BusinessManagement

FINANCELEARNING INTENTIONS

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We are learning about …

1. The Circular Flow of Income Flow of goods and services and factors of production between firms and

households. Leakages (Withdrawals) Injections

2. Advice and Support Accountants Solicitors Banks Business Consultants Government Agencies

3. Sources of Finance Bank loan Loan from friends or family Retained profits Mortgage Share issue Government grants Hire purchase Bank overdraft

4. Cash Budgets Purpose of a Cash Budget Cash Flow Problems Resolving Cash Flow Problems

5. Break Even Charts and Graphs Definition of terms Preparing Break Even Charts Interpreting Break Even Charts

6. Final Accounts Income Statements Statement of Financial Position

7. Role of Technology in Finance Accounting Packages Spreadsheets EPOS EFTPOS

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Contents

Circular Flow of Income.........................................................................................................................5

Advice and Support...............................................................................................................................7

Sources of Finance.................................................................................................................................8

Cash Budgeting....................................................................................................................................10

Cash Flow Problems............................................................................................................................12

Resolving Cash Flow Problems............................................................................................................12

Break-even..........................................................................................................................................13

Break-even Charts...............................................................................................................................14

Interpreting Break-even Charts...........................................................................................................15

Producing a Break-even Chart.............................................................................................................16

Final Accounts.....................................................................................................................................17

Income Statements.............................................................................................................................19

Statement of Financial Position...........................................................................................................20

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Circular Flow of Income

The circular flow of income shows connections between different sectors of our economic system. It revolves around flows of goods and services and factors of production between firms and households.

Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.

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Leakages (Withdrawals)

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

(1) Put aside for future spending, ie savings in banks accounts(2) Paid to the government in taxation eg income tax and national insurance(3) Spent on foreign-made goods and services, ie imports which flow into the economy

Injections

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income

(1) Capital spending by firms, eg investment in new technology(2) The government, eg government expenditure on the NHS or defence(3) Overseas consumers buying UK goods and service, ie UK export expenditure

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Starting up a business can be risky

The owner/s take the risk that: The product may not sell He/she may lose the money used to start up the business He/she may not be able to pay back all the money borrowed The firm may not make enough profit and may not survive Cash may not come in quickly enough to pay day-to-day expenses

Advice and Support

There are a number of organisations that provide financial assistance and also business advice:

Source of Advice /Support Advice/Support Provided

AccountantsProvide assistance in financial matters such as record keeping, taxation and VAT

SolicitorsProvide advice on legal issues such as partnership agreements, buying /selling property

Banks Provide advice on loans, accounts, business insurance

Business ConsultantsOffer advice on a wide range of topics such as public relations, marketing and recruitment

Further Advice and Support

There are a number of Government Agencies providing advice and support on how to start up a business.

Scottish Enterprise Business Gateway Highlands and Islands Enterprise (HIE) Princes’ Scottish Youth Business Trust (PSYBT)

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Sources of Finance

All businesses require finance (money) for various reasons and can access a wide range of sources of finance.

Finance is needed to -

start up a business expand cover day-to-day running costs pay off debts buy new equipment

The source of finance that a business will use depends on –

what the finance is required for the amount required how long the money is needed for the type of business

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The following table provides details of the main sources of finance for businesses in the private sector.

Source of Finance

Description Advantages Disadvantages

Bank loan Money received from a bank that is repaid over a specific period of time. Interest is charged.

Easy to obtain Usually fairly quick to

obtain Payments are spread over

a long period of time

Interest is charged The bank may not

approve the loan

Loan from friends or family

Money received from friends or family that is paid back but the period of time is more flexible and usually no interest or lower rates of interest is charged.

Interest is not usually charged

Easy and quick to obtain

Arguments may occur between borrower and lender

Retained profits

A business can reinvest profit made from sales back into the business rather than paying it out to owners/ partners or shareholders.

No repayments to be made

No interest charged

If profit levels are low, there won’t be much finance available to reinvest

Growth may be slowed down

Mortgage Similar to a loan but is used to buy premises or land and is taken over a longer time (usually 25 years but can be up to 40 years).

