Understanding & Managing Finance

Seminar 5

Seminar 5 - Activities

Activities to prepare for the seminar: From Week 4: M & A Ex 2.6 For this week:

P & L Activity Spreadsheet M & A ex. 3.8

FINANCE AND BUDGETS - MCLANEY & ATRILL - EXERCISE 2.6 Original Balance Sheet

ASSETS CLAIMS

Freehold Premises £145,000 Capital £203,000

Furniture and Fittings £63,000 Bank Overdraft £43,000

Stock-in-trade £28,000 Trade creditors £23,000Trade Debtors £33,000

Total 269,000 Total £269,000

M & A 2.6 Original Balance Sheet

FINANCE AND BUDGETS - MCLANEY & ATRILL - EXERCISE 2.6

TRANS EFFECT Amount

A Reduce Stock £8,000Reduce Bank Overdraft £11,000Increase Profit This Year £3,000

B Reduce Stock £17,000Increase Debtors £23,000Increase Profit This Year £6,000

C Reduce Bank Overdraft £18,000Reduce Debtors £18,000

D Reduce Bank Overdraft (NB neg!) £100,000Increase Share Capital £100,000

E Create new category "Van" £10,000Increase Capital £10,000

F Increase Stock £14,000Increase Creditors £14,000

G Reduce Creditors £13,000Increase Bank Overdraft £13,000

M & A 2.6 Trans-actions

Revised Balance Sheet

ASSETS CLAIMS

Freehold Premises £145,000 Capital £313,000

Van £10,000 Trade creditors £24,000

Furniture and Fittings £63,000 Profit this year £9,000Business Bank A/C £73,000

Stock-in-trade £17,000

Trade Debtors £38,000

Total 346,000 Total £346,000

M & A 2.6 Revised Balance Sheet

The Profit (or Loss) Equation

Profit (loss)

Total expenses incurred in generating

the revenue

less

equals

Total revenue

Explain each of the three different elements.

The P & L Account Headings

Normally a Profit & Loss Account will consist of:

Sales (Turnover)Less Cost of Sales

= Gross ProfitLess Overheads

= Net profitLess Interest on Loans

= Profit Before TaxLess Tax

= Profit after TaxLess Dividends

= Retained profit for the year

What is meant by each

heading?

Some Issues

Capital & Revenue Costs Cost of Sales Valuation of Stocks Depreciation Bad Debt Provision Prepaid Expenses Accrued Expenses

Give a brief explanation of each of these

issues.

Capital & Revenue Costs

Capital Costs are incurred in purchasing assets Revenue Costs are incurred in delivering the goods or services

and operating the company Capital Costs are not charged directly to the Profit & Loss

Account. They are reflected in a depreciation charge over their useful life.

Accounting profit = Revenue Income less Revenue Expenditure - Capital expenditure is only deducted from Accounting profit through depreciation

To “capitalise” an item means to treat it as capital expenditure

Cost of Sales (1)• This is the cost of goods sold over a period. • For retail and manufacturing companies this will mainly be

the amount of stock throughput, and can be calculated by:

Opening stock level for the Period+ Amount of stock purchased during the period - Closing stock level for the Period = Cost of materials during the Period

Cost of Sales Example• At the start of January, a small furniture retailer held £35,000

worth of stock. During the month, a further £12, 000 was bought in, and at the end of the month, the stock level was £27,000.

• Calculate the cost of Sales for January.

Opening stock: £35,000 Purchases:£12,000

Total £47,000

less Closing stock: £27,000 Cost of materials:£20,000

Cost of Sales (2)

• In service and some manufacturing industries, The cost of sales may also include other Direct Costs. These are costs directly incurred as a result of making the sale, manufacturing the item, or in carrying out the service.

Direct Costs:• Cost of Materials• Labour costs incurred • Transportation costs• Fuel & other costs

Stock Valuation Opening and Closing Stocks must be taken into account

when calculating Direct Costs to in order to keep to the matching convention

Where sales volume is high (or prices are standard) an average price may be used

Manufacturing Companies may incorporate cost of manufacture into stock value (e.g. materials, power, labour)

Stock Valuation Conventions

Where stock is bought in at different times, from different suppliers and at different prices, the valuation of stock may be an issue.

There are basically three conventions: FIFO (First In First Out) LIFO (Last In First Out) AVCO (Weighted Average Cost)

Stock Valuation Methods

Three methods

First in, first out (FIFO)

Last in, first out (LIFO)

Weighted average cost (AVCO)

Stock Purchases and Sales

Opening Stock Level 200 items @ £10 each

Purchase # 1 100 items @ £12 each

Purchase # 2 200 items @ £15 each

Sales 400 items @ £20 each

FIFO Stock Valuation Example

Opening Stock Level 200 items @ £10 eachPurchase # 1 100 items @ £12 eachPurchase # 2 200 items @ £15 eachSales 400 items @ £20 each

FIFO = First in, First OutItems will be sold in the order in which they were bought.

