Welcome and overview€¦ · Web viewIntroduction to financial analysis 34. Liquidity analysis 35. Financial risk ... financial statements must be filed with the Australian Securities

Accounting for Business Studies

Matthew Parsons BCom, Llb, Grad Dip Ed.

Accounting for Business Studies Page 1

Table of contents

Welcome and overview...................................................................................................................3

The Role of Accounting and Finance..............................................................................................6

The Balance Sheet.........................................................................................................................10

Finance: Sources and uses of funds...............................................................................................22

The Income Statement...................................................................................................................28

Cash cash cash...............................................................................................................................31

Operational reports: budgets & forecasts......................................................................................32

Break even analysis.......................................................................................................................33

Introduction to financial analysis...................................................................................................34

Liquidity analysis...........................................................................................................................35

Financial risk analysis....................................................................................................................36

Efficiency analysis.........................................................................................................................37

Glossary of board of studies terms................................................................................................38

Appendix.......................................................................................................................................39

Answering case studies..................................................................................................................39

Appendix.......................................................................................................................................40

Resources on the web....................................................................................................................40

Answers to questions.....................................................................................................................41

Appendix.......................................................................................................................................42

Glossary of terms...........................................................................................................................42

Appendix.......................................................................................................................................46

Video resources.............................................................................................................................46


Chapter 1

Welcome and overviewTo successfully run a business you need to know what you own, what you owe, whether you’re making money, and whether you have enough cash to pay your bills and implement your business strategy.

If you do not have this information, your business will quickly fail.

These questions are the simple questions that accounting and finance answers for every business:

What does the business own? (called assets) What does the business owe? (called liabilities) Is it making money? (called profit, or losses) Can it pay its bill in the next 12 months? (called working capital) Does it have enough cash for its needs? (called cashflow) How will it fund its plans in the future (called finance strategy) How much value is left for the owners? (called owner’s equity)

Without accounting and finance, the owners and managers of a business would have no idea of the financial status of their business. They would not know whether they made money last year, whether they can pay next month’s wages, and whether they have enough cash to implement the business strategy.

Further, these financial statements are used by a number of other stakeholders. Without financial statements, potential investors in the business would not be able to understand the prospects of the business, taxation authorities could not work out the correct amount of tax, banks could not work out whether to loan the business money, and suppliers could not work out whether they want to trade with the business and risk not getting paid. Without financial statements, there would be no business.

Only three…

There are only three financial statements produced by the Accounting function within a business, each of which has a different purpose. But there are only three.

These three financial statements, which must be prepared according to rules of format and calculations (called Accounting Standards these are rules used so businesses can be compared and understood), are:

The Balance Sheet (shows what the business owns and owes) The Income Statement (shows how much money the business made (or lost) last year The Cash Flow Statement (shows where cash came from, and went, during the last year).

Accounting started with the Venetian merchants in Italy, and the names of these financial statements have changed over time, which can be confusing if you do not realise that they are just different names for the same things.

The table below shows the preferred name, alternate names and questions answered by each of the three financial statements.

Preferred name Also known as… Tells usBalance Sheet Statement of Financial Position What the business owns and owes

What is left over for the owners of the business

Revenue Statement Statement of Financial PerformanceProfit & Loss StatementIncome Statement

How much money the business made or lost last year

Cash Flow Statement Statement of CashflowsFunds Statement

Where cash came from, and went, last year


Headings at the top of financial statements

The headings at the top of these statements are slightly different, as follows:

Balance Sheet for Movie Moments Pty Ltd as at 30 June 2011 Revenue Statement for Movie Moments Pty Ltd for the year ending 30 June 2011 Cash Flow Statement for Movie Moments Pty Ltd for the year ending 30 June 2011

Can you tell what’s different?

Whilst each of the headings include the name of the statement, and the name of the company, the balance sheet heading refers to a particular date (“as at 30 June 2011”), whereas the other two refer to “for the year ending 30 June 2011”. This reflects the different purpose of the statements.

The balance sheet is telling you what the business owns, and is owed, on a given date, whereas the others are telling you what profit was made over a period, or the cash movements over a period.

There is a separate chapter and exercises on each of these three financial statements in the following pages.

The three statements are then used to perform financial analysis using the numbers

Once the financial statements have been prepared, the numbers on those statements can then be used in calculations and ratios to better understand what is happening in the business - we can analyse the business, to tell how efficient, how profitable, and how risky it is. This is called financial statement analysis, because you are analysing the business using the information that you have collected in the three financial statements.

Unless the three financial statements have been prepared, you cannot perform this financial analysis of the business. A key part of the HSC Syllabus for Business Studies is performing financial analysis, and making recommendations and conclusions based on your analysis of the financial statements.

What do I have to know?

As you know, the Syllabus for Business Studies outlines what is required to be known by students, and can be easily found on the Board of Studies website at . As a student you are putting yourself at a significant disadvantage if you do not have a copy of the syllabus, and take the time to be very familiar with it.

The Syllabus for Business Studies provides the following in relation to Accounting and Finance.

[extract of accounting and finance from HSC]

The outcomes you are expected to achieve in

Source: HSC Syllabus, Board of Studies

Importantlly, please note that the Syllabus has changed twice in recent years, and the expectations for HSC exams in 2010 are different to those in 2009, and different again in 2011. You must have a copy of the Syllabus that applies for the year you are completing the HSC.

Resources to help

This book contains a range of descriptions and exercises, and completed answers can be found at the end of the book. In addition, a range of online resources have been created for you, including videos, revision quizzes, exercises, powerpoint presentations, and links to a range of helpful web resources and case studies to enable you to engage with master financial statements, and financial analysis.

