Some Notes on Unit 5

Some notes on Unit 5 Compiled by Raaga

Financial Accounts

Two main documents at the end of the year.

1. Balance sheet (owe, own, how it is funded)

2. Profit and Loss (revenue, spending, profit and loss)

Managerial Accounts

Cash flow, budget, break even.

Profit and loss

Profit and loss account for Smiths for the year ending March 2007

- £ £

Sales Revenue

(Turnover)- -

Cost of Sales - -

Opening Stock 3000 -

Purchases 2000 -

Closing Stock 500 -

- - 4500

Gross Profit - 45500

Operating Profit

(10000 from sale of

factory)

- 55500


Expenses - -

Heating 2000 -

Rent 2500 -

Depreciation 500 -

- - 5000

Net Profit - 50500

Gross Profit = Sales Revenue – Direct Costs

Operating Profit = gross profit less - operating costs.

Net Profit = Operating Profit – expenses

Depreciation

The fall in value of an asset over a period of time. There are two methods.

1. Reducing balance method

2. Straight line depreciation

E.g.

machinery costs £100000

sold value £40000


sold after 4 years

An asset will depreciate due to use, obsolescence and time.

Depreciation impacts differently on the main business accounts:

Records a large outflow when the asset is bought and an inflow when the asset is sold.

Profit and Loss account

Depreciation is recorded as an expense

Balance sheet

Record the Net Book Value of the asset = cost – depreciation

Profit quality

Profit that is a result of businesses training. If the profit has come from a one off source it is

low quality. E.g. selling an asset or profits on foreign exchange transactions (exchange rates).

Investors will be looking for high quality profit.

Profit Utilisation


How a business uses its profit. There are two main things a business can do with its profit.

1. Pay dividends

2. Retained Profit

The profit amount of a business can choose to spend is the profit after tax figure.

1. Future plans – expand, grow, introduce new product.

2. What the shareholders want.

3. Stakeholders – pension scheme, community

4. Competition

Businesses will make decisions between keeping money in the business and paying dividends

to customers for future of the business.

Balance sheets

What a business owes, is owed, and how it is funded.

Stock 50000

Debtors 50000

Fixed assets 1 200 000

Cash 100 000

Reserves 270 000

Long term loans 550 000

Share capital 400 000

Current liabilities 180 000

-£

000s

£

000s


Fixed Assets - 1200

- - -

Current Assets - -

Cash 100 -

Debtors 50 -

Stock 50 -

- - 200

Current liabilities - 180

- - -

Net current assets (working capital) - -

- - 20

Net assets (Assets employed) - -

- - 1220

Represented by: - -

Long term loans 550 -

Reserves 270 -

Share Capital 400 -

- - 1220

Intangible assets

Assets that you can’t see or touch.

One school of thought is that as these assets are not easily quantifiable they shouldn’t

be included as they could misrepresent the true value of a business. On the other hand

businesses will argue that these assets should be valued as they do have worth.


Stock

Can be valued at what was paid for it or what it is worth. The rule in accounting is

that stock must be recorded at the lower end of cost, or net reliable value (what it is

worth on that day).

Working capital

The day to day finance of a business.

Working capital = current assets – current liabilities.

The working capital of a business shows whether it can pay its short term debts using

its most liquid assets. Working capital problems can occur if you have poor control of

debtors. It can also occur if too much money is tied up in stock. It may also mean that

creditors are being paid too quickly.

Capital and Revenue expenditure

Businesses can be split into two categories.

Capital spending – buying fixed assets – a life over a year.

Capital spending is recorded as fixed assets on the balance sheet with any

depreciation shown as an expense on the profit and loss.

Revenue spending – buying day to day items such as stock, wages, marketing.

It is mainly recorded in the profit and loss account.

Limitations of public accounts

Profit and loss and balance sheets in isolation mean little. To have a true reflection of

the financial position of a business you need to see previous years and like businesses.

It is also important that ratio analysis is used to assess the true performance of a


business. One of the main problems with accounts is window dressing. Window

dressing isn’t illegal. It is dressing the accounts in a way to present the business in as

favorable way as possible.

