3.4 Financial statements

Financial statements

1.      Income Statement

2.      Balance Sheet

1.    Income Statement

A financial statement measuring financial position of a company over one accounting year.

Formula

Revenue – Expenditure = Profit

·        Trading A/C

v  First section of the income statement

v  It is used to calculate gross profit

·        Profit and Loss A/C

v  Second section of income statement

v  It is used to calculate net profit

·        Profit and Loss Appropriation A/C

v  Third section of income statement

v  It shows profit allocation in limited companies

Format of Income Statement

Format of Profit and Loss Appropriation A/C

2.    Balance Sheet

A financial statement that summarizes a company’s assets, liabilities and shareholders’ equity over one accounting year.

Formula of accounting equation

Assets = Liabilities + Equity

·        Assets

Resources owned by the business.

v  Fixed asset

v  Current asset

·         Liabilities

Debts of the business.

v  Current liability

v  Long-term loan

·       Equity

Money put into the business as capital by the owner.

Format of Balance Sheet

Purpose of accounts to the stakeholders:

1.     Shareholders

External stakeholders who are interested to know company’s profit for the dividends they would going to retain.

2.     Managers

Internal stakeholders who are interested to see whether the company is operating efficiently or not within one year.

3.     Employees

Internal stakeholders who are interested to know whether the company is doing well to pay them more and their jobs are secure.

4.     Investors

External stakeholders who find potentiality in buying shares of the company.

5.     Creditors

External stakeholders who are interested to know the financial position of the company so they feel secure enough to get back their debts.

6.     Customers

External stakeholders who are interested to see whether the company will survive in future so that they can get the availability of after sales service, etc.

7.     Government

External stakeholders who are interested to scrutinize the factual records relating profit earned by the company so that tax can be calculated.

N.B.“every stakeholders have interest on financial statements of businesses”

3.3 Cost and break-even analys

Costs of production

To generate revenue cost incurs in production process.

·        Fixed cost

Costs remaining fixed or constant irrespective to the level of output produced. Also known as indirect cost. E.g. salaries, rent, rate, loan repayment, etc.

·        Variable cost

Costs varying respective to the level of output produced. Also known as direct cost. E.g. raw materials, power, wages, utilities, etc.

·        Total cost

Sum of fixed costs and variable costs.

Formula:

Total cost = Fixed cost + Variable cost

·        Average cost

Production cost per unit of output. Also known as unit cost.

Formula:

Average cost = Total cost / Total output

Break-even analysis

An analysis to determine the point at which total revenue equalizes total costs. Break-even analysis is done so that information regarding costs along with sales revenue can be projected in order to find out whether the product is going to make profit or not. Most importantly, it helps to know how many units the company needs to sell to break even.

·         Total revenue > Total cost (Product is making a profit)

·         Total revenue < Total cost (Product is making a loss)

·         Total revenue = Total cost (Product is at break-even point)

Break-even point (BEP)

The point at which forecasted revenue is exactly the same as estimated costs, therefore at break-even point it neither incurs profit nor loss.

Formula:

Break-even point = Fixed cost / Contribution per unit

Contribution

Contribution is the amount generated from selling a commodity by subtracting all the variable costs from revenue.

Formula:

Contribution per unit = Selling price per unit – Variable cost per unit

Margin of safety (MOS)

Margin of safety is the benchmark within which sales above break-even causes profit and beyond causes decreasing profit or ultimately loss.

 Formula:

  Margin of safety = Current output – Break-even output

Given,

Selling price = £ 25

Variable cost = £ 5

Fixed cost = £ 20,000

Current output = 2,000 units

·         Contribution per unit = Selling price per unit – Variable cost per unit

                                          = £ 25 – £ 5

                                        = £ 20

·         Break-even point = Fixed cost / Contribution per unit

                                  = £ 20,000 / £ 20

                                  = 1,000 units

·         Margin of safety = Current out – Break-even output

                                    = 2,000 units– 1,000 units

                                  = 1,000 units

·         At BEP,

                    i.            Total revenue = £ 25,000

                  ii.            Total cost       = £ 25,000

Advantages of a break-even chart

1.      Helps to know how much output business has to produce in order to break even

2.      Estimates the cost, revenue and profit at different  levels of output

3.      Helps to know the margin of safety

Disadvantages of a break-even chart

1.      The TC and TR are shown as straight lines. In practice they may not be straight lines and fluctuates due to various reasons.

