PRESTWICK ACADEMY

NOTES BOOKLET

Management of Finance

Business Management

National 5

ContentsOUTCOME 2:HOW THE MANAGEMENT OF FINANCE CONTRIBUTES TO THE SUCCESS OF SMALL AND MEDIUM SIZED ORGANISAITONS

Describing sources of finance and outlining their costs and benefits

Interpreting a break even chart

Interpreting a cash budget to identify cash flow issues and outlining appropriate solutions

Preparing and interpreting an income statement and identifying reasons for a loss

Technology used in the finance department

2

The role of the finance function

Finance is important to every organisation, because all organisations have to deal with money.

Every organisation must manage its finances efficiently to ensure the success of its business – whatever this is. For example, every organisation must make sure that it:

has enough money to pay the wages and salaries of its employees has enough money to pay its bills – for things like supplies of raw

materials, electricity, advertising and so on has enough money to develop new products to avoid being overtaken by

competitors checks how much it is spending – organisations, which have high costs,

are often unsuccessful.

The finance department is responsible for the financial affairs of the organisation. Its role is to manage the finances of the organisation and to make sure that the organisation meets its financial objectives.

The role of finance is to:

Pay wages and salaries to employees Pay bills, e.g. electricity, insurance and advertising Record and maintain financial records, e.g. cash budgets and income

statements

3

Describing sources of finance & outlining their costs & benefits

SOURCE DESCRIPTION ADVANTAGES DISADVANTAGESOwner’s savings

When owners, e.g. sole traders, invest own personal cash into the business.

No loss of control of the business

The owner loses use of their personal cash

Bank overdraft

An agreement by the bank that the firm may draw up to a certain amount more than it has in its bank account.

Easy and quick to arrange for a short period of time.

Usually only for a small amount of money.

Daily charges and/or interest applied.

Bank loans

A loan of money from the bank repaid over time with added interest.

Quick and easy to set up.

Can be repaid over a long period of time in agreed installments.

Interest will have to be paid.

Small businesses may find it harder to obtain and may pay higher rates of interest.

Hire purchase

Buying an item now and paying for it at a later date (often over a period of time). Usually used to obtain equipment or vehicles.

Can receive item immediately without paying.

Interest could make the item expensive.

Item isn’t owned until all payments made.

Mortgages

A long-term method of borrowing from a bank, used to buy premises. Paid back in installments with added interest.

Can be taken out over a long period of time, e.g. 25 years.

Interest rate is often lower than a bank loan.

Interest will have to be paid.

Can lose the property if payments aren’t kept up.

Government grants

Money from the government that does not have to be paid back.

Doesn’t need to be paid back.

Only given if the business can meet certain criteria

Can take time to get.

Retained profits

Using money from previous year’s profits that has not been spent.

No money has to be repaid.

The money could be used for something else.

Selling shares

A private limited company can issue more shares to

Large amount of money can be raised.

Dividends have to be paid to shareholders

4

raise more finance. Don’t have to pay money back

5

Interpreting a break even chart

The break even point is the point at which total sales revenue (income) and total costs are equal.

At this point the business is not making either a profit or a loss. Any sales above the break even point mean the business will make a profit. Businesses work out the break-even point to find out how many units of a product they have to sell before they start to make a profit.

Types of Costs

Costs is another name for expenses (money going out of the business). There are 3 types of costs:

Fixed Costs – these are costs that always stay the same, no matter how many units of a product are made. Examples include rent, rates, insurance, loan repayments etc.

Variable Costs – these are costs that change depending on how many units of a product are made. Examples include raw materials, electricity, cost of labour etc.

Total Costs – these are fixed costs and variable costs added together.

Revenue

Revenue is the name given to money that a business receives through selling a product. The more products sold, the higher the total revenue will be!

Total revenue = selling price x units sold

Note: total revenue is not the same as ‘profit’ as no costs have been taken off yet.

Break-even Calculation:

To calculate the break-even point, we need the total costs figure and total revenue.

Break-even point (BEP) = Total Costs (TC) = Total Revenue (TR)

6

Worked Example

Rob has a joinery business making and selling wooden tables. He has calculated his total costs and total revenue and these are detailed in the following table:

NUMBER OF UNITS SOLD

TOTAL COSTS (TC) TOTAL REVENUE (TR)

0 £200 £01 £205 £252 £210 £503 £215 £754 £220 £1005 £225 £1256 £230 £1507 £235 £1758 £240 £2009 £245 £225

10 £250 £25011 £255 £27512 £260 £30013 £265 £325

From the table, you can see that Rob will have to sell 10 tables in order to break-even (when TC = TR). He will not begin to make a profit until he has made 11 tables.

This information can then be used to create a break-even chart. A break-even chart will show how costs and revenue changes depending on the number of units sold.

Break-even Chart for Rob’s Joinery

BEP TR£400

£300 TC

£200

£100

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Units (number of tables)

£ (c

osts

and

reve

nue)

7

Interpreting a cash budget to identify cash flow issues and outlining appropriate solutions

Cash is an important resource for any business. Without it, bills would not get paid and staff would not get paid. Cash is needed on a day-to-day basis to operate.

Cash flow (the amount of cash in a business) has to be carefully monitored. Businesses that do not have a healthy cash flow can face problems.

