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

Understand financial management. Objective 4.01 Understand financial management.

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

Financial planning

Financial 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.

Financial Planning continued Phases 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.

Business budgets

Business 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.

Business Budgets continued Steps 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.

What is income? Money received for goods or services Net Sales Revenue Receipts Earnings Interest

What is expense? Cost or charge incurred; a payment of money Salaries Advertising Utilities Telephone Rent Repairs/Maintenance Insurance Taxes

Sample Company Budget January 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  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 (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 Office Supplies 2,250 3,000 (750) Insurance 3,900 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 1,250 250 Taxes & Licenses 11,700 10,000 1,700 Total Expenses 133,290 106,850 26,440 Net Income $69,210 $61,850 $7,360

Startup Budget March 17, 2011 Cash Needed % of Actual Cash to Start   Actual Cash to Start Total Spent Variance Monthly Costs Salary 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% 4.3% Delivery expense 400 0.9% 2.1% (600) 19.0% Supplies 500 1.1% 1,500 (1,000) 31.6% Telephone Other utilities 760 1.6% (260) 8.2% Insurance 600 1.4% 1.3% Taxes, including social security Interest Maintenance 300 0.7% 0.6% Legal and other professional fees 3,000 6.9% 3,300 7.0% (300) 9.5% Miscellaneous 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) Decorating and remodeling 1,200 2.6% (200) 6.3% Installation charges Starting inventory 5,000 11.4% 4,000 8.5% -31.6% Deposits with public utilities Licenses and permits Advertising and promotion for opening Cash 750 1.7% Other 200 0.5% 0.4% $19,950 45.6% $20,450 43.6% Totals $43,750 100% $46,910 ($3,160)

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

Financial records and statements

Financial Records and 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. 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.

Financial Records and 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

Financial Records and 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

Financial Records and 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.

What are assets? Assets are things that a business (or person) owns Examples: cash, inventory, real estate, equipment, accounts receivable

What are liabilities? Liabilities are things that a business (or person) owes Examples: debt, accounts payable, loans

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

Financial Records and Statements continued What are financial statements? Financial statements provide a picture of the financial performance of a business What are financial statements? Financial statements provide a picture of the financial performance of a business. What is the difference between a balance sheet and an income statement? A balance sheet includes assets, liabilities, and owner’s equity. An income statement includes sales, expenses, and net profit or loss.

Financial Records and Statements continued What 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

Revenue vs. Expenses Revenue 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.

Revenue vs. Expenses The business has net income when revenue is greater than expenses. The business has net loss when expenses are greater than revenue.

Sample Income Statement

Sample Balance Sheet

Financial performance ratios

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

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.

Financial Performance Ratios continued Debit 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.

Current Ratio and Debt to Equity 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 = 2 or 1200,000 : 600,000 2 : 1 Debt to Equity Ratio Required: Calculate debt to equity ratio. External Equities / Internal Equities = 1,200,000 / 1,800,000 = 0.66 or 4 : 6 Equity share capital Capital reserve Profit and loss account 6% debentures Sundry creditors Bills payable Provision for taxation Outstanding creditors 1,100,000 500,000 200,000 500,000 240,000 120,000 180,000 160,000

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.

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.

Return on Equity Ratio and Net Income Ratio Return 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 Ratio Formula: 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. Net sales = (520,000 – 20,000) = 500,000 Net Profit Ratio = [(40,000 / 500,000) × 100] = 8%

Ratios Financial Performance Ratio Formula Current Ratio Current 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

GROSS vs. NET Gross means amount before any expenses are deducted Net means amount after expenses are deducted

Discrepancies Discrepancies are differences between actual and budgeted performance. Also know as a variance