Managing Cashflow

Managing Cashflow and Financial Statement Analysis

Analysis of Financial Statements

• Specific Learning Outcomes:

  • Describe the main elements of an income statement: revenue, costs of sales, gross profit, operating profit, profit for year, and retained earnings.

  • Describe the main elements of a statement of financial position: non-current assets, current assets, current liabilities, net current assets, non-current liabilities, equity, and reserves.

Final Accounts

• Final accounts are usually produced once a year.

• Helps owners revise and fine-tune business strategies.

• Stakeholders interested in final accounts:

  • Managers

  • Lenders

  • Shareholders

  • Government (tax)

  • Suppliers

  • Workers

Final Accounts of Limited Companies

• Income Statement (formerly Profit and Loss Account):

  • Shows the gross and operating profit of the company.

  • Details how the operating profit is split between dividends to shareholders and retained earnings.

• Statement of Financial Position (formerly Balance Sheet):

  • Shows the net worth or equity of the company.

  • Difference between the value of assets and liabilities.

• Cash-Flow Statement:

  • Shows where cash was received from and what it was spent on.

Income Statement vs. Statement of Financial Position

• Income Statement:

  • Shows a firm’s sales revenue over a trading period and all relevant costs generated to earn that revenue.

• Statement of Financial Position (Balance Sheet):

  • Shows an organization’s assets and liabilities at a precise point in time, usually the last day of the accounting period.

Income Statement

• Records the revenue, costs, and profit (or loss) of a business over a given period.

• Detailed income statement for internal use, produced frequently (e.g., monthly).

• Less-detailed summary in published accounts for external users, produced at least annually.

Uses of Income Statements

• To measure the success of a business compared with previous years or other businesses.

• To assess actual performance compared with expectations.

• To help obtain loans from banks or other lending institutes.

• To enable owners and managers to plan ahead.

Income Statement Components

• Four main stages:

  1. Gross Profit: Difference between income (revenue) and cost of goods sold.

  2. Operating Profit: Calculated by deducting overhead expenses (distribution, administration costs) from gross profit.

  3. Profit Before Taxation: Calculated by including interest received and interest paid (financing costs).

  4. Profit After Taxation: Calculated by deducting the amount of tax payable for the year.

Income Statement - Key Definitions

• Revenue (formerly Sales Turnover): Total value of sales made during the trading period (selling price × quantity sold).

• Cost of Sales (or Cost of Goods Sold): Direct cost of the goods that were sold during the financial year.

• Gross Profit: Sales revenue less cost of sales.

• Operating Profit (formerly Net Profit): Gross profit minus overhead expenses.

• Profit for the Year (Profit After Tax): Operating profit minus interest costs and corporation tax.

Calculating Gross Profit

• Cost of sales = Opening Inventory + Purchases - Closing Inventory

Income Statement - Cost of Goods Sold (COGS)

• To determine COGS, a business must identify:

  • Beginning inventory value: cost of raw materials, work in process, finished goods at the start of the tax year.

  • Additional inventory cost: inventory costs gained throughout the tax year (purchases and associated costs).

  • Ending inventory value: value of raw materials, work in process, finished goods at the end of the year.

Formula for COGS

• Beginning Inventory + Purchases - Closing Inventory = COGS

• Example:

  • Beginning inventory: $20,000

  • Purchases: $10,000

  • Closing inventory: $10,000

  • 20,000 + 10,000 - 10,000 = 20,000

  • COGS: $20,000

Practice Activities

• Calculate revenue, cost of sales, and gross profit.

• Example data provided for Cozy Corner Retailers Ltd., and Dale with values for sales, opening inventory, purchases, and closing inventory to calculate gross profit.

Calculating Operating Profit

• Operating profit is the net operating profit or loss made by the business.

• Operating profit = Gross Profit - Expenses

• Expenses are payments for items of immediate use to the business (cash and non-cash).

