Unit 3 Flashcards
When are Budgets set?
Typically on an annual basis
Budgets can be developed for….
The entire business or around individual business functions (eg: production, marketing, finance and human resources)
A master budget is comprised of
Cash budget, projected profit and loss, projected balance sheets
Actual budget results are….
Compared to the budgeted values by using a variance analysis
Variance formula (Not in FB)
Variance = actual income - budgeted income (not in FB)
How is variance labelled?
Variance is labelled either favourable or unfavourable depending on the line item being compared
Budgets and variance analysis provide a business a way to
Monitor and control costs, measure departmental and corporate objectives, motivate and help managers identify problems, allocate resources, and prioritise activities
Positive and negative variance example
A positive variance doesn’t always mean it’s favourable: ie: positive for expenses would mean that the business experienced higher costs than bogeyed which is unfavourable
Disadvantage of budgets
Setting of budgets can be costly, time consuming, and ultimately not very accurate
What effects the outcome of a variance analysis or budget
The dynamic nature of business and changes in the external environment
One way to set budgets
Based on profit and cost centres
Profit centre
Part of the business that directly generates measurable revenue and costs
A cost centre does not
Generate revenue that can be directly measured
A cost centre
Generates measurable costs
Profit and cost centres can be created within a business based on….
Location (eg: China vs Europe), departments/functions (eg: human resource and marketing departments are often considered cost centres as they do not directly generate measurable revenue) Brands/products (eg: Toyota can separate sales and costs by car model)
Advantages of using profit and costs centres tend to be short-term and….
Increase accountability and responsibility, improve cost control, ability to monitor revenues and profit, increase in employee motivation in the short-term. Help identify strengths and weaknesses
Some disadvantages of using profit and cost centres are….
Unhealthy competition within w business, difficulty in allocating costs and revenues accurately and fairly, too much focus on own area of concern of quantitative aspects (eg: loss of the big picture)
Cash flow statements
Record the cash inflows and outflows of business
Cash flow forecasts
Provide projected cash inflows and outflows rather than historical ones
Investment appraisal used net cash flows….
To estimate the payback period or return on an investment - these projected cash flows come from a cash flow forecast
Net cash flow formula (Not in FB)
Net cash flow = cash inflows - cash outflows (Not in FB)
Closing balance formula (not in FB)
Closing balance = opening balance + net cash flow (not in FB)
Usually, cash flow forecasts are done
On a monthly basis
Inflows
These are usually made up of projected cash sales from the current month and cash coming in from credit sales sold in previous months
Outflows
The second section of the cash flow forecasts identifies the projected cash payments for each month
Net cash flow
A business wants their net cash flow to be positive
Opening balance
The opening balance is the closing balance of the previous month, the initial opening balance will be provided
Closing balance
Calculated by adding net cash flow for the month to the opening balance - if the closing balance gets close to 0, the business would need to consider strategies to deal with cash flow problems
Strategies to deal with cash flow problems
Reduce cash flow, improve cash flow, look for additional finance
Improving cash flow….
Is often difficult to do, s business could implement strategies to increase sales (eg: cut prices or provide incentives for customers to pay cash)
Reducing cash outflow
To do this, a business could downsize their workforce, cut back expansion plans, or delay payments to suppliers
Looking for additional finance
If w business in unable to reduce cash outflows or improve cash inflows to remain operational, they might have to consider squiring additional finance (eg: overdraft, swot factoring, or sale of assets)
Profitable firms….
Can have cash flow problems
Working capital
Is one measure of the short term health of a business
Working capital is calculated by….
Current assets - current liabilities (not in FB)
Cash
Begins and ends the working capital cycle
Creditors
Using cash or credit, the business purchases raw materials from suppliers, purchasing supplies on credit gives a business some time to complete the next steps in the cycle without running out of cash
Stock
Raw materials are then converted into stock through the production process
Deptors
Products are then sold to customers, this can be done in cash bit often sales are done in credit
Cash//Payment
The final step is collecting payment from the debtors, in most cases the amount of cash received exceeds the amour of cash paid, otherwise the value of the business has to be questioned, the cycle then continues with the purchase of additional raw materials
Elements of the working capital cycle
Creditors, stock, debtors, cash
Cash injections and cash drains
Help explain the full picture on the cash position of an organisation
What are cash injections and cash drains
Cash that enters or leaves the business outside of the working capital cycle
Cash injections typically fall into two categories….
