Basic accounting and financial management

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Basic Accounting and Financial Management

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entrepreneur subject

Transcript of Basic accounting and financial management

Page 1: Basic accounting and financial management

Basic Accounting and Financial Management

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Definition of accounting• Process of identifying, classifying, recording and

summarizing of business transactions in monetary terms• Interpreting and communicating the results to the interested

parties to enable them to make decisions.

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Difference between accounting and bookkeeping

a process of recording every business transaction in books of account.

Bookkeeping

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Accounting

Recording

Record all business transactions in books of account, e.g. journals and ledgers

Classifying Classify all source documents, i.e. invoice, vouchers and credit notes in an orderly

manner

IdentifyingIdentify the economic events to ensure only transactions that relate to a business are

taken into account

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Communicating

Communicate the accounting information to the various users in assisting them to make decisions

Interpreting Interpret the accounting data to provide meaningful information to interested users

SummarizingPeriodically summarize the accounting record in the final accounts, such as income

statement or trading, profit and loss account and balance sheet

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Summarizing Communicating

Interpreting

Relationship between accounting and bookkeeping

Identifying Classifying Recording

Accounting system

Bookkeeping

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Management accounting and financial accounting

Managers and employees

Shareholders, potential investors, creditors and government

Internal Users

External Users

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Management accounting(internal accounting)

• Concerned with providing internal users the company’s financial information to assist them in making effective and efficient decisions.

• Relate to the process of identifying, presenting and interpreting information gathered specifically from cost accounting to formulate strategies, plan, control and make decisions to meet company objectives.

• Focus on the provision of information to external parties (outside the organization)

Financial accounting (external users)

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Differences between management accounting and financial accounting

Characteristic Financial accounting Management accounting

User Report is utilized by external users such as shareholders

Report is normally used by internal users, such as employees and managers

Legal Requirement Preparation of financial reporting (annual report) is a statutory requirement for public listed companies

Preparation of management accounting report is optional for organization. Normally produced if the benefit derived is more than the cost of producing the report

Scope The report provides information about the whole of the organization

The report focuses on one part or several parts of the organization

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General accepted accounting principle (GAAP) and financial reporting standard (FRS)

Financial reporting must follow GAAP and FRS and conform to legal requirement

Management accounting reporting is not subject to the legal requirement, and FRS and GAAP principles

Time frame The report contains past information

The report delivers information which is expected to occur in the future such as forecasted sales demand and costs for the coming year.

Frequency The report will be produced on the basis of semi-annual or annual basis.

The report will be produced more frequently such as daily, weekly or monthly depending on the nature of the organization.

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Similarities between management accounting and financial accounting

Characteristic Description

Use of basic accounting process

Both gather information by applying basic accounting process, which includes identifying, classifying, selecting, measuring and accumulating data and business events

Objective Both aim to deliver relevant information to the interested users of the organization in assisting them to make decisions.

Controlling and performance evaluation purposes

Both processes are used for the purpose of controlling and performance evaluation. Management accounting reports are used by the manager to control and evaluate the current operation of the organization.

Financial accounting reports are important for external users such as shareholders, to evaluate whether the existing management is able to run the business efficiently in order to maximize shareholders’ wealth.

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Basic accounting concepts Basic Accounting

Concepts

Business entity

Going concern

Money measurement

Periodicity

Historical cost

Consistency

Accrual or matching

Realization

Dual aspect

Materiality

Prudence/ conservatism

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Accounting equation

•Assets = Capital (Resources supplied by the entrepreneur)•Assets = Capital + Liabilities

( Resources supplied by outsiders or external parties )

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Financial position in business :

• Assets = Owner’s equity + Liabilities• Owner’s equity = Assets – Liabilities• Liabilities = Assets – Owner’s Equity

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Elements Of Accounting• Assets - Economic resources owned by the business.• Divided by two main groups:- Fixed assets- Current assets

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Liabilities• Amounts owed by the business to external parties.• Two types of liabilities :- Long-term liabilities- Current liabilities