Exercises for this chapter


1.1 Name the three financial statements

1.2 Which financial statement displays the revenues and profits of the business for the last financial period?

1.3 Which financial statement displays the items that the business owns (assets) and the items that the business owes (liabilities) on a given date?

1.4 Which financial statement displays what the owner of the business owns (owner’s equity) as at a certain date?

1.5 Which financial statement displays the source and amount of cash movements during the last financial period?

1.6 Describe the headings used for each of the financial statements and explain any differences.


Chapter 2

The Role of Accounting and FinanceAccounting and Finance is one of the four key functions of a business. The four key functions of a business are:

Operations Employment Relations Marketing Accounting and Finance

[insert picture here]

The naming of this function, Accounting and Finance is significant, as there are two distinct tasks which the employees in the Accounting and Finance function of the business perform. The accounting tasks are different to the finance tasks. Whilst a large business will have distinct employees in the accounting and finance function, in a small business, the accounting and finance functions of the business may be undertaken by someone in the business as one part of their job, and they may work with an external accountant who may prepare the financial statements for them from financial records collected and provided to them.

Simply stated, accounting tasks record the financial transactions of the business and then use that information to prepare financial statements. These financial statements are then used by a range of internal and external stakeholders. The records that accounting use can include bank statements, receipts, wage slips, supplier invoices, cheques, insurance bills and taxation assessments.

Finance tasks, on the other hand, involve planning how the business is going to fund (or finance) its operations in the future. For example, when the business starts, where is the money going to come from? If the business needs more cash to expand, where is it going to come from,? When will it have to be paid back (repaid)? How much will it cost (what are establishment costs, interest rates?)? The Finance tasks depend on the accounting tasks being done first in order to be able to forecast how much money will be needed, how much the business can afford to borrow, and when the business will be able to pay it back.

Who uses the Financial Statements for a business?

In addition to the owners and managers of the business, the contents of financial statements are very important for a range of other individuals and organisations.

Where the business has obtained a loan from a bank, the bank will require copies of financial statements to be provided in order to ensure the business is trading as expected. If the business is seeking further investment from new shareholders, they will require financial statements in order to understand the current financial position and performance of the business. Taxation authorities will require the financial statements to be filed each year with the tax return of the business. For companies listed on the stock exchange, financial statements must be filed with the stock exchange every quarter, and for every company, financial statements must be filed with the Australian Securities and Investment Commission every year.

Definitions to know

The role of accounting is to accurately record the financial transactions of a business to prepare reports that summarise a business’ financial position and financial performance over a period of time.

The role of finance is to plan and fund start up and ongoing operations of the business, and identify sources of funds for expansion and growth, which may be internal (from existing shareholders or new shareholders) or external (from banks, other lenders, and non shareholders).


What you need to be able to do at the end of this chapter

You need to be able to: explain what each of Accounting and Finance is in the context of a business identify stakeholders who use the Financial Statements.

Exercises

You are establishing a DVD Store, called Movie Moments Pty Ltd, renting a store in a shopping mall owned by ABC Property. You will sell DVDs you source from different suppliers, and sell drinks and popcorn sourced from another supplier. You will employ three staff, have a website, advertise in the local paper and insure the goods in your store. You will finance your startup and purchase of stock with a loan from the ANZ Bank, a loan from a friend, and all of your savings.

Your projections for the business show you expect to be profitable in your first year, and you have taken advice on how GST and taxes work from your accountant.

2.1 When your business is running, what type of financial records will be created or available for your Accounting function to record?

2.2 Who are the stakeholders of the business known as Movie Moments Pty Ltd who would require financial statements?



2.3 What is the role of each of Accounting and Finance for Movie Moments Pty Ltd?

Further resources

Websites on role of accounting and financeMaybe a quiz


Chapter 3

The Balance Sheet

There are three financial statements, indicated in the table below. This chapter will address the balance sheet, which tells us what the business owns (assets) and owes (liabilities), and therefore what is left over for the owners (owner’s equity).






What is a balance sheet?

A balance sheet is a structured way of listing what the business owns, what the business owes, and what is left over for the owners.

Consider Movie Moments Ptd Limited, a business selling DVDs, drinks and popcorn in a rented store, which started two years ago by issuing $1,000 worth of shares to the sole shareholder and owner, John Smith. On 30 June 2010, the business has the following items that it owns and owes:

Car 30,000Loan from bank 25,000Payable to suppliers 30,000Owing from customers 12,000Shop fittings 10,000DVD stock 30,000Loan from shareholder 10,000Overdraft 5,000Credit card debt 12,000Soft drinks for sale 1,000

Whilst this list is accurate, it tells us nothing about the business. Can you easily tell what the business owns? Can you tell what the business owes? Can you see what is left over for the owners?

From this list of things the business owns (called assets) and the things the business owes (called liabilities) we simply cannot easily tell the financial position, or state of affairs, of the business as at 30 June 2010. A balance sheet helps us sort this out.

A balance sheet is no more than a structured way of rewriting this list of what the business owns (assets), and what the business owes (liabilities).

[picture]

Discuss total assets = total liabilities + owner’s equity


As indicated in figure x, the layout of a balance sheet has a section called current, and non current, for each of assets and liabilities. The word “Current” signifies whether the asset will be converted to cash in 12 months or less (for assets), or whether the liability has to be repaid in 12 months of less (for liabilities). This is an important concept to master – current relates to whether an item will have a cash impact within the next 12 months.

The first step in creating a balance sheet from the list above is to first determine which categories each of the items relate to – to sort identify what sort of asset and liability they are. The list below has classified each of the items as either current or non current asset, or current on non current liability, and indicates the reason why that classification was made.

