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Financial Management

Higher Business Management

• Role of Finance
• Annual Accounts
• Trading, Profit & Loss Account
Role and importance of
Financial Management
Efficient management of finance is crucial to
organisation’s success. They have to:

• Ensure adequate funds are available for

resources needed to help achieve
organisational objectives
• Ensure costs are controlled
• Ensure adequate cash flow
• Establish and control profitability levels
Duties of Finance
• Maintain financial records
• Payment of bills and expenses
• Collection of accounts due
• Monitoring of funds
• Payment of wages and salaries
• The main role Finance provides
information for managers and
decision-makers within business
Annual Accounts
• There are four main financial
statements used (called Final

• Trading account
• Profit and loss account
• Balance sheet
• Cash flow statement
Trading, Profit & Loss
• The trading account records how much
money is made from selling goods
against how much it costs to make. The
gross profit is calculated in the trading

• The profit and loss account shows the

businesses incomes and expenditures.
The net profit is calculated in the profit
and loss account.
Trading Account Format
£ £
• Turnover (or sales)
• Cost of sales
• Opening Stock 40,000
• Purchases 95,000
• Less: Closing Stock (45,000)
Profit and Loss Account
£ £
• Gross Profit 90,000
• Other income
• Interest received 11,000
• Expenses
• Rent and rates 25,000
• Wages and salaries 45,000
• Insurance 2,000
• NET PROFIT 29,000
Profit and Loss Account
Key Terms
• Trading account – provides summary of
business’s trading activity during financial
• Sales – monies received through selling
• Cost of sales – cost of sales to a business
before a profit margin is added
• Opening stock – value of stock at start of
the financial period
• Closing stock – value of stock at end of
the financial period
Profit and Loss Account
Key Terms
• Purchases – cost of goods business has
bought for resale to customers
• Purchase returns – value of goods
purchased but returned to supplier
• Sales returns – value of goods bought
by customer but returned to the firm
• Expenses – any expenses incurred by
the business in the course of normal
Interpretation of Trading,
Profit & Loss Accounts
• Was this year’s trading result good or bad,
compared with last year or with a rival

• Has the Gross Profit improved this year,

compared with last year?

• Are we making efficient use of our stock?

• Does our Net Profit figure compare

favourably with those of other
• Role of Finance
• Annual Accounts
• Trading, Profit & Loss Account
• Balance Sheet
• Assets
• Liabilities
• Capital
• Liquidity
• Working Capital
Balance Sheet
• The profit and loss account shows
the history of the business activity
throughout the financial year.
• The balance sheet shows a
snapshot of a particular date in


Balance Sheet

Assets Liabilities &


• Assets – are what a business owns

• Fixed assets – have a lifespan of

more than one year, eg machinery,
motor vehicles

• Current Assets – are constantly

changing eg stock, debtors, bank,
• Liabilities – what is owed by the

• Current Liabilities – eg trade creditors

(suppliers of goods on credit), bank
overdraft, short-term loans (less than
1 year)

• Long-term liabilities – normally longer

than 1 year – eg mortgage, bank loan
• Capital – provided by the owner of the
business and treated as being owned
to the owner of the business

• Profits – may increase capital

• Drawings – may decrease capital
• Reserves – monies retained by
• Liquidity shows us whether a
business has enough assets to
cover its debts.

• Turning assets into cash to pay off

debts is what normally happens.

• Stock is the hardest to turn into

cash. Why?
Working Capital
• Working Capital is:
• Current Assets – Current Liabilities

• If a business has too much working

capital then they are not using
their resources properly.
• If too little, then they may not be
able to pay off short term debts.
Balance Sheet Format
• Fixed Assets
• Current Assets
• Balance Sheet
• Assets
• Liabilities
• Capital
• Liquidity
• Working Capital
Today… Ratio Analysis
• What are ratios?
• Uses of ratio analysis
• Limitations of ratios
• Profitability ratios
• Liquidity ratios
• Asset usage ratios
What are Ratios?
• Ratios are a way of comparing different
• Ratios should only be used when
comparing like with like (ie same size of
business; same industry)
• Ratios can compare results with
previous years or rival firms
• Ratios, however are historic, and do not
take into account of other factors such
as quality of workers, inflation,
economic situation
Uses of Ratio Analysis
• Compare current performance with
previous years
• Compare performance against
similar organisations
• Identify changes in performance to
aid future actions
• Identify trends over time
Limitations of Ratio
• Information is historic
• Comparisons must only be made
with similar organisations (size,
• No account of external factors
• No account of NPD or declining
• No account of human factors (staff
morale, staff turnover)
• Profitability • Liquidity

• Gross Profit • Current Ratio

percentage • Acid Test Ratio
• Net Profit
percentage • Asset Usage
• Return on Capital • Rate of Stock
Employed (ROCE) Turnover
Gross Profit Percentage
Gross Profit
Sales Revenue 100%
• Measures profit made from buying
and selling stock
• For every £1 of sales, how much profit is
• Increase = more sales generated or cost
of materials have fallen
• Decrease = cost of materials may have
went up
Net Profit Percentage
Net Profit
Sales Revenue 100%
• For every £1 of sales, how much
profit after expenses is made?