Equity (share capital, retained profit) or debt (loan capital)
Cash drains
The most common cash drain is capital expenditures (eg: purchase/upgrade of a fixed asset) but they can also include tax and dividend payment
Management of the working capital cycle….
Is important for a business so they have enough cash on hand for daily operations
The shorter the working capital cycle….
The better as this means that the business is getting a quick return from producing and selling their product
A longer working capital cycle
Could lead to liquidity problems, so the business will not be generating cash quickly enough to find its operations
Profit formula
Profit = income - expenses
Profit, income, and expenses are….
Often recorded and calculated using an accounting method called accurate accounting
Accurate accounting
Records transactions according to date rather than the day when cash is actually paid or received - it attempts to take credit transactions into account to generate an accurate picture of a business’ financial performance/position
Cash flow
Money going in and out of the business for a given period of time - it is important to keep track of this as a firm can be profitable but go bankrupt due to problems with cash flow
If s company does not have enough cash….
In its bank account to make daily payments (eg: rent, utilities, salaries, etc) that is required to function, it will struggle to survive
Cash flow is used….
In quantitative tools such as investment appraisal and cash flow forecast
Profit is used in….
Quantitative fools such as break even analysis, final accounts, ratio analysis, and budgeting
Financial transactions are….
Recorded by businesses according to accounting principles (these principles vary by country and business)
A profit and loss account….
Captures financial performance of a business throughout a given period of time (eg: quarterly, semi-annually, or annually)
The title of the profit and loss account
Will describe the time period (eg: for the year ended December 31 2015)
The profit and loss accounts starts with….
Income received from its main operations, deductions are made to generate different measures of profit (eg; gross profit, net profit, retained profit)
The profit and loss account captures….
Any revenue expenditures which are more short term costs like repairs to assets
A balance sheet
Is a picture of the financial position of a business at a given point in time.
The title of a balance sheet….
Will include a certain date (eg: as of December 31 2015)
What does a balance sheet show?
It shows what the business owns (assets) what it owes (liabilities) and how it is funded (eg: equity)
Assets are acquired….
Through capital expenditures using one or w combination of sources of finance (eg: share capital, loan capital, and retained profit)
A financial statement title includes:
The company name, name of the financial statement, and time period
Currency and units of a financial statement
$ - US dollars
M - in millions
Therefore, sales revenue of 700 is $700,000,000 or 700 million
Sales revenue
Also known as income, sales, or revenue - is the total value of the company’s sales of goods and services to its customers (including cash and credit sales)
Cost of goods sold
Also known as COGS or cost of sales. This is the sum of costs incurred to generate the main operations or sales (eg: COGS from a manufacturing firm would include raw materials, labour, and factory overheads
Gross profit formula
Gross profit = sales revenue - cost of goods sold (this can also be reported as a percentage - gross profit margin)
Expenses
Also known as operating expenses, they represent the remaining expenses incurred in daily operations of the business that are not directly related to sales, that is, the costs of goods sold.
Each company has….
Different policies on what they include as cost of goods sold vs expenses
Generally speaking, expenses include items like….
Salaries and benefits paid to employees, accounting and legal fees, research and development costs, marketing expenses, utilities, business licenses
Net profit before interest and tax formula
NPBIT = gross profit - expenses (this can also be reported as a percentage as in net profit margin)
Interest (profit and loss account)
The amount of interest paid on debt (which can also be reported as a net figure in using any interest income from investments)
Net profit before tax formula
Net profit before tax = Net profit before interest and tax (NPBIT) - interest
Tax (profit and loss account)
The amount paid to the government can vary from country to country, but most businesses will have to pay some tax
Net profit after Interest and tax
Net profit after Interest and tax = net profit before tax - tax
Dividends
Dividends is the amount paid to shareholders. Along with retained profit, shows how the net profit after interest and tax is distributed. The amount of timing of the dividend can vary and is decided by the BOD
Retained profit (profit and loss account)
The amount of money left over that is carried into the line item ‘retained profit’ in the balance sheet
If retained profit is positive….
