FINANCE

1. FINANCE “raising, controlling and monitoring funds”

2. What you should know from N5 • Sources of finance • How to interpret a Break Even Chart • Cash Budget • Simple Profit and Loss Statement

3. What you will need to know for Higher • The role of finance • Sources of finance • Cash flow and Budgeting • Final Accounts – Income Statement and Statement of Financial Position • Ratio Analysis

4. Why do you think firms need finance? • Start-up capital • Pay operating costs ie buying goods, production • Cover expenses - day-to-day running costs such as wages and salaries • Expansion/growth • Research • New product development • Marketing

5. The Role of Finance

6. Role of Finance

7. The Role of Finance • To control costs and expenses – these must be controlled to avoid financial problems • Forecasting future financial information – consider past financial records to identify trends and their possible impact on the future • Check performance – use financial information to compare one year against previous year to see if performance has improved • Generate appropriate financial information for managers and decision makers • Monitor cash flow – ensure there is adequate cash flow to cover all payments going out

8. Government Agencies HMRC (Her Majesty’s Revenue and Customs) “The Tax Man” As well as collecting tax, HMRC administer benefit payments, helps to protect national interests and carry out wide ranging activities that helps to keep Britain in the black. HMRC generates an annual revenue of £436 billion for the UK. Competition Commission prevents companies taking advantage of a monopoly position, lack of competition or behaving in an unreasonable way eg exploiting customers

9. Memory Test! How many sources of finance can you remember? List them!

10. How did you get on? Short Term • Bank overdraft • Retained profits • Government grant • Hire purchase • Leasing (H) • Trade Credit • Debt Factoring • Sale of Assets • Bank Loan (short term) Long Term • Share issue (H) • Mortgage • Debentures • Venture Capital/Business Angels (H) • Bank Loan (long term)

11. Exam Question – 5 marks. A plc is considering expansion • Justify sources of finance that could be used to expand a business. Plural = more than one source This is a long-term decision, so long-term sources are required NOT bank overdraft! Command word is JUSTIFY = give reasons

12. Additional shares could be issued to existing or new shareholders because large amounts of capital can be obtained this way (1 mark). The funds received in this way do not have to be repaid (unlike loans which required repayment plus interest) (1 mark). A bank loan could be requested and if successful then the funds would be available within a short period of time (1 mark). The business could consider leasing equipment rather than buying it outright which would help improve the cash flow situation (1 mark). This would also mean that the business would be able to keep equipment up-to-date as they will not have to pay large sums of money when equipment requires up-dating or replacing. (1 mark) Other considerations – debentures, venture capitalists, retained profits, government grants, mortgage

13. REFER TO YOUR HANDOUT Final Accounts Income Statement And Statement of Financial Position

14. Income Statement - Trading Account The Trading Account shows: TURNOVER minus COST OF SALES = GROSS PROFIT The profit from trading ie buying and selling goods

15. Income Statement - Profit and Loss Account It takes into account: • REVENUES • EXPENSES GROSS PROFIT + REVENUES – EXPENSES = PROFIT FOR THE YEAR

16. Statement of Financial Position A snapshot of a business at a particular point in time showing its financial worth. It contains information about its ASSETS, LIABILITIES and CAPITAL. CAPITAL = ASSETS - LIABILITIES

17. ASSETS Resources a business owns. They can be divided into: Non-Current (Fixed) Assets - productive resources kept for more than one year such as machinery, fixtures Current Assets - resources that constantly change and can be easily turned into cash such as inventory (stock) and trade receivables (debtors)

18. LIABILITIES Debts of a business. They can be divided into: Current Liabilities – short-term debt normally repaid within a year such as trade payables (creditors) and a bank overdraft Non-current (Long-term) Liabilities – debts paid over an extended time such as debentures and mortgages

19. EQUITY (CAPITAL) Shows the funds invested by the shareholders through the purchase of shares

20. RATIO ANALYSIS

21. The Analysis of Final Accounts is used to:- • Compare performance from year to year • Compare performance with competition • Compare performance with industry • Identify trends • Identify problem areas

22. Profitability Ratios Used to analyse the profit made from buying and selling. GROSS PROFIT PERCENTAGE Gross Profit X 100 = ? % Sales Revenue The higher the % the better. % - more GP per £ of sales % - less GP per £ of sales

