Purpose of accounts for stakeholders
- By referring to its accounts, an organisation can analyse its performance in terms of profitability, liquidity, efficiency and gearing in combination with accounting rations. Given this, accounts allow senior managers to make adjustments to a tatical and strategic direction.
- Accounts satisfy legal requirements in the case of publicly traded companies and thus allow calculation of corparate tax liabilities demanded by the goverment.
- Accounts allow a degree of transparency on the company’s financial position to external stakeholders such as potential investors, lenders and suppliers.
- Current and potential investors are especially concered with profitability and gearing aspects of the balance sheets. The wish to see the balance sheet over time and an picture of the external enviroment.
- Lenders of fund are concered with liquidity, profitability and gearing, and amount of fixed assets for collateral purposes.
- Suppliers will be interested with liquidity arising from the current assets and liability sections.
Sidenote: Nowadays, much is automated with software.
Final accounts to stakeholders
Published accounts that outline the performance of the company.
Internal accounts (aka. managerial accounts)
Very detailed and revealing accounts that are, for that reason, not made available to competitors or other external competitors.
- Accounting: (1) The annual sales volume net of all discounts and sales taxes. (2) The number of times an asset (such as cash, inventory, raw materials) is replaced or revolves during an accounting period.
- Human resource management: The number of employees hired to replace those who left or were fired during a 12 month period.
- Finance: The volume or value of shares traded on a stock exchange during a day, month, or year.
examples of intangible assets
An asset that cannot be physically touched or seen.
- branding (reprising a personality trait, the power to define people)
- goodwill (typically in the form of ownership change with the acquirer paying more than the book value in recognition of the previous owner’s past branding efforts or workers working additional hours for no extra pay, which is an valuable asset for an organisation [e.g. health and education sector])
- patents (provide entrepreneurs with exclusive rights to use, sell or control their new invention; patents expire and therefore loose book value with each year)
A reduction in value of an asset over time, due to wear and tear.
- encourages forward planning
- appropriate price for customer
- is noted in the business balance sheet
The role of finance
Capital expenditure - Long term
The purchase of fixed assets. It involves the purchase of resources that an organisation intends to keep for longer than one year and that help with the productive capacity now and in the future (e.g. buildings, machinery, vehicles).
Revenue expenditure - Short term
Fixed assets will need maintaining/repairing and these costs are counted as revenue expenditure. Working capital such as labour, material, electrical power.
- personal funds (for sole traders)
the initial contribution to start a business; is risky and may cause family conflict
- retained profit
retained earnings finance projects with no interest and dilution of ownership (might be perceived positively or negatively by stakeholders, depending on their objectives)
- sale of assets
a firm disposes of old fixed assets, which may weaken productive capacity, balance sheets and shareholders value and therefore be unpopular; however, with a good use of that cash, it can be popular too
- improving the working capital cycle
- share capital (sales of shares)
A publicly traded company may issue further shares to existing shareholders or to new shareholders. +Significant sums can be raised -dilution of ownership (debt vs euqity dilemma)
In order for the share issue to be successful, a clear growth objective or strategic plan will need to be given to encourage shareholders. Shares might not be purchased if the perception is that the funds are only going to pay off existing debts.
- loans & overdrafts
borrowing additional funds are loans; overdrafts are very short term while loans vary in duration from 1 to 30 years depending on the reason
Fixed interest loans by firms or individuals. Debenture holders usually have first claim on firm’s asset if the company is put into liquidation and bankruptcy proceedings are started.
- trade credit
Offering trade credit means allowing customers to receive goods and services wihtout full upfront payment, or allowing discounts for early payment.
- grants & subsidies
Governments or local community bodies may provide grands and subsidies to encourage new business start-ups. A grant may be a simple sum and subsidies may allow discounts. No repay needed. However, usually small in size.
- debt factoring
It allows a third party or debt factor to collect an unpaid owed to a business. The debt factor charges a fee for this service.
The firm sells an asset but then lease or hire it back to use without the responsibility of ownership.
