Finance why do we need finances?

1. Start up capital
2. Working capital for day to day operation
3. Expansion of business; need money to buy capitals
4. Buy out another firm
5. Contingencies: recessions, fires, etc.
6. Pay for R&D


Working capital is current assets minus current liabilities. It is money used to finance for
day to day operation such as rent, salaries, paying for raw material etc.

How much working capital is needed?
- We need enough so business dont become illiquid
- We cannot have to much or else opportunity cost will be too high
- We need more working capital if we give out lots of credit for sales, we need less if
we receive credit more than we owe to creditors
Working Capital cycle: buy supplies on credit ->sell on credit ->receive money >money to
buy supplies/pay suppliers
The longer the working cycle takes to complete the more working capital will be needed.

Managing Working Capital: dangers from both too much or too little working capital.

4 main components of the cycle:
1. Debtors (Customers) :
- Give shorter credit terms, debt factoring, not credit to new customers, only credit to
credit worthy customer, offer discounts to those pay early
Capital expenditure:
Money to buy or upgrade physical assets that last more than 1 year; require long term
source of finance

Revenue expenditure:
Money used in day to day operation which is paid for by working capital; money that is
used to generate revenue; short term source


2. Creditors (Suppliers) :
- Negotiate longer terms, delay payment, pay for more on credit
3. Stock (Product)
- Use JIT stock ordering with accurate demand forecast, more efficient stock control
preferably using computer to keep sales record, stock level, and reorder when
needed, keep less stock
4. Cash (Money) :
- Use cash flow forecast, sell unused assets, buy less capital and invest less











Sources of finance:
Internal External
1. Retained earnings 1. ST/LT bank loans, debentures
2. Owners investment 2. Bank overdraft
3. Sale of shares or new partnership 3. Grants
4. Sale of unused assets
5. Sale and leaseback of assets
6. Reduction in working capital

Evaluation of internal sources of finances:
This type of capital has no direct cost to the business.
Although, if the assets are leased back once sold, there will be leasing charges.

Why do we use published accounts?
To knows its financial position as at the end of the year. E.g.: How much does the
business owe?


To know the result of its business operation. E.g.: It has made profit or loss.
To help it make business decision.
To compare the results of the business operation.

Internal External
1. Business managers: measure
performance, help make decisions, set
targets
1. Customers: safe to buy from bus,
purchase of after sale service
2. Employees: job security, demand for
higher wages
2. Community: to see whether business
expands or not, income
3. Owner/shareholder 3. Government: calculate tax, whether in
danger of closing down, abiding
accounting laws
4. Banks: can pay back loans or not
5. Investors: assess potential profitability
and outlook
6. Creditors: should supply on credit or
not

Limitation Of Published Accounts
All stakeholders have a use for the published accounts of the business.
The companies will only release the absolute minimum of accounting information as laid
down by company law.
Company directors obviously wish to avoid sensitive information falling into the hands of
competitors or pressure groups.

Data that does not have to be published in a companys annual report & accounts
include:
a) Details of sales & profitability of each goods & services.
b) The R&D plans of the business.
c) The future plans for expansion & rationalization of the business.
d) The performance of each department.
e) Evidence of the companys impact on the environment & the local community.
f) future budgets or plans.



Are Published Accounts Really Accurate?
Stakeholders are often concerned about the accuracy of the published accounts.
No company can publish accounts that it knows to be illegally misleading.
There are many instances when in compiling accounts it is necessary to use judgement &
estimations.
These judgements can often lead to a difference of opinion between accountants. E.g.:
Over the precise value of goods (stocks) or the value of other assets.

Common forms of window dressing accounts include:
a) Selling assets such as building.
b) Reducing the amount of depreciation of fixed assets.
c) Ignoring the fact that some customers (debtors) who have not paid for goods delivered.
d) Giving stock levels a higher value then they are worth.
e) Delaying paying bills or incurring expenses until after the accounts have been published.

For these reason, published accounts of companies need to viewed with caution by
stakeholders.
They are useful starting point for investigating the performance of a business.

Several branches of accounting:
a) Financial accountants
b) Management accountants

Financial accountants - Prepare the published accounts of a business & usually concerned
with the past. They need to know about accounting technique, company law, auditing
requirement & taxation law.

