Processes Flashcards
planning and implementing - financial needs, developing budgets, record systems
Financial needs: identifying the financial actions that need to be taken to achieve goals - includes balance sheets, income + cash flow statements, budgets etc
Developing Budgets: a common planning tool → shows expected costs and revenues over a set period of time = enable constant monitoring + control of objectives
Record Systems: mechanisms employed by a (b) to ensure data is recorded + info provided is accurate, reliable, efficient, accessible - management bases decisions on info - w/o unable to accurately control its spending e.g. cash flow statement = important record
planning and implementing - financial risks, financial controls
Financial Risks: is risk of the (b) of being unable to cover its financial obligations (internal + external) → can be minimised (generating enough profit to cover costs) but not eliminated = need to identify factors that could harm financial position e.g. heavy reliance on machinery → breaks down, rising interest rates etc
Financial Controls: are the policies + procedures that ensure plans of a (b) will be achieved efficiently
Control exists to prevent problems + losses e.g. thefts, fraud, damage, loss of assets, errors in record systems
- help (b) achieve its goals by coming up with procedures e.g. clear authorisation + responsibility of each task, separation of duties, policies around credit, spending of staff (keep track of spending, reduce wastage etc)
Debt financing - ADV + DISADV
ADV
- Funds readily available/can be acquired on short notice –> capitalise on (b) opportunities
- interest, fees + charges are tax-deductible –> pay less tax = may lead to greater profit
- Flexible payment periods + types of debt are available
- ownership not diluted (compared to other sources)
DISADV
- Increased risk if debt comes from financial institutions e.g. interest or bank/govt charges may increase
- Regular payments must be made (despite (b) perf)
- Lenders = first claim on money if (b) goes bankrupt
- Can be expensive i.e. interest = increased costs
Equity financing - ADV + DISADV
ADV
- Less risk for (b) + owner (compared to other sources) –> won’t be affected by external factors
- less expensive than other sources (no cost - interest)
- Low gearing (not using external sources = low debt)
DISADV:
- Ownership = diluted (i.e. owners = less control)
- takes time + can miss (b) opportunities
- Lower returns + profits to owner - will take time = need to pay shareholders, other debt etc
- (b) uses owner’s equity or retained profits = unable to claim a tax deduction as no funds are borrowed –> as retained profits are re-invested into (b), investor = unable to invest in other opp, which may provide better returns.
Matching the Terms + Sources of Finance to (B) Purpose
- Short-term finance = should be used to purchase short-term (current) assets e.g. paying suppliers
- long-term finance should be used for long-term (non-current) assets e.g. buying a factory
- Use of short-term finance to fund long-term assets or vice versa causes financial problems
- length of debt has to equal the lifetime of the asset
Monitoring and Controlling - cash-flow statement
- Indicates movement of cash receipts + cash payments resulting from transactions over a period of time (cash inflow + outflow)
Purpose = how effective the financial funds are being used + if are sufficient funds to cover debts on time - Allow (b) to plan ahead + organise short term finance - a planning tool
Show whether a firm can: - Generate favourable cash flow (exceed outflows)
- Pay its financial commitments as they fall due
- Have sufficient funds for future expansion or change
Monitoring and Controlling - income statement
- Summary of the income earned + expenses incurred over a period of trading
- Purpose = show the profit and loss of a (b)
- Is a report in two halves: first = gross p, second = net p
- Sales can equal = sales, revenue, income
Equations: - COGS = opening stock + purchases - closing stock
- Gross profit = sales - COGS (only the profit on the goods you are selling)
- Net profit = gross profit - all expenses
Monitoring and Controlling - Balance sheet
- Represents a (b)’ assets + liabilities at a particular point in time, expressed in money
- Represents net worth of (b) - shows financial stability
- Assets = Liabilities + Owners’ Equity
CA: items of value that may change (less than 12 months) e.g. cash, inventory, accounts receiveable
NCA: items of value that normally won’t change (more than 12 months) e.g. equip, land, property, plants, vehicles
Intangibles: part of NCA e.g. goodwill,copyright,trademarks