- venture capital
volatile capital made available by individuals/institutions to be put into potentially profitable but risky projects. Sometimes, the investors are too short-term focused.
- business angels
the informal investment given by affluent individuals who seek potential investments and provide start-up capital in return for some ownership or equity stake. In contrast to the aggressive and more decision-making demand, the angles are more hands-off.
short term – to meet immediate liquidity needs and those up to six months
medium term – achieve objectives within six months to two years
long term – longer-term strategic plans
The appropriateness, advantages and disadvantages of sources of finance for a given situation
Purpose and time considerations
For immediate liquidity concerns, an extension to a bank overdraft should be sufficient. For other short-term finance, internal methods may give quicker access to funds, like using profit reserves, rather than trying to raise external finance. An extension of credit or the use of a debt factor may be appropriate.
For medium-term financing, debentures or other external sources with fixed interest rates are appropriate.
For longer-term (larger sums), SWOT analysis and proffesional consultants are the most effective method.
Planning and size are important factors in determining the cost of finance. Lazy planning will cost the business more money. TNCs have a economies of scale and trust of institutions.
The debt versus equity dilemma
In response to a new strategic plan or aim, does a large organisation issue more shares, and consequently dilute ownership for existing shareholders? This would raise more funds without the need to borrow and interests.
Or does the organisation allow more debt onto the balance sheet to finance this new strategic goal? However, if the new goal is poorly received, the organsiation keeps the existing level of control, there is no dilution and less potential threat of a takeover.
Types of cost
Fixed or indirect (overhead) – costs that have to be paid but are not dependent on the level of output, indrectly connected to product. (e.g. rent, insurance)
Variable or direct – output dependent costs, directly connect to product (e.g. material, wages)
Semi-variable – may be fixed costs intially but after a certain level of output may rise (e.g. electricity, telephone charges)
Total revenue (definition)
The amount of money generated from trading activities. The amount of debtors listed under current assets on a balance sheet can be counted as a form of deferred revenue.
Non-operating income refers to revenue earned things other than trading (e.g. dividends from investments).
A method to collect revenue.
examples for online businesses
- subscription payments
- advertising fees
- transaction fees
- volume and unit selling
- sponsorship and co-marketing partnerships
contribution (definitition and purpose)
contribution per unit
profit calculated from contribution
Contribution can be used in calculating how many products need to be sold in order to cover a firm’s costs.
It determines how much a product contributes to its fixed costs and proft after deducing the variable costs.
It is important when determining the overall proftiability brought by a product (not the same as profit).
contribution per unit = price per unit - variable cost per unit
If a table sells for 150€ and its variable cost per table is 60€, then the business makes a contribution of 90€ per table towards paying its fixed costs.
- total contribution = total revenue - total variable cost*
- total contribution = contribution per unit x # of units sold*
Following from the above example, if the business sells 100 tables, then:
total contribution = (150 x 100) - (60 x 100) = 9,000€
profit = total contribution - total fixed costs
Purpose of break-even analysis
Break-even and contribution anaylsis are important decision-making tools.
Should organisation X release a new improved version of an existing product?
How many units of the new improved version the company will need to sell before it covers the osts of introducing it?
In case this improved version may not generate a large profit given the estimated break-even point is higher, what if the new version provides contribution to fixed or indirect costs and makes a small loss?
revenue = cost
i.e. no profit or loss is made
critical for start-ups
Break-even quantity (formula)
fixed costs / [(price - variable cost per unit) or contribution]
break-even quantity with profit target (formula)
(fixed costs + profit target) / contribution or (price - variable cost per unit)
break-even revenue = (fixed costs / contribution per unit) x price per unit
total revenue = price x quantity
total costs = fixed costs + variable costs
profit = total revenue - total costs
Margin of safety level of output
The extent to which existing sales exceed the break-even level of output.
margin of safety = present output - break-event quantity
Making price cuts is not always the most effective mehtod to generate increases in revenues or profits. It only works if demand for the good is expected to rise significantly more than the price increase in percentage terms. (Will the price cut affect the perception of quality? What if competitors follow this price reduction?)