Fairly easy to obtain Repayments are made

over a long period of time Allows a business to

purchase buildings or land that they would otherwise not be able to afford

Interest is charged The interest charged

can change depending on the Bank of England base rate

The bank can repossess the property if repayments are not made

Share issue Selling more shares in the organisation to new or existing shareholders.

Large amounts of finance can be raised

Funds do not need to be repaid

Shareholders have to be paid a dividend

Can be expensive to issue shares

Government grants

Money given to a business by the government if certain conditions are met.

Grants do not need to be paid back

No interest paid

Conditions usually have to be met

Can take a long time to get a grant

Hire purchase

Buying a equipment/vehicles and paying for it over a period of time.

Cost is spread over time The business gets to use

the asset before they fully own it

Can be an expensive form of borrowing

The asset is not owned by the business until the last repayment is made

Bank overdraft

Short-term loan where money is borrowed from the bank. Allows a business to take money out of their bank account when the balance is zero.

Easy to arrange Interest is only charged for

the period an overdraft is used

Interest charges can be high

Usually only small amounts of money are available

Short term

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Cash Budgeting

Businesses generate cash by two main methods. They either buy in products and re-sell them for more money or they make goods or services and sell them.

Both methods, if carried out efficiently and effectively, should generate a profit for the business. This then gives the business more money to spend on new projects.

In a business environment, cash is spent on a lot of things! The first main item is raw materials. This is either the stock it is going to sell on or the materials needed to make the product. Other costs incurred by a business include electricity, gas, advertising costs, wages, rent and rates.

If a business does not have enough cash, it will be unable to pay for the expenses mentioned above. This would result in the business getting into debt and then possibly closing down.

To try and avoid the situation of not having enough cash, it is essential that all businesses plan how they are going to manage the cash they have. In a large organisation there will be a designated Finance Department that deals with all the financial aspects of the business.

In smaller organisations where there no designated department, outside help from an accountant may be needed.

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Cash Budgets

A cash budget is a prediction of how cash will be used in the business in the future. It forecasts the money that the business expects to receive and what it expects to spend. Cash budgets are usually produced for 3, 6, 9 or 12 months.

A cash budget helps a business to plan, control and monitor the finances of the business. It helps provide targets and identifies problems early.

The following is an example of a cash budget –

Maclean Enterprises Cash Budget for May – July

May£

June£

July£

Opening Balance 500 1670 3620

Cash In (Receipts) Cash Sales 4500 4800 4000Credit Sales 1500 1800 1750Total In 6500 8270 9370

Cash Out (Payments)Purchases 1000 900 1050Wages 3000 3000 3500Advertising 200 120 150Rent 550 550 550Rates 80 80 80Purchase of equipment 0 0 5000Total Out 4830 4650 10330

Closing Balance 1670 3620 -960

From the cash budget you can see that the closing balance for July is - £960. This shows that the business will have a problem with their cash flow in July as they do not have enough cash to pay for the things they need.

It is clear from the example above that the reason for the shortfall in cash is the purchase of the new equipment but there are many reasons why a business may not have enough cash.

When a business has a shortfall of cash, it is commonly referred to as having CASH FLOW PROBLEMS.

NOTE: A Cash Budget DOES NOT show Profit or Loss

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Cash Flow Problems

There are many reasons why a business may not have enough cash to pay for things. These can include –

Spending too much money on purchases of new equipment or machinery Sales being low The owner taking out too many drawings Bills increasing (electricity, gas, telephone, fuel etc) Too much money being tied up in stock Debtors not paying on time Not being given enough time by suppliers to pay for purchases

As cash is important to an organisation, it must monitor the cash flow and if it identifies any problems, it must find ways to fix the problem.

Resolving Cash Flow Problems

Cash flow problems can be resolved in different ways.

Action Taken Reason for ActionSell assets Organisations could consider selling assets that are no longer

needed. If it does this, it could raise enough money to spend as it wishes.

Increase promotion activities or advertise more

This will increase awareness of the business and the products/services on offer. Promotions usually encourage customers to buy the product which result in increased sales.

Reduce owners drawings This will leave more money in the business to pay for things that are needed.

Move to a different utility provider

This could help reduce the organisations utility bills which means there would be more money for other things.

Introduce computerised stock control of J.I.T

This will reduce the amount of money that is tied up in stock.

