C1/H3 - Finance

Question 1

The Role of the Finance Department

Answer 1

The Finance Department is important to an organisation as the business has to know how viable it is and balance revenue with costs in order to make a profit.

The finance department of a business takes responsibility for organising the financial and accounting affairs including the preparation and presentation of appropriate accounts, and the provision of financial information for managers.

Question 2

The main areas covered by the financial department include:

Answer 2

> Book keeping procedures -
Keeping records of the purchases and sales made by a business.

> Creating published accounts -
Financial statements need to be produced at given time intervals, for example at the end of each financial year.

Records of purchases and sales are totalled up to create an Income Statement. A Balance Sheet showing the assets and liabilities of a business at the year-end is also produced.

> Providing management information -
Managers require financial information to enable them to make better decisions.

For example, they will want information about how much it costs to produce a particular product or service, in order to assess how much to produce and whether it might be more worthwhile to switch to making an alternative product.

> Management of wages -
The payroll section of the finance department will be responsible for calculating the wages and salaries of employees and organising the collection of income tax and national insurance for the Inland Revenue.

> Raising capital -
The finance department will also be responsible for the technical details of how a business raises finance e.g. through loans, and the repayment of interest on that finance.

In addition it will supervise the payment of dividends to shareholders.

Question 3

Sources of Finance

Answer 3

Businesses cannot survive without finance, whether in the form of initial funds to start the business, working capital to run the business day-to-day, or investment capital to help the business grow.

Small-to-medium enterprises (SMEs) are businesses which:

• Employ <250 persons
• Annual turnover is

Question 4

The most suitable finance option for a business depends on many things:

Answer 4

• How much funding is needed?
• The amount of time the money is required for
• What the finance will be used for
• The affordability of repayments
• Whether or not personal or business assets are available as security
• Whether or not the business owner is willing to give up a share of ownership, perhaps through taking on a partner or selling shares

Question 5

Internal Sources of Finance

Answer 5

This is where finance for the business comes from within the firm. This includes:

> Retained Profit

> Working Capital

> Sales of Assests

Question 6

Retained profit

Answer 6

The profits retained (kept) after dividends have been paid to shareholders.

Advantages:
•It is cheap and readily available and it does not incur interest/repayments as long as profit is made

Disadvantages:
•Opportunity cost, e.g. pay dividends to please shareholders

Question 7

Working capital

Answer 7

The money that is used to run the business day to day.
This can be increased by reducing their trade credit period offered to customers and collecting debts more quickly.

Advantages:
•Short term source of finance - can help the business manage their cash flow better

Disadvantages:
•Can dent reputation, if demand cannot be met if stock is not available, or customers go elsewhere if their trade credit is reduced.

Question 8

Sale of assets

Answer 8

This is when the business is able to sell premises, machinery, or other assets

Advantages:
•It will bring in a lump sum immediately

Disadvantages:
•The business has lost the use of the assets

•Smaller businesses are unlikely to have unwanted assets and, if growth is an objective, they are much more likely to want to acquire assets as opposed to losing them.

Question 9

External Sources of Finance

This is where finance for the business come from outside of the business and includes:

Answer 9

> Borrowing from friends and family
> Bank Loans
> Overdrafts
> Trade Credit
> Factoring
> Leasing
> Hire purchase
> Commercial mortgage
> Sale and Leaseback
> Share capital
> Venture Capitalists
> Government grants

Question 10

> Borrowing from friends and family

Answer 10

Borrowing from friends and relatives
Where the business owners borrow money from their family or friends, it tends to be informal.

Advantages:
• Low rates of interest or no interest.

• Easy to negotiate/set up.
• Immediately available.

Disadvantages:
• Tends to be informal and this can be a problem – people may fall out

• They may need urgent repayment if circumstances change.

Question 11

Bank Loans

Answer 11

A loan is borrowing a fixed amount, for a fixed period of time, perhaps 3–5 years. Monthly payments made up of interest and capital.

Advantages:
•Bank loans can be difficult for small businesses to secure but once agreed all of the money is available immediately.

•Fixed repayments help firms manage cash flow

Disadvantages:
•Interest must be paid.

• Banks require collateral.
• Difficult to obtain for those with no proven track record

Question 12

Overdraft

Answer 12

An overdraft is the facility to withdraw more from an account than is in the bank account, resulting in a negative balance.

Advantages:
•Flexible way of borrowing - useful for day to day transactions, easing cash flow needs

•Only pay interest when account is overdrawn i.e. do not have to pay off regular sums.

Disadvantages:
•Expensive form of borrowing

• May be an arrangement fee
• Can be called in withdrawn by a bank with 30 days notice – it is repayable on demand

Question 13

Trade credit

Answer 13

A business buys from its suppliers and pays at a later date in effect short term interest-free credit.