Management accountants - Prepare detailed & frequent information for internal use by
the managers of the business who need financial data to control the firm. Concerned with
the future. They need knowledge on accounting concepts & methods & they also require
training in economics & management science. They involved in decision making.

The Work Of Financial & Management Accountant
Financial Accounting
a) Collection of data on daily transactions.
b) Preparation of the published report & accounts of a business.


c) Information is used by external groups.
d) Accountants are bound by the rules & concepts of the accounting profession.
e) Accounts prepared once or twice a year.
f) Covers past periods of time.

Management accounting
a) Preparation of information for managers on any financial aspect of a business, its
departments & products.
b) Information is only made available to managers.
c) Accounting reports prepared as & when required by managers.
d) No set rules.
e) Cover past time periods, but can also can be concerned with the present or future.

Foundations Of Accounting - Accounting Concepts & Conventions
The Double-Entry Principle
Every time a business engages in a transaction. E.g.: Buying materials or selling goods, the
accounting records must include it.



Business accounts

1. Profit and loss account
2. Balance sheet
3. Cash flow statement

1. Profit and loss account

A forecasted income statement example.




Source: cie 2011 m/j paper 33

(A) Forecasted income statement

Forecasted income statement for fpc year ending 31 may 2012






Gross profit margin
=(revenue cost of
good )/revenue
72% = (56-cogs)/56
Cogs =15.68

(B) Usefulness of forecasted income statement
Forecasts of future profits and losses
Allow comparisons with budgets and past performances
Useful for decision making what if questions
Based on forecasts such as market research, past data etc. So considerable
inaccuracy
Ceo might be window dressed profits to push decision and optimize data
(C) Continue or not?
Clearly profitable = npm increase from 14% to 19.5 % which is 5.5 % increase
56% increase in net profit
Fpc = plc so should please shareholders demands for high dividends
Operation ends in a few years so pressure group will be pleased to know that
No?
Against mission statement
Pressure groups may reduce fpc reputation and sales which has long term
impact on profitability
Evaluation.
How powerful are pressure groups?
Can forest be sold to another business?
Will stockholders care about forest that much to cease operation
Business customers may not be driven by ethical thinking

A legit income statement: records revenue, cost, and profit over a given period.

3 parts: trading, profit and loss, and appropriation
Revenue
(sales)
0.80x50x1.15 =46+10=56
Cost of good
sold
15.68
Gross profit 40.32
Overhead
costs
29.4
Net profit 10.92



Income statement for abc for year ending in 21, june, 2014
Sales revenue Quantity sold x selling price
Cost of goods sold Opening stock +purchases closing stock
Gross profit Revenue cost of goods sold
Overheads
expenses
-utilities ,rent, admin cost, depreciation
Net profit Gross profit - overheads
Less tax paid Corporate taxes
Less dividend Share of profit in return for investing in
company
Retained earnings Whats left from deductions, usually used for
reinvestments (placed in capital employed
under shares in balance sheet)

Used to assess profitability of business in a given period
Help investors to decide whether to invest or not
Bank will use it to decide whether business is profitable enough to repay loans
Determine expected profit in the future (forecasted income statements)

2. Balance sheet: net worth of business in a given period

Balance sheet for year ended 31, december 2014

Current assets:
cash
inventory
accounts receivables
Total current assets
fixed assets
building
machinery
land
intangible assets: goodwills
Total fixed assets
Current liabilities:
short term loans
bank overdraft
trade payables
Total current liabilities
Long term loans
Total liabilities

Capital and reserves
shares capital
retained earnings


Total asset Total liabilities and capital employed
Where total assets and total capital employed is equal

1. Cash flow statements: shows inflows and outflows of cash in a given period
****important statement: inability to generate enough cash flow = liquidation
Purpose:
1. Show sources and uses of cash
2. Helps managers realize why a profitable business may be out of cash
Critics say:
1. Little info, no legal requirement to disclose it
2. Based on historical information, more useful if it is based on future predictions
Cash flow forecast:

A cash flow forecast is all expected receipts and payments of a cash in a month usually
produced for a 12 month period.