Ratio Analysis

Business accounts in isolation have little meaning. To make a true assessment of the financial

performance of a business you would need previous years, like businesses, and an assessment

using ratio analysis.

Ratio analysis allows a business to make meaningful comparisons with other businesses and

investigate the efficiency of different departments within the business.

You must learn the ratios, understand what they mean and what the business must do to

improve.

A ratio is a comparison of two figures. The second digit is always 1. However, some of the

ratios appear as a percentage.

Liquidity Ratios

These show whether a business can meet its short term debt.

There are two liquidity ratios.

Current ratio


E.g.

This means that the business has £3 of current assets for every £1 of short term debt. A

businesses current assets are cash, debtors, and stock. In terms of the current ratio, ideally is

should be about 1.5 : 1. Anything less will make the business struggle, and more and you are

not using money wisely.

sell shares

raise underused fixed assets

increase long term borrowings

A problem with the current ratio is it includes a businesses stock. It can be a little unrealistic

to assess liquidity and include stock because to sell this would mean being unable to continue

business activity.

The acid test ratio is perhaps a fairer assessment.

Acid test ratio

Ideally this should be 1 : 1


Gearing Ratios

This shows how reliant a business is on borrowed money.

Gearing

Capital employed is share capital, reserves and any long term loans.. More than 50% is too

high = highly geared.

Shareholder Ratios

These ratios look at whether or not shareholders are likely to benefit financially from the

firm.

Dividend per share

It has limited use without context. To improve it, you need to increase profit.

Dividend yield

Expresses the dividends paid as a percentage of the price of the shares.

The higher the better. But, compare with competitors.


The above calculations ignore any gains or losses from owning shares. If the share price

increases, the dividend yield will fall. However, the higher prices might make the shares

attractive to buy.

Profitability Ratios

These ratios compare profit with the size of the business. There are three main ratios. The

higher the percentage the better.

Gross Profit Margin

This calculates how much of the turnover is gross profit.

The higher the percentage the better.

Increase revenue and lower costs to improve.

Net Profit Margin

It is always worth comparing gross profit and net profit margins as it will give a clue to

expenses, and over previous years if gross profit margin is increasing and new profit margin

is decreasing.

Return on capital employed

Capital employed is the money used in the business – loans, reserves, and shareholders.


Return on capital employed is what kind of return there is on the money you put in the

business.

Efficiency / Activity ratios

Stock turnover

Stock turnover measures the number of times a year a business sells its stock.

This needs to have knowledge of the business it’s working on. You can convert this into the

average number of days a business holds stock using the formula:

Increase sales not stock.

Reduce stock levels not sales.

Debtors collection period

How long it takes to collect your debts.


Limitations of ratio analysis

Ratio analysis analyses financial information but its not the only measure of a businesses

success and to rely on these will give a limited focus.

Reliability - The data itself might be unreliable. Asset valuation can be subjective,

especially intangible assets. Different accounting methods. Situations change daily

and they can window dress their accounts to be more favorable.

Historical - Accounts only show where you’ve been. Show what happens, doesn’t

show why.

Comparisons - Within a firm (intrafirm) or inter (between two businesses). No two

sets of data are the same. Within both of these, businesses will suffer differences.

More established branches can have economies of scale and global businesses.

Comparison over time – inconclusive because of the peaks and troughs of a business

cycle. Comparison may effect the economy more than the business. Ratios may

measure the economy, not the business. Ratios may measure the economy not the

business. Comparison with a standard E.g. current ratio = 1.5: 1 we take a risk that the

standard is out of date.

Limitations of corporate objectives

Ratios assume that profit is the main objective by there are others.

Reputation – exploiting customers and you will eventually lose money.


Human relations

Product quality

Contributions and Break Even

Limitations of external influences

Company performance is dependent on outside factors and it is vital that these are considered

before conclusions are drawn – SWOT analysis.

Ratios are an excellent guide to performance. Don’t ignore them but bear in mind their

limitations.