Advantages:
•Useful short term source of finance to help manage cash flow

•Usually interest free if the business pays the suppliers within the agreed credit terms

Disadvantages:
•Suppliers may stop supplying if the business owes too much

• May become a credit risk
• Will not benefit from cash discounts related to prompt payment

Question 14

Factoring

Answer 14

For larger firms it is possible to let a debt factoring company buy problem debts.
The debt factoring business chases the original debtor for as close to the full amount as possible. Anything above what was paid to buy the debt is a profit for the debt factoring company.

Advantages:
•The business receives a lesser amount than the original debt but it receives it promptly, it can now spend this cash.

•The factoring firm will take responsibility for recovering the money owed to the business improving cash flow.

Disadvantages:
•The business will not receive the full amount which it was originally owed.

•Not suitable for a start up business.

Question 15

Leasing

Answer 15

A business effectively rents an asset, for a monthly fee. It does not and will not own it, examples include, vans, machinery.

Advantages:
• A form of renting used for machinery – no large sums of money needed to buy it.

• Likely to get replacement machine if it breaks down.
• Useful if machinery is only needed occasionally

Disadvantages:
• More expensive over machine lifetime than buying outright.

• Will never own the machinery – unless given option to purchase.

Question 16

Hire purchase

Answer 16

Similar to leasing but at the end of the hire period the asset belongs to the company that hires it.

Advantages:
•Can have equipment immediately

•May be easier to obtain credit from hire purchase companies than banks for some.

Disadvantages
:•Do not become owner until last payment made.

• If the business falls behind with payments then asset can be repossessed.
• Usually higher rates of interest than banks.

Question 17

Commercial Mortgage

Answer 17

A business gets a long-term loan in order to purchase a property.

Advantages:
•Commercial mortgages might run for 10-15 years have predictable costs – helps budgeting and cash flow

Disadvantages:
•Failure to make repayments may lead to the property being repossessed.

Question 18

Sale and leaseback

Answer 18

The business sells assets (e.g. buildings, machinery) to a finance company and then lease (rent) the asset back.

Advantages:
•An asset can be turned into capital for reinvestment in the business

• Capital produced can be reinvested into growing the business.
• Sale and leaseback also carries potential tax benefits as the leasing costs are offset as an operating expense.

Disadvantages:
•The business no longer owns the asset

•They may not receive market-rate for the asset

Question 19

Share capital

Answer 19

Selling a share of the company to investors who seek a return on their investment, via increasing share price and dividends.

Advantages:
•The business doesn’t have to pay interest

•Can sell more shares as and when funds are needed in the business

Disadvantages:
•Selling shares can dilute the control of the business owners

•In extreme circumstances leave the original owners vulnerable to takeover threats

Question 20

Government grants

Answer 20

Local and central government may offer finance to business start-up schemes.
The qualifying criteria do tend to be quite narrow and businesses setting up in regions of high unemployment tend to be favoured.

Advantages:
•Money does not need to be re - payed

•Interest free

Disadvantages:
•Administration requirements – forms to complete to meet what can be strict criteria.

• Tend to come with certain conditions which must be met.
• The amounts available tend to be relatively small and are for a limited period of time.

Question 21

Evaluation

Answer 21

Businesses must consider many factors when deciding upon a source of finance

> Existing borrowing
> Risk
> Short term/long term source
>Interest rates 
> Security against loans 
> Availability of finance

Question 22

Existing borrowing

Answer 22

Evaluation - Start-up business:

•Not applicable to a new business.

Evaluation - Existing business:

•Need to consider the amount of existing borrowing and interest to be paid.

Question 23

Risk

Answer 23

Evaluation - Start-up business:
• Taking on a source of finance is high risk, 80% of new businesses fail within 18 months.

• May have to use personal assets as security against a loan.

Evaluation - Existing business:
• Less risk - as existing businesses will be more established in the market.

• Proven track record - can take advantage of supplier discounts and trade credit.

Question 24

Short vs long term source

Answer 24

Evaluation - Start-up business:
• Short term better for a new start up, as less risky as the business may not be successful or have a high enough turnover to afford longer term borrowing with additional interest repayments.

Evaluation - Existing business:
• Depends on how established the business is, e.g., how many years it has been trading?

• Easier to get larger sums of money that required longer payback periods due to higher sales value/volume.

Question 25

Interest rates

Answer 25

Evaluation - Start-up business:
• A significant cost for a new business

• Affects the level of profit made

Evaluation - Existing business:

• Affect the costs and profits of the business if interest rates rise

Question 26

Security against loans

Answer 26

Evaluation - Start-up business:
• New businesses are usually sole traders and have unlimited liability.

• Sole traders will have to use their own personal assets as security against borrowing.

Evaluation - Existing business:
• As the owners are a separate legal entity in limited companies, only the assets of the business will need to be used as security.

Question 27

Availability of finance

Answer 27

Evaluation - Start-up business:
• Will usually rely on personal savings or money from family.

• A smaller range of sources available to new start-up businesses.
• External borrowing harder as the business has not made any sales.