Why do business prepare cash flow forecasts?
1. To identify cash shortages and surplus (in example: march, april, june, august =
shortages) so that businesses know when they need to borrow money and how
much they need to borrow
2. Supporting document for when business wants to obtain a loan (shows prospects
of business and whether business have enough cash flow to pay interest)


3. Aid in planning: for finances, for marketing, hr etc.
4. Calculate variance between predicted figures and actual figures at the end of the
year to figure out what happened (perhaps there is a positive variance where
cash flow is better than expected or perhaps a negative variance)
Evaluation:
1. Forecast is not the most accurate because it is based on past data
2. Ignores external environment that brings unpredictable changes

Importance of cash
flow
A. Business will not be able to pay suppliers on time if lack cash
flow, sometimes supplier may stop supplying and/or bring
business to court and then firm can face liquidation
B. Wages and salaries need to be paid on time to reduce labour
turnover and demotivation
C. New capital equipment cannot be paid for which may reduce
efficiency of firm
D. Taxes might not be paid for
Why do we need to
manage it? Profit
vs. Cash
When we make a sale on credit, we count that as revenue but we
dont actually get the cash until a later time. We might be making a
profit, but much of it is made up by receivables. If our suppliers ask
us to pay them or our credit is up, then even if we are making profit,
we dont have the cash to pay our debts until a later date. Hence, a
profitable business can be insolvent.
Insolvency Company does not have enough assets to meet liabilities
Managing cash
flow
1. Size and timing of cash inflows (debtors management)
2. Size of timing of cash outflow (credit management)
3. Finances to cover for cash shortages
Control over cash
flow
1. Keep up to date business records
2. Plan ahead and produce accurate cash flow forecast
3. Operate a tighter credit control system to prevent late or bad
debts
Cash flow problems
1. Reduce or delay
capital spending
-no immediate negative effects
like with suppliers and
customers
-reduced efficiency, less
competitive with old equipment
2. Delay payment -no interest charge -supplier can refuse to delay


to suppliers payment
-worsen relationship with suppliers
3. Rent or lease
equipment rather
than outright buy
-reduce capital costs
-lease company responsible for
maintenance
-lease payments decrease long
term cash flow
-never own asset; wont increase
balance sheet value
4. Reduce debtor
period and insist
cash payment
-avoids fund being tied up
-reduce bad debts
-customers might not want to buy
anymore if no credit is offered
5. Debt factoring -release cash from debts
-risk of bad debts taken by
factoring company
-expensive, lost % of debt
-customer might not like dealing
with factoring company
6. Bank overdraft,
short term loans
-avoid conflict with supplier
and customer
-flexible form
-high interest
-overdraft might need to be repaid
at a very short time; business could
become insolvent


Costing Provide financial information on what to base decisions on, help to
identitfy profitable activities, avoid waste and provide information for
cost cutting
Classifying cost -some costs is hard to allocate as variable cost or fixed cost
-if we are producing multi-products in the same factory, is admin cost
a fixed cost for both? We will be double counting then.
Cost center Specific costs are allocated to a department or specific part of
business Ex. Large company splits itself into cost centers where cost
can be allocated
generate team spirit: sense of belonging to a group
each individual know that if they dont keep cost down,
company will trace it back to the cost center that is incurring
the most cost
identify cost generated by each department and firm can
decide whether it is using too much $$ then what it is making
Profit center Section of business which cost and revenue can be allocated
Ex. A Mcdonalds branch


-budget will be drawn up for revenue and cost (profit) of profit center
for forthcoming year
-allows power to be delegated to profit center managers to speed up
decision making
-profit and loss account can be a financial incentive for everyone in
the profit centre
-but makes it harder to coordinate all small branches from central
office
Unit cost Average cost of producing each unit of output
Total costs/number of units produced
Overheads/indirect
cost
1. Production: rent, depreciation of equipment
2. Selling and distribution: packing, salaries
3. Admins: office rent, clerical, management salaries
4. finance: interest on loans
Full/absorption
costing
Charge all the cost of producing that unit of output
Advantages easy to calculate and understand
use it for single product business
all costs are allocated
good bases for pricing decisions
Disadvantages no attempt to allocate overheads to cost center
costs figures may be misleading since its based on past data
average full cost only accurate if actual output = that used in
calculation
very time consuming, complex, expensive
Contribution Revenue direct costs (sales-variable costs)







Budgets: detailed financial plan for the future that is agreed in advance



Managers will not allocate resources without a plan to work towards. Budgeting then
becomes the plan.

