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Financial ManagementFinancial ManagementHigher Business Management
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Role and importance of financial Role and importance of financial managementmanagement
Efficient management of finance is crucial to an organisation’s success. It has to:
ensure adequate funds are available for the resources needed to help achieve the organisational objectivesensure costs are controlledensure adequate cash flowestablish and control profitability levels.
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Duties of financial managementDuties of financial management
Maintain financial recordsPay bills and expensesCollect accounts dueMonitor fundsPay wages and salariesProvide information for managers and
decision-makers within the business
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Annual accountsAnnual accounts
There are four main financial statements used (called Final Accounts):
trading account profit and loss account balance sheet cash flow statement.
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Answer a questionAnswer a question
Explain the role of the finance department in an organisation.(4 marks) 2010
8 minutes
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Peer markingPeer markingYou are going to swap answers.
Has your partner answered well?Does the answer make sense?Is it worth a mark?
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SolutionSolution Control costs – the finance department will help control
costs of an organisation, which should help it be more profitable.
Monitor cash flow – will closely monitor cash flow and take corrective action if any problems arise to ensure proper liquidity.
Plan for the future – by analysing past and future trends the department will hopefully make decisions that will improve the organisation’s efficiency.
Monitor performance – use the final accounts to analyse how the organisation has performed and help improve any areas of weakness identified.
Make decisions – the department will make use of the information it has to plan budgets and make financial decisions; this should help an organisation’s performance and profitability.
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Trading, profit and loss accountTrading, profit and loss account
The trading account records how much money is made from selling goods against how much they cost to make. The gross profit is calculated in the trading account.
The profit and loss account shows the business income and expenditure. The net profit is calculated in the profit and loss account.
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Trading account formatTrading account format £ £
Turnover (or sales) 350,000
Cost of sales
Opening stock 60,000
Purchases 105,000165,000
Less: Closing stock (35,000)130,000
Gross profit 220,000
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Profit and loss account formatProfit and loss account format£ £
Gross profit 220,000
Other income
Interest received 7,000
227,000
Expenses
Rent 18,000
Wages 75,000
Insurance 5,000 98,000
Net profit 129,000
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Profit and loss account key termsProfit and loss account key terms
Trading account – summary of trading where gross profit is calculated.
Sales – income received through selling goods/services.
Cost of sales – cost of items sold.Opening stock – value of stock at the
beginning of the financial period.Closing stock – value of stock at the end of
the financial period.
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Profit and loss account key termsProfit and loss account key terms
Purchases – cost of goods bought to sell on to customers.
Purchase returns – total value of goods purchased by business but returned to suppliers.
Sales returns – total value of goods purchased by customer but returned to the business.
Expenses – outgoings such as overheads, rent, wages.
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Interpretation of trading, profit and Interpretation of trading, profit and loss accountsloss accounts
Was this year’s trading result good or bad, compared with last year?
Was this year’s trading result good or bad, compared with a competitor?
Has our gross profit improved this year?
Are we utilising our stock effectively and efficiently?
Has our net profit improved this year?
Does our net profit compare favourably with that of other organisations in the same industry?
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Balance sheetBalance sheet
The balance sheet shows a snapshot of a precise point/date in time.
It is a record of assets and liabilities.
Capital = assets – liabilities
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Balance sheetBalance sheet
Assets Liabilities and capital
Balance
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AssetsAssets
Assets – what a business owns.
Fixed assets – have a lifespan of more than 1 year, eg machinery, motor vehicles.
Current assets – constantly changing, eg stock, debtors, bank, cash.
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LiabilitiesLiabilities
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.
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CapitalCapital
Capital – provided by the owner of the business and treated as being owed to the owner of the business.
Profits – may increase capital.Drawings – may decrease capital.Reserves – monies retained by the
business.
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LiquidityLiquidityLiquidity 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?
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Working capitalWorking capitalWorking capital is:
current assets – current liabilities
If a business has too much working capital then it is not using its resources properly.
If a business has too little working capital, then it may not be able to pay off short-term debts.