Cash flow problems

Cash flow problems can arise even if the firm is successful in selling a lot of its goods. Poor cash flow can be caused by:

Spending too much money on stock that has not sold Giving customers too long to pay their debts Not receiving enough money from sales Not having enough time to pay bills from suppliers Owners taking too much money out of the business (drawings)

Methods of improving cash flow

There are many ways in which organisations can improve their cash flow. Some of these include:

Looking for cheaper supplies of raw materials as this would reduce the variable costs of making a product.

Offering discounts to customers who pay on time, as this will encourage them to pay more quickly.

Taking out bank loans. Small organisations can get a loan from friends or partners. By doing this, the organisation will get an inflow of cash but repayments (including interest) will have to be made regularly.

Selling equipment or machinery no longer needed as this will bring in cash that can be used to fund other activities.

Spreading purchase costs – hire purchase or leasing. This will mean that the outflow of cash will not be in one month but will be spread over a number of months.

Carry out advertising – to bring in more customers which will increase sales and therefore cash.

Tight stock control – ensuring capital is not tied up in too much stock. This will help to keep the outflow of cash to a reasonable level.

8

Cash Budgets

A cash budget contains a list of cash the business expects to receive (receipts) and the cash expected to be paid out of the business over a period of time (payments).

The benefits of preparing a cash budget are:

It shows if the business will have a surplus (more cash expected to come in than will go out) or a deficit (more cash going out than coming in).

It can show if additional finance is required, e.g. overdraft or a loan. It can help control expenses by highlighting periods when expenses

could be high. It can help in making decisions.

The following example explains and illustrates a cash budget. The information is for Les King, a sole trader. It applies to his first three months of trading.

Before we can do a cash budget, we need some background information about Les’s business. Les started up his business with £500 savings and he estimates his receipts for the next three months to be as follows:

June Start up government grant

£1,500

July Sales £1,600August Sales £1,400

His monthly payments are as follows:

Rent £300Telephone £40Advertising £100Electricity £100Wages £250

He also has to buy stock as follows:

June £800July £700August £700

9

Cash Budget for Les King – June–August

June July AugustOpening Balance £500 £410 £520

Add RECEIPTSGrant £1,500Sales £1,600 £1,400

£2,000 £2,010

£1,920

PAYMENTSRent £300 £300 £300Telephone £40 £40 £40Advertising £100 £100 £100Electricity £100 £100 £100Wages £250 £250 £250Purchases of stock for resale

£800 £700 £700

£1,590 £1,490

£1,490

Closing Balance £410 £520 £430

In June, Les had £500 available in the bank at the start of the month. This is called his opening balance.

This is added to the total receipts – the money that has been received into the business – for example, from selling goods. This gives the total cash available for that month.

Then, the total payments – any amounts that have been paid out of the business – are taken away from the total cash available.

This gives the closing balance – the amount of money left in the business at the end of the months trading.

The closing balance at the end of one month is the opening balance for the next month.

A cash budget can therefore be used to help the decision making process in businesses. It shows whether there is enough money for the business to do what it plans. It can also show whether a business needs to find cash from somewhere else. It can help business answer questions such as:

10

Do I need to arrange an overdraft/loan? Do I have enough money to buy a new piece of equipment?

Preparing a simple income statement from data provided

Final accounts

Financial records must be kept to:

keep a secure record of all transactions to prevent fraud produce accounts for tax purposes monitor business performance so that managers and owners can see

how well the firm is doing.

Businesses prepare final accounts to provide a financial summary of all trading activities during the year. An income statement is an example of a final account.

Income Statement

This shows two types of profit:

Gross Profit - the profit made from buying/making and selling

Profit for the year – the profit after subtracting expenses from Gross Profit.

An example of an Income Statement is shown below:

D Bloom Income Statement for period ending 31 December

Sales

Less Cost of Goods Sold

Gross Profit

LessExpenses

TelephoneRentWagesElectricity

PROFIT FOR THE YEAR

£

100150175200

£3,500

1,700

1,800

625 £1,375

Other key terms :

11

Sales revenue – the amount of money the business receives from selling its product.

Cost of goods sold (cost of sales) – how much the business paid for the goods or spent on making the goods that it has sold.

Expenses – other costs the business has had to pay, such as wages, delivery, telephone, advertising etc.

Identifying reasons for loss and justifying solutions to problems

You should be able to look at an Income Statement and identify any issues and suggest solutions.

Some common solutions:

To increase sales revenue the business could increase the price it charges the customers.

To reduce spending on the cost of goods sold the business could find a cheaper supplier.

To reduce expenses they could: Find a cheaper premises Cut staff working hours or make staff redundant.

12

Role of technology in managing finance

Spreadsheets (Microsoft Excel) are widely used to record and edit numerical information.

Spreadsheets could be used to: record cost information and calculate break-even point prepare cash budgets calculate profit create graphs

Advantages of using spreadsheets are:

less chance of errors as formulae can carry out automatic calculations data can be saved an edited later to save time a business can easily see the effect changes will have, e.g. changing

figures in cash budgets will allow them to see the effect on the closing balance quickly.

What if scenarios can be created, to help managers make decisions Charts can be created to make figures more easily understood

Other technology which can be used in finance:

Online banking can be used to make immediate payments and manage accounts remotely without having to visit the bank.

EPOS allows customers’ payments to go straight into the business’s bank account.

Email can be used to send out invoices quickly. Word processing or desktop publishing can be used to prepare financial

reports. The internet can be used to compare lenders when looking for a

loan/mortgage. Tax returns can be completed and tax bills paid online.

13