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Owner’s Equity• Residual amount after deducting all business assets with all

business liabilities-Capital -Drawings

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Revenues• Income earned by a business which results in an inflow of

assets such as money or debtors

Commision earned interest received rent receivedDiscount received

REVENUES

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Expenses• Cost incurred to operate a business

Salaries and wagesWater and electricityRates and rentStationeryGeneral expenses

Interest on loanCarriage outwardsInsuranceSundry expenses

EXPENSES

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Budget• Important tools that can be used to create comparisons,

analyses and help manage your organization• Budgets are changeable• If your organization’s actual revenues and expenditures are

widely different from your budget, you need to determine the reason for the differences

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• Budgets estimate the profits, financial performance, and cash flow of a business for a particular period of time

• Budgets help evaluate operational efficiency, monitor financial health of your business, assess managerial decision, plan business financial future, and create business that meets your financial goals.

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Budget estimate• Sales• Marketing• Production• Inventory• Payroll• Operating expenses• Fixed asset purchases• Cash needed and potential sources

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Financial statement• Three-year projected income statements• Three-year projected balance sheets• Three year projected cash flow reports

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Four budgets• A private budget will show how much money you need to pay

your personal outgoings.• The startup budget will show how much money you need to

open/start/establish your business.• The operating budget shows your expected business income

and outgoings.• A cash budget shows, month by month, whether you will have

money in account/bank to pay your expected costs.

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Financial Statement•Provide information regarding the financial position, performance and cash flow of a business to entrepreneur• Businesses record their performance in standard formats•Derived from bookkeeping information

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Complete set of financial statement

• Income statements (trading, profit and loss account)• Balance sheet (statement of financial position, or a statement

of financial condition)• Cash flow statement

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Income statement• Income Statement communicates the inflow of revenue , and

the outflow of expenses , over a given period of time

• Revenue is the inflow of assets (i.e. cash account receivable) to a company in return for services performed, or goods sold.

• Expenses are the outflow or consumption of assets (i.e. cash, inventory, supplies), or obligations incurred (i.e. accounts payable, taxes payable) while generating revenue.

• The difference between these two is the Net Income .

• An Income Statement therefore shows the operating profit (or loss)

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Income statements (Profit and loss statement)• Shows changes in assets throughout the year• Reflects if an organization is operating with a surplus or deficit• Highlights areas of concern• Is typically required for loans• Performance over a given period

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Income statement

Income statement

Trading accountNet sales – Cost of goods sold = Gross

profit

Profit and loss account

Gross profit + Revenue – Expenses

= Net Profit

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Balance sheet• Shows the overall value of your organization• Shows total assets, subtracts total liabilities, and reports net

assets• Generally viewed at year end• Banks or accountants may ask for this document

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Sections of balance sheet• Assets – resources of the firm that are expected to increase or

cause future cash flows (everything the firm owns)• Liabilities – Obligations of the firm to outsiders or claims

against its assets by outsiders (debts of the firm)• Owners’ equity – the residual interesrt in, or remaining claims

against, the firm’s assets after deducting liabilities (rights of the owners)

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Balance sheet

Capital Employed = Owners’ Equity + Long Term Liabilities

Working Capital= Current Assets – Current Liabilities

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Balance sheet transactions• Affected by every transaction that an entity encounters• Each transaction has counterbalancing entries that keep total

assets equal to total liabilities and owners equity. i.e: the balance sheet equation must always be balanced

• Balance sheet must always balance• It should be prepared after every transaction• Balance sheets are usually prepared monthly or on some

other periodic schedule

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Project Implementation Cost and Sources of funds

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Project implementation Cost• Implementation simply means carrying out the activities

described in your work plan.

• Project implementation (or project execution) is the phase where visions and plans become reality.

