Finance and AccountsBy: K. Venkat Swamy

M.B.A., B.Ed., (ICWAI)Accounting and Business Studies Faculty

swamybks1@gmail.comPh. 009609973472

009186869932272013

IntroductionA business has many different costs, from paying for raw materials through to paying the rent or the heating bill.

By careful classification of these costs a business can analyse its performance and make better informed decisions.

The main ways in which a business needs to manage its costs are as follows:

Classification of costs

FIXED COSTS

VARIABLE COSTS

SEMI-FIXED COSTS

FIXED COSTS

Fixed costs are any costs that do not vary

directly with the level of output. Fixed

costs remain the same, no matter how

much the business produces. Fixed costs

exist even if a business is not producing

any goods or services.

FIXED COSTS

e.g., insurance costs, administration, rent, some types of labour costs (salaries), some types of energy costs, equipment and machinery, buildings, advertising and promotion costs etc.,

In the long term, fixed costs can alter. The

manufacturer referred to earlier may decide to increase

output significantly; this may require renting additional

factory space and negotiating loans for additional

capital equipment. Thus rent will rise as may interest

payments.

Variable costs Variable costs are those costs that change in proportion to the amount of output produced.

e.g., raw material costs, some direct labour costs, some direct energy costs

Semi-fixed costs

Semi-fixed costs are costs which only change when there is a large change in output.

For example, costs associated with buying a new machine to cope with increased production.

COSTS

Costs are the expenses incurred by a firm producing and selling its products, this is likely to include expenditure on wages and raw materials etc.,

Total costs (TC) = Fixed costs + Variable costs

Average costs (AC) =

Marginal costs(MC) = TC n – TC n-1 the cost of producing one extra or one fewer units of production.

REVENUETotal Revenue is the value of total sales made by a business within a period (usually one year).

Sales revenue (TR) = Quantity of goods sold (Q) X selling price (P)

TR=Q x P

PROFITS

Profit is the difference that arises when a firm’s sales revenue exceeds its total costs. (TR >TC)

Profit = Total revenue – Total costs

P = TR-TC

Normal Profit–the minimum amount required to keep a business in a particular line of production

Abnormal/Supernormal Profit–the amount over and above the amount needed to keep a business in its current line of production

CONTRIBUTION

The difference between the selling price and the variable costs.

Contribution = Sales – Variable Cost

Or

Contribution = Fixed costs + Profit

BREAK EVENOccurs where Total Costs = Total Revenue Start-up costs –fixed costs

Running costs –variable costsRevenue stream depends on price charged‘Low’ price –need to sell more to break-even‘High’ price –lower level of sales required before breaking even

Purpose of AccountsProvide information for stakeholders –customers, shareholders, suppliers, etc.

Provides the opportunity for the business to monitor its own activities

Provides transparency to enable the firm to attract investment

Reduces the chance for fraud –not 100% successful!!

Accounting and FinanceTypes of Information:

Profit and Loss Account –the revenue and costs of a business over a time period

Balance Sheet–the assets and liabilities of a business at a specific point in time

Use these sources to give ratios –the relationship between different aspects of the business

Profit and Loss Account

Shows the flow of sales and costs over a period

Shows the level of profit or loss made

Shows what has been done with the profit or loss

Balance Sheet* A snapshot of the firm’s position at a point in time.

* Shows what a company owns (assets) and what it owes (liabilities).

* Balance Sheet shows what assets a company has (use of funds) and where the money came from to acquire those assets (source of funds)

Balance Sheet

A guide to the structure of the assets of a company.

A guide to the level of gearing–the ratio of loan to share capital

Gives a guide as to the degree of working capital–the amount the company has to be able to pay its everyday debts (current assets –current liabilities)

Shows the total value of a firm at that moment in time

Accounti ng and F inanceAssets: the resources a business owns -Fixed Assets–those lasting more than one year and not used up in

production –equipment, machinery, buildings, etc.

Freehold assets–where the business has full ownership of the assets

Leasehold assets–agreement permitting the leaseholder the right to use the asset for a fixed period in exchange for a regular payment

Goodwill–the difference between the audited value and the market value of a business –the image, brand name, the existence of patents or trademarks, etc.

Current Assets–assets used up during production and which will realise cash within a year –debtors, raw materials, stock, etc.

Accounti ng and Finance

Liabilities:The financial obligations of a business –what a business owes * Loans, shareholders funds, creditors, tax liability, interest owing

Current liabilities–those obligations the business has to meet within a year

The Purpose of Accounts:To provide information for stakeholders

Shareholders progress of their investmentGovernment tax liabilitySuppliers credit worthinessCustomers long term future of the businessProspective Investors decision makingPotential bidders in acquisition activityTrade Unions negotiations with the companyManagement monitor performance of the businessEmployees their position in the business (they may

well also be shareholders!)

Rati o AnalysisKey types:

1. Profitability ratios- a measure of how much profit its activities generate

2. Liquidity ratios– ability of a business to meet its debts

3. Investment ratios– a measure of the performance of the business

Advantages of ratios

• Comparisons are relative to other figures• Compare businesses of different size• Gives picture of company strategy• Financial and trading performance• Compare with industry averages• Simple summary of complex information

Reasons for using ratios

• Gives summary statistics• Helps identify industry benchmarks• Input to formal decision model• Standardise for size

Applications of analysis

• Predictions of corporate earnings• Construct projected financial statements• Predict corporate failure• Indicators of financial distresse.g. Altman’s models, combination of ratios

Problems with ratio analysis

• No agreement on definitions or specific set of ratios

• Accounting estimation• Data not available• Timing of data does not match• Differing accounting policies• Negative numbers and small divisors

Limitations of ratio analysis

• Diverts attention from the underlying information• May not give sufficient attention to the notes to

the accounts• Accounting policies may affect comparison• Industry differences

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