CL: debts required to pay back in year (less than 12 monts) e.g. overdrafts, payables, wages
NCL: debts not required to pay back in year (more than 12 months) e.g. long-term loans, mortgage
OE: money contributed by owner to (b) e.g. capital, retained, net profits, drawings (are subtracted)
Analysis of balance sheet can indicate whether: - (b) has enough assets to cover debts, assets are being used to max profits, owners making good return
Financial Ratios - current ratio (liquidity or working capital ratio)
- Ability to meet short term financial obligations
- Current assets / current liabilities (ratio form)
- E.g. 5:1, the (b) is under utilising their capital + should invest some of their equity for growth, 0.5:1 = non-liquid and cannot pay short-term debt - unstable
e. g. The (b) has $5 of CA to cover $1 of CL. The (b)’s ratio is very high compared to the industry average of 1.5:1
Financial Ratios - gearing ratio (debt to equity or solvency ratio)
- Ability to meet long term financial obligations
- Total liabilities / total equity (ratio form)
- Ratio high (e.g. 5:1): highly geared = lots of debt, reliant on external sources of finance, risk of becoming insolvent
- Ratio low (e.g. 0.32:1): low geared = not reliant on debt finance, low risk of becoming insolvent
E.g. (b) has 0.32c of L for every $1 of OE. The ratio is lower than the industry average of 0.75:1, therefore this (b) is lowly geared/ solvent (sound + safe financial position)
extra: (b) would benefit from increasing L to invest in tech or innovative products/methods of production, to be closer to the industry average
ADV of low gear: would be low risk = have low debt repayments = lower risk of (b) failure
DIS of low gear: may be missing out on using more debt than equity = lead to greater potential for profit
ADV of high gear: potentially higher profit
DIS of high gear: greater risk of failure if (b) does not generate sufficient cash to meet its debt repayments as they fall due
Financial Ratios - gross profit ratio
- measure return (b) provides to the owner (profitability)
- Gross profit / sales x 100 (percentage form)
- This is the % of each $ that is gross profit
- Does not include expenses: aims to increase from previous year
E.g if the gross profit ratio is 20% this means for every $1 of sales the (b) makes 20c of profit –> depends on industry average but therefore is/ is not profitable
Financial Ratios - net profit ratio
- Measures profitability
- Net profit / sales x 100 (percentage form)
- Net Profit= Gross profit - expenses
- Below 10% gen means struggling w/ costs + expenses
- E.g. 10% means for every $1 of sales the owner makes 10 cents of net profit –> depends on industry average but therefore is/ is not profitable
Financial Ratios - return on equity ratio
- Shows how much owner’s investment makes on (b) earnings
- Net profit / total equity x 100 (percentage form)
- Must be compared to past performance/ industry standards
- Anything under 15% requires (b)’ss to reassess their financial strategies
Financial Ratios - efficiency (expense ratio)
- Gives a manager a clear picture of level of expenses compared to sales
- Total expenses / sales x 100 (percentage form)
- e.g. 80% not efficient
- The lower the % the better
- For every $1 the (b) makes in sales the (b) is spending 80 cents on expenses –> compare to industry average then judge efficiency e.g. therefore inefficient
- EXAMINE: inefficient compared to competitors, resulting in reduced cash flow due to an inability to control CA = reducing its liquidity
Financial - efficiency (accounts receiveable turnover ratio)
- Measured in no. of days
- How efficient (b) is in collecting accounts receivable
- Sales / accounts receivable = (ans) –> 365 / (ans) = days
- Measures effectiveness of the (b)’s credit policy
- Can be compared to another (b) or industry standard
- EXAMINE: if inefficient –> may hinder cash flow and prevent growth
- e.g. the (b) takes 27 days to collect its AR which is sig higher than the industry average of 18 days - therefore inefficient with its time in collecting AR
Comparative Ratio Analysis - over different time periods, with similar (b)’s, against standards
How used to assess financial position:
Over different time periods: could be comparing financial data within different years or financial periods
- to analyse liquidity, gearing, profitability + efficiency
- to understand how these have changed + put strategies in place to address any issues
Against similar (b)’s: could see the financial position of the competition to understand if their expenses are too high compared to competitors.