• This is the logical conclusion, after evaluating, deciding, visioning, planning, applying for funds and finding the financial resources of a project

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Objectives of the Implementation Phase

• The objectives of the implementation phase can be summarized as follow:

• Putting the action plan into operation • Achieving tangible change and improvements • Ensuring that new infrastructure, new institutions and new

resources are sustainable in every aspect • Ensuring that any unforeseen conflicts that might arise during

this stage are resolved • Ensuring transparency with regard to finances • Ensuring that potential benefits are not captured by elites at

the expenses of poorer social groups

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Advantages and disadvantages of project implementation

Advantages Disadvantages

Implementation gives the opportunity to see the plans become a reality

Evidence of corrupt practices in procurement will undermine the entire process and waste precious resources

Execution of projects allows end-users to have access to better services and living environment

Poor financial planning can lead to budget constraints in the midst of implementation

Success stories and experiences can be shared with specialists from other cities and towns, encouraging others to adopt similar approaches, which in turn may improve water resources management in the local area

The decision on when a project is complete often causes friction between implementers and the community. Completion for the implementer is quite straightforward. It is defined by contracts, drawings, and statutes. Communities have a more practical approach to completion. Once the project produces the benefits for which they agreed to undertake it they see no reason to spend further time and money on it

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Example of project implementation cost

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Sources of fundsA company might raise new funds from the following sources:

· The capital markets:i) new share issues, for example, by companies acquiring a stock market listing for the first timeii) rights issues

· Loan stock· Retained earnings· Bank borrowing· Government sources· Business expansion scheme funds· Venture capital

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New shares issues• A company seeking to obtain additional equity funds may be:

a) an unquoted company wishing to obtain a Stock Exchange quotationb) an unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation

c) a company which is already listed on the Stock Exchange wishing to issue additional new shares.

The methods by which an unquoted company can obtain a quotation on the stock market are:

a) an offer for saleb) a prospectus issuec) a placingd) an introduction.

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Right Issues

• A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.

• For example, a rights issue on a one-for-four basis at 280c per share would mean that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold, at a price of 280c per new share.

• A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.

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Loan stock• Loan stock is long-term debt capital raised by a company for which interest is paid,

usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.

• Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax.

• Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital

• Debentures with a floating rate of interest• These are debentures for which the coupon rate of interest can be changed by the

issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile.

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• Security

• Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge.

• a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and buildings. The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.

• b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular asset.

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Retained earnings• For any company, the amount of earnings retained within the

business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

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• Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.

• A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

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Bank Lending• Borrowings from banks are an important source of finance to

companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.

• Short term lending may be in the form of:

• a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day;

• b) a short-term loan, for up to three years.

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• Medium-term loans are loans for a period of from three to ten years.

• The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower.

• A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.

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• Lending to smaller companies will be at a margin above the bank's base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS.

- Purpose- Amount- Repayment- Term- Security

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P The purpose of the loan A loan request will be refused if the purpose of the loan is not acceptable to the bank.

A The amount of the loan. The customer must state exactly how much he wants to borrow. The banker must verify, as far as he is able to do so, that the amount required to make the proposed investment has been estimated correctly.

R How will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments?

T What would be the duration of the loan? Traditionally, banks have offered short-term loans and overdrafts, although medium-term loans are now quite common.

S Does the loan require security? If so, is the proposed security adequate?

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Leasing• A lease is an agreement between two parties, the "lessor" and

the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time.

• Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases".

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Operating leases• Operating leases are rental agreements between the lessor

and the lessee whereby:a) the lessor supplies the equipment to the lesseebb) ) the lessor is responsible for servicing and maintaining the

leased equipmentc) the period of the lease is fairly short, less than the economic life of the asset, so that at the end of the lease agreement, the lessor can either;

i) lease the equipment to someone else, and obtain a good rent for it, orii) sell the equipment secondhand.

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Finance leases• Finance leases are lease agreements between the user of the

leased asset (the lessee) and a provider of finance (the lessor) for most, or all, of the asset's expected useful life.

• Suppose that a company decides to obtain a company car and finance the acquisition by means of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the company. The company will take possession of the car from the car dealer, and make regular payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of the lease.

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• Other important characteristics of a finance lease:

• a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not involved in this at all.

• b) The lease has a primary period, which covers all or most of the economic life of the asset. At the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset would be worn out. The lessor must, therefore, ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment.

• c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the lessor.