2.      It is assumed that all the outputs are sold and there is no unsold goods. Many businesses hold stock of finished goods to meet future demand at higher selling price.

3.      Inaccurate data collection and analysis may lead to error.

N.B“project break-even point first,

then go for production”

3.2 Budgets and cash flow forecast

  

Budget

It is a monetary plan. It shows revenues and expenditures of a business unit or department for future time period.

Types of budget

·         Sales budget
·         Production budget
·         Marketing budget
·         Others

Advantages of budget:

1.      Control and monitor
2.      Reduce fraud
3.      Planning
4.      Efficiency
5.      Motivation

Format of Budget

Cash flow forecast

It shows inflows and outflows of money of a business of future time period.

Cash Inflows

The money coming into business. Incomes are:

·         Sales revenue
·         Loans
·         Fresh capital
·         Interest received, rent received, etc
·         Sale of assets

Cash outflows

The money going out of business. Payments are:

·         Wages, salaries

·         Loan repayment

·         Materials

·         Rent, rates, utilities

·         Tax, fees

·         Purchase of assets

Net cash flow

It is the difference between cash inflows and cash outflows.

Formula:

Net cash flow = Cash Inflows – Cash Outflows

N.B.Non-cash items like depreciation, provisions, etc are not taken into account in the cash        flow forecast.

Importance of cash flow forecast

1.      Identifying cash deficit or shortages

2.      Supporting applications for funding

3.      Help when planning the business

4.      Monitoring cash flow

 Format of Cash Flow Forecast

N.B. “to win one needs strategy,

to spend you need a budget!”

3.1 External and internal sources of finance

Need for funds:

1.     Start-up

During commencing a business finance is required to purchase resources like premises, plants and machineries, to pay bills for legal formalities, etc.

2.     Cash flow for day-to-day cost / Working capital

Working capital is the money required to fund the day-to-day expenses of the business.

3.      Expansion

Every firms wish to grow and expand. To expand funds are required to purchase new land and machines, employ more labour, etc.

4.     Emergency funding

If there is insufficient funds to settle unexpected payments like tax, etc then businesses need to introduce new capital, take loans, etc.

Types of sources of finance:

1.     Internal sources of finance

Funds come from inside the business. Types of internal sources of finance are:

v  Retained profit

v  Working capital

v  Sale of assets

2.     External sources of  finance

Funds come from outside the business. Types of external sources of finance are:

·        Short term sources of finance

Funding obtained for less than one accounting/fiscal year, i.e. the payback period is expected to be within one year. The sources are:

v  Bank overdraft

v  Unsecured bank loan

v  Hire purchase

v  Leasing

v  Factoring

v  Trade credit

v  Credit cards

·        Long term sources of finance

Funding obtained for more than one accounting/fiscal year, i.e. the payback period is expected to be over more than one year. The sources are:

v  Owner’s equity

v  Share capital

v  Loan capital

v  Debentures

v  Mortgages

v  Venture capitalist

3.     Government finance

Governments give financial support to the businesses. Government finance schemes are:

v  Enterprise Finance Guarantee (EFG)

v  Working Capital Scheme

v  Capital for Enterprise Fund (CFE)

v  Enterprise Capital Funds (ECFs)

Choosing sources of finance:

1.     Cost of finance

Businesses prefer the cheapest source of finance which means the interest payment, administration cost, other expenses will be cheapest.

2.     Use of funds

If funds are used for heavy capital expenditure then long-term sources are used.

3.     Status and size of the business

Different types of businesses have access to their respective sources of finance. E.g. limited companies are bigger firms so they often raise finance from sale of shares.

4.     Financial situation

If the liquidity position of the company is not sound then it’s difficult to raise funds. Also the lenders are reluctant to lend funds without collateral assets.

5.     Risk

In limited companies one way of measuring the risk of choosing source of finance is looking at the gearing of the company. Gearing shows the relationship between the loan capital and the share capital of a company.

Formula:

Working Capital = Current Assets – Current Liabilities

Format of Working Capital

Businesses improve working capital by:

·         Reducing debtors

·         Delaying creditors

·         Selling assets

·         Getting O/D or short-term loan

·         Introducing new or fresh capital

N.B.“don’t waste time and money,

Spend smartly!”