• Examples of overhead expenses:

  • Wages and salaries

  • Rent and rates

  • Heating, lighting, and insurance

  • Distribution costs

• Operating profit should be:

  • Up by at least the rate of inflation compared with the previous year.

  • At least as high a percentage of capital employed as that achieved by rival companies.

  • High enough to reinvest in the future of the business while still paying satisfactory dividends to shareholders.

Profit Before and After Taxation

• Financing Costs:

  • Can add to or take away from the operating profit.

  • High borrowings lead to large interest charges. Some companies have substantial bank deposits earning interest.

• Profit Before and After Taxation:

  • Businesses pay corporation tax on their profits.

  • In 2015, the UK corporation tax rate was 20%.

  • Profit after taxation is also known as the company's 'earnings'.

• Using Profits:

  • 'Earnings' can be distributed or retained.

  • Distributed profit: dividends paid out to shareholders.

  • Retained profit: reinvested in the business for the future.

Exam Question Example

• Example income statement calculation with revenue, cost of sales, operating expenses, other expenses, tax, and dividends.

• Includes calculation of gross profit, operating profit, profit before and after tax, and retained profit.

Statement of Financial Position

• Formerly known as the balance sheet.

• Record of the value or worth of a business at a particular moment in time (end of accounting period).

• Overview of a company’s financial position on a particular date showing its total assets and liabilities.

Statement of Financial Position Details

• Gives the value of the business at a given time.

• Lists and gives a value to all assets (what it owns or is owed) and liabilities (what it owes) on a particular day.

Vertical Presentation

• Basic pattern:

  • Non-current assets + Intangible assets + Current assets = Total Assets

  • Current liabilities + Long-term liabilities = Total Liabilities

  • Net Assets = Total Assets – Total Liability

• Capital employed / Shareholders’ Equity:

  • Opening capital / Share capital + Retained profits = Net assets

Key Principles of the Statement of Financial Position

• The totals of the Net assets and the Total Equity must balance.

• If they do not balance, there is an error.

Non-Current (Fixed) Assets

• First section of the statement.

• Items of value that the business has bought and will use for an extended period.

• Often referred to as tangible assets.

Intangible Assets

• Goodwill: Arises when a new owner pays above the book value of the business for its good reputation.

• Does not represent an item of value.

Current Assets

• Assets readily available in the company for paying debts (within one year).

• Includes inventories, trade receivables (debtors), money in the bank, and cash held on the premises.

Total Assets

• TA = NCA + CA

Current Liabilities

• Amounts owed to suppliers or lenders due to be repaid shortly (within one year).

• Includes accounts payable (creditors), bank overdrafts, VAT, and loans due to be repaid in less than one year.

Non-Current Liabilities

• Long-term liabilities, sometimes called deferred liabilities.

• Not due for payment until some time in the future.

• Such as a mortgage on company property or a long-term bank loan.

Total Liabilities

• TL = CL + NCL

Net Assets

• Difference between the total assets and total liabilities.

• The figure to which the accounts should be balanced.

• Total equity should result in the same figure as the net assets.

Equity

• Shows where the money came from to run the business.

• Shareholders’ funds: share capital and retained profit.

• Share capital: capital originally paid into the business when shareholders bought shares.

• Retained earnings/profits: kept in the business.

• Also known as reserves.

Key Terms

• Statement of financial position (balance sheet): an accounting statement that records the values of a business’s assets, liabilities, and shareholders’ equity at one point in time.

• Shareholders’ equity: total value of assets – total value of liabilities.

• Asset: an item of monetary value that is owned by a business.

• Liability: a financial obligation of a business that it is required to pay in the future.

• Share capital: the total value of capital raised from shareholders by the issue of shares.

• Non-current assets: assets to be kept and used by the business for more than one year.

• Intangible assets: items of value that do not have a physical presence, such as patents, trademarks, and goodwill.

• Current assets: assets that are likely to be turned into cash before the next balance sheet date.