• Increase = handling expenses


• Decrease = expenses may have

went up
Return on Capital
Net Profit (ROCE)
Capital 100%
• If you invest £100 in a firm how
much will you get back?

• ROCE should be measured against

interest rates. Since your savings
can make money in a high interest
bank account
Current Ratio
Current Ratio = Current Assets:Current
Looks at how business can pay off its debts

A ratio of 2:1 is considered prudent, but does

not take into account stock being held.
Higher than 2:1 means money may not
being invested in the business properly
Having less than 2:1 may mean the firm is in
danger of not being able to pay off debts (too
much money tied up in stock?)
Acid Test Ratio
• Acid Test =
• Current assets – stock: current
This is a tougher ratio than the current
ratio because it excludes stock, since
stock is the hardest asset to transform
into cash.

This ratio should be around 1:1.

Rate of Stock Turnover
Cost of Sales
• Stock turnover =
Stock hanging around is bad for the firm.
Stock’s can go off, out of fashion or out of
This ratio works out how many times stock is
used up.

Note: Average Stock is calculated by adding

Recap… Ratio Analysis
• What are ratios?
• Uses of ratio analysis
• Limitations of ratios
• Profitability ratios
• Liquidity ratios
• Asset usage ratios
• Cash Flow Statements
• Cash Budgets
• Cash Flow Problems
• Budgets are statements of
anticipated future expenditure
covering a specific time period

• Cash Budgets – show expected

receipts & payments on a monthly
basis to help assess potential cash
flow problems
Uses of Budgets
• To monitor & control

• Gain information

• To set targets

• To delegate authority
How budgets help
• Make them accountable for
• Help check income & expenditure
• Can highlight need for corrective
• Help develop long term plans
• Assists with decision making
• A means of comparison with actual
Cash Flow Statements
• Cash Budgets/Cash Flow Statements
contain estimated figures of cash
position of an organisation over a period
of time.
• Remember the closing balance is cash
and not profit!
• Cash Budgets are used to highlight
potential shortages or surpluses of cash
Cash Budget
Cash Budgets and Role of
Plan Borrow or not?
Organise Bulk buying? Trade discounts?
Command Departmental budgets
Coordinat Departmental reports
Control Measure performance
Delegate Budgets spent by Dept. Mgrs.
Motivate Giving financial control may
empower individuals
Cash Flow Management
• Liquidity – as mentioned, to check either
shortages or surpluses of cash

• Decision-making – the role of the

manager can be aided by cash budgets.

• Projection – different variables and

scenarios can be used (on a
spreadsheet) to see what can affect the
cash position of the organisation.
• Cash Flow Statements
• Cash Budgets
• Cash Flow Problems
• Users of Financial Information
• Internal Sources of Finance
• External Sources of Finance
• Additional Sources of Finance
Users of Financial
• Shareholders – can assess Board’s
performance and decide about
investment or disinvestment
• Potential Shareholders – decide
whether firm is a worthwhile risk
• Short term creditors – should credit
be granted to the firm?
• Long term creditors – should
money be lended to the firm? Will
it be paid back?
Users of Financial
• Government and local authorities – look to
directors’ report and business plan. Do
these plans affect local area?
• Competitors – compare themselves with
rivals to work out market share and if plans
conflict with their own
• Employees – can the firm pay better wages?
Is the future sound?
• Management – use info to evaluate past
performance and used to plan for future
• Customers – is firm likely to still be around?
Other concerns, eg environment
Sources of Finance
Internal Sources of
• Retained Profits – profit kept by
company for future activities

• Selling Assets – money raised by

selling off an asset no longer

• Both are Short-term

External Sources of
• Long Term (10 years +)
• Issuing Shares – capital raised by
selling shares
• Debentures – a fixed interest long
term loan
• Loans – borrowing money, repaid
over a time period with interest
• Mortgages – a loan secured for
External Sources of
• Medium Term (1-10 years)
• Leasing – renting equipment or
• Hire Purchase – acquiring an asset
on credit followed by fixed
payments. After last instalment
purchaser owns asset.
• Loans
External Sources of
• Short Term (up to 1 year)
• Overdraft – borrowing more money
than is available in bank account
• Trade Credit – businesses receive
goods first, then pay later
• Factoring – a specialist business
collecting unpaid debts for a fee
Additional Sources of
• LEC – Scottish • Grants and
Enterprise allowances –
Renfrewshire Repayable
• Local authorities – Grants, Soft
East Renfrewshire Loans, Subsidies
Council • EU grants –
• Government Regional
Partnerships – Development
Business Gateway Fund & Social
• Users of Financial Information
• Internal Sources of Finance
• External Sources of Finance
• Additional Sources of Finance
a) What four main areas does financial
information cover?
b) For what purposes might a manager
use financial information?
c) List at least four characteristics of
useful financial information.
d) List at least five users of financial
e) Taking the users of financial
information that you have made,
suggest a reason for each of them to
be using the information.