Lesson 1, Topic 1
In Progress

6.5 Manage finances of a new venture

ryanrori June 19, 2020

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1.    Explain financial aspects involved in running new venture.

 1.1 The concepts of start-up capital and working capital are explained in relation to a business.

 Start-up Capital:  is any amount paid for creating your business before you begin operating the business.  Most start-up capital is a one-time expense.  The start-up capital is mostly used for purchasing of furniture for the business (or offices), a down payment on a building and purchasing manufacturing equipment.  When you estimate your start-up capital you will need to think of a longer time period.  Just because you open your doors for business, does not mean that your business will automatically begin to earn a profit.

Working capital:  Working capital is the cash you need to run your business. This type of capital is capital that works for you to generate a profit. Working capital is used to buy raw materials, pay wages, pay for electricity etc.

Because you are likely to have only a limited amount of working capital available, and income generated from sales is not always enough to pay your operating expenses, plan your money supply very carefully. To do this, work out a cash flow statement indicating how much money you will need and when you will need it.

Because working capital is not profit, but money needed to generate future profits, be careful how you use it.

1.2 The relationship between cash flow and profit are explained with examples within a business.

 Profit is not included in the amount of money a business owner pays himself/herself. Many new entrepreneurs forget to count the costs of their time and take out a regular salary. Or when times are tough the salary is the first thing they forget.

Profit is not the difference between the costs of the product or service and the price being charged for it. In addition to the costs of the product sold you must account for the fixed costs that are paid regularly each month, no matter what. These include such items as rent or mortgage payments, utilities, regular salaries, insurance, etc.

Next you must remember to plan for the variable costs of running the business that fluctuate with the success of the business and resulting needs for advertising, staffing, supplies, etc. The fixed costs and the variable costs together are known as overheads. Overheads, as well as the costs of the products sold, are subtracted from the income from sales before profit can be made.

Read the following article from the SBA Woman’s Business online Centre


The Importance of Cash Management

Catherine’s business is growing and she’s making a good profit. However, she never seems to have enough money to pay her bills. This month she had to pay the business insurance premium with her credit card. What is wrong with this picture?

Catherine has what is known as a “cash flow problem. ” That means that the cash flowing into her business is out of synch with the cash moving out. The result is that she is temporarily caught short when her bills come due. Catherine needs to plan ahead so she will know whether or not she will have enough cash available when she needs it.

How many of you have had something similar happen to you? Business analysts report that poor management is the major reason why most businesses fail. It would probably be more accurate to say that business failure is due to poor cash management. So how can you manage your cash situation better? In this section we’ll take a look at the cash flow process to find out.


Cash is ready money in the bank or in the business. It is not inventory, it is not accounts receivable (what you are owed), and it is not property. These might be converted to cash at some point in time, but it takes cash on hand or in the bank to pay suppliers, to pay the rent, and to meet the payroll. Profit growth does not necessarily mean more cash — as we will see.

A lesson that all entrepreneurs learn is the difference between profit and cash. Profit is the amount of money you expect to make if all customers pay on time and if your expenses are spread out evenly over the time period being measured. However, it is not your day-to-day reality. Cash is what you must have to keep the doors of your business open, while you are busy trying to make a profit. Over time, a company’s profits are of little value if they are not accompanied by positive net cash flow. You can’t spend profit; you can only spend cash.


Cash flow simply refers to the flow of cash into and out of a business over a period of time. Watching the cash inflows and outflows is one of the major management tasks of an owner. The outflow of cash is measured by those cheques you will write every month to pay salaries, suppliers, and creditors. The inflows are the cash you receive from customers, lenders, and investors.


If the cash coming “in” to the business is more than the cash going “out” of the business, the company has a positive cash flow. A positive cash flow is very good and the only worry here is what to do with the excess cash. Like good health, a positive cash flow is something you’re most aware of if you don’t have it.


If the cash going “out” of the business is more than the cash coming “in” to the business, the company has a negative cash flow. A negative cash flow can be caused by a number of reasons. For example: too much or obsolete inventory or poor collections on your accounts receivable (what your customers owe you) can cause you to be short of cash. If the company can’t borrow additional cash at this point, the company may be in serious trouble.



A Cash Flow Statement is typically divided into three components so that you can see and understand the sources and uses of cash. These components include internal and external sources:

 Operating Cash Flow

Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It is the cash generated from sales of the product or service of your business. It is the real lifeblood of your business, and because it is generated internally, it is under your control.

Investing Cash Flow

Investing cash flow is generated internally from non-operating activities. This component would include investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations.

