MTG388 Finance

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  • Created on: 22-12-18 17:22


What is accounting?                                Collection, analysis and communication of financial info

Financial Accounting

Deals with making financial statements for external organisation use, gives info on the financial position(wealth/worth) and performance(profit) of an entity to users making economic decisions(Invest/supply/work/loan).  Info is given in a set reguated format.

Managment Accounting

Gives financial and non-financial info to people within the organisation concerned. Allows for planning of activities within budgets;, controlling of buisness future with performance reports; organisation of info which best fits purpose; communication through installing and maintaining reporting system; motivation of eployees within companies; and decision-making.

Financial mangment

How a buisness funds are raised and spent. E.g. --> loans, overdraft, partnership, share issue for new ventures.  Allows the optimisation of riska dn return to increase organisations value.

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Financial Vs Accounting

Why - General use by external,   Specific use by internal

Detail - Overview,     Considerable

Regulations - External regulations, audits, stock exchange rules, company law,     None

Reporting interval(When) - Annual/bi-annual,     As and when needed for that specific report

Time horizon - Backward,     Back and forwards

What info? -

Quantifiable monetary info for financial statements, annual includes non-financial disclosures for depth of understanding

Financial and non-financial info, emphasis and cinetents defined by users needs

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Annual report

Comes uder financial accounting, produced and audited once a year, used for economic decisions

4 main statments:       1.Income statement        2.Statment of financial position      3.Statement of changes in equity       4. Statement of cash flow

Can also include narrative most of which isnt regulated and acts as a marketing tool

Regulations:  Statutary regulations - must be true and fair to inform shareholders and creditors, show neccesity of audit(independant review to determine truth), outline distribution of statements  Accounting standards-UK accounting standards board & international standards accounting board Stock exchange regulation - More frequent and detailed reporting

Regulation and annual reports are needed to inform stakeholders, so they can compare companies on a level playing field. Allows rational investing decisions, so meaning the capital markets are run efficiently and inc the wealth of a nation.

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Income statement

=profit and loss acount


Manufacturing and production costs, e.g opening inventory+purchases-closing inventory+ production cost

Profit from sales minus cost to produce, gives success of core business

Selling, marketing and shipping costs

Office and HR costs, inc accountant, lawyer, debt collection, invoicing & director costs

Profit from operation, includes the one off costs not present in gross profit.

Any small side/one off incomes

Intrest on loans, leases and overdrafts, MUST be lower than operating costs

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Changes in equity

NO details needed!

Gives shareholders info on what has happened to equity in the last year

Dividends(annual payment to shareholders) are shown on this statement

Profits are made on shares either through value increase or payment of dividends

Company doing well = inc share price and payment of consistent dividends

Equity= the amount a company owes to shareholders, value of shares issued by a company, is equal to shares.

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Financial position

=balance sheet - shows company worth and gives info on financial position

Assets- resource expecting to bring profits, 2 types: Current=temporary assets--> inventory(finished goods, part finished goods and raw materials), trade recievables(debators- money owed to the company from customers), & prepayment(bills paid in advance); Non-Current= fixed assets--> buildings, furniture, machines& vehicles ( all tangible assets) plus, brands, patents, and goodwill (intangible assets)

Liabilities-like debts-obligation of company due to past settlement involving tranasfer of resources, 2 tpyes: Current= trade payables(creditors- amount owed to suppliers) and accruals(amount owed in bills not recieved yet where buisness has used the service/product, e.g outstanding gas/electric bills); Non-Current=long term bank loan, debentures, loan notes, sometimes preference shares.

Equity-issued share capital(, share premium(issued price-nominal price) and reserves(revenue reserves and capital reserves- profit made since comany became incorperated)

Accounting equation          Assets=Liabilities + Equity          what the company owns is set set against what the company owes, links to double entry- buy a car = inc in Non-current assets and dec in current asset(cash)

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The sale of a product or service on credit, or an expense on credit, no actual cash is exchanged initially but it does go onto the books.

Its counted in the revenue/expenses but the cash has not yet entered/left the cash flow of the compnay.