Review each line in the table below.

Item Category ReasonCar 30,000Loan from bank 45,000Payable to suppliers 30,000Owing from customers 12,000Shop fittings 10,000DVD stock 30,000Loan from shareholder 10,000Overdraft 5,000Credit card debt 12,000Soft drinks for sale 1,000

Non current assetNon current liabilityCurrent liabilityCurrent assetNon current assetCurrent assetNon current liabilityCurrent liabilityCurrent liabilityCurrent asset

Will not be sold within 12 monthsDoes not have to be repaid within 12 monthsHas to be paid within 12 monthsWill be receivedin cash within 12 monthsWill not be sold within 12 monthsWill be sold within 12 monthsDoes not have to be repaid within 12 monthsHas to be repaid within 12 monthsHas to be repaid within 12 monthsWill be sold within 12 months

Taking this list, and then allocating the various items into the correct structure from Figure 3.x is as follows:

Movie Moments Pty LimitedBalance Sheet as at 30 June 2010

Asset LiabilitiesCurrent assets Current liabilitiesOwing from customers (Receivables) 12,000 Payable to suppliers (Accounts payable) 30,000DVD stock 30,000 Overdraft 5,000Soft drinks for sale 1,000 Credit card debt 12,000 Total current assets 43,000 Total current liabilities 47,000

Non current assets Non current liabilitiesCar 30,000 Loan from bank 15,000Shop fittings 10,000 Loan from shareholder 10,000 Total non current assets 40,000 Total non current liabilities 25,000

Total assets 83,000 Total liabilities 72,000

Owner’s equityIssued shares 1,000Retained profits 10,000 Total Owner’s equity 11,000

Total assets 83,000 Total liabilities + owner’s equity 83,000

By using the structure of the balance sheet, and sorting the list into current assets, non current assets, current liabilities and non current liabilities, we can see that:

in addition to the $1,000 in shares, the owner’s have retained profits from the business of 10,000. We can see this because the total assets ($83,000) are $11,000 more than the total liabilities ($72,000), and this difference is owner’s equity. This means owner’s equity must total $11,000. As we know that owner’s


equity will contain the $1,000 of issued shares, this means there must be $10,000 of retained profits. This is the profit that business has made over the last two years.

From the total current liabilities, we can see that the business owes $47,000 due in the next 12 months. However, the business only has current assets (ie items that will be turned to cash in the next 12 months) of $43,000. It is $4,000 short. The business may need to increase its overdraft, or borrow some money during the next 12 months. The difference between current assets and current liabilities is called working capital. Movie Moments has -$4,000 in working capital, which may be a problem.

Please note and highlight the following things:

The heading of the balance sheet contains the name of the business, and the date at which the balance sheet is being drawn up. Balance Sheets are always expressed as at a specific date.

There are separate headings for Assets, Liabilities and Owner’s equity There are separate headings for Current Assets, Non current assets, Current Liabilities and Non Current

Liabilities There are separate totals for current assets, non current assets, current liabilities, non current liabilities There are separate total for Assets, Liabilities, and Owner’s Equity The last line has been inserted as a check for us. It is not a formal part of the balance sheet, but confirms to

us that the maths is correct. The reason a balance sheet is called a balance sheet is because the assets balance (or equal) the total of liabilities and owners equity.

This is sometimes expressed as the accounting equation:

Total Assets = Total Liabilities + Owner’s equity.

So, the balance sheet is merely a structured way of sorting and writing down the things that a business owns, and owes, as at a given date. Once we know what the business owns (assets) and what the business owes (liabilities) the difference between the two is what the owner’s own. If total liabilities are greater than total assets, the owner’s shares are not worth anything, as the company will have made losses!

The balance sheet above has been set out with assets on the left, liabilities and owner’s equity on the right. It is also permissible to stack the elements of a balance sheet vertically (called a narrative form of the balance sheet). In this form, assets are first, followed by liabilities and then owner’s equity. Below is the same balance sheet for Movie Moments, except drawn in the narrative form where assets are above liabilities, which are above owner’s equity.


AssetCurrent assetsOwing from customers (Receivables) 12,000DVD stock 30,000Soft drinks for sale 1,000 Total current assets 43,000

Non current assetsCar 30,000Shop fittings 10,000 Total non current assets 40,000

Total assets 83,000

LiabilitiesCurrent liabilitiesPayable to suppliers (Accounts payable) 30,000Overdraft 5,000


Credit card debt 12,000 Total current liabilities 47,000

Non current liabilitiesLoan from bank 15,000Loan from shareholder 10,000 Total non current liabilities 25,000

Total liabilities 72,000


Total liabilities + owner’s equity 83,000

Exercises

3.1 Why is a balance sheet called a balance sheet?

3.2 What is the accounting equation?

3.3 Describe the major structural features of a balance sheet.


3.4 Provide the heading for a Balance Sheet for JB Hifi Limited for the year that started 1 January 2010.

3.5 Describe what is different with a narrative balance sheet form.

3.6 From the Balance Sheet for Movie Moments at 30 June 2010, find and complete the following information:

Total assets

Total current liabilities

Total current assets

Total liabilities

Owner’s equity

Issued shares


Retained earnings

3.7 Describe and give an example of a current asset.

3.8 Describe and give an example of a current asset.

3.9 Describe and give an example of a non current liability.

3.10 Describe and give an example of a non current asset.

Classifying financial items

In the next section we will explore the items typically found in each of the rectangles on a balance sheet. That is, what is typically found in current assets, non current assets, current liabilities, non current liabilities, and owner’s equity.


Typical current assets

Current assets are items of value to the business, which are either already cash, or will be turned to cash during the course of the next 12 months.

