Essential Standard 4.00 Understanding the role of finance in business. 1

Objective 4.01 Understand financial management. 2

Topics  Financial planning  Business budgets  Financial records and statements  Financial performance ratios 3

Financial planning 4

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. 5

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. 6

Business budgets 7

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. 8

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. 9

Sample Company Budget January 1, xxxx to December 31, xxxx CategoryActualBudgetDifference Inflows Net Sales385,400300,00085,400 Cost of Goods Merchandise Inventory, January 1160,000 0 Purchases120,00090,00030,000 Freight Charges 2,500 2, Total Merchandise Handled282,500252,00030,500 Less Inventory, December 31100,000120,000(20,000) Cost of Goods Sold182,500132,00050,500 Gross Profit202,900168,00034,900 Interest Income (200) Total Income202,500168,70033,800 Expenses Salaries68,25045,00023,250 Utilities5,8004,5001,300 Rent23,000 0 Office Supplies2,2503,000(750) Insurance3,900 0 Advertising8,6509,000(350) Telephone2,7002, Travel and Entertainment2,5502, Dues & Subscriptions1,1001, Interest Paid2,1402,500(360) Repairs & Maintenance1,2501, Taxes & Licenses11,70010,0001,700 Total Expenses133,290106,85026,440 Net Income$69,210$61,850$7,360 10

11 Startup Budget March 17, 2011 Cash Needed% of Actual Cash% of to StartTotal SpentTotalVarianceTotal Monthly Costs Salary of owner-manager$6, %$6, %($500)15.8% All other salaries and wages7, %7, %(100)3.2% Rent1,0002.3%9001.9% % Advertising2,0004.6%2,0004.3%0 Delivery expense %1,0002.1%(600)19.0% Supplies5001.1%1,5003.2%(1,000)31.6% Telephone5001.1%5001.1%0 Other utilities5001.1%7601.6%(260)8.2% Insurance6001.4%6001.3%0 Taxes, including social security1,0002.3%1,0002.1%0 Interest5001.1%5001.1%0 Maintenance3000.7% %0 Legal and other professional fees3,0006.9% 3,3007.0%(300)9.5% Miscellaneous5001.1% %0 Subtotal$23, % $26, %($2,660)84.2% One-Time Costs Fixtures and Equipment$10, % $11, %($1,000)31.6% Decorating and remodeling1,0002.3% 1,2002.6%(200)6.3% Installation charges5001.1% %(100)3.2% Starting inventory5, % 4,0008.5%1, % Deposits with public utilities1,0002.3% 1,2002.6%(200)6.3% Legal and other professional fees5001.1% %0 Licenses and permits5001.1% %0 Advertising and promotion for opening5001.1% %0 Cash7501.7% %0 Other2000.5% %0 Subtotal$19, % $20, %($500)15.8% Totals$43,750100% $46,910100%($3,160)100%

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

Financial records and statements 13

Financial Records and Statements  What is the purpose of financial records?  Financial records used by businesses:  Asset records  Depreciation records  Inventory records  Records of accounts  Cash records  Payroll records  Tax records 14

Financial Records and Statements continued  What are financial statements?  What is the difference between a balance sheet and an income statement? 15

Sample Income Statement 16

Sample Balance Sheet 17

Financial performance ratios 18

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 19

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. 20

Financial Performance Ratios continued  Debit to equity ratio  Equals total liabilities/owner’s equity  Shows how much the business relies on money borrowed externally versus money from within the business. Ideally, this ratio should be less than 2.0.  Normally, the lower this ratio, the more favorable it is for the company. 21

Current Ratio and Debt to Equity Ratio  Current 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 Ration Required: Calculate debt to equity ratio. Calculation: External Equities / Internal Equities = 1,200,000 / 18,000,000 = 0.66 or 4 : 6 22 Equity share capital Capital reserve Profit and loss account 6% debentures Sundry creditors Bills payable Provision for taxation Outstanding creditors 1,100, , , , , , , ,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. 23

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. 24

Return on Equity Ratio and Net Income Ratio  Return on Equity 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) / 1000,000 )× 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. Calculation: Net sales = (520,000 – 20,000) = 500,000 Net Profit Ratio = [(40,000 / 500,000) × 100] = 8% 25