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Statement of cash flow

NOT needed to usderstand in detail

Shows general movemt of cash within the buisness, giving cash inputs and outputs

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Profitability Ratios 1

Ratios are used to help comparison over time and between companies, and allow easy depiction.

ROCE --> Return On Capital Employed

ROCE= Operating profit / Equity funds+Non Current liabilities, shows success of manegment using funds, allows informed decisions on weather or not to invest by showing how well previous funds had been used. Shows profitability and Efficiency of asset use, return on invest

Gross profit margin= (Gross profit / Turnover ) *100%

Forecast gross profit margin can be calculated using predicted figures, consistency in gross margin is preferable for buisness and investors, gives gross profit per £1

Operating profit margin = (Operating profit / Turnover) *100%

This value includes all costs and gives best overall picture, again can be used as a forecasting tool, changes can highlight expense change and explain them hence cost control from managment, gives profit per £1

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Profitability Ratio 2

Net asset turnover = Turnover / (Equity+Non current liabilities)

Shows the turnover made per each £1 invested, can compare company over time or between mulitiple companies, 


Keep in mind the depreciation of Non-Current assets, hence old assets will be worth less than the inital investment made by a company. The initial investment in new non-current assets are an initially high expense hence expansion asset will be high. Investment won't lead to instant increased revenue, theres often a slight lag time.

If a buisness is highly labour intensive rather than high in physical assets turnover of staff costs ? number of employees may be useful allowing the revenue per employee, gives a more reflective view of the company

ROCE= key ratio in how company is confirmed, its includes company's profitability and efficiency, making it the most useful measure.

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Liquidity Ratios -ability to make payments

Liquidity is a buisnesses ability to make enough cash to pay liabilities when they are due, its directly linked to the companys short term solvency, if a buisness cannot pay debt=bankrupt. Companys with good working capital management( Working capital management= Current assets- Current liabilities) will mach all necessairy debts, this involves not holding inventory more than needed, collecting trade recieveables and payment promptly of trade payables.

Current Ratio= Current Assets / Current Liabilities,

For every £1 of liabilities the company has £x in current assets, if value is larger than 1 the company can meet debts. Perfect value depends on industry, e.g low for supermarkets. If the ratio is too high it implies ineficiency with large cash reserves, it could be better used by investing to generate profit

Acid test ratio= (Current assets - Inventory) / Current liabilities

Inventory is removed due to time lag in turning into cash, not always relevant, e.g if inventory is quick sale

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Efficiency Ratios

Inventory holding period= (Closing inventory / Cost of sales ) * 365 days

Trade receivables collection period= (Trade receivables / Revenue) * 365 days  -  normally 30 ish

Too long - poor collection policy, or unhappy customers not paying.

Too short - lose customers to competitors with better credit terms, or offering discount for quick payment. 

Trade payable payment period= (Trade payables / Cost of sales) * 365 days

Should match with Trade receivables collection period. Paying quicker can be better, can mean discount. If too long can result in poor relationship with supplier potential issue with future costs and contracts.

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Risk and Solvency

Includes long term/ medium solvency. IE can the buinseness survive in th medium/long term. The medium-term capital structure refers to the medium time scale liquidity if a buisness.

2 main risks to investors, No annual return, and not being repaid.

Solvency, this is assesed based on gearing which looks at how a company is financed. If a buisness has many non-current liabilities(debt) meaning there is potential that medium-long term term patyment on these loans will not be fufilled, making it a financial risk.

Debt ususally consists of non-current liabilities and preference shares. Preference shares can carry a fixed rate of interest for anual payment, in a winding up of a company these are regarded as debt as they must be paid back first. A current loan or overdraft which is semi permenant is also included under debt.

Equity is the ordinary share plus the reserves as the reserves are owned by equity shareholders.

Gearing =Det / Equity = (Loans+Overdrafts) / (Share Capital+Reserve)

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Buisness with high gearing will have high levels of interest payable. This interest must be met byoperating profit.