23. Changes because of: • Alterations in selling price • Suppliers raise/lower stock prices • Decrease in sales (less marketing or more competition) • Loss of stock (theft or damage) Improve % by: • Raising selling price (more revenue) – or cut prices?? • Finding a cheaper supplier • Negotiate discounts • A marketing drive

24. PROFIT FOR THE YEAR (NET PROFIT) PERCENTAGE Profit for the Year X 100 = ? % Sales Revenue Shows the profit made once expenses have been paid – the higher the % the better. % - more Profit per £ of sales % - less Profit per £ of sales

25. Changes because of: • Alterations in gross profit • Expense costs have increased/decreased Improve % by: • Increasing GP • Find cheaper sources of expenses eg utility bills • Economy drive

26. Efficiency Ratio RETURN ON EQUITY (CAPITAL) EMPLOYED Profit (before tax) x 100 = ? % Equity (Capital) employed (start) Used to analyse how well a business is using its resources. Shows how well a business has used the equity (capital) invested. % - equity has been used wisely (higher return to investors) % - equityhas been wasted (lower return to investors)

27. Changes because of: • Increased/reduced gross/net profit • Increased/reduced equity (capital) invested Improve % by: • Raising gross profit • Raising profit

28. Trade Payables Period • This ratio measures the period of time it takes the business to pay the suppliers for goods purchased on credit. It can be measured in days, weeks or months. • Where this figure is high it could indicate a cash flow problem or difficulty paying short-term debts • The business should ensure debts are paid on time otherwise the supplier may revoke extended credit. • Average Trade Payables x 365 (to obtain answer expressed in days) Credit Purchases

29. Trade Receivables Period • This ratio measures the period of time it takes the business to receive money from customers who have purchased goods on credit. It can be measured in days, weeks or months. • Where this figure is high it could indicate a cash flow problem and require the business to chase outstanding accounts • The business should ensure that customers do not abuse the credit period extended to them. • Average Trade Receivables x 365 (to obtain answer expressed in days) Credit Sales

30. Liquidity Ratios Used to show how able the organisation is to pay its short-term debts. CURRENT RATIO Current Assets : 1 Current Liabilities Shows how able the business is at meeting short-term debts without borrowing. Ideal ratio is 2:1  2:1 – more able to pay off debts but funds not working!  2:1 – danger of struggling to pay debts

31. Changes because of: • Increased/reduced current assets • Increased/reduced current liabilities Improve if ratio is below 2:1 by: • reducing liabilities (eg trade payables (creditors) or any overdrafts) • increasing current assets (eg hold more money in the bank) Improve if ratio is above 2:1 by: • reducing amount held in bank account (investment opportunities) • reducing the closing stock figure (more efficient stock control system) • reducing debtors figure by offering cash discounts for prompt payment

32. ACID TEST RATIO Current Assets – Inventory (Stock) = ? : 1 (or ? to 1) Current Liabilities Shows how able the business is at meeting short-term debts without having to sell its inventory (stock), which is difficult to convert into cash quickly. Ideal answer is 1:1 (1 to 1)  1:1 – more able to pay off debts but funds not working!  1:1 – danger of struggling to pay debts

33. Changes because of: • Increased/reduced current assets (not inventory (stock)) • Increased/reduced current liabilities Improve if ratio is below 1:1 by: • reducing liabilities • increasing current assets (not inventory (stock)) Improve if ratio is above 1:1 by: • reduce current assets (not inventory (stock))

34. Limitations of Ratios • Figures are historic – out-of-date • Do not show recent changes (eg investments) • Comparisons must be like with like (similar size, type of organisation, calculation methods, etc) • Competitor comparison may be hampered by unpublished data • Little use on their own - external factors generally ignored (eg state of economy) • Do not indicate key changes in a business (eg new management) • No info about internal conditions (eg staff morale)

35. Lets get analysing! The following information relates to 3 businesses in the local area all supplying similar products. Study the information and compare each to the industry average. Company A Company B Company C Industry Average (last year) GP% 55.38% 55.06% 55.44% 35% Profit for Year% 15.10% 19.75% 30.74% 26% Current Ratio 2.1 : 1 1.4 : 1 0.85 : 1 1.68 : 1 Which Company would you give advice to? What advice would you give?