Offer discounts for prompt payment

Offering customers a discount to entice them to pay earlier will result in its accounts being paid sooner, which means more money is coming in to the business.

Arrange longer payment terms with suppliers

This will mean that the business will have longer to pay for purchases so will be able to use cash for other things.

Arrange a new source of finance – Bank Loan, Overdraft

This would allow an organisation to receive cash to use when they need it and they can pay it back over a period of time.

Increase capital The owners/shareholders could invest more money in to the business. This would increase the amount of cash the business has available.

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Break-even

Break-even is a tool used in planning as it shows the relationship between costs, sales, output levels and profit.

To break-even, the sales of a business must equal the costs. This means that the business is not making a profit OR a loss.

If sales go above the break-even point then the business will be making a PROFIT. If the break-even point is not reached, the business will be making a LOSS.

Some Definitions

Fixed Costs - These are bills or expenses that the business has to pay and they do not change as output increases. They remain the same and always have to be paid even if sales are very low. Some examples of fixed costs are: rent, rates, salaries, mortgage.

Variable Costs – These are the bills or expenses that the business has to pay that change as output changes. The more a business produces, the higher the variable costs will be. Variable costs are the costs associated with making a product. Examples include: materials, factory wages, electricity, gas.

Total Costs – This is calculated by adding Fixed Costs and Variable Costs. Total costs need to be calculated before a business can start to work out whether they are making a profit or a loss.

Profit – A profit is made when sales are HIGHER than total costs.

Loss – A loss is made when sales are LOWER than total costs.

Contribution – This is the amount that is left after variable costs are deducted from sales. It shows the amount that will go towards paying off the fixed costs and can be shown using the following formula –

Contribution = Selling Price – Variable Costs

Break-even Point – This is when total costs are equal to sales. It can be calculated using the following formula –

Break-even Point = Fixed CostsContribution

It can also be written as –

Break-even Point = Fixed Costs_______________ (Selling Price – Variable Costs)

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Break-even Charts

The most effective way to see where the break-even point occurs is by the use of a break-even chart.

The following graph is an example of a Break-even chart –

You can see from the above graph that the break – even point (BEP) is where the Total Costs line crosses with the Sales line.

A lot of information can be extracted from the above chart.

The following page contains a worked example on how to interpret a break-even chart.

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Interpreting Break-even Charts

1. The first piece of information that is needed from the break-even chart is to find the break-even point. This is where the TOTAL COSTS line crosses with the SALES line.

From the graph on the previous page -

Break-even Point = 30 Units

2. Fixed costs are the easiest and most straight-forward information to extract from a break-even chart.

From the graph on the previous page -

Fixed Costs = £300

3. The next cost that is needed is the variable cost. As there isn’t a variable costs line on the graph, the easiest way to find the variable cost is as follows –

Find the TOTAL COST at the BEP and DEDUCT the FIXED COSTS. This gives you the TOTAL Variable Costs for that number of units.

From the graph on the previous page -

Total Variable Costs = TC – FC= £750 – £300= £450

VC per Unit = 450 30= £15 per unit

4. The final piece of information needed from the graph is the selling price. As above, the easiest way to do this is to use the information at the BEP.

From the graph on the previous page -

Selling Price = SalesNo of Units

= £75030

= £25 per unit

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Producing a Break-even Chart

Worked example

Tain Tech Ltd makes calculators and sells them for £5. They have fixed costs of £5000. The variable cost for each calculator is £2.50. Production is limited to a maximum of 5000 units.

Before a Break-even chart can be constructed, a break-even table needs to be produced.

Units Variable Costs Fixed Costs Total Costs Sales0 0 5000 5000 01000 2500 5000 7500 50002000 5000 5000 10000 100003000 7500 5000 12500 150004000 10000 5000 15000 200005000 12500 5000 17500 25000

Although it is clear from this table what the break-even point is (2000 units), this is not always the case.

The following procedure should be followed to produce a break-even chart –

1. Draw the axis - labeling the horizontal axis as Units and the vertical axis as £2. Plot the Fixed Costs line (this will be a straight line running parallel to the x-axis)3. Plot the Total Costs 4. Plot the Sales5. The point at which Total Costs and Sales cross is the Break-even point.