Typical current assets and their descriptions are outlined in the table below. Note that the same item can sometimes be called other things (synonyms). For example, cash could be called cash, cash at bank, cash on hand, or deposits. All of these things are the same.

In the table, where an items is called by other words they are also displayed as also known as

Cash Also known as Cash at bank Cash on hand Deposits

Cash is a current asset because it is already cash.

Accounts receivable Also known as Trade debtors Debtors Trade receivables

This is amounts that the business is owed by others, often the payment for goods that have already been provided to your customers. It is a current asset because the payment is expected to be received within the next 12 months. The language of receivable is because it is an amount to be received by the business. The language of debtors refers to a debt that is owed to the business by someone else..

Inventory Also known as Stock Stock on hand Closing Stock Closing inventory

Inventory is the value of items that you have on hand for sale. For Movie Moments, stock is the DVDs on the shelves, and also the soft drink in the fridge for purchase. Inventory (or stock) is expected to be sold and turned to cash within the next 12 months, and hence is classified as a current asset. The language of “closing” refers to the amount of stock at the end of the year, which is contrasted to “opening” stock which is the level you had 12 months ago, at the beginning of the financial period. Businesses which sell stock will conduct a physical stocktake at the end of their financial year to determine how much stock they have – this is a manual counting process of all of the items that they have on hand for sale.

Short term investments Also known as Short term loans Listed shares

These are short term, liquid investments, that can be turned to cash, or loans the business has extended to another party which are repayable within the next 12 months.

Prepayments Also known as Prepaid insurance

Prepayments relate to where a business pays an amount in advance (for example an insurance premium) and the period of cover extends beyond the end of the financial period. For example, if Movie Moments paid contents insurance on 1 June 2010 for one year for $120, then only $10 would relate to the year ended 30 June 2010, and $110 will relate to next year. The prepayment, of $110, is displayed on the balance sheet because it is of value to the company and has not been used. Any prepayment for a service to the business which will be performed or delivered after the end of the financial period is recorded here as a current asset.

Typical non current assets

Non current assets are items of value to the business, which will not be sold or turned to cash during the course of the next 12 months.


Typical non current assets and their descriptions are outlined in the table below. Note that the same item can sometimes be referred to by other synonyms. For example, property could be called land and buildings, real estate, buildings or land holdings. All of these things are the same.


Land and buildings Also known as Real Estate Property Factories

These items are not expected to be sold within the next 12 months, as they are part of the ongoing things the business needs to function. For Business Studies purposes, these are recorded at their cost, that is, what the business paid for the assets.

Furniture and fittings Also known as Furniture Fixtures Equipment Shop fittings Machinery Plant and equipment

These items are not expected to be sold within the next 12 months, as they are part of the ongoing things the business needs to function. For Business Studies purposes, these are recorded at their cost, that is, what the business paid for the assets.

Depreciation For Business Studies purposes, depreciation means the reduction in value of a non current asset which has occurred through use, wear and tear, or simply time by growing old. For example, a new car purchased ten years ago by the business is not today worth what the business paid for it. The difference between the original purchase price, and the value of the item if sold today, is called depreciation. Depreciation is recorded in the balance sheet as a negative non current asset – placed near the non current asset to which it relates. For example, any depreciation on the car owned by movie moments would be shown in the balance sheet as:

Depreciation on motor vehicle (2,000)

In the non current assets section of the balance sheet.

Intangibles Includes Trademarks Copyright Goodwill Patents Mastheads Intellectual property Designs

These items are intangible, that is, they are not physical objects like machinery or land or buildings. Intangibles can, however, be very valuable. Examples include copyright rights, trademarks and mastheads of newspapers. Valuation of intangibles can be difficult and involve third party specialist valuers.

Current liabilities

Current liabilities are debts or obligations that the business must repay within the next 12 months. In other words, cash will be used to pay these items within the next 12 months.

Typical current liabilities and their descriptions are outlined in the table below. Note that the same item can sometimes be referred to by other synonyms. For example, accounts payable could be called creditors, trde credtiros, or payables. All of these things are the same.


Trade creditors These are unpaid bills from your suppliers, for goods or services you have bought


also known as Creditors Accounts Payable Payables

from them but have not yet paid for. In the business you will have received invoices for these services, however you have not yet paid them on the date of your balance sheet. These amounts are payable within the next 12 months. Every business will have trade creditors on their balance sheet, as every invoice is never paid on a given balance sheet date.

Overdraft An overdraft is a loan from the bank which you progressively withdraw as you need it. You can withdraw up to the limit of the overdraft. Banks can require immediate repayment of overdrafts, hence they are classified as a current liability.

Short term loan Loans from others to the business which are required to be repaid within the next 12 months are current liabilities. An example would include a short term loan from a shareholder to help a business over a cyclical cash flow problem (like a toy store with low sales in the early months of the year).

Accruals Also known as Accrued insurance Accrued wages Wages owing Income tax payable

These are expenses that the business has incurred, but has not yet received an invoice for and has not paid. On the basis of experience, the business knows that an expense has been incurred during the year, for which it will be invoiced, and so a current liability is recorded in the balance sheet for that amount.

Non current liabilities

Non current liabilities are financial obligations or debts of the business which are not required to be paid in the next 12 months. That is, cash will not be required to pay these amounts within the next 12 months.

Typical non current liabilities and their descriptions are outlined in the table below. Note that the same item can sometimes be referred to by other synonyms. For example, Long Term Debt could be called Long Term Borrowings, or Bonds. All of these things are the same.