• Current liabilities: debts of the business that will usually have to be paid within one year.

• Non-current liabilities: value of debts of the business that will be payable after more than one year.

• Inventories: stocks held by the business in the form of materials, work in progress, and finished goods.

• Trade receivables (debtors): the value of payments to be received from customers who have bought goods on credit.

• Accounts payable (creditors): value of debts for goods bought on credit payable to suppliers; also known as ‘trade payables’.

Key Questions

• What is the difference between trade receivables and (account) trade payables?

• Which of the following is not a non-current asset?

• Which of the following would be included as a non-current asset in the statement of financial position?

• Which of the following is a current liability?

• Which of the following would be included as a current asset in the statement of financial position?

• A company has recently purchased a new vehicle at a cost of £50,000 which has been financed using a long-term bank loan. As what will the £50,000 bank loan be recorded on the company's statement of financial position?

• A public limited company has a debenture for £100,000. As what will this be shown on the company's statement of financial position?

• The following information has been extracted from a company’s statement of financial position. What is the value of current liabilities?

• What was the cost of goods sold?

• Which of the following would not be included in the calculation of gross profit?

Analysis of Financial Statements - Specific Learning Outcomes

• Explain how the main users might use accounting information.

• Calculate and explain the significance to businesses of accounting ratios: return on capital employed (ROCE), gross profit margin, profit margin, inventory turnover, days’ sales in trade receivables, current ratio, acid test ratio, and gearing ratio.

Users of Accounting Information

• Accounting information is crucial for any business or financial entity.

• Based on this information, better investment and business-related decisions are made.

Internal Users of Accounting Information

• Owners: need information about the financial performance and position of the business.

• Management: use accounting information for various purposes:

  • To understand the financial health of their business units

  • To set organizational goals

  • To evaluate progress toward organizational goals

  • To take corrective action where needed

• Employees: interested in accounting information because their salary appraisals, bonuses, and other monetary and non-monetary benefits are attached to the company’s financial position.

External Users of Accounting Information

• Investors: looking for business opportunities make decisions based on accounting data.

• Creditors: use accounting information to evaluate creditworthiness and whether to offer loans to a business.

• Government agencies: need accounting information from businesses in order to levy tax effectively and accurately.

• Customers: divided into four categories (producers, wholesalers, retailers, final consumers), and need assurance about the continuous supply of materials.

• Public: interested in accounting information because this informs them about the financial health of individual businesses which determines the overall impact on the country’s economy.

Ratio Analysis

• The method of examining an organisation’s accounting data to assess their performance by using financial data from the Income Statement and the statement of Financial Position.

• Ratio is a term applied to calculations that are used to compare a business or businesses performance over a period of time.

• It is one number expressed as a percentage of another or simply one number divided by another.

Types of Ratios

• Profitability: A measure of how much profit activities generate

• Gearing: Measures the levels of risk

• Liquidity: Ability of a business to meet its debts

• Efficiency: A measure of business performance

Profitability Ratios

• Gross Profit Margin (GPM)

• Operating Profit Margin (OPM)

• Return on Capital Employed (ROCE)

Gross Profit Margin

• What does the gross profit margin compare?

  • Compares gross profit with revenue.

  • Assesses how successful the management of the business has been at converting revenue into profit.

  • The gross profit margin is a good indicator of how effectively the mangers have 'added value' to the cost of sales.

Gross Profit Margin Formula

• gross profit margin % = (gross profit / revenue) × 100

Operating Profit Margin

• What does the operating profit margin compare?

  • The operating profit margin compares operating profit to the revenue.

  • It is a good indicator of management effectiveness at converting revenue into profit after all costs and expenses.

Operating Profit Margin Formula

• operating profit margin %= (operating profit / revenue) × 100

ROCE (Return on Capital Employed)

• What does RoCE assess?

• What is the formula for RoCE?