Then it will be put back into the business for future growth (eg; the purchase of assets)
If retained profit is negative
Then capital will be taken away from the firm
Fixed assets (balance sheet)
These are items that the company owns that are not consumed or sold during the normal operations of a business, intangible assets are also often included in this section of the balance sheet, these are non physical assets
Items that would be considered fixed assets:
Land, buildings, major equipment, and vehicles (these assets depreciate lose value over time)
Intangible assets examples
Copyrights, patents, trademarks, and goodwill
Current assets (balance sheet)
Are items owned by the business that get used up during the normal operations of a business or turned into cash within one year
Current assets include….
Cash (amount of money a company had on hand to pay bills) debtors, (amount of money owed to the company by its customers resulting from credit transactions) and stock (inventory/costs of raw materials, semi processed foods, finished goods)
Current liabilities (balance sheet)
Items the business owes to other businesses and financial institutions within 1 year, this included overdraft, creditors, short term loans.
Creditors (balance sheet)
The amount of money owed to suppliers resulting from purchases made on credit
Net current assets (working capital) [balance sheet]
Net current assets (ie: working capital) =current assets - current liabilities (the amount of liquid finds that s business has to run its daily operations)
Total assets current liabilities formula (balance sheet)
Total assets less current liabilities = fixed assets + current assets - current liabilities OR fixed assets + net current assets
Long term liabilities (debt) [balance sheet]
These are the amounts the business owes to other businesses and financial institutions to be repaid in more than 1 year from the date of the balance sheet
Net assets formula [balance sheet]
Net assets = total assets less current liabilities - long term liabilities
Net assets (balance sheet)
This is the top half of the balance sheet that must balance or equal the bottom half of the balance sheet (ie: equity)
Financed by share capital (balance sheet)
The value of the shares that have been sold. It is the amount of money paid by the original owner(s) is the company.
Difference between share capital and dept
Unlike dept, it is permanent capital and not to be repaid unless the business is terminated
Financed by retained profit (balance sheet)
The balance carried over from the profit and loss account - they are either re-invested in the business (eg: to purchase assets) or set aside as reserves for future objectives
Equity formula (balance sheet)
Equity = share capital + retained profit (funds continued by the owners and retained profit)
To Depreciate is….
To decrease in value
What is subject to depreciation?
Buildings, vehicles, machinery, homes, cars, equipment
Purpose of a balance sheet
To provide an accurate picture of what the company owns, while providing an accurate up to date value of their assets
Depreciation and balance sheets
The cost of an item is noted in the balance sheet, and after a certain amount of time, this has to be rerecorded. The amount of depreciation expense accumulated over the lifetime of the assed and is recorded on the BS to reflect the value of that asset accurately.
There are 2 main ways to calculate depreciation
The straight line method, the reducing / declining balance method
The straight line method
Divides the amount of depreciation equally over the expected life of the asset
Amount of depreciation formula (not in FB)
AOD = original cost - residual value / useful of life of asset
What are estimated?
The residual value and useful life of the asset - (these will usually be provided to you)
Annual depreciation formula (not in FB)
Original cost - estimated cost following lifetime / lifetime
What gets reported?
The amount of depreciation expense recorded each year in the profit and loss account - then carries over to balance sheet each year - decreasing the value until it reaches residual value
Reducing or declining balance method
Decreases the value of the asset according to a fixed percentage rather than fixed amount
Amount of depreciation formula (not in FB)
Amount of depreciation = box value of asset X depreciation rate (depreciation rate usually provided, book value needs to be calculated)
When calculating depreciation using the reduced balance method
Make sure to calculate the book value each year prior to the depreciation rate - the amount of depreciation should decrease each year with this method
The annual amount of depreciation in years one and two
Using the reduce method is larger than in the straight line method - this is reversed for years 3-5
Even though it varies, generally the reducing balance method
Allows businesses to deduct more depreciation expense early in the asset’s life vs the straight line method
What would a business what to deduct more depreciation early in the asset’s life?
Taxes! When a bios was records depreciation in their profit and loss account, they will report less profit as this means paying less taxes
Another reason for why a business what to deduct more depreciation early in the asset’s life?