Long term debt Also known as Bonds Long term borrowings

These are money that others have loaned to the organisation where repayment is not due in the next 12 months. The sources of the borrowings can be different. Banks may extend loans that are not repayable for several years. A shareholder, or an investor, may loan the business money that is not repayable for several years. Larger businesses can issue bonds in the capital markets, on which interest is payable during the life of the bond, and the bond amount is repaid at the end. For example, Walt Disney company has several billion dollars in bonds issued as a way of financing its business.

Mortgage When a business needs long term debt to finance the purchase of specific assets, such as land and building, or new large machinery, the bank may extend a long term loan which is secured by the asset being purchased. The security taken by the bank is called a mortgage. The terms of the mortgage will provide that if the business does not repay the loan with interest as agreed then the lender can sell the asset on which they have the mortgage. Until the loan is repaid, the business cannot sell the property that is subject to the mortgage, which protects the interests of the bank. Technically speaking the item on the balance sheet should say “Long term loan” rather than mortgage, as the mortgage is an additional contract between the lender and the borrower that protects the interests of the lender under the loan agreement.

Debentures These are long term borrowings from the public, usually by larger companies, and require the issue of a prospectus to potential investors. Typically an annual rate of interest is paid on the debenture, and the full amount of the debenture repaid at the end of the term.


Owner’s equity

Issued shares Also known as Issued capital Shares Capital contributions Owner’s capital

This is the amount that the owners of the business have paid to the company for the issue of shares, and is one of the sources of finance for the business when it started originally. When the business started, once the shares had been issued and the money received, the balance sheet would have shown the same number in issued shares, and cash at bank – at that time there would only have been two items on the balance sheet.

Retained earnings Also known as Net profits Reinvested earnings Reinvested profits

This is the total of the profits and losses that have been earned by the business since it started, less any amounts that have been paid to the shareholders as dividends. The language of retained earnings comes from the fact that the business has not distributed all of the earnings to the owners of the business – it has retained some of the earnings to fund the operations and growth of the business.

Drawings Drawings is an amount taken from the business by the owners, and in simple examples may be shown as a negative in the owner’s equity section of the balance sheet.

Exercises

3.11 Complete the following table to classify the following items by ticking the correct column.

CurrentAsset

Non-CurrentAsset

Current Liability

Non-CurrentLiability

Owner’sEquity

Issued capitalAccounts payableDebentureTrade creditorsInventoryPrepaid insuranceMotor VehicleDepreciationAccrued wagesPrepaid insuranceLand & BuildingsDebtorsFurniture and fittingsOverdraftLong term loanMortgageRetained profitsPayablesTrademarksReceivablesCreditorsCash at bankCredit cardDrawingsIntangibles

3.12 Why is retained earnings called retained earnings?


3.13 Describe prepaid expenses and accrued expenses and identify where they are classified in the balance sheet.

3.14 List four items often found in current assets on a balance sheet.

3.15 List four items often found in non current assets on a balance sheet.

3.16 List four items often found in current liabilities on a balance sheet.


3.17 List four items often found in non current liabilities on a balance sheet.

3.18 List two items often found in owner’s equity on a balance sheet.

Internet resources

Flashcards for classification of balance sheet itemsVideo review of the balance sheet

WebsitesMootley fool


Chapter 4Finance: Sources and uses of funds

This chapter will explore where a business can obtain finance (money) to startup, and to operate and grow the business. We will first look at a case study of a startup, and then continue to a discussion of the range of sources of funds for businesses in various stages of the business cycle.

Case study: John Smith starts Movie Moments, a DVD store

When Movie Moments started several years ago, John Smith had saved $15,000. When he created a financial plan for the year ahead, he figured he would need the following items even before he opened the doors:

Car 30,000DVD stock 30,000Shop fittings 10,000Soft drinks for sale 1,000Rent bond 9,000

$80,000

In addition to this $80,000, John would need to pay rent, wages, advertising, website costs, insurances and other regular expenses – and he expected he would make losses for the first early months before he got the shop up and running. For these things he figured he would need a further $30,000.

So John needs $110,000 to cover opening costs and operating costs for the first few months, but only has $15,000 himself.

How can he fund the business?

This is the key question that Finance addresses, both when starting a business, and during the life of the business throughout the business and economic cycles. Accounting and Finance is two distinct concepts – and this chapter explores the Finance tasks.

Financing the startup of Movie Moments Pty Ltd

After talking to his accountants, John agrees that we will use his $15,000 in the following way. First, he will take $1,000 and subscribe for 1,000 shares to be issued by the company to him. He will own all the shares in the company. The issued capital of the company will be $1,000, being 1,000 shares of $1 each.

Secondly, he will take the rest of his savings, $14,000, and loan those to the company for five years at 5% interest. Movie Moments opens a bank account, and deposits both the $1,000 received for the shares, and the $14,000 loan.

At this stage, the balance sheet of Movie Moments looked like the following:

Movie Moments Pty LimitedBalance Sheet as at 1 July 2008

Asset LiabilitiesCurrent assets Current liabilitiesCash at bank 15,000

Total current assets 15,000 Total current liabilities 0

Non current assets Non current liabilitiesLoan from shareholder 14,000

Total non current assets 0 Total non current liabilities 14,000



Owner’s equityIssued shares 1,000Retained profits Total Owner’s equity 1,000


But the business needs a further $95,000 in order to open the doors and trade for the first few months.

There are two sources of funds for a business, called debt, and equity. Debt is money borrowed by the company that must be repaid. Equity is money received by the company in exchange for ownerhip rights (shares) in the company.

So far, Movie Moments has raised $1,000 of equity funds and $14,000 of debt funding. John Smith has no more money to invest in the business, and is not willing to share ownership of the business with anyone else – so further funding from equity (or ownership) sources is not possible. If John had been prepared to share the ownership of the business, equity funding might have been obtained from other potential investors, family members, or venture capital firms that invest in businesses.

