Business 9609

Revision notes with

Sir Muzammil Ameer
UNIT 5: Accounting and Finance

SIR MUZAMMIL BUSINESS SCHOOL

 Finance and why a business needs finance

 Finance is the money that a business needs

 start up (to buy machinery, equipment, or inventory)
 grow (to open another branch, office, or factory)
 survive (to meet daily routine expenses)
 Distinction between short and long term need
for finance

 Short-term financing can be for periods as short as weeks (or even days), or as
long as one to two years. Short-term financing is typically used to cover short-term
needs like materials purchases, inventory, and cash flow fluctuations.
 Long-term financing is typically credit extended for periods over two. Long-term
financing is typically used to cover equipment purchases, vehicles, facilities, and
other assets with a relatively long useful life.
 Difference between cash and profit

 Cash is the physical money that a business hold while

 profit is the difference between revenue and total expenses

 Business failure as a consequence of lack of
finance

 Bankruptcy is a situation when a business has no money to cover its expenses

or payment of liabilities
 Liquidation is a situation when a business is declared bankrupt and its assets is
sold to cover its expenses or liabilities
 Working capital

 Any amount that a business is needed to cover day-to-day expenses. It is

calculated
working capital = Current assets – current liabilities
 It is important for many reasons
 It saves from bankruptcy
 It is required to buy inventory
 It is used to cover daily routine expenses
 Managing trade receivables and trade payables

Trade receivables is an amount owed to the business and trade payable is an

amount owed by the business. A business allows a limited credit time period for
payment to credit customers for example 30 days to pay invoices and the same
receive a credit time period from suppliers so managing trade receivables and
trade payables are important. For example, if a business allows its customers 30
days and receives from a supplier 24 days so it can create cash flow problems for
that business. The trade payable period should always be more than the trade
receivable period
 Distinction between capital expenditure and
revenue expenditure

 Capital expenditure is an amount that a business spent on buying non-current

assets. For example, buying buildings, machinery, etc
 Revenue expenditure is an amount that a business spent on daily routine
expenses. For example, payment of rent, wages, etc
Reasons to differentiate
 To calculate profit, revenue expenditure must be identified
 To see the net worth of business
 To prepare financial statements at the end of the year
 Internal source of finance

 Owner investment
 Retained earnings
 Sale of unwanted assets
 Sale and leaseback of non-current assets
 Working capital
 External source of finance
 Share capital
 Debentures
 New partners
 Venture capital
 Bank overdrafts
 Leasing
 Hire purchase
 Bank loans
 Mortgages
 Debt factoring
 Trade credit
 Micro-finance
 Crowd funding
 Government grants
 Factors influencing the choice of sources of
finance

 Cost of borrowing
 Flexibility in amount
 Flexibility in time period to pay
 Business structure
 Purpose of finance
 Level of existing debt
 Cash flow forecast and its benefits

It is a prediction of cash inflow and cash outflow during a period of

time. It is important for many reasons
It helps to identify any cash deficit month so can manage cash in
advance so save such worse situation
It saves from bankruptcy as business always hold cash to cover daily
routine expenses
It enables to take loans
It saves from high cost of borrowing in emergency
 How to improve cash flow

Share capital (only available for limited companies)

Bank loans
New partner
Own investment
 Accurate cost information and its importance

Costs refer to all spending incurred by the business in producing the

product. The average unit cost of producing a hamburger is USD$2.
It is important for many reasons
To set the selling price
To identify the breakeven output
Setting budgets for the business
To calculate accurate profit
Measuring efficiency
 Different types of costs
 Fixed cost. Cost that does not change with the change in output. For example, rent,
insurance
 Variable cost. Cost that changes with the change in output. For example, raw material
 Direct cost. Cost that can be traceable or identified on a single unit. For example, raw
material
 Indirect cost. Cost that cannot be traceable or identified on a single unit. For example,
rent
 Average cost = total cost / total output
 Marginal cost. Cost of making one extra unit that a business pays. For example, raw
material
 Total cost = fixed costs + variable costs
 Contribution costing

A costing method that considers only variable cost (raw

material and direct labour) as unit cost. It means it takes all
variable costs only to determine unit product cost.
Contribution is term used to cover fixed cost in contribution
costing.
Contribution is used in many decisions i.e. make or buy,
produce or discontinue
 Difference between contribution costing and full
costing