• Return on capital employed (%) = (operating profit / capital employed) × 100

• Capital employed: the total value of all long-term finance invested in the business: it is equal to (non-current assets + current assets) - current liabilities or non-current liabilities + shareholders' equity.

Profitability Ratios

• Most firms’ main aim is to make a profit for the owners.

• The profitability ratios help to show a firm’s efficiency in achieving this objective and producing profit. They relate the profit made by the firm to its size.

• Profitability – A firm’s profit in relation to its size.

Liquidity Ratios

• Current Ratio

• Acid-test Ratio

Liquidity Ratios

• These ratios assess the ability of the firm to pay its short-term debts. They are an important measure of the short-term financial health of a business.

• They are not concerned with profits, but with the working capital of the business.

• If there is too little working capital, then the business could become illiquid and be unable to settle short-term debts. If it has too much money tied up in working capital, then this could be used more effectively and profitably by investing in other assets.

Current Ratio

• What does current ratio compare? It looks at the relationship between current assets and current liabilities. It examines the liquidity position of the firm.

Acid-Test Ratio

• Also known as the quick ratio, this is a stricter test of an organisation’s liquidity. It ignores the least liquid of the current assets – inventories (stocks).

• Inventories have not yet been sold and there can be no certainty that they will be sold in the short term.

• By eliminating the value of inventories from the acid-test ratio, the users of accounts are given a clearer picture of the organisation’s ability to pay short-term debts.

Acid-Test Ratio Formula

• Liquid Assets / Current Liabilities

• Liquid assets: current assets - inventories (stocks) = liquid assets.

Gearing Ratio

• Shows the long term financial position of the business.

• Gearing is the extent to which an organisation’s operations are funded by loan/borrowing.

• Gearing ratio measures the degree to which the capital invested in the business comes from loans. These examine the degree to which the business is relying on long-term loans to finance its operations. It is a reflection of a business’s financial strategy.

• Proportion of long term debt compared to the total value of money invested in the business.

Gearing Ratio (continued)

• Looks at the relationship between loans (non current liabilities) and total capital employed

• If more than 50% then highly-geared

• Can prove to be more risky

• To increase gearing a business can buy back ordinary shares

• To reduce gearing, can issue more ordinary shares, retain more profits, repay loans.

• Formula: (Non-current liabilities / Capital Employed) * 100

Gearing Ratio (continued)

• If Gearing (%) > 50% it is said to have high gearing

• Can prove to be more risky because firm has borrowed a lot of money compared to its total capital.

• Usually figures below 25% would be considered to have low gearing.

• Low gearing indicates a firm has raised most of its capital through alternative sources of finance such as retained profit or selling shares.

Efficiency Ratios

• Inventory turnover ratio

• Inventory turnover ratio (days)

• Day sales in trade receivables

Efficiency Ratios

• There are many efficiency or activity ratios that can be used to assess how efficiently the assets or resources of a business are being used by management.

• The two most frequently used are inventory turnover ratio and days’ sales in trade receivables ratio.

Efficiency Ratios - Definitions

• Inventory turnover ratio: Measures the number of times an item of inventory (stock) is bought in and sold in a year.

• Inventory turnover ratio (days): Measures the average number of days that money is tied up in inventories (stock).

• Cost of goods sold/Inventory level

Days’ Sales in Trade Receivables Ratio

• Looks at the receivables shown on the statement of financial affairs and the sales in the income statement.

• Shows how long a business has to wait for customers to pay up what they owe.

• (Trade accounts receivable/Revenue) * 365

Analysis of Financial Statements - Specific Learning Outcomes

• Analyse the limitations of ratio analysis results and published accounts to users.

• Define working capital.

• Analyse the problems caused by insufficient liquidity.

• Evaluate methods for improving the management of working capital.

Value and Limitations of Ratio Analysis

• Basic, nuns, easy, compare, range, calculated, perform

• Method used to assess company financial performance by calculating relationship ratios between different figures like profit, sales, debts, assets

Capital vs Revenue Expenditure

• Cash spent on investment is normally referred to as 'Capital Expenditure'

• Contrasted with spending on day to day operations which is known as 'Revenue Expenditure'.