Key Requirements:
1) Departments cannot make conflicting plans (Ex. Marketing wants to increase sales
by lowering price but production wants to cut costs by reducing output so to reduce
labour cost budget, HR wants to hire part times to reduce cost wont work out
for marketing if no one is producing)
2) Managers should be involved in budgeting to give them a sense of purpose and
they should be praised on meeting targets

Stages:
Stage 1: Determining most important organization objectives based on last years
performance, external environment and forecasts based on research
Stage 2: Identify factor that make business successful sales revenue
Stage 3: Sale budget is prepared
Stage 4: subsidiary budgets are prepared in sale budget: cash budget, admin budget,
materials budget, selling and distribution budget
Stage 5: Making sure budgets do not conflict with each other from all departments
Stage 6: Master budget prepared + budgeted profit and loss account + balance sheet
Stage 7: Budget approved by board: budgets will become organization plans for each
department and cost center

Setting Budgets:
1) Incremental budgets: use last years figure to use it as starting point; using raise
sales budget by a target amount while expecting cost to stay the same or lower to
put pressure on staff to be more productive
2) Zero Budgeting: start from 0 or a clean sheet and requires all budget holder to
justify their budgets; usually very time consuming

Advantages of setting budgets:
1) planning to translate objectives of firm and give sense of purpose to workforce
2) set targets to be achieved
3) Coordination and communication everyone work together to achieve targets
4) effective allocation of resources and that capital is fully employed
5) Allow for modification: if plan cannot be achieved then we need to modify it


6) Means to control income and expenditure, regulate spending and draw attention to
waste, inefficiency, losses
7) Emphasize responsibility of execs
8) Delegation of responsibility to subordinates and expect them to meet targets

Drawbacks:
1) Lead to resentments: fewer budgets than last year etc.
2) Inflexible budgets might make managers lose out on opportunities
3) if actual figures varies too much from budget then budget is useless






Budgets - Variance Analysis: At the end of the period, budgets and actual figures are
compared and the reason for difference or the variance is examined.

Variance analysis is seeing whether the same production and style can be achieved at
lower cost
- Differences from planned performance
- Assist in analyzing the causes of deviation from budget
- Reasons for deviation can be used to change future budget to make it more
accurate

Favorable variance: effect of increasing profit (Revenue higher than budgeter, cost lower
than planned)
Unfavorable/Adverse variance: reduces profit (cost is higher than planned)

Fixed Budget Example:


Actual Level: cost is reduced by $2000, that shows favorable variance but fixed budget is
misleading because output changed to 80 (20% below budgeted) so obviously cost


decreased.

Flexible Budget Example:


Flexible budgets show that at 80 units, direct material should be budgeted at $16000,
where the actual variance is adverse by $2000.

Why is profit less than budgeted?
1) Lower than expected prices thus reduces total revenue
2) Lower than expected # of customers which deviates from market research figures
3) Labour costs higher than budgeted
4) Overhead costs more than expected: higher admins and salaries
5) Promotion: less or more than expected

Evaluation of budgetary control: Is it worthwhile?

1) Detailed plan to allocate money and resources give focus and direction to all
departments
2) To know how much each cost center should spend and produce
3) To compare and measure performance between departments
4) To know and monitor progress
5) Gives responsibility to those who are budget holders = empowerment







Business Accounts Analysis: Accounting Ratios
The thing with business accounts is that if we wanted to use it to tell us about how the
business is doing or what the prospects of the business is, it is virtually useless if you just
look at the accounts for one year and try to expect some magical explanation to come up.