That leaves the other source of financing: debt.

Debt is borrowing someone else’s money in order to use in the business, often in the form of loans, leasing arrangements (leasing or renting equipment), or other forms of borrowing. Applying for loans will require a business plan and a financial plan so that the potential lender can make an assessment of whether to provide the loan to the business. Where a loan is agreed, typically an application fee and establishment fee will be payable, and interest will be payable on the loan.

John approaches the ANZ bank with his business and financial plan. After reviewing the plan, the bank offers to extend the following facilities to Movie Moments, if John agrees to personally guarantee repayment of the debts.

Limit Interest rateCredit card $5,000 20%Overdraft $50,000 11%Five year business loan $50,000 9%Total facility $105,000

The total facility is $105,000. Note the different interest rates that are payable on various elements of the debt financing. John accepts the offer of finance, signs the loan documents, and uses the business loan and overdraft to fund the setup costs for his business. He buys the car, the stock, attends to fitout and pays the rent bond.

The balance sheet for Movie Moments now looks like the following:


Movie Moments Pty LimitedBalance Sheet as at 1 July 2008

Asset LiabilitiesCurrent assets Current liabilitiesCash at bank 0 Overdraft 15,000Inventory drinks 1,000Inventory DVDs 30,000 Total current assets 31,000 Total current liabilities 15,000

Non current assets Non current liabilitiesCar 30,000 Loan from shareholder 14,000Rent bond 9,000Shop fittings 10,000 ANZ loan 50,000 Total non current assets 49,000 Total non current liabilities 64,000


Owner’s equityIssued shares 1,000Retained profits 0 Total Owner’s equity 1,000


As can be seen in the balance sheet above Movie Moments:

used all the cash that John loaned the business (see cash at bank is now nil), used all of the $50,000 five year facility from the ANZ (see the non current liability), used $15,000 of the $50,000 overdraft (see the current liability). purchased $31,000 of inventory (see current assets) purchased non current assets (car and shop fittings), paid the bond (which he will get back at the end of the rent contract)

Given the different interest rates that apply for the different parts of the facilities from the ANZ bank, Movie Moments has been careful to first use the sources of finances that are the cheapest – those that have the lowest interest rates.

As he goes to open the doors of the business, he has $35,000 left of the overdraft he can drawn down on, and a $5,000 limit on the credit card. He expects to use these sources in his early months of trading where he expects the business will make losses until he can establish strong marketing presence, customer relationships, and steady revenues.

The finance approach for this business has been to use a mix of debt and equity, with the debt coming from a shareholder loan, and facilities from the ANZ Bank.

We can also see how the Balance Sheet gives us a clear outline of the financial position of the business as it starts to operate. It has working capital (current assets – current liabilities) of $16,000, and a range of non current assets supported by non current loans.

Exercises

4.1 What are the two sources of funds for a business?


4.2 Describe how equity works as a source of funds for a business, and where it is seen on the balance sheet.

4.3 Describe why Movie Moments needed to consider its financing structure.

4.4 Describe Movie Moments debt and equity structure.

4.5 Why did Movie Moments want to arrange financing facilities for more than the $80,000 it needed to open the doors of the business?


4.6 After the financing and purchases of the current and non current assets, what is the working capital of Movie Moments?

Sources of funds: overview

Matching sources and uses of funds

Debt Equity Other

Internal Shareholder loans Short term loans Long term loans

Share capitalRetained profits

External Individual loans Short term loans Long term loans

Bank facilities: Bank loans Mortgages Overdrafts Credit cards Leasing Bank Bills

Amounts owed: Creditors Accrued Expenses

For larger businesses: Debentures Bonds

Venture capital Slow paying creditors

Factoring debtsFast debt collection

Grants

The


Gearing and debt to equity

When expanding, or buying new machinery, may need debt financing

To manage cash flow movements in cyclical business, may need financing

Where does finance come from?

Internal and external sources of finance

Advantages and disadvantages of debt financing

Leverage

Debt to equity ratios (mention other ratios later)

Focus on role of finance to manage the debt position

Use Apple and walt Disney and david jones and jb hi as examples in looking at their current and non current liabilities.

Exercsise

Describe the two sources


Chapter 5The Income Statement

There are three financial statements, indicated in the table below. This chapter will address the Income Statement, which tells us whether the business made money (profit) or lost money (losses) during the last financial period..






What is an Income Statement?

A income statement is a structured way of listing the revenue and expenses of the business for a specified period. It tells us not only whether there was a profit or loss, but the structure of the income statement also tells us important things that contributed to that result which can help us better manage the business in future.what the business owns, what the business owes, and what is left over for the owners.

Consider Movie Moments Ptd Limited, a business selling DVDs, drinks and popcorn in a rented store, which started two years ago by issuing $1,000 worth of shares to the sole shareholder and owner, John Smith.


Asset LiabilitiesCurrent assets Current liabilitiesOwing from customers (Receivables) 12,000 Payable to suppliers (Accounts payable) 30,000DVD stock 30,000 Overdraft 5,000Soft drinks for sale 1,000 Credit card debt 12,000 Total current assets 43,000 Total current liabilities 47,000

Non current assets Non current liabilitiesCar 30,000 Loan from bank 15,000Shop fittings 10,000 Loan from shareholder 10,000 Total non current assets 40,000 Total non current liabilities 25,000




We will now look at the Income Statement for the business for the last financial year, the year ended 30 June 2010.