Evaluation - Existing business:
• More sources available to established businesses.

• Can take up better credit terms than a new start-up due to proven track record of success/sales.

Question 28

Revenue, Costs and Profit

Answer 28

Revenue, Costs and Profit

Question 29

Revenue

Answer 29

Revenue (also known as: income, turnover, sales receipts, takings)

Revenue is the monetary value of sales made by a business within a period, usually one year.

The formula used to calculate a firms total revenue is:

Total Revenue = Selling Price per unit x Quantity Sold/ or Output

TR = SP x QS

The amount of revenue a firm makes is a critical factor in determining the firm’s success. To increase revenue a business may:

1. Increase selling price:
   •Firms may choose to increase their selling price in order to achieve higher revenue from each individual sale.
   •This is favoured by companies selling designer clothes or high technology products.
   •This approach can mean some consumers will choose not to purchase the product at the higher price so could potentially have a negative impact on overall revenue.
   •Likely to be unsuccessful if the firm sells a product where there are many direct competitors.
2. Decrease selling price:
   •This should lead to an increase in quantity sold.
   •This is an approach taken by firms such as supermarkets.
   •Firms tend to take this approach when they have lots of direct competitors and consumers are not especially brand loyal.

Question 30

Costs

Answer 30

Costs are the expenses incurred by a firm in producing and selling its products. This is likely to include expenditure such as wages as well as the costs of raw materials needed to produce the products.

How well a firm is able to manage their costs will directly impact the overall profits and success of the firm.

Examples of costs which firms have to pay are : labour, packaging and shipping etc.

Question 31

A firm’s costs can be classified into 3 categories:

Answer 31

• Fixed costs
• Variable Costs
• Semi-Variable Costs

Question 32

Fixed Costs

Answer 32

Fixed Costs are costs which do not vary directly with the level of output e.g. rent.

This means that fixed costs such as rent will not increase if the firm produces and sells more units (as output increases).

Even if the firm does not produce/sell any units at all, they will still need to pay their rent, therefore even when output is 0 units fixed costs remain the same.

(Fixed costs are shown on a graph as a flat line)

Question 33

Variable Costs

Answer 33

Variable Costs are costs which change as output changes, e.g. raw materials.

In this case as output increases more raw materials will be required, so variable costs will increase.

Whereas if the firm does not produce many units they will not need as many raw materials therefore the variable costs will be reduced.

If a firm doesn’t make any units, variable costs will be £0.

Formula to calculate Total vraible cost is:

Total Variable Costs = Variable Costs per unit x Output
or
Total Variable Costs = Variable Costs per unit x Quantity Sold

TVC = VC per unit x QS

Total variable costs (TVC) are shown on the graph below as an increasing line which always starts at zero

Total Costs

A business must calculate its total costs by adding total variable costs and fixed costs. This is an important figure in calculating profits. The formula is below:

Total Costs = Fixed Costs + Total Variable Costs

TC = FC + TVC

Question 34

Semi- Variable Costs

Answer 34

Semi-variable costs
Not all costs can be defined as fixed or variable.
Some costs, are made up as a fixed and a variable aspect.
For example, the salary for a member of staff is fixed for working a 38 hour week.
However, when it is busy they may be asked to work 5 hours overtime due to increased demand, therefore the cost changes with output.
These types of costs are called semi-variable.
Other examples include mobile phone contracts; a sales manager may have a company mobile phone, with a contract costing £20 per month for 500 minutes. In busy months the sales manager may exceed 500 minutes incurring additional (variable) costs of £5 for each additional 100 minutes.

Average Total Costs

Average total costs are the average cost of producing each unit of output. As output increases then average total costs start to fall, the business is experiencing economies of scale.
This fall in average total costs will continue until a point is reached where dis-economies of scale force variable costs to rise pushing up the average total costs of production.

Average Total Costs = Total Costs
No. of units produced

Question 35

Direct and indirect costs

Answer 35

It is important for managers to be able to judge profitability. Decisions need to be made on continuing or discontinuing production – whether to make an investment in developing a product, whether to start training programmes or input more human resources.
Without information on profitability, or lack of profitability, effective decisions cannot be made. To enable these decisions to be made businesses must have a method of allocating costs to each product, department, branch or factory.
This can be done by cost allocation – assigning costs into direct costs and indirect costs (overheads).

Question 36

Direct costs

Answer 36

are costs, which can be identified directly with the production of a good or service. They are costs that arise specifically from the production of a product or the provision of a service. Examples of direct costs include:

• Materials or components
• Direct labour
• Expenses such as copyright payments on a published book, or licence fees for use of patents

These direct costs can be totalled to give the direct costs of producing the product. However, revenue minus direct costs does not indicate profitability.

Question 37

Indirect Costs (or overheads)

Answer 37

The business must also allocate overheads or indirect costs to the product. The production of any product results in a business paying costs not directly related to each specific product or service provision.

For example, a factory producing 10 different goods, to each of which managers allocate direct costs, will employ a secretary or receptionist.