Interest cover = Operating Profit / Interest Payable   this shows the businesses ability to cover interest payments.

High levels of gearing mean changes(drop) in operting profit have a larger % impact on the profit before tax made

Although high gearing means greater financial risk due to the need to repay but it avoids diluting share ownership, and the repayment timescale and intrest can be negotiated. Payment of intrest is done before taxation making it cheaper in some ways.

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Management accounting - Costing

Allows decision making for costing products and services to ensure profit is made and prices are right. To tender for a project accurate estimates of future costs. Short term choices may also be based off costing like giving disount if not running to full capacity.

Absoption costing is a way to findfull cost of a product or service. This cost is used for valuation of inventory in the annual report and used to determine product price.

2 Types of cost:     Product cost= Manufacrturing costs( inventory and cost of sales); direct materials+direct labour+other direct expenses= Prime cost, Prime cost+indirect production cost(or overhead) = Product cost.   Direct cost are ones related to a product, service or project. Indirect costs are ones related bur not economically feasible to track.

Period cost= office cost, including admin expenses and distribution costs. 

Adsorption cost gives a process to follow, traces direct and indirect cost to cost centres, divide up overheads based on items, and adsorb costs into products.

Can be used in buisness if large part are direct cost, NOT if largly manufactureing overhead are cost, in buisness with a competetive market, or if buisness is niche/premium product.

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Economic Theory

Selling point(Price) of a service or product is defined by the market, price is dependant on demand, most products if price goes down demand will increase

Elaticity of demand, shape of demand curve depends on elasticity- does price change lead to more than proportional change in qauntity demand, if so its said to be elastic. Products which can be swaped or substituted are said to be elastic. Gives a more shallow demand curve.

If a price change leads to a less than proportional change in quantity demand its inelastic. Includes premium or luxery products such as Aston Martins. Present a very steep demand curve.

Economic theory also includes the idea that the supply is dependant on price. Most goods/services with higher price lead to greater supply, as current suppliers try and produce more and new suppliers enter the market.

Supply curve shows as price increases so does quantity. Market price= Equilibrium price= the cross between the demand curve and the supply curve

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Accept market price?  If in competition with multiple sellers and buyers, yes.  If luxury/premium product, No.    Few competitors/monolopoly, No.    Branded with high reputation, No.

Cost based pricing 2 types     1. Absorption costs used to calculate product cost, add markup and use as selling price. Mark up must give enough to cover non manufacturing overheads and a suitable level of return.

2. Marginal costing- calcualte direct cost of product then apply mark-up. Mark-up should cover all overheads and allow profit. Mark-up must be realistic to fall in line with competititors. Short term its viable to price low so costs are covered but profit not made to allow startup to build clienetel and brand. 

Target pricing- analysis of market conducted to find price point, profit margin needed is removed, this leaves cost that production must be achieved within. If cost is lower than current norm cost reduction programs and re-engineering of a product occurs, volume increase can reduce unit cost and lowering quality or reducing specification. E.g Car industy.

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Premium needs and Life cycle analysis

To fetch a premium price point:

-Brand awareness          -Percieved high quality of product

-Uniquness, something special and identifiyable          -Social image

-Corporate social responsibility

Life cycle=duration or project, product or companys existence. Birth, Research, Development, Launch, Growth, Maturity, Saturation, Decline, Death.

Investment in research, development and launch, all these costs must be covered inrevenue as well as production cost. Initially in a lifecycle production cost per unit 

Good exmple=uber price depends on real time supply and demand

Discount and intro offers can be used to attract initial custom, from booking trains early through to intro offers with banks.

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Costs- decision making

Relevant costs and revenues change based on choices made moving forwards hence make a difference to the decisions made for the buisness

Sunk costs = past costs

Variable costs=relevant, these costs vary in direct proportion to the volume of activity

Fixed costs are not relevant, these are equal across multiple output levels. Long term nothing is truely fixed as things ware through.

Oppertunity costs=relevant, the gain you would get from anouther corse of action which is therefore a negative on this course. For example, going to uni might cost £9000, with a £2000 bursary, but the opertunity cost would be the £20,000 you could have earned so the real cost would be £27,000.

