Understanding financial objectives


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Understanding financial objectives

  1. 1. Understanding financial objectives
  2. 2. Key terms Can you match the key word to the correct definition?Key word DefinitionAssets raw materials and other items necessary to production to take place. They also include finished products that have not been soldCapital measures the ability of a business to meet its short term debtsCreditors cash the business has for its day to day runningInventories represent money owed by a businessLiquidity people or organisations to which a business owes moneyWorking capital money invested into the business and is used to purchased assetsLiabilities items owned by a business
  3. 3. We will examine• How to analyse balance sheets• How to analyse income statements• How to use financial data for comparisons, trend analysis and decision making• The strengths and weaknesses of financial data in judging a businesses performance
  4. 4. A balance sheet is a financial statement What is a recording the assets and liabilities od a business onbalance sheet? a particular day at the end of and accounting period
  7. 7. Balance sheets are an essential source ofinformation for a variety of business decisionsand for a number of stakeholders;• Shareholders• Suppliers• Managers
  8. 8. Assets1. First classification• Non-current assets (e.g. land, property)• Current assets (e.g. cash, inventories)2. Second classification• Tangible assets (e.g. machinery, equipment)• Intangible assets (e.g. goodwill, brands)
  9. 9. Liabilities• Current liabilities (e.g. overdraft, tax due)• Non-current liabilities (e.g. bank loan, mortgages)• Total equity (shareholders’ funds)
  10. 10. Structure of a Balance sheet Name of the business and date Assets Liabilities Financed by
  11. 11. Structure of the balance sheet Marks and Spencer’s consolidated balance sheet as at 31st March 2008 2008 £mIn-tangible non-current assets 305.5Tangible non-current assets 5673.8Inventories 488.9Receivables and cash 692.8Total assets 7167.0Current liabilities (1988.9)Net current liabilities (807.2)Non-current liabilities (3208.1)Total liabilities (5191.0)Net assets 1964.0Share capital 628.0Reserves and retained earnings 1336.0Total equity 1964.0
  12. 12. Interpreting the balance sheetManagers , potential investors and accountantscan gain a great deal of information about acompany from reading its balance sheetIt is possible to assess the short-term financialpositions of the business and its longer-termfinancial strategy
  13. 13. Short term• Ability to pay bills• Shows the businesses short term debts (current liabilities) and also the current assets it has to pay these debts (creditors)• This is known as the working capital (current assets- current liabilities)• If a business has more current assets than current liabilities it has a positive figure• If it has more current liabilities than current assets it has a negative figure-this causes liquidity problems
  14. 14. Long term• Movement of non-current (fixed) assets- increase in non-current assets indicates a rapidly growing company• Where capital has come from- borrowing money can be risky• Reserves- indication of business profits
  15. 15. Working capitalWorking capital Current Assets CurrentEssential for the day to Cash at the bank, trade LESS Liabilities day running of the = and other receivables, Debts, trade and other business inventories payables, tax due • Measures the amount of money available to a business to pay its day to day expenses • Working capital is what remains of a business’s liquid assets once it has settled all its immediate debts
  16. 16. Too much WC• Holding excessive amounts of WC is not wise• Liquid assets e.g. cash has little or no return for the business• A well managed business will hold sufficient liquid assets to meet its need for WC Factors influencing the amount of WC • Volume of sales • Amount of trade credit offered • If the firm is expanding • Length of the operating cycle • Rate of inflation
  17. 17. Causes of WC problems• External changes• Poor credit control• Internal problems• Financial mismanagement
  18. 18. How important is WC?• WC can be described as the ‘lifeblood’ of a successful enterprise• If a business becomes insolvent it will be forced to close downWC is important for;1. Small businesses2. Businesses wishing to expand3. Businesses with a long working cycle
  19. 19. DepreciationThe reduction of the value of an asset over aperiod of time Year Value of asset on Amount Balance Sheet at depreciated end of year (£) annually (£) 2008 60000 20000 2009 40000 20000 2010 20000 20000 2011 0 20000 Depreciation of brewing equipment in ‘The Norfolk Ale Company’
