Essential Standard 4.00

Essential Standard 4.00Understanding the role of finance in business.

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Objective 4.01Understand financial management.

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Topics Financial planning Business budgets Financial records and statements Financial performance ratios

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Financial planning

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Financial PlanningWhy should a business do financial

planning? Reduces financial uncertainties Increases control of financial activities Provides a ‘map of finances’ for business Makes it easier to ‘stick’ to financial

processes and goals.

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Financial Planning continuedPhases of business

Start-up Financial planning includes determining the amount of

money needed to start and operate the business until a profit is made. Also the major sales and expenses are determined.

Operation Financial planning includes determining whether they are

making enough money to operate. The basic formula used is Revenue – Expenses = Profit or Loss.

Expansion Financial planning includes determining whether enough

money is made to cover growth opportunities.

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Business budgets

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Business BudgetsTypes of business budgets:

Start-up budget used by a new business or during expansion of a business until profits are made.

Operating budget used for ongoing business operations for a specific period.

Cash budget used to estimate cash flow in and out of a business.

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Business Budgets continuedSteps for preparing a business budget: Prepare a list of income and expense

items. Gather accurate information from

business records. Create the budget. Clearly communicate the budget to

key employees in order to make sound business decisions.

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Sample CompanyBudgetJanuary 1, xxxx to December 31, xxxx

Category Actual Budget Difference Inflows Net Sales 385,400 300,000 85,400 Cost of Goods Merchandise Inventory, January 1 160,000 160,000 0 Purchases 120,000 90,000 30,000 Freight Charges 2,500 2,000 500 Total Merchandise Handled 282,500 252,000 30,500 Less Inventory, December 31 100,000 120,000 (20,000) Cost of Goods Sold 182,500 132,000 50,500 Gross Profit 202,900 168,000 34,900 Interest Income 500 700 (200) Total Income 202,500 168,700 33,800 Expenses Salaries 68,250 45,000 23,250 Utilities 5,800 4,500 1,300 Rent 23,000 23,000 0 Office Supplies 2,250 3,000 (750) Insurance 3,900 3,900 0 Advertising 8,650 9,000 (350) Telephone 2,700 2,300 400 Travel and Entertainment 2,550 2,000 550 Dues & Subscriptions 1,100 1,000 100 Interest Paid 2,140 2,500 (360) Repairs & Maintenance 1,250 1,000 250 Taxes & Licenses 11,700 10,000 1,700 Total Expenses 133,290 106,850 26,440 Net Income $69,210 $61,850 $7,360

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Startup BudgetMarch 17, 2011

Cash Needed % of   Actual Cash % of   % of to Start Total   Spent Total Variance Total

Monthly CostsSalary of owner-manager $6,000 13.7% $6,500 13.9% ($500) 15.8%All other salaries and wages 7,000 16.0% 7,100 15.1% (100) 3.2%Rent 1,000 2.3% 900 1.9% 100 -3.2%Advertising 2,000 4.6% 2,000 4.3% 0 Delivery expense 400 0.9% 1,000 2.1% (600) 19.0%Supplies 500 1.1% 1,500 3.2% (1,000) 31.6%Telephone 500 1.1% 500 1.1% 0 Other utilities 500 1.1% 760 1.6% (260) 8.2%Insurance 600 1.4% 600 1.3% 0 Taxes, including social security 1,000 2.3% 1,000 2.1% 0 Interest 500 1.1% 500 1.1% 0 Maintenance 300 0.7%  300 0.6% 0 Legal and other professional fees 3,000 6.9%  3,300 7.0% (300) 9.5%Miscellaneous 500 1.1%  500 1.1% 0 Subtotal $23,800 54.4%  $26,460 56.4% ($2,660) 84.2%

One-Time Costs  Fixtures and Equipment $10,000 22.9%  $11,000 23.4% ($1,000) 31.6%Decorating and remodeling 1,000 2.3%  1,200 2.6% (200) 6.3%Installation charges 500 1.1%  600 1.3% (100) 3.2%Starting inventory 5,000 11.4%  4,000 8.5% 1,000 -31.6%Deposits with public utilities 1,000 2.3%  1,200 2.6% (200) 6.3%Legal and other professional fees 500 1.1%  500 1.1% 0 Licenses and permits 500 1.1%  500 1.1% 0