The 400 items sold will be made up of: 200 items @ £10 each £2000 (prev. stock) 100 items @ £12 each £1200 (purch. #1) 100 items @ £15 each £1500 (purch. #2) Total Cost of Sales: £4700

LIFO Stock Valuation Example

Opening Stock Level 200 items @ £10 eachPurchase # 1 100 items @ £12 eachPurchase # 2 200 items @ £15 eachSales 400 items @ £20 each

FIFO = First in, First OutItems will be sold in the reverse order of purchase.

The 400 items sold will be made up of: 200 items @ £15 each £3000 (purch. # 2) 100 items @ £12 each £1200 (purch. # 1) 100 items @ £10 each £1000 (prev. stock) Total Cost of Sales: £5200

AVCO Stock Valuation Example

Opening Stock Level 200 items @ £10 each £2000Purchase # 1 100 items @ £12 each £1200Purchase # 2 200 items @ £15 each £3000Sales 400 items @ £20 each

AVCO = Weighted Average CostAn average cost will be calculated. All items sold will be charged at that cost.

Total value of stock = £2000+ £1200 + £3000 = £6200Total no. of items = 200 + 100 + 200 = 500Average value of stock = £6200/500 = £12.40 per item

Total Cost of Sales = 400 @ £12.40 = £4960

Depreciation

Depreciation is the method used to spread the cost of a purchase (normally of a fixed asset) over a number of time periods (usually years)

• This is a way of charging to the business the cost of the asset, in a way which accounts for the ‘wear and tear’ of the asset, and the fact that over time it is reducing in value.

• Depreciation is shown in the Profit & Loss Account as an Overhead

Calculating a depreciation charge

Factors to be considered

Cost of the asset

Useful life of the asset

Residual value of the asset

Depreciation method

The depreciation charge is calculated as a result of these four factors: Initial Cost How long it will be

used for What it will be worth

at the end Calculation method

less

Residual value

equals

Cost

Depreciable amount

Annual depreciation charge

Year 1 Year 3Year 2 Year 4 and so

on

Calculating an annual depreciation charge

Whatever method is used, the procedure is the same:

Depreciation Methods

There are two main methods used: Straight-line depreciation = Cost of item

divided by number of years over which it is to be written off

Reducing balance = Current value x Depreciation%

Written-down value (£000)

Asset life (years)

10

20

30

40

0 1 2 3 4

Graph of written-down value against time using the straight-line method

The same amount is used to reduce the asset value each year.

Written-down value (£000)

Asset life (years)

10

20

30

40

0 1 2 3 4

Graph of written-down value against time using the reducing balance method

The amount used to reduce the asset value decreases year on year.

Depreciation calculation

Purchase of a piece of equipment costing £10,000

Straight-line over 5 years Reducing balance at 30% Written down Written down Depreciation Value Depreciation Value

Year 1 £ 2,000 £ 8,000 £ 3,000 £ 7,000Year 2 £ 2,000 £ 6,000 £ 2,100 £ 4,900Year 3 £ 2,000 £ 4,000 £ 1,470 £ 3,430Year 4 £ 2,000 £ 2,000 £ 1,029 £ 2,401Year 5 £ 2,000 £ 0 £ 720 £ 1,681Year 6 £ 0 £ 0 £ 504 £ 1,176

The Problem of Bad & Doubtful Debts

Many businesses sell goods on credit. The revenue generated is recognised in accounts as soon as the goods are passed to the customer.

As soon as this happens, the sale is recorded, and the amounts appear as Turnover on the P & L account, and as Trade Debtors on the Balance Sheet.

There is a risk that the customer will not, or cannot pay. If this occurs then this is called a bad debt and must be written off.

This involves reducing debtors on the Balance Sheet, and creating an expense in the ‘Overheads’ section for Bad Debt.

Provision for Doubtful Debt

In some enterprises the problem of bad debt is endemic, and it may not be possible to identify with certainty the amount of debt which is “bad”, or which will not be retrieved.

In this case, the business will use past experience to estimate the amount of debt which might be lost in the accounting period.

The Provision for Doubtful Debt is calculated as an estimate and this will be used to reduce debtors on the Balance Sheet, and create an expense in the ‘Overheads’ section called Provision for Doubtful Debt.

Prepaid Expenses

Pre-paid expenses - goods or services which have been paid for in advance.

When you eat in MacDonald's, they require you to pay ‘up front’ before you get the food. At the point at which you have paid, before you get your meal. This is a prepaid expense.