There are 2 ways to examine the performance of a business:
1. Comparing accounts of previous years
2. Using accounting ratios then comparing ratios from previous years

There are 5 ratios that we use to assess performance of the business.
Liquidity Profitability Efficiency Gearing Shareholders
1. Current Ratios
2. Acid test
Ratios

1. Gross profit
margin
2. Net profit
Margin
3. Return on
capital
employed

1. Inventory
turnover
2. Sales turnover
1. Gearing ratio
2. Interest cover
1. Earning per
share
2. Dividend yield
2. Dividend
cover


Liquidity Firms ability to pay short term debts or liabilities; concerned with
managing of working capital
1. Current
ratios

-This means for every $1 of debt,
Nairobi has $2 to pay for it (more
liquid position), and for Kingston,
for every $1 of debt, firm has $1
to pay for it
-higher is good but means
business has too much money
tied up in working capital = lost
opportunity cost
-banks, investors, suppliers might
be interested current ratio to see
whether business can repay short
term debts
2. Acid test
ratio

-Inventory is less liquid than cash
so this accounts for business
actual ability to repay debts


Improve
liquidity ratios
(working
capital)
1) better control over debts
2) offer discounts for early payment
3) reduce stock level to reduce storage cost and stock holding cost
4) increase credit terms, sale of asset to increase current assets, sale and
leaseback, loans








Profitability or
performance
Compare profits of the business with sales, assets, capital employed;
how successful business is at getting profit from sale; measure
performance of company
Affects profitability:
1. Changes in overhead costs.
2. Impact of competition.
3. Government policy.
4. Income - Nature of the product (Luxury or necessity)
5. Changes in the external environment.
6. Market segments being targeted.
7. Cost structure of the business.
1. Gross profit
margin (profit
before
overheards)

-measures how good business is at adding value
-owners, managers, employees, investors likely to be interested in this
-must take into account objectives to increase sales = lower price =
lower gross profit margin
-can reduce cost while maintaining revenue
-need to compare ratios in same industry because there is different


level of risk in different industries and gross margin will be different
Net Profit Margin
(NPM) compares
net profit with
sales turnover.


The profitability gap between these 2 businesses has narrowed. This
suggests that Nairobi has high overheads compared to sales.
Kingston could narrow the gap further by reducing expenses whilst
maintaining sales without an increase in overhead expenses.
A comparison of results with those of previous years would indicate
whether the performance & profitability of a company were improving
or worsening.
Return On
Capital Employed

higher the value of ratio = greater the return
compared both with other companies & previous year.
Increased by increasing the profitable, efficient use of the assets
owned by the business, which were purchased by the capital employed.
many different methods so cause discretion


Efficiency ratios Ability to use resources to make profit
Stock turnover
ratio
Number of times a business sells stock in a 12 month period

-the ratio shows the number of times a business sells its stock and
reorder the stock level
-higher means you generated more revenue


-means business is more efficient: perhaps use JIT
Debtors days ratio
(days sales in
receivables)
How long it takes to get money back from sales on credit


-means it take 109.5 days to collect debts on average for Nairobi
-shorter time to collect debt is good because money can go toward
working capital to pay debts
-take long time may mean that business risk being insolvent


Gearing ratio Measure of how much of the business is funded by interest bearing long
term debt


-highly geared over 50% means lot of business is funded by debt
-under 50% means business is unambitious and playing it safe
-shareholders might not get that much dividends since business needs
to pay interest first
-more risking more creditors as business become highly geared because
they run the risk of not being paid
-business might want to get finances from loans rather than from
stakeholders so they dont lose control
-low geared doesnt mean shareholder are going to get a lot of
dividends
Shareholders or
investment
Investors or shareholders use these to determine the worth of the
company and their shares; investing in a company can result in 2 kinds


ratios of gains: capital gains and dividend yields, these ratios analyze how
profitable an investment is in firm
Dividend yield
ratio
Dividend per share as a % of current share price
-measures rate of return a shareholder gets at current share price
-compare it with bank interest rates and dividend yields from other
companies

This means for every 3.00 you invest in Nairobi, you get 5% return
annually.
-need to be compared with previous years and other companies
Dividend cover Profit after tax/annual dividend
Measures how many times a companys dividend can be paid from net
profit
-the higher the ratio means the company couldve paid dividend x
times more had it paid out all of its profit after tax
-that means more of the profit is used from reinvesting into the business
Price/Earning
ratio (EPS)
Market price of shares as a proportion of earning per share; shows how
much investors are willing to pay for current earnings ( for every 0.30
cents earning, investors are willing to pay $1.50)
=market price per share/earning per share(profit after tax/number of
ordinary share)
Ex. Market price per share = $1.50, earning per share is 30 cents
$1.50/$.30=5
This means it will take 5 years to earn the cost of the share from
dividends
-Fluctuations of price in shares means price earning ratio need to
change constantly























Investment Appraisals: methods to assess the value of investment projects.


