Financial Management Int 2 Business Management
Role and importance of Financial Management Efficient management of finance is crucial to an organisation’s success. They have to: Ensure adequate funds are available for resources needed to help achieve organisational objectives Ensure costs are controlled Ensure adequate cash flow
Establish and control profitability levels
Duties of Finance Maintain financial records Payment of bills and expenses Collection of accounts due Payment of wages and salaries
The main role Finance provides information for managers and decision-makers within business
There are four main financial statements used (called Final Accounts):
Cash Flow Statements Cash Budgets/Cash Flow Statements contain estimated figures of cash position of an organisation over a period of time. Remember the closing balance is cash and not profit!
Cash Budgets are used to highlight potential shortages or surpluses of cash resources
Cash Budgets and Role of Manager Giving financial control may empower individuals Motivate Budgets spent by Dept. Mgrs. Delegate Measure performance Control Departmental reports Coordinate Departmental budgets Command Bulk buying? Trade discounts? Organise Borrow or not? Plan
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.
Trading, Profit & Loss Account The trading account records how much money is made from selling goods against how much it costs to make. The gross profit is calculated in the trading account.
The profit and loss account shows the businesses incomes and expenditures. The net profit is calculated in the profit and loss account.
Trading Account Format Turnover (or sales) 180,000
Less: Closing Stock (45,000) 90,000
Profit and Loss Account Format
Wages and salaries 45,000
Profit and Loss Account Key Terms Trading account – provides summary of business’s trading activity during financial year Sales – monies received through selling goods/services Cost of sales – cost of sales to a business before a profit margin is added Opening stock – value of stock at start of the financial period
Closing stock – value of stock at end of the financial period
Purchases – cost of goods business has bought for resale to customers Purchase returns – value of goods purchased but returned to supplier Sales returns – value of goods bought by customer but returned to the firm Profit and Loss Account Key Terms
Expenses – any expenses incurred by the business in the course of normal operation
Interpretation of Trading, Profit & Loss Accounts Was this year’s trading result good or bad, compared with last year or with a rival company? Has the Gross Profit improved this year, compared with last year? Are we making efficient use of our stock?
Does our Net Profit figure compare favourably with those of other organisations in the same industry?
Balance Sheet The profit and loss account shows the history of the business activity throughout the financial year. The balance sheet shows a snapshot of a particular date in time.
CAPITAL = ASSETS - LIABILITIES
Balance Sheet Assets Liabilities & Capital Balance
Assets Assets – are what a business owns Fixed assets – have a lifespan of more than one year, eg machinery, motor vehicles
Current Assets – are constantly changing eg stock, debtors, bank, cash
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
Capital Capital – provided by the owner of the business and treated as being owned to the owner of the business Profits – may increase capital Drawings – may decrease capital
Reserves – monies retained by business
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?
Working Capital Current Assets – Current Liabilities If a business has too much working capital then they are not using their resources properly.
If too little, then they may not be able to pay off short term debts.
Interpretation of Balance Sheet Do we have enough working capital to avoid cash flow problems? Are we making enough use of available trade credit?
Is our level of debtors comparable with that of our industry competitors?
What are Ratios? 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 of other factors such as quality of workers, inflation, economic situation
Uses of Ratio Analysis Compare current performance with previous years Compare performance against similar organisations Identify changes in performance to aid future actions
Identify trends over time
Limitations of Ratio Analysis Comparisons must only be made with similar organisations (size, industry) No account of external factors (PEST) No account of NPD or declining products
No account of human factors (staff morale, staff turnover)
Return on Capital Employed (ROCE)
Gross Profit Percentage 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 X 100%
Decrease = cost of materials may have went up
Net Profit Percentage For every £1 of sales, how much profit after expenses is made? Increase = handling expenses better X 100%
Decrease = expenses may have went up
Return on Capital Employed (ROCE) If you invest £100 in a firm how much will you get back? X 100%
ROCE should be measured against interest rates. Since your savings can make money in a high interest bank account
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 being invested in the business properly
Having 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?)
Acid Test Ratio 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.
Rate of Stock Turnover Cost of Sales Average Stock Stock hanging around is bad for the firm. Stock’s 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
Users of Financial Information Shareholders – can assess Board’s performance and decide about investment or disinvestment Potential Shareholders – decide whether firm is a worthwhile risk Short term creditors – should credit be granted to the firm?
Long term creditors – should money be lended to the firm? Will it be paid back?
Users of Financial Information Government and local authorities – look to directors’ report and business plan. Do these plans affect local area? Competitors – compare themselves with rivals to work out market share and if plans conflict with their own Employees – can the firm pay better wages? Is the future sound? Management – use info to evaluate past performance and used to plan for future
Customers – is firm likely to still be around? Other concerns, eg environment
Sources of 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
External Sources of Finance 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 for property
External Sources of Finance Leasing – renting equipment or premises
Hire Purchase – acquiring an asset on credit followed by fixed payments. After last instalment purchaser owns asset.
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
Additional Sources of Finance LEC – Scottish Enterprise Renfrewshire Local authorities – East Renfrewshire Council Government Partnerships – Business Gateway Grants and allowances – Repayable Grants, Soft Loans, Subsidies
EU grants – Regional Development Fund & Social Fund