The overhead cost of employing the secretary or receptionist needs to be apportioned or allocated to the products to gain a picture of true profitability.

For retailers such as Tesco, advertising is an overhead; the cost of advertising should be shared out amongst all retail outlets (each Tesco store) to better judge profitability of each store.

So the true profitability of a product, factory, outlet etc. can only be judged if we take both direct costs and indirect costs (overheads) from revenue.

Question 38

Profit

Answer 38

The primary motive of most firms is to maximise their profits. In order to do this they try to maximise the money which they receive through sales (their revenue), whilst minimising the costs associated with the production of the good or service which they provide.
Profit is the difference between total revenue and total costs.

Profit = Total Revenue - Total Costs
Profit = TR - TC

Question 39

Percentage change

Answer 39

% change = Change between two values / Original x100

Question 40

Break-Even Analysis

Answer 40

Break-even is the level of sales a firm must achieve to cover its costs. It is when total costs are equal to total revenue (TR = TC). In other words the business is making neither a profit nor a loss.

Question 41

Contribution

Answer 41

In order to calculate break-even firms must first understand the concept of contribution.

Contribution is the difference between sales revenue and variable costs of production.

Contribution per unit can be calculated with the following formula:
Contribution per unit = selling price per unit - variable cost per unit
Contribution per unit = SP – VC per unit

Contribution per unit shows how much each unit:

• Firstly contributes to paying fixed costs
• After fixed costs have been covered any additional funds contributes to a firms profits

Question 42

Break-even point

Answer 42

Calculating the breakeven point for a product requires the following information:
• Selling price of the product
• Fixed costs
• Variable cost per unit

The formula for calculating breakeven is given below:

Break even = Fixed Costs / Contribution per unit

Break even = Fixed Costs / (Selling Price - Variable Cost per unit)

Break even = FC / (SP - VC per unit)

Question 43

Margin of Safety

Answer 43

The margin of safety is the difference between the break-even point and level of activity designed to achieve the profit target (i.e. actual or expected output).
E.g. If breakeven level of output is 25,000 units and the business actually produces 40,000 units

Calculating profit or loss the easy way - using the contribution method:

Calculating profit or loss using contribution is the quickest and easiest method.

Break-even analysis also allows us to calculate the profit or loss a business will make at different levels of output. An entrepreneur will only go into business if profits are likely to be at a certain level.

Profit = (Quantity sold x contribution per unit) – fixed costs

Question 44

What if analysis

Answer 44

In business, costs and revenues are not fixed, and a break-even chart can be used to show the effect of an increase or drop in revenue and/or costs on the profitability of a business.
In order to do this a business would simply add a line on the break-even chart to indicate the new level of revenue and/or costs.

Question 45

Evaluation of Breakeven

Answer 45

Advantages of Breakeven:

• Quick and easy to calculate
• Easy to interpret and understand
• Can estimate future level of sales needed to meet given objectives in terms of profits.
• Can be used to forecast the effect of changes to price, fixed and variable costs on both output required to break even and profits.
• Can be used to support application for bank loans as it helps the banks to see future profitability and levels of output required to cover costs.

Disadvantages of Breakeven:
• Assumes that costs increase gradually and does not take into account factors such as firms benefiting from buying in bulk.

• Assumes a constant selling price - ignoring the use of special offers and discounts
• Cannot be used for firms selling multiple products with different prices and costs.
• Assumes all output will be sold this may not always be true.
• The effectiveness depends on the accuracy of the data - poor quality data can result in inaccurate conclusions being drawn.

Question 46

How is Breakeven useful to these stakeholders?

> Shareholders / Potential shareholders

> Customers

> Employees

> The Bank

Answer 46

Shareholders / Potential shareholders -

• Potential investors and existing shareholders will be interested to see how many units must be sold before profit is made

Customers -

• If it takes considerable time to break even (because the variable costs are high, or the selling price is low), a business may decide to increase the selling price and this can affect the price customers have to pay and/or customer demand.
• If a product takes a considerable time to break even and is therefore not viable, the business may withdraw the product from the market, this can affect existing loyal customers.
• A business may decide not to market a product that takes too long to break even, impacting consumer choice.

Employees -
• If a product is withdrawn from the market as it is not viable (high breakeven point), this could impact on employee motivation and/or lead to job losses.

The Bank -
• In order to give a loan to the business, the bank will require financial evidence of potential sales and will need to see the break even data of the business.

Question 47

Budgeting

Answer 47

A budget is a financial plan relating to the use of resources to achieve specific objectives or targets over a given period of time. In other words it is a financial plan of income and expenditure.

All budgets should be objective driven. This means that the expected revenues and expenditures of each department will be ultimately based on what the business is trying to achieve.