Marginal cost is the cost of one additional unit of either a good or service, the added costs are the costs which change, hence the variable costs, therefore these are the ones considered in marginal costing. Fixed costs don't change with the addition of one additional unit so are not considered in marginal costing.

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Contribution = Sales Price - Variable costs, short term a project will be oked if it has a +ive conribution. 

Meaning it contributes to fixed cost and the ction of profit.

Profit= Sales Revenue - Variable Costs - Fixed Costs

Profit = Contribution - Fixed Costs

In short term decision making contribution is key with marginal costing, for long term standing decisions absorption costing should be used. If an alternative option for the extra capacity this should be considered and possibly the addition of an oppertunity cost.

Out-sourcing - if a part can be manufactured/bought externally to the buisness, the buisness must choose the more profitable option. If theres surplace capacity, variable costs of manufacture should be compared to purchase price. If not spare capacity, purchase price should be compared to variable cost+oppertunity cost of lost contribution.

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Break- even point

When neither profit or loss is made is termed the break-even point, hence total revenue=total costs, total costs include both variable and fixed costs.

Can be seen on a break-even chart or cost-volume-profit chart(CVP), this graph plots profit/cost against quantity, the lines for sales revenue and total cost are then plotted. The point at which they intercept is the break-even point.

Above BE =profit, below BE=loss. X intercept=fixed costs, X intercept to end of cost line=variable costs.

At BE:      Sales revenue-variable cost-fixed cost=0

                Break even point(quantity)= Fixed costs / Contribution

High fixed cost? If fixed costs are high per unit, theres two options, either a high price point or a high volume of sales.

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Break- even point 2

Target profit, if a buisness wants to make a certain level the BE formula can calculate the quantity of sales needed by adding the target profit to the fixed costs.

Margin of safety is the extra planned/actual sales above the BE to give a buffer zone, this is given as % of sales estimate

Using BE can be helpful in initial price setting, if you start seling in a buisness with high fixed costs where high sales quantities are not viable the price must be set at a point to cover re-occuring fixed costs to maintain the buisness.

It can also be used in buisness plans, knowing the expected sales targets plus buffer shows the risk involved in the proposed buisness plan.

Marketing can also use BE, as the cost of marketing can be added to the fixed costs showing what extra sales volume need to be hit to make this achievable and profitable.

Discounting items, the extra number of sales needed to maintain profit can be seen with the discount price point.

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Limits of break even

-Many assumptions made, often unrealistic in actual buisness, e.g semi-variable costs

-The production of a unit does not necesarily mean it has been sold

-The variable cost often changes with output numbers, as higher production is more efficient and bulk orders can give discount.

-Often multiple products  made by a single buisness

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Capital investment intro

Investment is not taking consumption(usually capital now) and using it to further the consumption later

A specific oppertunity is called a project

Investment appraisal is....

ID of relevant future cashflows for the project, projection of future cash in and outflows plus timescale, compared to set stanard within projects to show sustainability 

Often for a buisness stratergy investment, contracts or development are needed all of which require financial outlay, hence an investment decision. Decision can be whether to invest or which to invest in- Capital rationing.

Considerations: Risk/uncertainty, Monetary return, Non monetary buisness aims

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Appraisal techniques 1

Appraisal Techniques- all look at cashflow not pofit, more indicative of future wealth and don't suffer accounting allocations.   Techniques= Accounting rate of return,Payback period,Net present value,Internal rate of return

ARR=Average expected return / (Average capital employed/Investment)*100%

Simple and easy, like return on capital employed(key ratio to investors), if judged on ARR same internal and externa assesment.

Same value given to cashflow year 1 and 5, ARR before or after depreciation?, doesnt look at size of investment- 10% generated on £10 is far less than 10% generated on £10,000

Payback period- amount of time for internal investment to be repaid from the net cash inflows

Minimises impact of long term risk(goverment change, competitors copying...), quick and simple, avoids difficulties in projecting cashflow.