Income Statement for Movie Moments Pty LtdFor the year ending 30 June 2010

Revenue 229,000

Less Cost of Goods SoldOpening Inventory 28,000Add Purchases 120,000Less Discounts -5,000Add Freight inwards 2,000Less Closing Stock -31,000 114,000

Gross profit 115,000

Less ExpensesRent 60,000Insurance 2,000Wages 30,000Petrol 10,000Cleaning 5,000 107,000

Net profit 8,000

ShapeStructureCreating

Gross and net profit

Cost of goods sold

5.1 What is an Income Statement?

5.2 What is the difference between gross profit and net profit on an Income Statement?


5.3 What is deducted from revenue to arrive at gross profit?

5.4 What is the formula for cost of goods sold?

5.5 In what of the Income Statement would you find freight outwards?

5.6 What is non operating income, and where is it found on an Income Statement?

5.6 What is operating margin?

5.6 Calculate cost of goods sold with the following information.

5.6 Prepare an income statement from the following information.


Chapter 6Cash cash cash


Chapter 7Operational reports: budgets & forecasts


Chapter 8Break even analysis


Chapter 9Introduction to financial analysis


Chapter 10Liquidity analysis


Chapter 11Financial risk analysis


Chapter 12Efficiency analysis

http://boards.fool.com/alternative-names-for-financial-statement-terms-15627879.aspx?sort=postdatehttp://www.quickmba.com/accounting/fin/statements/


http://www.quickmba.com/accounting/fin/statements/

http://boards.fool.com/alternative-names-for-financial-statement-terms-15627879.aspx?sort=postdate

AppendixGlossary of board of studies terms


AppendixAnswering case studies


AppendixResources on the webMultinationals financial statement examples

The following are links to financial statements at Morningstar, which provides an excellent presentation of the financial statements, together with an excellent renditioning of various financial analhytics and ratios.

The site is Morningstar.com

This complete list of links can be found at

Company urlWalt DisneyApple IncCaterpillarStarbucksWal-MartGEExxon

Financial information for Australian companies

Financial information can be found for Australian companies on the web as pdf versions of published annual reports. Direct links to examples of annual reports are set out below

Company urlWestpacCBAThe NationalJB HiFiTelstraWesfarmersWoolworthsBHPRio TintoDavid Jones


AppendixAnswers to questions

Chapter 1:

1.1

1.2

1.3

1.4

Chapter 2:

Chapter 3:

Chapter 4:

Chapter 5:

Chapter 6:

Chapter 7:

Chapter 8:

Chapter 9:


AppendixGlossary of terms

AccountingThe recording of financial transactions and financial obligations involving the business.

Accounts payableAnother word for creditors, trade creditors or payables. This is an amount payable to another business as a result of a transaction. Amounts that are payable to suppliers at the end of the financial period are accounts payable. This is a current liability.

Accruals

Accured expenses

AssetAn item of value to the business.

Balance SheetA statement of what the business owns, and owes at a given date, that shows what the owners of the business

Bank Bills

Bonds

Closing inventoryThe value of stock (inventory) on hand in the business at the end of the financial period. This is the value of the goods that are held for sale by the business. It may be larger, or smaller, than the value of opening inventory. This is a current asset.

Copyright

Cost of goods sold

The cost of the goods that the business sold during the period. It is a calculation that appears on the income statement, and is deducted from revenue to yield gross profit.

It is calculated in the following way:

Opening stockAdd purchasesLess discounts receivedAdd freight inwardsLess closing stock


CreditorsAnother word for accounts payable, trade creditors or payables. This is an amount payable to another business as a result of a transaction. Amounts that are payable to suppliers at the end of the financial period are accounts payable. This is current liability.

Current assetAn asset that is expected to converted to cash within 12 months.

Current liabilityA liability that is required to be repaid within 12 months.

DebtorsAnother word for receivables, or trade receivables. This is an amount owed to the business as a result of a sale transaction. This is a current asset.

Discount allowedA discount allowed by you to your customers. On the income statement, revenue is reduced by discount allowed.

Discount ReceivedA discount allowed to you by your suppliers. This discount reduces the cost of your purchases, and is a reduction in the cost of goods sold calculation.

Dividends

Drawings

Expenses

External finance

Finance

Freight inwardsThe cost of getting goods to your business for sale. This is included in the calculation of cost of goods sold. Note that freight outwards, the costs of shipping goods to your customers, is an expense in the Income Statement and is not included in cost of goods sold.

Freight outwardsThe cost of getting goods to your customers. This is not included in the calculation of cost of goods sold. Note that freight inwards, the costs of shipping goods to you from your suppliers, is added to cost of goods sold in the Income Statement.

Gross ProfitAnother name for Operating Profit, and equals Revenue minus cost of Goods Sold. It appears on the Income Statement.


Income StatementAlso known as a Statement of Financial Performance, and Profit and Loss Statement. This statement reports the revenues and expenses of the business, in a way that separates gross profit revenue minus cost of goods sold) and net profit (gross profit less other expenses of the business).

Intangibles

Internal financeFinance (cash) which is sourced from existing shareholders, or from retained earnings of the business. This is distinguished from external finance.

LiabilityAn item the consequence of which will require the business to pay money to another. Liabilities include

MortgageA security taken over an asset to guaratee repayment of a loan, typically from a bank. The loan agreement is secured by a transfer of legal owership to the lender who is entitled to sell the asset if the loan is not repaid in accordance with its terms. Where a loan is secured by a mortgage, sometimes the loan is referred to as “mortgage” even though that is not technically correct.

Net ProfitGross Profit less other expenses of the business. Net Profit is always smaller than Gross Profit. Net Profit is shown at the bottom of the income statement.