• Most budgets are based on historical forecasts.
• Large firms will have budgets for each department or functional area

Question 48

How budgets are prepared

Answer 48

Establish the aims and objectives of the business
!
V
Set the production, marketing and financial busgets, these are the main functional budgets
!
V
Each budget should then be further broken down.
e.g. within the production budget there would be a training budget, a health & safety budget etc

Procedures for monitoring the budgets should be set up.
This should include regular checking and communication between managers and budget holders

Any variance from expected budgets should be identified and analysed - why did it occur?

The experience and knowledge gained should be used when setting budgets in future

Question 49

Types of budgets

Answer 49

Production budget
o This is an expenditure only budget.
o The objectives of the business have established the output levels required, the production budget attempts to put these output levels into
practice.
o This will involves costs of raw materials / components, direct labour costs, amongst others.

Marketing budget
o Both revenues and costs are included
o Revenues are from predicted sales
o Costs are from operating the business’s marketing strategy

Financial budget
o Based upon the cash flow forecast
o Will income cover expenditure or will there be a need to examine methods of raising funds to finance other budgets?

Question 50

The purpose of a budget

Answer 50

 Control expenditure.
 Identify variance between actual and budgeted figures
 Provide a means of monitoring different departments
 Process can facilitate efficient allocation of resources

Question 51

Budgetary Control (Variance Analysis)

Answer 51

Variance analysis involves calculating the difference between actual figures and budgeted figures.
It is important to remember that any variance should be described as either favourable or adverse.
• Favourable variance (shown as ‘F’ in brackets) occurs when:
o the actual revenues are higher than expected
o Expenditure is less than expected.
o The figures are better than the figures that were budgeted for – they result in higher profit

• Adverse variance (shown as ‘A’ in brackets) occurs when:
o The actual revenue are lower than expected
o Expenditure is higher than expected
o The figures are worse than the figures that were budgeted for – they result in lower profit

Sales variance = actual figures – budgeted figures (A-B)

Expenditure variance = budgeted figures – actual figures (B-A)

Question 52

Zero budgeting

Answer 52

Zero budgeting is an alternative form of budgeting. It involves managers starting with a clean sheet – they have to justify all expenditure made. This does the following:
• Improves financial control
• Helps with allocation of resources
• Limits the tendency for budgets to increase annually with no real justification for the increase
• Reduces unnecessary costs
• Motivates managers to look at alternative options

Question 53

Evaluate the use of budgets to a business and its stakeholders

Answer 53

Advantages of Budgets :
• Budgets regulate the spending of money and highlight losses, waste and inefficiency. This allows firms to plan ahead and make considered decisions as to where they should allocate spending.

• They act as a review and allow time for corrective action to take place. Businesses can use variance analysis to monitor the performance of different departments/products.
• They allow delegation without loss of control – subordinates can be set their own targets to be met and should help employees to focus on costs. This should motivate employees.
• They help in the co-ordination of a business and improve communication between different sections of the business and can improve accountability within a business.

Disadvantages of Budgets:
• Some personnel can resent having to meet budget targets that they have had no part in constructing, this can lead to demotivation and missed targets.

• Some budgets can be rigid and inflexible; this means the firm may lose out on opportunities if employees are over focussed on sticking to/meeting budgets rather than growing the business.
• Rely on good quality information in order to be useful
• Many managers overstate budgetary needs in order to protect their departments, this results in poor allocation of resources.
• Not actual figures, it is difficult to estimate figures, especially sales figures for new products.

Question 54

Uses of Budget of stakeholders

Answer 54

Shareholders/ Investors -
• To see what level of sales the business is predicted to have. This will impact on the level of dividend received by shareholders.

• A potential investor may not invest in a business that has adverse variances on its sales revenue in the past

Employees -
• To see if the business is forecast to make enough sales and profit to ensure employees have job security.

• If sales are predicted to increase, employees may be interested to see if they need to work overtime and so receive higher rates of pay and/or bonuses.
• If employees receive part of the profits, they may look at the budget to see what level of profit-share they may receive.

The Bank -
• In order to grant a loan or mortgage, a bank will need to see evidence of forecast sales and expenditure.

Suppliers -
• If a business has an adverse sales or expenditure variance this may concern suppliers who have supplied raw materials on credit to the business. If the business does not generate enough profit they will be unable to pay their debt to their suppliers.

Question 55

Summary of budgets

Answer 55

Budgets are an important management tool. They help with financial control and in co-ordinating business activity. They can also assist in motivating staff.
However, a poorly-prepared budget is valueless: it wastes time, can demotivate staff and may restrict business activities so that management cannot react to changes in the market place

Question 56

Cash Flow Forecasting

Answer 56

Cash is the most liquid of all business assets. A business’s cash is the notes and coins it keeps on the premises and any money it has in the bank.

Cash is the lifeblood of the business, without it the business would cease to exist; it is required to pay employees and suppliers.
Cash Flow is the movement of cash into and out of a business over a period of time. It shows how much cash is or will be available in a business.