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Interpretation of balance sheetInterpretation of balance sheet
Have we enough working capital to avoid cash flow problems?
Can we improve our trade credit?
Is our debt level serviceable?
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Answer a questionAnswer a question Distinguish between:
a) gross profit and net profitb) fixed assets and current assetsc) debentures and shares
(6 marks) 2007
10 minutes
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Peer markingPeer markingYou are going to swap answers.
Has your partner answered well?Does the answer make sense?Is it worth a mark?
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SolutionSolution Gross profit is turnover less cost of sales – the money made on
buying and selling goods.
Net profit is the profit after all the firm’s expenses have been deducted from the gross profit.
Fixed assets are items which the business owns and will be kept for longer than 1 year.
Current assets are items which the business owns and will be kept for less than 1 year.
Debentures is a loan where there fixed interest is paid over the stated period of the loan and then the full amount is paid back.
Shares are investment in a company that receives a dividend each year if profits allow.
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What are ratios?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 other factors such as quality of workers, inflation, economic situation.
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Uses of ratio analysisUses of ratio analysisCompare current performance with
firm’s previous years.Compare firm’s performance against
similar organisations.Identify changes in performance to aid
future actions.Identify trends over time.
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Limitations of ratio analysisLimitations of ratio analysisInformation is historic.Comparisons must only be made with
similar organisations (size, industry).Does not take external factors
(PESTEC) into account.Does not take NPD or declining
products into account.Does not take people issues (staff
morale, staff turnover) into account.
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RatiosRatios
Profitability
Gross profit percentage
Net profit percentage
Return on capital employed (ROCE)
Liquidity
Current ratioAcid test ratio
Asset usage
Rate of stock turnover
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Gross profit percentageGross profit percentage
Gross profit
Sales revenue
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.
Decrease = cost of materials may have gone up.
× 100%
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Net profit percentageNet profit percentage
Net profit
Sales revenue
For every £1 of sales, how much profit after expenses is made?
Increase = handling expenses better.
Decrease = expenses may have gone up.
× 100%
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Return on capital employedReturn on capital employed(ROCE)(ROCE)
Net profit
Capital employed
If you invest £100 in a firm how much will you get back?
ROCE should be measured against interest rates, since your savings can make money in a high-interest bank account.
× 100%
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Current ratioCurrent 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 be invested in the business properly.
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?).
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Acid test ratioAcid test ratio
Acid test =
(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.
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Rate of stock turnoverRate of stock turnover
Stock turnover =cost of sales
average stock
Stock hanging around is bad for the firm. Stocks 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.
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Answer a questionAnswer a question
a) Describe ratios to ensure profitability and liquidity.(5 marks) 2008
a) Explain the limitations of using accounting ratios.(5 marks) 2010
12 minutes
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Peer markingPeer markingYou are going to swap answers.
Has your partner answered well?Does the answer make sense?Is it worth a mark?
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Solution to a)Solution to a)
Gross profit % measures the gross profit on each sale.
Net profit % measures the profit after expenses on each sale.
Mark-up – measures how much has been added to the cost of the goods as profit.
Return on capital employed – measures the return on investment in the business.
Current ratio – shows how able a business is to pay its short-term debts.
Acid test ratio – ability to pay short-term debts after stock is deducted.
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Solution to b)Solution to b) Information is historical, which means it could lead to bad
decisions being made. Does not take into account external factors, eg the
business may have performed well during a recession. Does not show staff morale, which may be poor and the
business has therefore performed well. Recent investments are not shown, which could result in
future increase in performance/profits. New products could just have been launched and again
these may improve performance although ratios will not show this.
Can only be used to compare against similar organisations, which may not be of great use in certain situations.
Different accounting process used from one year to the next can alter ratios, which could result in the wrong decisions being made.
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BudgetsBudgetsBudgets are statements of anticipated
future expenditure covering a specific time period.
Cash budgets – show expected receipts and payments on a monthly basis to help assess potential cash flow problems.
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Uses of budgetsUses of budgetsTo plan for the future (forecasting).Financial or goal-oriented target setting.Evaluation and analysis of
performance.Delegation of financial responsibility (eg
departmental budgets).Data and information collection.