Hard to predict necesaiy expenditure especially if large -ive cashflow at end of project, ignores time value of money, favours short term over long projects.

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Appraisal techniques 2

Time value of money, over time intrest will be paid on any sum of money hence £100 today with 10% intreset will be worth £133 in the 3 years time. This increase is called compunding. The reverse is called discounting, if we know it'll be worth £133 in 3 years we can back track and calculate the initial value.

With investment appraisal we use discounting, we estimate cash flows expected and discount them at an appropriate rate of intrest(accounts for inflation plus firms required rate of return. The required rate of return depends on project risk involved and oppertunity cost of not investing elsewhere. The discount rate used for invetment appraisal=cost of capital.

Net present value. Once timing and future cashflow are known the firms cost of capital can be applied giving cash flows thier present value. Total present value= Net present value. +ive Net present value should be accepted.           NPV=total present value - investment 

Recognises time value of money, looks at different investment size, allows addivity(mulitlayer projects can be assesed)

Hard to explain to general public, gives monetary answer not % for comparison(an investment of double the amount may give 10% more profit, using this it would be a better investment)

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Appraisal techniques 3

Internal rate of return is the discount rate which would give a NVP of zero, this shows the return from an investment oppertunity, calculating IRR is done using; a computer package, trial and error or graphically.

NVP is preferable over IRR, becasue if net cash flows are both +ive and -ive there can be multiple IRRs. IRR is also a % wher buisness usually prefer a value when lloking at cashflow.


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Business forms

Sole trader- self employed individual one operates alone

Partnership- 2+ coming together under a partnership agreement to run a business(John lewis)

Limited company- legal aggrement where small business is incorperated. The owner acquires shares in a company.(Laing O'Rowke)

Public limited company- incorperated buisness where shares can be made availabe to the public(Next plc).

Sole trader/ partnership  is NOT a seperate legal entity

Accounting point of view, a buisness is seperate from the owners= Buisness Entity Concept. Meaning there should be a clear difference in finances between buisness and owners. That said if the buisness makes a loss and cannot pay the owners assets can be used, they put their private assets at risk.

Risks: health and safety legislation, employment law, enviro legislation, product warrenty issues. An owner or partner can and will be sued, parnters must trust each other= joint/several liability

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Funding buisness

Initial funding for sole trader/partnership - normally owners/partners individual contributions, known as capital of the buisness.

Retained earnings- profits not distributed but put back in to finacne the buisness, these increase the owners capital(belong to owners), these give a groing buisness added funding, best funding source as they have to cost or intrest other than oppertunity cost.

Working capital funding- Should cover day to day operations, = current asset- current liabilities

Buy inventory -> Produce product -> Sell product(makes customer credit) -> Collect cash from customer and replace inventory -> buy inventory....

Overdraft- short term to cover working capital but often incurs charges and high intrest rate, should never be used for non-current assets, growth or long term projects only for short term investment.

Loans- to fund expansion buisness owners can add capital or obtain a loan, loans from banks require workable buisness plans with forecasted cash flows with payment of intrest built into projectionsalongside loan repayment. Colaterol is often needed to secure the loan.

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Limited companies

Small buisness qualify for government grant, but these can be lengthy to obtain with niche and strict conditions. Can be area dependant(Northern power house fund). Can relate to activity(reseach and development). Start-up loans. Buisness support and advice(Connectivity vouchers). Employee related(Vocational trainning)

If a imited company the earnings are "the companies" not the owner meaning the owner does not have to include it in their earning hence do not need to pay tax on the earning.

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Public Limited Company

Normally large and initially funded by shares. Shares can be offered to public either through placement or full issue. To secure more funding a company can issue more shares to existing share holders via a rights issue or again a full issue.

Debt Vs Equity

To raise finances, the choice of the two may arise. Equity holders take on more risk and ususally want a higher return (dividend or capital growth). Debt is riskier to a company as intrest must be paid no matter the profit that year. Intreset payments are usually lower, and are paid before taxation, loans sheild profit from taxation.

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