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Final Accounts

At the end of every financial year, all businesses will prepare a set of final accounts. These accounts enable the business to assess their performance over the year and help with planning their work for the following year.

Most businesses will prepare the following final accounts –

Trading Account Profit and Loss Account Statement of Financial Position

The Trading Account

This shows how much money has been made from selling your product. The profit made is known as GROSS PROFIT. (Profit before expenses are deducted from SALES REVENUE)

The Profit and Loss Account

This shows PROFIT FOR THE YEAR. It starts with the GROSS PROFIT from the Trading account. EXPENSES are then deducted from the gross profit to give the PROFIT FOR THE YEAR.

Statement of Financial Position

This is a statement prepared at the end of the financial year that states how much the business is worth. It shows what the business OWNS (ASSETS) and what the business OWES (LIABILITIES). It also shows how much EQUITY (CAPITAL) was invested in the business by the owner.

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These 2 are usually combined in the Income Statement.

Some Definitions

Sales RevenueThis is the money received from selling goods or services.

Sales Returns This is the value of goods/services that have been returned by customers because they are faulty, damaged or simply not wanted.

Cost of Sales This is the cost to the business of making the sales.

Opening Inventory (Stock)The value of stock at the start of the financial year.

Purchases This is the cost of goods bought for the business to sell.

Purchase Returns The value of goods returned to the supplier by the business.

Closing Inventory (Stock) The value of stock at the end of the financial year.

Gross Profit This is the amount of money made after cost of sales have been deducted from sales.

Expenses These are the costs incurred during the day to day running of the business.

Profit for the YearThis is the profit made after all expenses have been paid.

Assets These are the things that the business OWNS. They can be split in to CURRENT and NON-CURRENT (FIXED). Current assets change value frequently and can easily be turned in to cash. Non-current (Fixed) assets are more permanent and are worth a lot more.

Liabilities These are the things a business OWES. They can be split in to CURRENT and NON-CURRENT (LONG TERM). Current liabilities are short term debts paid back within 12 months. Non-Current (Long term) liabilities are debts paid back for more than 12 months.

Equity (Capital) The amount of money initially invested in the business by the owner.

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Profit Statements

The following is an example of an Income Statement. The layout of the account is the same for almost all organisations.

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Statement of Financial Position

The following is an example of a Statement of Financial Position. The layout of the account is the same for almost all organisations.

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Role of Technology in Finance

In all departments within an organisation, technology has an important part to play. The Finance department has many uses for technology, some more obvious than others.

In any Finance department you would expect to see the following software/hardware being used –

1) Specialised Accounting Packages eg Sage2) Spreadsheet software eg Excel3) Presentation software eg PowerPoint4) Word Processing eg Word5) EPOS (Electronic Point of Sale)6) EFTPOS (Electronic Funds Transfer Point of Sale)

Specialised Accounting Software

Specialised Accounting software is used by many small, medium and large businesses. It allows a business to do the following electronically -

Store customer details Issue quotes and invoices Issue refunds Analyse supplier debt Store supplier details Manage and pay VAT Manage stock Balance cash flow Create and manage budgets Create profit and loss accounts and balance sheets

Spreadsheet Software

Spreadsheet software is used to store numerical information. It allows calculations to be carried out using formula, graphs to be created and various reports to be produced. The finance department would use it to calculate budgets, prepare profit and loss accounts and balance sheets, produce break-even charts and make reports for use in presenting financial information to stakeholders.

Presentation Software

Presentation software allows presentation to be made that can be shown on a screen. It makes presentations look professional. They can also be sent electronically to people as an attachment in an email and can be stored on a network for future reference. The finance department would use presentation software to present financial information to shareholders.

Word Processing Software

Word processing software allows the finance department to produce memos, letters and financial reports. These can all be stored electronically for future use.

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EPOS/EFTPOS

These two systems are used in the retail industry.

EPOS is the system used to record all sales and purchases. It is often used as a computerised stock control system and this will be talked about more in the Operations unit.

EFTPOS is the system used to take payments from customers at the point of sale using a debit or credit card. It is often referred to as chip and pin. Using this system means that money is received by the finance department a lot quicker than cheques and an electronic record is also kept of all transactions.

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