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How budgets help managersHow budgets help managers
Make managers decisions accountable.Help check income and expenditure
levels.Used in long-term planning.An aid to decision making.An aid for comparing projections with
actual results.Used as a tool to act on problems.
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Cash flow statementsCash flow statementsCash budgets/cash flow statements contain
estimated figures of the cash position of an organisation over a specific time period.
Remember the closing balance is cash and not profit!
Cash budgets are used to identify shortages or surpluses of cash resources.
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Cash budgetCash budget
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Cash budgets and the role of the Cash budgets and the role of the managermanager
Plan Borrow or not?
Organise Bulk buying? Trade discounts?
Command Departmental budgets
Coordinate Departmental reports
Control Measure performance
Delegate Budgets spent by department managers
Motivate Giving financial control may empower individuals
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Cash flow managementCash flow managementLiquidity – 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.
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Answer a questionAnswer a question
Explain why managers use cash budgets.(5 marks) 2009
10 minutes
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Peer markingPeer markingYou are going to swap answers.
Has your partner answered well?Does the answer make sense?Is it worth a mark?
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SolutionSolutionManagers can compare actual figures with planned
budgets and, if there are any deviations, take corrective action where required.
Highlights periods where a negative cash flow is expected and allows for appropriate finance to be arranged for that period.
Allows for investment to be made in times of excess cash flow to best utilise surplus profit.
Corrective action can be planned in advance of cash deficits, for example a loan may be arranged.
Allows managers to control expenditure and ensure they don’t go over the set budget.
Used to set targets for workers and managers, which can be a motivational tool.
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Users of financial informationUsers of financial information
Shareholders – can determine if current performance is worthy of more investment or if other action required (sell shares or remove board at AGM).
Potential shareholders – decide whether or not firm offers a good investment.
Short-term creditors – should credit be granted to the firm?
Long-term creditors – should money be loaned to the firm? Will it be paid back?
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Users of financial informationUsers of financial informationGovernment and local government – will
analyse firm’s reports and business plans. Will the firm’s future plans impact on community (voters!)?
Competitors – compare themselves with rivals to work out market share and how future plans may affect their own operations.
Employees – can the firm pay better wages? Is the future sound (are their jobs safe)?
Management – use information to analyse, compare and evaluate performance and plan for the future.
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Sources of financeSources of finance
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Internal sources of financeInternal sources of financeRetained profits – profit kept by
company for future activities.
Selling assets – money raised by selling off an asset no longer needed.
Both are short-term sources.
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External sources of financeExternal sources of finance
Long-term (10+ years)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 on property.
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External sources of financeExternal sources of finance
Medium-term (1–10 years)Leasing – renting equipment or
premises.Hire purchase – acquiring an asset on
credit followed by fixed payments. After last instalment purchaser owns asset.
Loans.
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External sources of financeExternal 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.
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Additional sources of financeAdditional sources of finance
LEC, eg Scottish Enterprise
Local authorities, eg South Lanarkshire Council
Government partnerships, eg Business Gateway
Grants and allowances, eg repayable grants, soft loans, subsidies
EU grants, eg Regional Development Fund and Social Fund
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Answer a questionAnswer a question
Describe four different sources of long-term finance available to a private limited company.(4 marks) 2010
8 minutes
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Peer markingPeer markingYou are going to swap answers.
Has your partner answered well?Does the answer make sense?Is it worth a mark?
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SolutionSolution Bank loan – paid back over a number of years with
interest. Commercial mortgage – a loan on property paid back
over a long period with interest. Venture capitalists – invest in an organisation if a more
risky venture is undertaken, but they may request a share in the organisation in return.
Invite new shareholders to invest in the organisation. Local/national government grants, which do not have to
be paid back but must meet certain criteria. Sell off unwanted assets to raise finance quickly. Debentures – issued to investors and interest payments
are made yearly, with the lump sum paid back at an agreed time.
Retained profits of the organisation reinvested into the business.