In the examination, you must remember that cash and profit are two different things!
• Profit will be made if a firm’s revenue is greater than its costs over a given period of time.
o To survive a business must make a profit in the long run; however, a business can survive without making profit over a short period of time.

• Cash Flow relates to movement of cash in and out of the business.
o Businesses need to insure that enough money is coming in to the business to allow payment –for stock, raw material and labour etc – to be made.
o A business cannot survive without cash!

Cash flow forecasts list all the likely receipts (cash inflows) and payments (cash outflows) over a future period of time. All the entries in the forecast are estimated because they have not occurred yet.

Question 57

Why do businesses forecast cash flows?

Answer 57

 To identify the timing of cash shortages and surpluses
 To monitor the movement of cash in and out of the business
 To enhance the planning process
 To support applications for funding

Question 58

Key terms and components of a Cash Flow Forecast

Answer 58

> Receipts / Cash Inflow /Sales Revenue / Turnover - Receipts relates to money received through either cash sales or credit sales. 
Credit sales (buy now, pay later) should be included in the month that payments are forecast to be received not when the initial sale occurred.

> Payments / Cash Outflow / Expenditure - Payments - this is the money leaving the business this relates to payments made in return for items such as rent, wages, raw materials and electricity etc

> Net cash flow - the difference between the total inflow and the total outflow. This figure could be negative if the total outflow has exceeded the total inflow.
Negative figures are indicated by placing brackets around the relevant figure. The formula for Net Cash Flow is:

Net Cash Flow = Total Receipts – Total Payments

> Opening balance - is simply an indication of the money contained in the firm’s bank account at the beginning of the month.
The closing balance from the previous month

> Closing balance - is simply an indication of the money contained in as firm’s bank account at the end of the month. It can be calculated by adding the net monthly cash flow to the opening balance for the corresponding month. i.e., how much money was there and the start of the month, and after all inflows and outflows have taken place, how much is left at the end of the month.

Opening balance + Net Cash Flow

(if Net Cash Flow is negative this becomes Opening balance - Net Cash Flow )

Question 59

Factors that can cause poor cash flow in a business

Answer 59

1. Sales not at expected level, this could be due to:

• Increased/decreased competition
• Economic growth/decline
• Changing spending patterns of consumers/ changing fashions
• Government influences, e.g. increased or decreased taxation

2. Increased costs:

• Raw materials cost increases
• Higher than expected level of inflation
• Interest rate increases
• Increased labour costs

3. Internal factors:

• Poor initial predictions of income and expenditure
• Late payment of debtors
• Poor budgeting and lack of control of spending

Question 60

Methods to improve cash flow

Answer 60

> Arrange a bank overdraft -
Explanation:
•Useful when the business has fewer sales or higher expenses
•It is quick and easy to arrange and can be short/long term
Evaluation:
•Not all business be eligible
•Can often carry high interest rates

> Increase selling price of products -
Explanation:
•The business will generate more cash from each individual sale

Evaluation:
•Businesses in competitive markets may not be able to increase selling price as consumers would switch to competitors.

> Spread payments equally over the year -
Explanation:
•Paying in installments means the business will not have irregular cash flows that could lead to a cash deficit.

Evaluation:
•This could lead to paying more overall as there may be interest to pay to suppliers as they are not receiving all of their cash up front.

> Delay purchases of expensive capital equipment -
Explanation:
•If the business has poor cash flow, it can put off buying expensive equipment until it has a surplus.

Evaluation:
•This depends on whether the capital purchases are essential.

> Reduce fixed costs -
Explanation:
•Some overhead costs could be reduced by, for example, finding a cheaper supplier for electricity or possibly renting cheaper premises.

Evaluation:
•This may reduce the quality of products offered and impact upon customer loyalty.

> Buy cheaper raw materials -
Explanation:
•Buying cheaper raw materials can save the business money in the short-term, however, it depends if the quality of raw materials remains the same.

Evaluation:
•This could damage the reputation of the business

> Pay suppliers on trade credit -
Explanation:
•Delay payment to suppliers by purchasing raw materials and other supplies on credit and paying after one month or more.

Evaluation:
•This may damage relationships with suppliers

> Reduce trade credit terms offered -
Explanation:
•This requires customers to pay in a shorter time frame, which won’t be popular!

Evaluation:
•This may damage relationships with customers

> Extra funding -
Explanation:
•This could be a new injection of capital from the owner, or perhaps a business loan. However, if cash flow is predicted to be poor, then loans become unlikely.

Evaluation:
•Outside investors could possibly be interested, but are unlikely to act quickly and will want a share of the business

Question 61

Benefits of using/preparing a cash flow forecast

Answer 61

• An accurate cash flow forecast will allow a business to get a clear idea of how it is performing (although it does not provide an accurate statement of profitability), and how it is likely to perform in the future.
• The forecast allows managers to be able to specify times when the business may need additional funding, such as when cash outflow exceeds inflow.
• In addition, inconsistencies in future performance can be identified and remedied.
• Also, when there is predicted to be a large positive cash flow, businesses can plan ahead on how to use this money – perhaps by investing or paying off debts.

