets
22
Financial Records and Statements
continued

What are financial statements?
Financial statements provide a picture of
the financial performance of a business
23
Financial Records and Statements
continued

What is the difference between a balance
sheet and an income statement?

Balance sheet includes assets, liabilities
and owner’s equity

Income statement includes sales, expenses
and net profit/net loss
24
Revenue vs. Expenses
Revenue is all income received by the
business during the period. Sources of
income include the sale of products and
services, plus interest earned from
investments.
 Expenses are all the costs incurred by
the business during the period. Expenses
include operations, purchase of
equipment, supplies, inventory, payroll and
taxes.

25
Revenue vs. Expenses

The business has net income when
revenue is greater than expenses.

The business has net loss when expenses
are greater than revenue.
26
Sample Income Statement
27
Sample Balance Sheet
28
Financial performance ratios
29
Financial Performance Ratios

Financial performance ratios are
comparisons using a company’s
financial data to determine how well
a business is performing.

The four main types of financial ratios:
◦
◦
◦
◦
Current ratio
Debt to equity ratio
Return on equity ratio
Net income ratio
30
Financial Performance Ratios continued

Current ratio
◦ Equals current assets/current liabilities
◦ Represents assets that the business could convert
into cash in < 1 year compared to liabilities that it
must pay in < 1 year; shows ability of company to
pay debts as they become due. Ideally, this ratio
should be over 1.0.
◦ Normally, the higher the ratio, the more favorable
it is for the company.
31
Financial Performance Ratios continued

Debit to equity ratio
◦ Equals total liabilities/owner’s equity
◦ Shows how much the business relies on money
borrowed externally which will have to be paid
back versus money provided by the owners.
Ideally, this ratio should be less than 2.0.
◦ Normally, the lower this ratio, the more favorable
it is for the company.
◦ Too much debt puts a business at risk because it
may have trouble meeting its obligations to its
lenders.
32
Current Ratio and Debt to Equity Ratio

Current Ratio
Current assets are $1,200,000 and total current liabilities are $600,000.
Calculate current ratio.
Calculation:
Current Ratio = 1,200,000 / 600,000
=2
or
1200,000 : 600,000
2:1

Debt to Equity Ratio
Equity share capital
Capital reserve
Profit and loss account
6% debentures
Sundry creditors
Bills payable
Provision for taxation
Outstanding creditors
1,100,000
500,000
200,000
500,000
240,000
120,000
180,000
160,000
Required: Calculate debt to equity ratio.
Calculation:
External Equities / Internal Equities
= 1,200,000 / 1,800,000
= 0.66 or 4 : 6
33
Financial Performance Ratios continued

Return on equity ratio
◦ Equals net profit/owner’s equity
◦ Indicates the rate of return the
owners/stockholders are receiving on their
investments. There is not an ideal ratio; however, it
is used to compare with other types of
investments to see if there may be another
investment that is more desirable.
◦ Normally, the higher the ratio, the more favorable
it is for the company.
34
Financial Performance Ratios continued

Net income ratio
◦ Equals total sales/net income
◦ Shows the amount of sales needed for each dollar
of net income. While there is not an ideal ratio,
managers use this number to compare to past
periods to determine how changes in sales affect
net income.
◦ Normally, the lower the ratio, the more favorable
it is for the company, as it takes less in sales to
generate net income.
35
Return on Equity Ratio and Net Income Ratio

Return on Equity Ratio
Return on equity or ROE can be calculated as,
Calculate return on equity share capital from the following information:
Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation rate: 50% of net profit; Net profit
before tax: $400,000.
Calculation:
Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) / 1,000,000 )× 100]
= 15.5%

Net Income Ratio
Formula:
Net Profit Ratio = (Net profit / Net sales) × 100
Example:
Total sales = $520,000; Sales returns = $ 20,000; Net profit $40,000
Calculate net profit ratio.
Calculation:
Net sales = (520,000 – 20,000) = 500,000
Net Profit Ratio = [(40,000 / 500,000) × 100]
= 8%
36
Ratios
Financial
Performance Ratio
Formula
Current Ratio
Current Assets/Current Liabilities
Debt to Equity Ratio
Total Liabilities/Owners’ Equity
Return on Equity Ratio Net Profit/Owners’ Equity
Net Income Ratio
Total Sales/Net Income
37
GROSS vs. NET
Gross means amount before any
expenses are deducted
 Net means amount after expenses are
deducted

38
Discrepancies
Discrepancies are differences between
actual and budgeted performance.
 Also know as a variance

39