  20. 20. Why do firms depreciate assets?Firms need to spread the cost of an asset over its usefullifeDepreciating assets ensures the value of the business isrelatively accurateIt allows firms to calculate the true cost of productionResale value declines for a number of reasons;• Wear and tear• Availability of modern equipment• Poor maintenance
  21. 21. Depreciation: A non-cash expense• It is an expense or a cost that is recorded on the income statement• However, it is not a cash expense- it doesn’t require the business to make any cash payment
  22. 22. Effects of depreciation Too much Too littleBalance sheet Value of the business will be Will give a false impression understated of the company’s worthIncome statements Expenses are over Reduces expense incurred estimated, reducing the by the business, this will level of profits over estimate profitWider effects Business may look May make the company unattractive to possible look more attractive to investors. Tax liability on possible investors but will profits which HMRC might also increase its tax liability investigate. Business may record a surplus when the asset is sold
  23. 23. Income StatementsAn accounting statement showing a firms REVENUE over a tradingperiod and all the relevant COSTS generated to earn that revenue
  24. 24. Key phrasesA LOSS is a situation where a business’sexpenditure exceeds its revenue over a specifictrading period.PROFIT can be defined in a number of ways, butis essentially the surplus of revenue over costs.
  25. 25. What is profit?1. Gross Profit- calculated by deducting direct costs from a business’s sales revenue. It gives a broad indication of a company’s performance without taking into account costs such as overheads (indirect costs).2. Net profit- a further refinement of the concept of profit and is revenue less direct costs and indirect costs. It gives a better indication of the performance of a business.
  26. 26. Quality of profit• Firms regard profit that is likely to continue onto the future as high quality profit e.g. a successful new product• Selling off an asset may add to a company’s overall net profit, however will not continue into the future- this is known as low quality profit• The amount of trading or operating profit earned is more likely to represent high quality profit• Shareholders are interested in the quality of profit as it gives an indication of the company’s potential to pay its dividends
  27. 27. Structure of an income statement Name of businessRevenueLESS direct costs Usually referred to as COGSGross ProfitLESS indirect costsOperating profit An indicator of a firms performancePLUS financing costsNet profit before tax Profit on which the Inland Revenue bases its tax calculationsLESS corporation taxNet profit after tax Important form of tax as the firm can decide what to do with this
  28. 28. Income statements and PLCs• PLCs are required by law to publish their accounts Group Income statements• In The last 25years many companies have been taken over by others to form groups. Each company within such a group retains a separate legal identity. But the group is also legally obliged to produce a group income statement (and balance sheet) Income statements and the law• The legal requirements relating to income statements are set out in the Companies Act 2006. (see book pg 26-27)
  29. 29. Interpreting Income StatementsManagers Shareholders• Cost of sales • Operating and expenses and net• Turnover and profits operating profit • Turnover• One-off items • Retained profit Income • dividends StatementsEmployees• Expenses(especially HM Revenue and wage costs) Customs• Profits after tax • Net profit• Retained profits v before tax dividends • Depreciation
  30. 30. Financial data for comparisons, trend analysis and decision-making pg28-29Balance sheets• The business’s working capital position• The extent of the business’s long term debtsIncome statements• Trends• The period to which the income statement relates• Comparing gross and net profit• The Business(es) to which the income statement relates
  31. 31. Strengths and weaknesses of financial data in judging performance• Window dressing• Financial statement is a historical document- not necessarily a good indication of what will happen in the futureBalance sheet Income statementProvides a measure of the value/worth of a Offers valuable information tobusiness stakeholders- it indicates growthShows sources of capital used by a Provides details of costsbusiness Shows net profit (interested stakeholders)Shows if the business has used expensivesources of capitalIllustrates cash/liquidity
  32. 32. Limitations of financial data• Quality of leadership is not shown by financial data• What is the position of the business in the market?• What about the motivation and performance of the workforce?