Opening inventoryThe value of stock (inventory) on hand in the business at the start of the financial period. This is the value of the goods that are held for sale by the business.

Operating marginThe percentage of revenue that is retained by the business as gross profit – this measure the profitability of the business before other expenses are deducted. It is calculated by gross profit divided by revenue x 100.

Operating profitAnother name for Gross Profit, and equals Revenue minus cost of Goods Sold. It appears on the Income Statement.

OverdraftA negative cash balance of the business with the bank. Overdrafts must be established in advance, and typically have an establishment fee and interest payable on amounts of the overdraft which is drawn down.

Prepayments

Profit and loss statementAnother name for the Income Statement.


ReceivablesAnother word for debtors, or trade receivables. This is an amount owed to the business as a result of a sale transaction.

Retained earnings

RevenueAnother name for sales. Revenue is the value of the transactions with customers.

SalesAnother name for revenue. Sales is the value of the transactions with customers.

Statement of Cash Flows

Statement of financial PositionAnother name for the Balance Sheet.

Sales returnsCancelled sales where customers return goods. Where sales return arises, these must be deducted from revenue in the Income Statement.

Trade creditorsAnother word for accounts payable, creditors or payables. This is an amount payable to another business as a result of a transaction. Amounts that are payable to suppliers at the end of the financial period are trade creditors.

Trade receivablesAnother word for receivables, or debtors. This is an amount owed to the business as a result of a sale transaction.

Working capitalTotal current assets – total current liabilities


AppendixVideo resources

A range of video resources is available on the internet that accompany this workbook. Links to the videos can be found at:

Accountingforbusinessstudies.wordpress.com

The links are as follows:

Koch

Debt versus equity

NSW govt debt v equity

Good summary on debt v equity

Good question and answer

WA govt

debt ratios

Introduction to balance sheets and working capital

Balance sheet detail video

Flashcards for accounting termsBusiness studies qui


http://www.classmarker.com/embedded_quizzes/?quiz=7f38c8aa9d8fbacef17a3fef6a03660f

http://quizlet.com/2657913/classifying-assets-and-liabilities-flash-cards/

http://screenr.com/dor

http://screenr.com/Bor

http://www.allbookkeepingsolutions.com.au/comparison-of-debt-and-equity-financing

http://www.smallbusiness.wa.gov.au/example-balance-sheet/

http://www.smartcompany.com.au/show-me-the-money/debt-versus-equity.html

http://www.referenceforbusiness.com/management/Comp-De/Debt-vs-Equity-Financing.html

http://www.smallbiz.nsw.gov.au/start/financecashflow/securingfinance/pages/debtorequityfunding.aspx

http://finance.yahoo.com/how-to-guide/career-work/12825

http://smallbusiness.yahoo.com.au/Category/GrowingYourBusiness

The Role of Accounting and Finance

Accounting and Finance is one of the four key functions of a business. The four key functions of a business are:

Operations Employment Relations Marketing Accounting and Finance

The naming of this function, Accounting and Finance is significant, as there are two distinct tasks which the people in the Accounting and Finance function of the business perform. The accounting tasks are different to the finance tasks.

Simply stated, accounting tasks record the financial transactions of the business and then use that information to prepare financial statements, which are used by a range of internal and external stakeholders. The records that accounting use can include bank statements, receipts, wage slips, supplier invoices, cheques, insurance bills and taxation assessments.

Finance tasks, on the other hand, involve planning how the business is going to fund (or finance) its operations in the future. For example, if the business needs more cash, where is it going to come from,? When will it have to be paid back? How much will it cost? The Finance tasks depend on the accounting tasks being done first in order to be able to forecast how much money will be needed, how much the business can afford to borrow, and when the business will be able to pay it back.

Who uses the Financial Statements for a business?

In addition to the owners and managers of the business, the contents of financial statements are very important for a range of other individuals and organisations.

Where the business has obtained a loan from a bank, the bank will require copies of financial statements to be provided in order to ensure the business is trading as expected. If the business is seeking further investment from new shareholders, they will require financial statements in order to understand the current financial position and performance of the businesss. Taxation authorities will require the financial statements to be filed each year with the tax return of the business. For companies listed on the stock exchange, financial statements must be filed with the stock exchange every quarter, and for every company, financial statements must be filed with the Australian Securities and Investment Commission every year.

Definitions

The role of accounting is to accurately record the financial transactions of a business to prepare reports that summarise a business’ financial position and financial performance over a period of time.

The role of finance is to plan and fund start up and ongoing operations of the business, and identify sources of funds for expansion and growth, which may be internal (from existing shareholders or new shareholders) or external (from banks, other lenders, and non shareholders).

You need to be able to: explain what each of Accounting and Finance is in the context of a business identify stakeholders who use the Financial Statements.



Exercise 1

You are establishing a DVD Store, called Movie Moments Pty Ltd, renting a store in a shopping mall owned by ABC Property. You will sell DVDs you source from different suppliers, and sell drinks and popcorn sourced from another supplier. You will employ three staff, have a website, advertise in the local paper and insure the goods in your store. You will finance your startup and purchase of stock with a loan from the ANZ Bank, a loan from a friend, and all of your savings.

Your projections for the business show you expect to be profitable in your first year, and you have taken advice on how GST and taxes work from your accountant.

When your business is running, what type of financial records will be created or available for your Accounting function to record?

Who are the stakeholders of the business known as Movie Moments Pty Ltd who would require financial statements?


balance sheet

ShapeClassificationCreating


The income statementsShapeStructureCreating


Documents

Welcome and overview€¦ · Web viewIntroduction to financial analysis 34. Liquidity analysis 35. Financial risk ... financial statements must be filed with the Australian Securities