Question 62

Limitations of using/preparing a cash flow forecast

Answer 62

• Drawing up cash flow forecasts takes management time that might be more productively used completing other tasks in the business.
• Cash flow forecasts need to be accurate to have value: this may be especially difficult to achieve if the business has little or no trading history to base the predicted cash flow on.
• The longer the timescale the less accurate the forecast is likely to be.
• Cash flow forecasts needs to be monitored to have on-going usefulness.

Question 63

Evaluation of impact of a cash flow forecast on stakeholders

Answer 63

Shareholders/ Investors -
•Effective cash flow management is absolutely crucial in order for the business to stay in business, poor cash flow management could lead to the business failing.

Employees -
•A cash flow forecast should reduce the likelihood of a business not having enough cash to pay its employees.

The Bank -
•Use of a cash flow forecast should help the business to manage its finances more effectively; therefore the bank should get paid back on time.
•The business may apply for an overdraft – an opportunity for the bank to profit

Suppliers -
•Cash flow forecasting should enable the business to pay suppliers on time, avoiding conflict and/or fines.
•The business may ask for extended trade credits terms to ease cash flow problems

Question 64

Income Statement

Answer 64

Income statements (previously known as Profit and Loss Accounts) are said to give a ‘historic view’ of the business’s trading income and expenditure over the previous 12 months. The account will show all income and expenditure received and incurred over the previous year.

Question 65

Trading account

Answer 65

A full profit and loss account has several sections, the first of which is called ‘The Trading Account’, The trading account shows what the sales of the business have been and the direct costs of making those sales – known as the cost of sales.

Tips: ‘Less’ means subtract, the left column is a subtotal column and the right is for final figures.

> Revenue
Trading income can be called different things: ‘sales’ or ‘revenue’ or ‘income’ or ‘turnover’, but they all mean the same thing.
The first line shows trading income for the year: i.e. the revenue gained from the goods the business has sold, or the services it has provided.

> Less Cost of sales
Cost of Sales (CoS) – these are the direct costs of purchasing the stock that is used in sales.
To calculate CoS, add opening stock (the stock the business has at the beginning of the year) to purchases the business has made during the year. Subtract closing stock (stock left over at the end of the year) as it has not yet been sold or used and can be sold in future.

CoS = opening stock + purchases – closing stock

> Gross Profit
Gross profit is calculated by taking the cost of sales away from sales.

Gross Profit = Revenue – Cost of Sales

£96,500 – £27,800 = £68,700

Gross profit is an indicator of how efficient the business is at making and selling its product.
However, the figure for gross profit on its own does not help us judge the level of efficiency: after all, a large business is likely to have a much higher gross profit figure than a small business, but the small business could be better run or have less stock damage.

Net profit is a much better measure of profitability.

Question 66

Profit and loss account

Answer 66

Once Gross profit has been calculated expenses must be deducted. Net profit is often referred to as ‘the bottom line’ in business. This is because the net profit figure tells us the actual profits of the business after all costs have been paid.

Expenses are the indirect costs that the business incurs, i.e. overheads.
These expenses are not direct costs of producing a specific product.
Examples of expenses include rent, interest payments and electricity.
The total expenses figure is placed in the second column, beneath the figure for gross profit.

Net profit = Gross profit – Total Expenses
£68,700 - £38,590 = £30,110
Net profit is an indicator of how efficient the business is overall, this is because all the business’s revenues and expenses are included in the calculation. Like the figure for gross profit, net profit on its own does not help us judge the level of efficiency.

Question 67

Presentation of Income Statements

Answer 67

The presentation of income statements for unlimited and limited business can vary greatly – there is no one correct way of presenting this financial information.
Sole trader accounts tend to be more straightforward and may not include an appropriation section as all the profit will go to the sole trader.
Private and public limited companies tend to produce more complicated income statements and can take a number of different layouts.

Question 68

Ratio analysis

Answer 68

.

Question 69

Profitability

Answer 69

Profitability is not the same as profit.
Profit is an absolute measure and is expressed in monetary terms (£).
Profitability is a relative measure; it shows profit as a % of sales revenue or capital invested into the business. Measuring profitability can give the business answers to questions like:
• Is the business making a profit?
• Is profit growing?
• How efficient is the business at turning revenues into profit?
• Is profit enough to finance reinvestment?
• Is profit sustainable (high quality)?
• How does profit compare with the rest of the industry?

Question 70

Gross Profit Margin

Answer 70

Gross Profit = Revenue – Cost of Sales

Gross profit is an indicator of how efficient the business is at making and selling its products. However, the figure for gross profit on its own does not help us judge the level of efficiency.

This is an accounting ratio called the gross profit margin (GPM). The better the performance the higher the gross profit margin percentage will be.