The benefits and limitations of break- even analysis
In order to sell higher quantities, the firm may have to reduce prices, which leads to the inverse impact on revenue and profit.
A break-even analysis should not be static, but different break-even points under different cost, price and revenue scenarios should also be examined (“What if…? analysis).
reason behind mutiple break-even points
The law of demand, which assumes a negative relationship between price and quantity demanded, results in a parabola.
On the cost side, the assumption that variable costs rise in a linear fashion can also be challenged. If large production runs are required, then a firm’s costs may fall due to economies of scale or rise due to diseconomies of scale, leading to multiple break-even points.
Total contribution versus contribution per unit
contribution = product price - variable cost per unit
total contribution = total revenue - total variable costs
total contribution = contribution per unit x current output
The importance of contribution, simply; if a product is making a loss, contribution analysis along with marketing and opertions considerations may provide justification for continuing to produce it becasue the total contribution it makes towards fixed costs, and ultlimately profit, may make this worthwhile.
Relevance of financial ratios
They measure the performance of an organsiation by criterias such as profitability or liquidity.
Taken in isolation and without considerations of the prevailing external environment or competitor’s performance, ratios are meaningless indicators of business success.
Also, if the financial figures look too good to be ture, then they probably are.
Profitability / efficiency ratios
gross profit margin = (gross profit / sales revenue) x 100
Key stakeholders: line and senior managers
- Assuming the selling price and purchase price remain constant over a trading period, this ratio should also be constant
- the higher, the better - If the ratio starts to deteriorate, the implication is that sales are not being transferred successfully into trading profits - a potential cause for concern.
net profit gain = (net profit before interest and tax / sales revenue) x 100
Key stakeholders: senior managers, current and potential investors
- The ratio signals the capacity the firm has to generate profits after overhead or indrect costs have been taken into account.
- the higher, the better - The ratio should be constant over a trading period. If it starts to fall, it implies that overhead costs are rising faster than sales and an investigation should begin.
return on capital employed (ROCE) = (net profit before interest and tax / total capital employed) x 100
Key stakeholder: current and potential investors, media groups, CEOs and goverment’s tax department
- The ratio looks at how efficiently an organsiation uses its capital or total assets to create goods and services that are in turn used to create profit.
- It is a measure of reward (in form of profit) for risk-taking by entrepreneurs.
current ratio = current assets / current liabilities
if it’s one you cover everything; if it’s more than 1, you have a bit extra, if it’s less than 1 you can’t cover your bills
acid test ratio (quick ratio) = (current assets - stocks) / current liabilities
Key stakeholders: lenders, potential lenders and suppliers
- The acid test ratio is a stringent measure of liquidity as stocks of unsold goods are not included in current assets.
- One should consider the cash ratio, where current assets have stock and debtors removed from current assets as we cannot guarantee that all monies from debtors will be paid.
see “liquidity” document for more information
Possible strategies to improve gross profit margin, net profit margin, current and acid test ratio and RROCE (evaluation)
Gross profit margin
If the ratio is falling the firm may have to look at stock control and purchasing decisions. If the cost of stock sold is rising, managers may have to consider alternative supply chain management strategies. There may also be significant marketing factors to consider such as the effectiveness of the current promotional mix, although, altering this could raise costs.
Net profit margin
If the ratio is falling, the firm may have to look at its overheads and indirect costs. Could the firm outsoruce some production to reduce overhead costs?
Current and acid test ratio
See the section on dealing with working capital and liquidity issues.
A fall in this ratio is relative to competitors’ ROCE over time may signal discusssions among senior managers about pursuing a new strategic direction, especially if the fall is sustained, to try to regain lost market share.
Teh firm may also consider restrucuting to try to reduce variable costs.
Differnece between profit and cash flow
net cash flow (formula)
Refers to the amounts of cash coming into and going out of a business while profit is the difference between income and expenses.