Prepaid expenses are things like rent & rates paid in advance, as well as some consultancy fees.

Accrued Expenses

• Accrued expenses - any amount which the organisation owes for expenses already consumed but for which a bill has not been yet received or paid

When you eat in a ‘posh’ restaurant they normally provide you with the food, then present you with the bill at the end. At the point at which you have eaten the meal, but not paid, this is an accrued expense.

Accrued expenses are things like tax, dividends, wages and fuel bills.

P & L Example Spreadsheet

Transactions for February OTHER PAYMENTS

STOCK CONTROL Wages Bill £2,400January Stocktake £8,125 Gas/Electricity £425

Petrol £25002-Feb Purchase £1,300 Rent/Rates £57505-Feb Purchase £1,250 Interest on Bank Loan £22510-Feb Purchase £1,000 Tax Payment £1,05012-Feb Purchase £1,30020-Feb Purchase £2,400

22-Feb Purchase £800 PROFIT & LOSS Activity

04-Feb Sales £1,900 1 Use the STOCK CONTROL data (left) to complete the06-Feb Sales £2,250 stock summary page, and work out the Cost of Sales11-Feb Sales £1,850 for February. (Assume all stock is of equal value )14-Feb Sales £1,700 2 Use this data, and the data above to complete the16-Feb Sales £1,400 Profit & Loss Account for February.21-Feb Sales £1,800

February Stocktake £11,050 Print this page

P & L Example – Solution Part 1

Stock Summary:

Opening Stock: £8,125Purchases £8,050Closing Stock £11,050Cost of Sales £5,125

January Stock Take figureJanuary Stock Take figure

February Stock Take figureFebruary Stock Take figure

Total of all Purchases for February

Total of all Purchases for February

Opening Stock

+ Purchases

- Closing Stock

Opening Stock

+ Purchases

- Closing Stock

P & L Example – Solution Part 2

Profit & Loss Account

Turnover £10,900Cost of Sales £5,125Gross Profit £5,775

Overheads £3,650Net Profit £2,125

Interest £225Profit Before Tax £1,900

Tax £1,050Earned Surplus (Profit) £850

P & L Example – Solution Part 2

Profit & Loss Account

Turnover £10,900Cost of Sales £5,125Gross Profit £5,775

Overheads £3,650Net Profit £2,125

Interest £225Profit Before Tax £1,900

Tax £1,050Earned Surplus (Profit) £850

Total of all Sales for February

Total of all Sales for February

Total of

Wages, Gas/Electric, Rent/Rates, Petrol

for February

Total of

Wages, Gas/Electric, Rent/Rates, Petrol

for February

Trading & Profit & Loss Account for the Year Ended 31 December

£000 £000 £000 £000Sales 382.5 420.2Less Cost of Sales 114.8 126.1Less 267.7 294.1Salaries & Wages 86.4 92.6Selling & Distribution Costs 75.4 98.9Rent & Rates 22.0 22.0Bad Debts Written Off 4.0 19.7Telephone & Postage 4.4 4.8Insurance 2.8 2.9Motor Vehicle 8.6 10.3Loan Interest 5.4 4.6Depreciation - Motor Van 3.3 3.1Depreciation - Fixtures & Fittings 4.5 4.3

216.8 263.250.9 30.9

2000 2001

M & A Ex 3.8 P & L Account

Trading & Profit & Loss Account for the Year Ended 31 December

£000 £000 £000 £000Sales 382.5 420.2Less Cost of Sales 114.8 126.1Less 267.7 294.1Salaries & Wages 86.4 92.6Selling & Distribution Costs 75.4 98.9Rent & Rates 22.0 22.0Bad Debts Written Off 4.0 19.7Telephone & Postage 4.4 4.8Insurance 2.8 2.9Motor Vehicle 8.6 10.3Loan Interest 5.4 4.6Depreciation - Motor Van 3.3 3.1Depreciation - Fixtures & Fittings 4.5 4.3

216.8 263.250.9 30.9

2000 2001

M & A Ex 3.8 Points to note

Increase in Sales Value & Gross profit

Increase in Sales Value & Gross profit

Increase in Salaries & Distribution Costs

Increase in Salaries & Distribution Costs

Increase in Bad debts

Increase in Bad debts

Decline in Net Profits

Decline in Net Profits

M & A Ex 3.8 Analysis

• There has been an increase in turnover & Gross profits• There has not been a corresponding increase in net

profits because:• There has been a significant rise in overheads• Increase in sales achieved only through greater

marketing effort• Increase in bad debt suggest that sales being offered

to poor credit risk customers• This seems to mark a sales policy shift from the previous

year, and has not been successful.