Gross Profit Margin = Gross Profit / Sales revenue x100
(£68,700 / £96,500) x 100 = 71.2%
It shows as a % how much out of each £1 of revenue is gross profit.

Question 71

Gross Profit Margin Interpretation

Answer 71

• The higher the gross profit the better however a business or stakeholder cannot just say if it is good (high) or bad (low) without considering the type of business involved.
• If it is rising year-on-year then the business is making more gross profit for every £1 of sales revenue.
• A fall in gross profit is most likely to be the result of some or all of the factors below:
o Fewer units sold
o Increasing costs of raw materials
o Price discounting or other reasons for a decrease in selling price
o Stock damage

• GPM will vary by both industry and the size of the business:
o A large supermarket chain will have a relatively low gross profit margin, this is because they rely on selling a large volume of units of products with a relatively low contribution per unit.
o A large supermarket chain may buy a can of beans from a manufacturer for 20p and sell it at 25p.
o Many supermarket chains have GPMs of around 18%.
o A corner shop may have a relatively high gross profit margin: it may buy a can of beans from the wholesaler at 25p and sell it at 40p.
o The supermarket can trade with a lower GPM because it can spread its other costs (expenses) over a large number of sales. On the other hand, the corner shop will have relatively high expenses in relation to sales and these have to be covered by a high GPM.
• Nonetheless, even with these influences on GPM, a judgment can still be made.
• Low GPM businesses include supermarkets, manufacturers of mass production goods and food manufacturers
• High GPM businesses will include service businesses with lower costs per unit and higher contribution per units such as restaurants and retailers of upmarket goods.
• Looking at the accounts of a fast-food outlet the GPM is 25% – this is likely to be poor, but if the accounts relate to a manufacturer of tinned vegetables, this level of GPM may be totally acceptable.
• An improving ratio is always positive and the higher the ratio, the better.

Question 72

Net Profit Margin

Answer 72

Net profit is an indicator of how profitable the business is overall: this is because all the business’s revenues and expenses in its calculation are included.
Like the figure for gross profit, net profit on its own does not help judge the level of efficiency – after all, a large business is likely to have a much higher net profit figure than a small business. However, the small one could manage its expenses more efficiently.

The accounting ratio used to judge the efficiency of the business, is called the net profit margin (NPM).

(£30,110 / £96,500) x 100 = 31.2%
It shows as a % how much out of each £1 of revenue is net profit.
The difference between gross profit margin and net profit margin lies in the overhead expenses. It is possible for the gross profit margin to be high but the net profit margin to be disappointingly low. This would be because the business is not efficiently controlling its expenses.

Question 73

Net Profit Margin Interpretation

Answer 73

• Commenting on NPM and judging whether it is good (high) or bad (low) is easier than when examining the GPM. The type of business involved must still be considered, but the NPM does not vary by quite as much as the GPM over different industries and sizes of business.
• The higher the NPM the better!
• A business with a high GPM often has proportionately higher expenses, whilst a business with a low GPM often has proportionately lower expenses.
• Knowing what to expect will help to make a critical comment on the NPM and, importantly, the difference between the NPM and the GPM.
• One important factor that will lower the NPM is if the business is relatively new. A newly established business, in its first years of trading, may have high expenses as it tries to establish itself. A good example of this would be high expenditure on advertising. As a result of these relatively high expenses, a new business could have a low NPM; but this low NPM may not necessarily indicate problems.
• If the difference between gross and net profit margins is low this suggests overheads are low
• It shows whether a firm is efficiently controlling their expenses.

NPM >18% = Good: indicating effective business management of costs and expenses
NPM of 10–17% = Satisfactory: Cost or expenses management could be improved.
NPM <10% = Poor: There are real opportunities for improving cost and expenses management

To reiterate, the type of business must be considered, Walmart, one of the biggest and most successful businesses in the world typically has a NPM of <10% (sometimes lower than 5%!)
 
• When commenting on accounts an allowance for the type and age of business should be considered. Walmart, the world’s largest retailer, has one of the lowest NPMs in the business, at below 3%! On the other hand, Microsoft has a NPM of around 48%.
o Why do you think this may be? Consider the type of products they sell.
• If the figures that have been calculated do seem low, businesses and stakeholders should look for the main causes of poor performance. Are costs of sales too high? Is too much stock perishing?
• When assessing the performance of the profitability ratios it is important to make comparisons with other businesses in the same industry as well as making comparisons over time.
• By comparing with similar size businesses in the same industry the profitability of the business can be compared ‘like with like’. The businesses would be expected to have similar features and therefore the comparison is more valid when judging the significance of their gross and net profit ratios.
• When evaluating the GPM and the NPM it is important to compare these over time. This can be by just comparing the business’s performance over, for example, a five-year period, or even better, comparing the business against similar businesses in the same industry over the five years.
• One year’s figures may be misleading and not a true reflection of the profitability of the business over a longer period of time. By analysing data over a longer period of time patterns can be identified and a more accurate evaluation of the profitability of the business may be carried out.