Essential Standard 4.00Essential Standard 4.00Understanding the role of finance in business.

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Objective 4.01Objective 4.01Understand financial management.

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TopicsTopicsFinancial planningBusiness budgetsFinancial records and statementsFinancial performance ratios

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Financial planningFinancial planning

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Financial PlanningFinancial Planning

Why 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 Financial Planning continuedcontinuedPhases 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 budgetsBusiness budgets

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Business BudgetsBusiness Budgets

Types 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 Business Budgets continuedcontinuedSteps 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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What is What is incomeincome??Money received for goods or

services

Net SalesRevenueReceiptsEarningsInterest

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What is What is expenseexpense??Cost or charge incurred; a

payment of money

Salaries AdvertisingUtilities TelephoneRent Repairs/

MaintenanceInsurance Taxes

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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 12

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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 Financial records and statementsrecords and statements

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Financial Records and Financial Records and Statements Statements What is the purpose of financial

records?

Financial records provide specific information about business activities that is used to analyze the financial performance of a business.

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Financial Records and Financial Records and Statements Statements Financial records used by businesses:

◦Asset records – buildings and equipment owned by the business, their original and current value, and the amount owed if money is borrowed to purchase the assets

◦Depreciation records – identify the amount assets have decreased in value due to their age and use

◦Inventory records – identify the type and number of products on hand for sale; help determine # products sold, damaged or lost and the current value of that inventory

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Financial Records and Financial Records and Statements Statements

◦Records of accounts – identify all purchases and sales made using credit Accounts payable record identifies the

companies from which credit purchases were made and the amount purchased, paid and owed.

Accounts receivable record identifies customers that made purchases using credit and the status of each account

◦Cash records – list all cash received and spent by the business

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Financial Records and Financial Records and Statements Statements

◦Payroll records – contain information on all employees of the company, their compensation and benefits.

◦Tax records – show all taxes collected, owed and paid. As a part of payroll, employers must withhold a certain percentage of employees’ salaries and wages for federal income tax. The company also makes payments for Social Security and Medicare and, in some cases, for unemployment compensation insurance. Businesses may have to pay several types of taxes on their income and value of their assets.

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What are What are assetsassets??Assets are things that a business

(or person) owns

Examples: cash, inventory, real estate, equipment, accounts receivable

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What are What are liabilitiesliabilities??Liabilities are things that a

business (or person) owes

Examples: debt, accounts payable, loans

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What is owner’s equity?What is owner’s equity?Owner’s equity is the value of the

owners’ investment in the business

Value of business after liabilities are subtracted from assets

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Financial Records and Financial Records and Statements continuedStatements continuedWhat are financial statements?

Financial statements provide a picture of the financial performance of a business

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Financial Records and Financial Records and Statements continuedStatements continuedWhat is the difference between a

balance sheet and an income statement?

Balance sheet includes assets, liabilities and owner’s equity

Income statement includes sales, expenses and net profit/net loss

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Revenue vs. ExpensesRevenue vs. ExpensesRevenue is all income received by

the business during the period. Sources of income include the sale of products and services, plus interest earned from investments.

Expenses are all the costs incurred by the business during the period. Expenses include operations, purchase of equipment, supplies, inventory, payroll and taxes.

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Revenue vs. ExpensesRevenue vs. ExpensesThe business has net income

when revenue is greater than expenses.

The business has net loss when expenses are greater than revenue.

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Sample Income StatementSample Income Statement

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Sample Balance SheetSample Balance Sheet

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Financial performance Financial performance ratiosratios

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Financial Performance Financial Performance RatiosRatiosFinancial 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 Financial Performance Ratios continuedcontinuedCurrent 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 Financial Performance Ratios continuedcontinuedDebit to equity ratio

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

money borrowed externally which will have to be paid back versus money provided by the owners. Ideally, this ratio should be less than 2.0.

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

◦Too much debt puts a business at risk because it may have trouble meeting its obligations to its lenders.

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Current Ratio and Debt to Equity RatioCurrent Ratio and Debt to Equity Ratio

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

Calculate current ratio.

Calculation:

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

= 2

or

1200,000 : 600,000

2 : 1

Debt to Equity Ratio

Required: Calculate debt to equity ratio.

Calculation:

External Equities / Internal Equities

= 1,200,000 / 1,800,000

= 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 Financial Performance Ratios continuedcontinuedReturn 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 Financial Performance Ratios continuedcontinuedNet 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 Return on Equity Ratio and Net Income RatioRatio

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) / 1,000,000 )× 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 $40,000

Calculate 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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RatiosRatiosFinancial Performance Ratio

Formula

Current RatioCurrent Assets/Current Liabilities

Debt to Equity Ratio

Total Liabilities/Owners’ Equity

Return on Equity Ratio

Net Profit/Owners’ Equity

Net Income Ratio Total Sales/Net Income

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GROSS vs. NETGROSS vs. NETGross means amount before any

expenses are deductedNet means amount after

expenses are deducted

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DiscrepanciesDiscrepanciesDiscrepancies are differences

between actual and budgeted performance.

Also know as a variance

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