Necessary Information for investment appraisals:
1. Initial cost of investment like equipment and installations
2. Estimated life of project: how many years of returns
3. Residual value of investment: at the end of project, assets may be sold
4. Forecast of net cash flows of project: all investments require forecast but forecast may
not be accurate representation of future so some amount if risk is involved with every
project that needs to be taken into account

Definitions
Investment: an expenditure on capital goods, construction, inventory, or public sector
investment in hope to yield a return in the future.

Net Cash flows: inflows outflows of cash; revenue from investment less operating cost



1. Payback Method

Calculates length of time taken to recover original investment from a projects net cash
flow

Ex 1) A project costs $2 mil. And is expected to payback $500,000 per year, the payback
period will then be 4 years.
Ex 2)




Techniques:
1. Payback Period
2. Average rate of return
3. Net present value
4. Internal rate of return (IRR): determine whether an investment project is worthwhile




2(a) (II) Payback period
= cost of project/annual return
=15/4.4
=3.409 = 3 years and 4.91 months

Why do we calculate payback period?
1. Business may have borrowed $$ and longer payback might mean more interest is paid
2. Faster the payback, the faster capital can be made use of in other projects
3. Cash flows received in the future is lesser in value than cash flows today because of
inflation and returns from savings and other investments
4. Some managers want to reduce risk, longer to payback = more uncertainties

Benefits of Payback Period:
1. Quick and easy to calculate and easily understood
2. Useful for businesses where liquidity is important to overall profitability
3. Result can eliminate projects that take too long to pay back
4. Technology changes rapidly so we dont want long payback periods which creates the


uncertainty that product will be outdated very soon

Disadvantages:
1. Does not consider cash earned after payback and overall profitability of project
2. Sometimes, very profitable investments might be rejected just because it takes longer to
pay back

2. Average Rate of return (ARR): measures net return per annum as a % of initial spending


Steps:
1. Add up all positive cash flows = $2m + $2m + $2m + $3m = $9m
2. Subtract cost of investment = $9m - $5m = $4m
3. Divide by life span = $4m/4 years = $1m
4. Calculate the percentage return: $1m/$5m x 100 = 20%

Result means that over 5 years, business can expect 20% on investment per year. Result
can be compared to ARR of other projects; Criterion rate can be set to use to refuse
projects that give return less than the criterion rate.

Example:




Source: 2008 MJ Paper 2
D(I) ARR
=annual return/initial investment
=total inflow = 0.25x5 =1.25
=1.25-1 = 0.25/5 = 0.05 per year
=0.05/1 = 5%
Advantages:
1. Uses all the cash flow data and take into profitability of whole project
2. Result easily understood and compare with other projects
3. Accept or reject using criterion rate

Drawbacks:
1. Ignores how it takes for cost to be recovered. 2 projects can have similar ARR but
different payback times
2. Less likely to be accurate as all cash inflows are included, later cash flows are more
uncertain
3. Time value of money is ignored


Evaluating ARR:
1. Very widely used but it is better to use payback with it too
2. Results then allow consideration of both profits and cash flow timings

3. Net present Value: looks at size of cash inflow over life of capital as well as timing of
money
-cash is more valuable now than later
Equation: A/(1-r)^n
A= money
R= discount rate
N= # of years
This gives us the present value of the money that we predict will receive in the future with
cash flow forecasts


Ex. $300,000 investment, discount rate = 10%, cash inflow = $75,000 per year for 5 years
with residual value 10000 after 5 years. Find NPV of project.

Year Cash flow Present value
0 -300000 -300000
1 75000 71428.57
2 75000 68027.21
3 75000 68787.82
4 75000 61702.69
5 85000 66599.72

NPV = $332546.01-300000=32546.01

4. Internal rate of return: where NPV =0 by guessing and checking discount rates which is
super complicated anyways and much harder to do than the other methods

Qualitative Factors: investment is not just about making profit
1. Impact on environment and local community: bad publicity may dissuade managers
to not go ahead because of long term impact on sales and image
2. Some projects does not receive planning permission and pressure groups may try to
influence business decisions
3. Aims and objectives of business
4. Risks that managers are willing to take