Break even

There are three ways or working out break even: 1. Using a formula

2. Using a table

3. Break even graph

The main assumptions with break even:

that you sell everything you make

that fixed costs stay the same

that every product is sold for the same place

that variable costs rise proportionality to units produced

There are 6 changes that can occur:


increase in selling price

decrease in selling price

increase in variable costs

decrease in variable costs

increase in fixed costs

decrease in fixed costs

Contribution

Contribution is one of the most important aspects in business studies. It is the term given to

the amount of money remaining, after all the direct and variable costs have been deducted

from the sales revenue. It is called contribution because it represents the amount of money,

which is available to contribute towards covering the businesses fixed costs. Once these costs

are covered it represents the amount of money which will contribute towards the profit of a

business.

Sales revenue – variable costs = contribution

Contribution – fixed costs = profit

Contribution can be analysed in two ways.

1. Contribution per unit

E.g. selling price £10

Variable costs £3

= contribution = £7

2. Total contribution

Total sales revenue – total variable costs.


Special order decision

A business decision relating to a one off contract. Usually the special order decision is needed

in response to a request to supply a fixed quantity of a product at a particular price.

(Invariably a lower price than usual).

PAYBACKWorks out how long it takes to repay the initial investment.

e.g. Investment A. costs £100. Annual return of £25 Length 5 years

YEAR NET CASH FLOW(ANNUAL RETURN)

CUMULATIVE CASH FLOW(CASH IN FLOW)

0 -100 -100

1 25 -75

2 25 -50

3 25 -25

4 25 0

5 25 25

Payback is 4 years.

Sometimes it is necessary to calculate the month of payback when the figure is reached part way through the year. To do this you would you use formula:

ADVANTAGES

Easy to calculate Easy to understand Most relevant to businesses with cashflow problems Emphasises speed of return – good in rapidly changing markets


DISADVANTAGES

Ignores money received after payback Can be difficult to establish a target payback period Doesn’t consider the future value of money Short term approach

AVERAGE RATE OF RETURNCompares profit with money invested.

To work this out, break it down into stages.

1. Calculate lifetime profit = total inflows – outflow 2. Divide by the number of years 3. Use the formula

e.g. Investment A cost £100 £25 return for 5 years

1. Inflow – outflow

£125 - £100

= £25

2. Divide by the number of years. 25/5 = 5

3. Use formula

5 / 100 X 100

= 5% return

ADVANTAGES

Percentage provides easy comparisons across projects Shows the profitability of a project


DISADVANTAGES

Harder and more time consuming Ignores time value of money

NET PRESENT VALUE (DISCOUNTED CASH FLOW)This takes into account the time value of money. It is based on the principle that money is worth more than it is in the future. The principle exists for two reasons:

1. Risk – money in the future is uncertain 2. Opportunity cost – Money could be in an interest account earning interest.

Discounting

This is the process of adjusting the value of money from its present value to its value in the future. The key to discounting is the rate of interest. The business chooses the most appropriate rate for the life of the project. It then identifies the discounting factor. The amount of money is then multiplied by the discounting factors to convert it to its net present value.

e.g. Project A £100 £25 return 5 years

YEAR NET RETURN DISCOUNT FACTOR NET PRESENT VALUE

0 -100 0 -100

1 25 0.952 23.8

2 25 0.907 22.675

3 25 0.864 21.6

4 25 0.823 20.575

5 25 0.784 19.6

= £108.25

£108.25 MINUS INITIAL COST (£100) = £8.25


Profit = £8.25

ADVANTAGES

Considers the time value of money Reducing discounting rate reduces future monies more heavily Only one method that gives a definitive answer Positive return – it is worth doing

DISADVANTAGES

Time consuming More difficult to understand Based on an arbitrary choice of interest rate

QUALIATIVE FACTORSInvestment appraisal techniques consider the financial results but there are other factors to be considered. These will be different for every organisation.

The aims of the business The reliability of the date The economy Image SWOT (strengths, weakness, opportunities, threats) analysis PEST analysis HRM issues Stakeholder analysis Anything else that needs to be considered

Documents

Some Notes on Unit 5