Costs and losses should be provided for before profits are taken by a business!
net cash flow = cash inflow - cash outflow
Relationship between investment, profit and cash flow
- Investments require finance and an organisation’s cash flow will be used to pay for this
- Profits are not guaranteed from an investment but it is certain that significant cash outflows will be experienced before cash inflows are earned.
- The organisation hopes to earn profit after all cash outlfows have been recovered.
For a movie studio, for instance, uses its cash flow to fund an investment in a new project up to three years before the movie is released. Cash outflow during this period of investment is significant while cash inflow (profit) may be zero.
Working capital (formula + role + possible sources)
(aka. day-to-day finance or circulating finance)
= current assets - current liabilities
Its role is to bring the other factors of production such as land, labour and man-made capital into productive use.
Second, working capital provides cash (for immediate use) and credit opportunities to allow businesses to trade with other firms.
Credit is a vital source of working capital. (A firm can be a creditor to its customers who have not yet paid and a debtor to its suppliers who have allowed delivery without advanced payment.)
Working capital cycle
Purchase of raw materials. Cash outflows or credit are used to pay.
Processing of materials and beginning to take orders. Cash flows out.
Orders are fulfilled and deilvered. Cash flows out due to delivery costs. Cash flows in with customer payments
Firm follows up on uppaid orders; pays its creditors. Profits are received. New orders are received. Process begins again.
This cycle can be cleaned from waste through lean production and other elemination of waste.
Too much working capital or too little?
Too little will
- hinder full production capacity
- restrict trading with other companies
- inevitable liquidity problems will result
Too much capital in reserves may imply that
- the firm is missing out on potential profitable opportunities
- If the firm is holding too much stock, then additional cost problems may arise.
Cash flow forecasts
- The closing balance at the end of the month will become the opening baance for the next month
- Cash flow forecasts are presented at the centre of a business plan for new start-ups.
- Lenders will wish to see whether the future cash flow issues can be anticipated.
- Liquidity problems will be potentially easier to solve if they can be foreseen.
Dealing with liquidity problems
Investment appraisal (definition + techniques + assumptions)
The assessment whether an investment opportunity should be taken. External and qualitative factors are not considered. There are three (one HL) technqiues to guide decision-making:
The time required before an investment opportunity pays back its initial cost.
payback period = initial investment cost / annual cash flow from investment
It assumes that the expected returns are receiveed evenly throughout the year and that the currency has the same value over time. Both assumptions can be challenged. (HL: NPV provides a more rigorous appraisel of the time value of money)
The longer the payback time, the more risky it becomes because it is hard to predict future developments.
Average rate of return (ARR)
ARR = average profit per year / cost of the opportunity
It assumes that the currency has costant value.
Do financial statements reflect the “truth” about a business?
Many businesses are introducing metrics about their environmental, social or ethical performance on the side of financial information. Can well-being, or other social variables, be measured?
How certain is the information we get from financial statements? For example, could we know in advance if an investment will be successful?
What is the role of interpretation in accounting? For example, could we compare businesses by just looking at their financial statements?
Often, financial information is presented to the wider audience in a graphical or summary form. Do such simplifying presentations limit our knowledge of accounts?
Does the accounting process allow for imagination?
Accounting practices vary from country to country. Is this necessary, or is it possible to have the same accounting practices everywhere?
What is equitiy?
euqity = share capital + retained profit
Equity is split into common shares and retained earnings and represents the residual interest owners have in the business after liabilities. Equity essentially represents net assets and is calculated using the accounting equation by subtracting liabilities from assets.
a sum of money paid to shareholders decided by the board of directors of a company
net assets (formula)
net assets = (total assets less current liabilities) - long-term liabilities
costs of sales
net profit before interest and tax
net profit before tax
net profit after interest and tax
gross profit = sales revenue - costs of sales
costs of sales = opening stock + purchases - closing stock
retained profit = net profit after interest and tax - dividends
net profit before interest and tax = gross profit - expenses
net profit before tax = net profit before interest and tax - interest
net profit after interest and tax = net profit before tax - corporation tax