Capital vs Revenue Expenditure (continued)

• Capital: Buying additional stock, heating and lighting bill, Purchase new machinery, Repair machinery, pay salaries.

• Revenue: Update computer Systems, Expand production facilities, Buy new delivery vehicle, Increase promotional spend.

Introduction to Finance and Expenditure

• Every business needs finance some to pay for day to day expenses (raw materials, stock, wages, bills)

• Others need finance to spend on capital expenditure (long term assets).

• While others may need finance to expand.

Working Capital

• Working capital is the money needed to pay for the day to day trading of a business

• It is shown on a business' Statement of Financial Position

• It is the amount left over after all the current debts have been paid.

• It is the relatively liquid assets of the business that can easily be turned into cash.

• Working Capital = Current Assets - Current Liabilities

Working Capital (continued)

• However, this is only the working capital situation at one particular moment in the organisation’s history.

• A business which manages working capital well needs to look at what might happen in the future.

• A more useful tool for controlling working capital, therefore, is the cash flow forecast.

Working Capital (continued)

• The liquidity Cycle

• Managing working capital is about 2 things:

  1. Ensuring the business has enough finance to meet its needs.

  2. Keeping cash moving quickly through the cycle to make sure there is enough to pay the costs associated with future orders.

• The challenge is to maintain sufficient liquidity in the business to ensure the business can survive and grow in the long-term.

Working Capital Problems

• Poor control of debtors – failure to collect debts on time

• Overstocking and understocking

• Overtrading – when a business has insufficient working capital for its level of turnover

• Overborrowing – borrowing to much in the short term

• Downturns in demand – commonly occurs during a recession

• Seasonal Demand – care taken with financial planning

Shivani's Working Capital Calculation Example

• Given a sample balance sheet for Shivani, calculate net assets based on the current assets and liabilities.

Working Capital Importance

• Managing working capital is about ensuring the firm has enough liquidity (cash) available to pay these wages, bills, etc., as they come in.

• If it doesn’t it could have a lot of problems, and in the worst situation of all, it may “go bust” (go into liquidation).

• Insufficient working capital is the main cause of business failure.

The Fitness Factory's Working Capital Calculation Example

• Fitness Factory's most recent balance sheet showing a breakdown of Current Assets; Liabilities; fixed assets & share capital and reserves.

Working Capital Importance (continued)

• Organisations can continue to meet their short term obligations such as paying staff, pay suppliers.

• Helps in Decision Making such as allocation of funds, Strengthening the Work Culture of Entity (on time payment of staff).

• Improves the organisation’s creditworthiness: (paying creditors on time improves their creditworthiness which could help them to get the funds as and when required easily.

More Information about Working Capital

Why is Working Capital Important?
Working capital is critical for the health of a business. It is the amount of funds a company has that are free for investing in future business endeavors, covering operational costs, earning interest, and paying debts, among other things.

Manage Working Capital

• How can a business manage working capital?

• A business can control its liquidity cycle, by minimising its working capital needs.

• It can do this by:

  • Controlling cash (cash flow forecasting)

  • Get goods to market as quickly as possible

  • Obtaining maximum possible credit from creditors

  • Effective credit control: i.e. collecting payment from debtors efficiently

  • Minimising spending on fixed assets (keeping cash in the business)

  • Controlling costs

  • Stock management (minimise stock levels to reduce working capital requirements) Just- in-time

Improving Working Capital

• In order to improve working capital of computer manufacturers:
  *Define working capital.
  *Better inventory management; JIT (minimise stock levels) credit control procedures improved to ensure trade receivables pay monies due; offer early settlement discounts;

• Use debt factoring services;
  *Discuss all must be linked and connected .Evaluation could be demonstrated through supported judgement as to which method might be the most appropriate.

Activity 161-170 Answer.y    !