- If the case, then (b) could change their supplier to a cheaper one
- Also, if competitors consistently made sales, even during slow periods, the (b) can analyse this to understand weaknesses, hence make adjustments
Against standards: can benchmark against common standards –> identify weaknesses + put strategies
- info can be used to compare the performance of (b) against the anticipated performance
Limitations of financial reports - normalised earnings
- Earnings that have been adjusted to take into account changes in the economic cycle or to remove one off of unusual items that will affect profitability
- Gives more accurate depiction of the true earnings of a company → makes it easier to compare profitability figures from one year to the next
E.g. the removal of a land sale → would achieve a large capital gain
Limitations of financial reports - capitalising expenses
- An accounting method where a (b) records an expense as an asset on the balance sheet rather than as an expense on the income statement
- Does not accurately represent the true financial condition of the (b) as it understates the expenses + overstates the profits/assets of the (b) = inaccurate representation
E.g. listing R&D as an asset
Limitations of financial reports - valuing assets
- Process of estimating the value of assets when recording them on a balance sheet
- Difficult to estimate, especially for NCA
- ADV: cost can be verified, DISADV: value may distort the (b)’s balance sheet
- can create grey areas in which a (b) may overquote or underquote their value which limits the usefulness of the financial reports
- Some assets are difficult to value (intangibles)
Limitations of financial reports - timing issues
- Under the matching principle, expenses incurred by a (b) must be recorded in the income statement for the accounting period in which the revenue is earned
- E.g. a real estate agent who sold a property in June should record the expense in June even though they are not paid their commission until July
- Gives more accurate representation of financial position
- Some (b)’s might manipulate when revenue or costs are declared to make reports look more attractive
Limitations of financial reports - debt repayments
- gearing ratio = often used to determine whether (b)’s are at risk of meeting their long-term financial commitments
- (b) that is highly geared may be alarming for some stakeholders as there is increase risk
- Can be limited as reports do not have capacity to disclose specific info about debt repayments e.g. how long has had/been recovering from debt, when due etc
- can be used to distort the reality of the (b)’s status -undertaken to provide a more favourable overview of the (b) at that point in time = limits interpretation of financial position
Limitations of financial reports - notes to the financial statements
- Report the details and add info that are left out of the main reporting documents
- Contain info that may be useful to stakeholders to help make sense of these statements + explain them
- E.g. info about the accounting methodologies used for recording/reporting transactions that can affect the bottom-line return expected from an investment
- May also contain further details about how figures in FS were calculated + procedures used to develop them
Ethical issues related to financial reports
An ethical issue related to the prep of FR:
- (b)’s may overestimate their revenue + understate their expenditure to give a false impression of their profitability
- This false impression gives an inaccurate picture + may encourage investors to invest in a (b) which appears to be in a stronger financial position than it actually is
- could paint an unrealistic forecast for future
- may purposefully underquote income to pay less tax
To ensure ethical:
- Can audit accounts: independent check of the accuracy of financial records = designed to establish truth + fairness of financial reports
- need to ensure adequate record keeping + practices
Strategies to improve efficiency ratios
Expense:
- utilise discounts for early payment (cash-flow strategy)
- use of cost controls (profitability strategies)
- reduce debt –> leasing (gen strategy in WC strategies)
Accounts receiveable:
- offer discounts for early payment
- control of CA: receiveables = efficient/effective invoicing, credit check on debtor, set credit limit
- use debt collection agencies or factoring = however, are a cost to (b)
- offer a shorter interest-free period
Strategies to improve current ratio
If ratio = low (0.5:1)
Control of CA: cash, inventory, AR
Control of CL: payables, loans, overdrafts
strategies: sale + sale and lease back
If ration = high (5:1)
= under utilising capital + should invest some of their equity for growth
Strategies to improve profitability ratio
use cost controls to decrease costs - fixed + variable - cost centres - expense minimisation use of revenue controls to increase sales - marketing objectives
Strategies to improve gearing ratio
Reduce debt = all give money to pay debt
- decrease inventory levels
- sale and lease back –> gives money to pay long-term debt
- improve accounts receiveable –> gives money to pay debt