36. Now pick a question …. • Describe the problems that can occur when using only accounting information to analyse performance (4 marks) • Describe the limitations of using ratio analysis (3 marks) Some hints: Command word – DESCRIBE (check the structure of your answer) Now write out your own answer! Peer mark – use your notes for the solution (comment on performance)

37. CASH FLOW AND BUDGETING

38. WHY DO YOU THINK FIRMS FAIL? Decline in sales (dogs!) Inadequate profit Poor location High debt Liquidity problems (POOR CASH FLOW)

39. Cash is a crucial resource for any organisation, it is required on a day-to-day basis in order to operate. • Liquidity is the ability to access cash to meet everyday financial commitments. • Cashflow considers the movement of money in and out of the business.

40. Liquidity Problems - Common Causes! • Too much money tied up in inventory (stock) • Too much time given to trade receivables (debtors) to repay • Unforeseen expenditure • Insufficient funds generated from sales • Fluctuating turnover eg seasonal/changes in demand • Dividends set too high • Buying fixed assets – large capital outlay • Overborrowing

41. Resolving a Liquidity Problem • Stimulate sales – marketing activities • Introduce JIT approach to stock management • Sell off fixed assets • Offer discounts to debtors to encourage payment • Sell debts to a factoring company • Negotiate extended credit with suppliers

42. CASH BUDGETS This is a forecast of the money expected to be received (receipts) and the money expected to be paid out (payments) over a period of time. • Benefits of preparing a Cash Budget: • Shows whether the business will have a surplus or deficit of cash • Shows whether additional finance is required • Helps control expenses by highlighting periods when expenses could be high • Helps with decision making

43. set targets for the business to work towards • monitors and control costs • assists in decision-making • demonstrates possible implications of actions • attracts investors/lenders (part of a business plan) • allow comparisons (projected vs actual) • highlight periods when loans may be required or where excess cash which could be invested • gives responsibility to department managers to work within their allocated budget Uses of Cash Budgets:

44. SIMPLE LAYOUT

45. Cash Budget Layout

46. Highland Jewellery • Highland Jewellery is a thriving jewellery business in Inverness. Recently the Board of Directors decided to expand and have seen the perfect premises in Edinburgh. • The expansion plans will require a bank loan. The Bank Manager has no issues with their existing business but has asked for a Cash Flow Statement for the projected first 6-months of trading to assess the likely financial future of the Edinburgh venture. Use the information below to prepare the Cash Budget. Note: The shop is expected to open in January 2017: • Sales are expected to be £50,000 for the first 3 months, rising by 20% from April. • Purchase of materials will be 40% of sales and suppliers will allow one month’s credit. • To cover part of the expansion further shares will be issued in January introducing new capital of £50,000. This will be spent immediately on fixtures and equipment.

47. The bank loan will be received in 2 stages - £25,000 in Jan and a further £25,000 in March. • A £3,000 lease will be payable monthly. In January the solicitors’ fees are expected to be £4,000. • Fuel costs will be £3,000 per quarter – first payment in March. • £10,000 will be spent on advertising every month. • Wages and Salaries are expected to be £25,000 per month. • £1,750 is to be put aside each month for repairs and maintenance. • A delivery van will be purchased in April for £28,000. • Loan repayments and interest of £2,600 will start in January • £1,000 per month is estimated for Admin expenses. • Motor expenses will be £600 in the month of purchase of the van and £500 per month thereafter.

48. Analyse the cash flow situation and give suitable advice The following information relates to a business in the local area. July Aug Sept Oct Opening Balance 29500 34000 -14000 -2000 Add Cash In Sales 35000 25000 25000 30000 New Capital 20000 64500 59000 31000 28000 Less Cash Out Expenses 30500 23000 13000 27700 Accountancy Fees 13000 Materials 10000 10000 Purchase of Premises 40000 Purchase of Machinery 20000 30500 73000 33000 50750 Closing Balance 34000 -14000 -2000 -22750

49. PROBLEM SPOTTING AND SOLVING Problem Possible Solutions Sales falling while purchases constant Reduce purchases of raw materials Find a cheaper supplier Offer cash discounts to debtors Use credit terms fully Encourage sales by advertising

50. PROBLEM SPOTTING - AND SOLVING Problem Possible Solutions Deficit in cash balance at the end of month 2 Arrange a bank overdraft Arrange a bank loan Rent or lease machinery rather than buy