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• Operating leases have further advantages:

• The leased equipment does not need to be shown in the lessee's published balance sheet, and so the lessee's balance sheet shows no increase in its gearing ratio.· The equipment is leased for a shorter period than its expected useful life. In the case of high-technology equipment, if the equipment becomes out-of-date before the end of its expected life, the lessee does not have to keep on using it, and it is the lessor who must bear the risk of having to sell obsolete equipment secondhand.

• The lessee will be able to deduct the lease payments in computing his taxable profits.

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Government assistance• The government provides finance to companies in cash grants

and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country.

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Venture capital• Venture capital is money put into an enterprise which may all be

lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term 'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme.

• The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk.

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• When a company's directors look for help from a venture capital institution, they must recognise that:

• the institution will want an equity stake in the company• it will need convincing that the company can be successful• it may want to have a representative appointed to the

company's board, to look after its interests.

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• The directors of the company must then contact venture capital organizations, to try and find one or more which would be willing to offer finance. A venture capital organization will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management:

a) a business planb) details of how much finance is needed and how it will be usedc) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecastd) details of the management team, with evidence of a wide range of management skillse) details of major shareholdersf) details of the company's current banking arrangements and any other sources of financeg) any sales literature or publicity material that the company has issued.

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Cash Flow statement• Provides information about all cash inflows and outflows from

operations and investments• Shows changes in cash throughout a given time period

(quarter or year)• It is important to know how much cash your organization has

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Pro-forma statements• After an entrepreneur estimates stat-up costs and comes up

with plan for the use of funds• Projections are reflected in pro-forma financial statement that

project (usually for three years) the financial condition of the new venture based on information available at the time made

• Pro-forma balance show financial structure of the business (its assets and liabilities)

• Pro-forma income statement offer estimates of profit and loss for the new business

• Pro-forma cash flow statement show the inflows and outflow of cash for the new venture

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• The final step in the budget process is the preparation of pro-forma statement

• Projections of a firm’s financial position during a future period (pro-forma income statement) or on a future date (pro-forma balance sheet)

• In preparation of pro-forma statement, the pro-forma income statement is followed by the pro-forma balance sheet

• Process for prepare pro-forma balance sheet is more complex

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Ratio analysis• Analysis of the firm’s ratios is generally the key step in a

financial analysis• Ratios are designed to show relationships among financial

statement accounts (comparison)• Different ratios are important to owners, managers, and

creditors for different reasons• Ratios provides the most effective tools for monitoring a

venture’s performance over time• It should be kept in mind that effective ratio analysis must be

done in comparison with firms within the same industry in order to gain the broadest possible insights

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• Balance Sheet Ratio Analysis• Important Balance Sheet Ratios measure liquidity and

solvency (a business's ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors' funding). They include the following ratios:

• Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.

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• Current Ratios

The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:

• Current Ratio = Total Current Assets / Total Current Liabilities• Quick Ratios

The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is figured as shown below:

• Quick Ratio = Cash + Government Securities + Receivables / Total Current Liabilities

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• Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner's equity):

• Debt/Worth Ratio = Total Liabilities / Net Worth• Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your

business, making it correspondingly harder to obtain credit.• Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:• Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company.

• Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows:

• Gross Margin Ratio = Gross Profit / Net Sales• Reminder: Gross Profit = Net Sales - Cost of Goods Sold

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• Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company's "return on sales" with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:

• Net Profit Margin Ratio = Net Profit Before Tax / Net Sales• Management Ratios

Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information.

• Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:

• Inventory Turnover Ratio = Net Sales / Average Inventory at Cost

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• Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. Getting the Accounts Receivable Turnover Ratio is a two step process and is is calculated as follows:

• Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)• Accounts Receivable Turnover (in days) = Accounts Receivable / Daily

Credit Sales• Return on Assets Ratio

This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows:

• Return on Assets = Net Profit Before Tax / Total Assets

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• Return on Investment (ROI) Ratio

The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows:

• Return on Investment = Net Profit before Tax / Net Worth• These Liquidity, Leverage, Profitability, and Management Ratios allow the

business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business's relative strengths and weaknesses.

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