Assets tend to be more productive generating more revenue in it’s early life - therefore it is argued ether the reducing balance method matches depreciation more accurately to revenue
Advantages of the straight line method:
Used the same amount of depreciation annually making calculations simple and predictable, useful when depreciation and other factors are difficult to predict
Advantages of the reducing balance method
Accelerates the rate or depreciation, potentially reducing the tax liabilities in the early asset’s life, provides a more accurate measure of depreciation for assets that become quickly obsolete (eg: technology)
Disadvantages of the straight line method
Does not consider rate at which the asset will depreciate, which can result in inaccurate valuations., increases the tax liability in the asset’s life
Disadvantages of the reducing balance method
Involves more complex calculations making it more difficult for financial forecasts, relies on applying an accurate of depreciation which is hard to estimate
Some countries….
Require specific depreciation methods to be used
Profit is….
An absolute measure of w business’s performance and is calculated by taking income - expenses
Profitability ratios
Express the profit of a business as a percentage of sales revenue
Expressing profitability ratios
Allows stakeholders to compare the performance of a business to its competitors and historical performance
Although most assets depreciate
Some fixed assets appreciate (increase) in value (eg: lands or building)
Accumulated depreciation
Is not a ‘line item’ in the profit and loss account
Two types of profitability ratios
Gross profit margin, net profit margin (formulas in FB!)
The higher the profit margin
The better it is for the business
A profit margin of 20% would mean:
For every $100 of sales, 20% (or $20) is kept by the company as profit
Comparing NPM with GPM
Is helpful for business decision makers to monitor and manage expenses (eg: overheads)
A single ratio
Does not provide a lot of information for decision makers, a through analysis involves comparing them to competitors or past performances
Working capital
An absolute measure of a firm’s ability to meet its short term financial obligations. Calculated by current assets - current liabilities, and is displayed on a balance sheet
Working capital formula (not in FB)
Current assets - current liabilities
Liquidity ratios
Express the ability of a business to meet its short term financial obligations as a ratio comparing current assets to current liabilities
The two liability ratios
Current ratio, acid test (quick) ratio (both in FB)
The optimal value for the current ratio
Varies depending on the industry - but generally ranges from 1.5 to 2
A current ratio their is close to 1 or below
Suggests that the business may have difficulty paying its short term depts
A current ratio that is too high
Signifies that a business is not investing its current assets wisely
The current ratio includes….
Stock, (ie: value of goods and materials a business has in inventory) in the calculation, however stock may not always easily convert to cash
An optimal value for the acid test….
1, but varies by industry
In the case of stock, an acid test is….
More accurate, and conservative measure of a business’s ability to meet its short term obligations because it does not rely on a business to sell its inventory
The 5 efficiency ratios
Return on capital employed (ROCE), stock turnover, debtor days ratio, creditor days ratio, gearing ratio
The 5 efficiency ratios attempt….
To measure how well a business is using its financial resources
Owners and managers will want to know….
How their money is being used so they can develop and implement effective business strategies
Return on capital employed (ROCE) (formula in FB)
Expressed profit in terms of the capital employed rather then in terms of sales revenue and it indicates how efficient w business is using its capital
GPM and NPM
Use values from profit and loss account only where we ROCE uses values from the profit and loss account and the balance sheet
ROCE is similar to GPM and NPM because….
A business seeks to maximise ratio and the higher the ROCE indicated that it is using its resources efficiently to return a profit
Stock turnover can be calculated
In two different ways
The first formula for stock turnover
Provides the number of times the stock turns over in a given period (usually a year). Business look to maximise this ratio
A business that has a stock turnover of 20 times
Indicates that a business is selling their stock rapidly turning their stock into sales revenue (selling their entire stock 20 times per year) a business with 5 times means that sales revenue is a lot slower
The second way of calculating stock turnover….
Provides the number of days it takes for a business to sell its stock / which businesses try to minimise. The lower the ratio, indicates the stock selling rapidly
With stock turnover….