Advertising and promotion for opening 500 1.1%  500 1.1% 0 Cash 750 1.7%  750 1.6% 0 Other 200 0.5%  200 0.4% 0 Subtotal $19,950 45.6%  $20,450 43.6% ($500) 15.8%

Totals $43,750 100%  $46,910 100% ($3,160) 100%

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SAMPLE Operating Budget July 1, 2004 to June 30, 2005IncomeMembership dues - 35 @ $25.00 $875.00Fund-raiser $100.00Contest entry award $25.00Aluminum can sales $27.00T-shirt sales $468.00Parties $200.00Total Income $1,695.00 ExpensesParties $710.00Intramurals $15.00Gifts $55.00Refreshments $100.00National/regional dues -35 @$5.00 $175.00Fund-raiser $44.00T-shirts $450.00Picnic $99.00Office supplies/duplicating $28.00State & County sales tax $19.00Total Expenses $1,695.00AVAILABLE FUNDS -0- 

Financial records and statements

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Financial Records and Statements What is the purpose of financial records? Financial records used by businesses:

Asset records Depreciation records Inventory records Records of accounts Cash records Payroll records Tax records

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Financial Records and Statements continued What are financial statements? What is the difference between a

balance sheet and an income statement?

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Sample Income Statement

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Sample Balance Sheet

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Financial performance ratios

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Financial Performance Ratios Financial performance ratios are

comparisons using a company’s financial data to determine how well a business is performing.

The four main types of financial ratios: Current ratio Debt to equity ratio Return on equity ratio Net income ratio

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Financial Performance Ratios continued Current ratio

Equals current assets/current liabilities Represents assets that the business could

convert into cash in < 1 year compared to liabilities that it must pay in < 1 year; shows ability of company to pay debts as they become due. Ideally, this ratio should be over 1.0.

Normally, the higher the ratio, the more favorable it is for the company.

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Financial Performance Ratios continued Debit to equity ratio

Equals total liabilities/owner’s equity Shows how much the business relies on

money borrowed externally versus money from within the business. Ideally, this ratio should be less than 2.0.

Normally, the lower this ratio, the more favorable it is for the company.

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Current Ratio and Debt to Equity Ratio Current Ratio

Current assets are $1,200,000 and total current liabilities are $600,000.Calculate current ratio.

Calculation:Current Ratio = 1,200,000 / 600,000

= 2or

1200,000 : 600,0002 : 1

Debt to Equity Ration

Required: Calculate debt to equity ratio.Calculation:

External Equities / Internal Equities= 1,200,000 / 18,000,000

= 0.66 or 4 : 6

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Equity share capitalCapital reserveProfit and loss account6% debenturesSundry creditorsBills payableProvision for taxationOutstanding creditors

1,100,000500,000200,000500,000240,000120,000180,000160,000

Financial Performance Ratios continued Return on equity ratio

Equals net profit/owner’s equity Indicates the rate of return the

owners/stockholders are receiving on their investments. There is not an ideal ratio; however, it is used to compare with other types of investments to see if there may be another investment that is more desirable.

Normally, the higher the ratio, the more favorable it is for the company.

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Financial Performance Ratios continued Net income ratio

Equals total sales/net income Shows the amount of sales needed for each

dollar of net income. While there is not an ideal ratio, managers use this number to compare to past periods to determine how changes in sales affect net income.

Normally, the lower the ratio, the more favorable it is for the company, as it takes less in sales to generate net income.

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Return on Equity Ratio and Net Income Ratio Return on Equity RatioReturn on equity or ROE can be calculated as,

Calculate return on equity share capital from the following information:Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000;

Taxation rate: 50% of net profit; Net profit before tax: $400,000.Calculation:

Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) / 1000,000 )× 100]

= 15.5%

Net Income RatioFormula:

Net Profit Ratio = (Net profit / Net sales) × 100 Example:

Total sales = $520,000; Sales returns = $ 20,000;  Net profit $40,000Calculate net profit ratio.

Calculation:Net sales = (520,000 – 20,000) = 500,000

Net Profit Ratio = [(40,000 / 500,000) × 100]= 8%

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