 There are two school of thought for calculating profit in costing

 The main difference between contribution costing and full costing is
that in unit product cost, contribution costing considers only variable
costs but full costing considers all variable and fixed costs both
 Full costing calculates fixed cost per unit but contribution costing
treats fixed cost as an expense in the period as it incurred
 Uses and limitations of full costing method

 It enables to calculate total cost of a single unit

 It is acceptable in accounting standards to calculate profit
 It is difficult to calculate fixed cost per unit
 Accuracy of full cost per unit is not possible
 Uses and limitations of contribution costing

 It is used only for short term decision making

 It does not consider fixed cost on a single unit
 Full cost per unit is not possible in contribution costing
 Difference between contribution and profit

Contribution is the difference between total revenue and total

variable costs.
Profit is the difference between total revenue and total costs (fixed
cost + variable costs)
Contribution comprised profit and fixed costs
Contribution = total revenue – total variable costs
Profit = contribution – fixed costs
Contribution is used in many decisions i.e. make or buy, produce or
discontinue
 Situations in which contribution costing would be and
would not be used

It can be used in make or buy decisions, acceptance of special

order, and produce or discontinue product.
It cannot be used in long term decision making or profit
calculation during a year
 How costs can be used for pricing decisions

To calculate contribution on each price and best price is consider at

highest contribution

How costs can be used to monitor and improve business

performance
Costs is compared with previous year’s production or make decision
either efficiency has achieved or not. Same on the other side it can
be compared with making or buying options so best option can be
chosen for maximum profit
 Breakeven analysis and its assumptions

Level of output where total revenue is equal to total costs. A business

earns neither any profit or loss at this output produced and sold. It is an
estimated output and is calculated on a few assumptions
Assumptions for breakeven
 All costs can be easily divided into fixed costs and variable costs
 All output that is produced must be sold
 Only single product is produced by the business
 Selling price/variable cost per unit will be constant
 Uses and limitations of breakeven analysis
 Benefits
 It enables to calculate forecasted cash flow at different output
 It helps in decision making. i.e. production decisions
 It shows margin of safety (sales above breakeven)

 Limitations
 It considers only single product for breakeven output
 Selling cannot constant as can be low of high because of demand and supply
 It considers output produced must be sold but this may be not possible

 Margin of safety

It is the difference between expected sales and

breakeven sales. It means above breakeven sales is
considering the margin of safety
 Budgeting

 It is the financial forecasting of different resources. For example, many budgets

are prepared by the business at the start of the year, sales budget, production
budget, cash budget, etc
Benefits and drawbacks of the use of budgets
 It enables to measures of performance at individual and department levels
 It helps in target setting of departments and individual level
 It can be helpful in decision making
 No flexibility if needed once these prepared
 External factors not consider
 Incremental budgets

Incremental budgeting is a type of a budgeting process

that is based on the idea that a new budget can best be
developed by making only some marginal changes to the
current budget. In other words, with incremental
budgeting, the current budget is used as a base to which
incremental assumptions are added or subtracted from
the base amounts to determine new budget amounts.
 Flexible budgets

 Flexible budgets are essentially budgets that can be

adjusted depending upon revenue and cost changes
throughout the fiscal year. Companies first estimate
fixed costs they expect, or at least costs that they don’t
change as the year progresses. They then allow for
fluctuating variable costs, reviewing costs periodically to
make real-time adjustments.
 Zero base budgeting

 Zero-based budgeting is a special method of budget planning

that is not based on the previous year's budget, but always
starts from scratch
 Zero-based budgeting is a method that has you allocate all of
your money to expenses for needs and wants, as well as
short- and long-term savings and debt payments. The goal is
that your income minus your expenditures equals zero by the
end of the month.
 Variance and its use

It is the difference in amount of budgeted figure and actual figure. For

example, budgeted sales were $5000 and actual sales were $6000 so
sales variance is $1000. It is favorable for the business

Variance can be favorable or adverse for the business. If a variance

increases profit then it is said a favorable variance and if decreases
profit then adverse variance. For example, budgeted raw material cost
is $3000 and actual raw material used costing $3500 so raw material
variance $500 is adverse