It is important to compete historical numbers for your business, or businesses in other industries. Eg: perishable products should sell in a few days, luxury products will take more days
If a business has strong stock turnover
Use the quick ratio
In the current ratio
Stock is included in the current assets suggesting that the business is confident that it will turn the stock into cash
The acid test (quick ratio)
Excludes stock
If a business has a weak stock turnover ratio
Would use the quick ratio to measure their liquidity since they are unable to convert stock to cash
Gearing ratio
Shows the percentage of a business that is funded through long term debt. A business would went to keep this low
If the gearing ratio is above 50%
A business may be paying too much interest and be too susceptible to increases in interest rates - however this can depend on the business
If a business has a high ROCE
(Generating a large amount of sales compared to capital employed) then a business may be able to afford the interest risk and expense that comes with a higher gearing ratio
Businesses that have a low gearing ratio (eg: under 25%)
May indicate that a business is being too conservative in perusing growth opportunities
Debtors
A current asset in the balance sheet which represents the amount of money owed to a business from its customers - these should be monitored so payment is collected in reasonable time
Businesses seek to minimise their Debtor days ratio
So they can collect money to strengthen cash flow - however they are too aggressive with their collection policy so they do not provide sufficient time to their customers to pay, might end up losing customers
Creditors
Current liability in the balance sheet and is the amount of money a business owes to suppliers
A business wants to maximise creditors
To delay payment to their suppliers, having too great of a ratio may result in a business paying extra fees or interest or harm in the relationship between the supplier and the business
If debtor days ratio is higher than creditor days
This indicates cash flow problems as they are paying suppliers faster than collecting from customers. Business managers compare these ratios
Financial ratios are use by stakeholders….
To analyse the financial position of a business
The higher the profit margin
The better
The values used to calculate NPM and GPM
Come from the profit and loss account
The acid test is a more accurate
Measure of liquidity for businesses that have difficulty selling their inventory In a timely manner
Ratio analysis has limitations:
EG: ratio analysis does not consider qualitative factors
Three investment appraisal techniques
Payback period, average rate of return, net present value - each having advantages and disadvantages
To calculate the payback period or average rate of return, the following values need to be estimated:
Initial investment cost, projected returns or net cash flows the investment will earn, life expectancy of the investment (length of time it will be used)
Net cash flows
Are different to revenue and profit
Payback period
How long it takes to recover the initial cost for the investment
Average rate of return
Considers the entire life of the investment, and is expressed as a percentage of the initial capital cost
If the NPV is positive
The investment should be considered
Limitations of investment appraisal
….
We categorise costs in two ways depending on if the cost very directly with:
The level of output (products produced) or the output level of a specific product or a department
Second way of categorising costs:
Direct and indirect (or overheads) costs - this is helpful when preparing financial accounts (eg: profit and loss account)
The first way of categorising costs leads to three types:
Fixed, variable, and semi variable. It is helpful to categorise like this when performing a break even analysis
Fixed costs
A cost that does not change with an increase or decrease in the amount of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any business activity.
Variable costs
A periodic cost that varies in step with the output or sales revenue of a company
Semi variable costs
Production costs that:
- remain fixed up to a certain volume, after which it becomes variable
- the total of which responds less than proportionately to changes in volume of activity
- or which has both a fixed cost (monthly rental) and variable cost element
Variable cost examples:
Workers wages, packaging, raw materials
Fixed cost examples:
Rent, lease payments, salaries for managers
Direct cost examples
Packaging, raw materials, royalties
Indirect cost examples:
Taxes, rent, insurance, utilities
Indirect cost:
An cost not directly associated with a single activity, event, or other cost object
Direct cost:
A cost that can be directly associated and traced to specific activities or products
Revenue
Money coming into the business is considered revenue, it consists of cash and credit transactions and is recorded the date the item was sold
Revenue is recognised
When the income is earned and not when it is received
Revenue for a given period of time is generally:
Revenue = price X quantity sold
The different types of revenue:
Sales, sales revenue, sales turnover, operational income
Non operational income
If a business may receive income from activities and sources not considered their main operation - this is called non operational income (and not revenue)
Examples of non operational income
Interest received from financial institutions, one time exceptional gains from the sale of fixed assets
Businesses that have a variety of revenue streams
(customers, products, markets) are usually more successful. This is especially important for small businesses
Revenue streams
A form of revenue. It is considered one of the building blocks of a business model canvas, revealing the earning a business makes
Break even analysis
A quantitative tool to help the planning of business decision makers in all departments: production, marketing, finance, human resources. It can be used to estimate the quantity of produce required in order to break even or make a profit
To calculate variable costs
Variable cost per unit X quality produced
Total costs =
Fixed costs + variable costs
Total revenue =
Price x quantity sold
Profit or loss =
Total revenue - total cost
Margin of safety
Actual output or quantity sold or quantity produced- break even quantity
The break even point occurs when
Total revenue = total cost
Contribution
The amount of income generated from a product that contributes to the payment of fixed costs
Contribution =
Price X quantity- variable cost per unit X quantity
Contribution per unit is
The amount of income per unit generated from the product they contributes to the payment of fixed costs
Contribution per unit =
Price - variable cost per unit
Break even quantity =
Fixed costs / contribution per unit
Another way to calculate break even quantity =
Price X quantity = fixed costs + variable cost per unit X quantity
Profit =
Price X quantity - fixed costs + variable cost per unit X quantity (total revenue- total cost)
Limitations of investment appraisal
Accuracy of estimated capital costs and net cash flows, the dynamic nature of business, company’s position, minimum return rates, tinting of cash flows, time value of money, qualitative factors
Subsidiary advantages:
Reduces costs of production, increases supply, firms cover costs without increasing prices, revenue for producers remains the same, demand increases, more supplies of the product, decrease in customer price
Subsidiary disadvantages:
Expensive, encourages inefficiency, may result in product shortages, opportunity cost for governments, difficult to measure success
Venture capital advantages:
Allows for connections to be formed, helps with legal struggles, guidance provided (important for a young business), helps with decisions, available when needed, resources
Venture capital disadvantages:
Potential loss of control with investors, losing management control as they will make decisions, minority ownership (potentially), they get a percentage of the profit, investors can pull out
Debt factoring advantages;
Improve cash flow, shorten the cash cycle, protection against debts, quick method to receive money, it makes it easy to recover the debt
Debt factoring disadvantages;
Interest rates are higher than bank financing, risk of harming customer relations, can influence the way the business operates
Loan capital advantages:
Can be secured or unsecured, the money can be used however the company wants, easily accessible, can be arranged quickly for specific purpose, repayments are normally spread evenly, provider does not share profits, you maintain ownership
Loan capital disadvantages:
Mandatory repayment, higher interest rates making it hard to afford, short term only, if interest increases so does dept, failure to repay may lead to seizure of a firm’s assets
Personal funds advantages:
No need to owe others, limited amount of people managing its movement, cheap, control over business, more motivation, don’t have to share returns with investors
Personal funds disadvantages:
Possible loss of money, everyone will want some, no more leftover for emergencies, risky (bankruptcy), might be insufficient, rebuilding might be hard and lengthy
Retained profit advantages:
Cheap, flexible, high control, growth, fast, no debt
Retained profit disadvantages:
Danger of hoarding cash, might not be enough
Sale of assets advantages:
Make a profit, reduce debt, simple, growth, short term finance
Sale of assets disadvantages:
Tax consequences, reduced value, loss of assets
Share capital advantages:
Shareholders are usually willing to invest in business expansion, no worrying about repayment, sometimes shareholders can bring partnerships or guidance, permanent capital, no interest, not dependent on a single person
Share capital disadvantages:
The company doesn’t have complete control, there are more than one investor (reducing profit), time consuming
Overdraft advantages:
Provides flexibility to the firm to keep functioning, timely payments, available always, less paperwork than long term loans
Overdraft disadvantages:
Higher risk of seizing, higher interest rates especially when the limit is exceeded, temporary
Trade credit advantages:
One of the cheapest forms of working capital finance, potential discounts, allows time for growth
Trade credit disadvantages:
Late payment fees, if payments are not completed in time - a company might lose their supplier, cannot be used by all businesses, businesses must be in a good position in the market and denied for new businesses, sales are hard to predict
Grants advantages:
Huge monetary rewards with one proposal, provides credibility/exposure, potentially large amount of money which is not paid back, easier to raise money from other sources
Grants disadvantages:
Come with requirements from the government, competitiveness, lengthy process, not always certain as you must be chosen, regulations as to what the money is spent on, proposals take a while
Leasing advantages:
Spread out over time, tax deductible, low initial costs, the person leasing has access to a new tool or product to help their business, create relationships
Leasing disadvantages:
Reduces net income of products, considered as debt, the lessee is responsible with the asset’s maintenance, and can’t sell, transfer, or pledge it, the lessee must pay interest