Financing Cash Flow

Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, the issuance of stock and the payment of dividends are some of the activities that would be included in this section of the cash flow statement.


Catherine might have been able to avoid using her credit card to pay an “unexpected” bill if she had been practicing good cash management. Good cash management is simple. It means:

o   Knowing when, where, and how your cash needs will occur,

o   Knowing what the best sources are for meeting additional cash needs; and,

o   Being prepared to meet these needs when they occur, by keeping good relationships with bankers and other creditors.

The starting point for avoiding a cash crisis is to develop a cash flow projection. Smart business owners know how to develop both short-term (weekly, monthly) cash flow projections to help them manage daily cash, and long-term (annual, 3-5 year) cash flow projections to help them develop the necessary capital strategy to meet their business needs. They also prepare and use historical cash flow statements to gain an understanding about where all the money went.


Activity 1

Explain the relationship between “cash flow” and profit in your workbooks after reading the article

1.3 An explanation is given of the difference between short-term finance and long-term debt finance with examples.

 Long-term debt  –

Debt financing is capital that entrepreneurs borrow and must repay with interest. Most entrepreneurs need some debt financing because very few of them have enough personal savings for the complete start-up costs. It is important to analyse different kinds of loans that are available and to know about the differences between the loans. For example, if you want to buy a house you apply for a special loan called a mortgage loan. Similarly, there are special loans to finance a start-up business. Long-term debt refers to loans that will be paid after a period of at least one year. This repayment agreement means, that as long as the business honours its part of the agreement, the lender will not have the right to demand quicker repayment. Should the business not honour its agreement, for example by not paying the monthly interest, the loan usually becomes repayable on demand. The new business man will have to ensure that it will be possible to meet the obligations timeously and to the letter, otherwise he may have to find other funds to repay the loan.

 Activity 2

Discuss the following examples of long term debt:

  1. Mortgage
  2. Hire purchase or lease

Give a short description of what it entails.

Short term finance

Short term debt or current liabilities are mainly creditors, bank overdrafts and payments on hire purchase due in the next year. The maximum amount of finance from this source is determined on the one hand by the current ratio: current assets to current liabilities and the amount that the bank and suppliers are prepared to allow a new business.

Examples of short term finance:

  1. Bank overdraft – A bank overdraft facility is a short term fluctuating loan granted by a commercial bank to a business, with a predetermined amount as maximum limit.
  2. Creditors or trade financing – This is financing the business obtains from its suppliers. Early in the life of the business this type of credit will not be easy to find, as the business has no record, as yet, of prompt payment. Still, this form of finance should not be neglected, as it is inexpensive and convenient.
  3. Other short term financing – There are other sources of short term financing such as invoicing debtors or short term loans from persons or businesses.
 Activity 3

How will you finance your venture? Write a paragraph on financing options that you will consider and motivate your choice.

 1.4 The difference between fixed and working capital is explained in terms of own business venture.

Working capital discussed under AC 1.1.

Fixed capital – Fixed capital is the money used to buy fixed assets for your business. These may be resources like buildings, machines, equipment, vehicles and furniture. These resources are usually purchased to be used by the business and not to sell to customers. Fixed assets usually decrease in value over time. This is called depreciation. Depreciation is an expense for your business and is recorded in your income statement. Land is the only fixed asset that does not depreciate.

 Activity 4

 Group activity- Visit a local small business owner and ask the following questions:

  1. How did you get your start-up capital? What percentage of your start-up capital was from your own resources?
  2. Ask the business owner advise on what he would suggest for your business.

2.  Apply cash flow management in the running of a new venture.

 2.1  The importance of cash flow management in a business is discussed in terms of the principles of a healthy business practice.

 A company’s income and expenditure statement is a record of its earnings or losses for a given period. It shows all the money a company earned (revenues) and all the money a company spent (expenses) during this period. It also accounts for the effects of some basic accounting principles such as depreciation. The income statement is important because it’s the basic measuring stick of profitability .

What are income statements used for?:

You use an income statement to track revenues and expenses so that you can determine the operating performance of your business over a period of time. Small business owners use these statements to find out what areas of their business are over budget or under budget. Specific items that are causing unexpected expenditures can be pinpointed, such as phone, fax, mail, or supply expenses. Income statements can also track dramatic increases in product returns or cost of goods sold as a percentage of sales. They also can be used to determine income tax liability.

2.2 An explanation is given of the use of cash flow forecast as a budgeting tool.

Turnover:  Usually calculated by year, turnover is the volume of shares traded relative to the total amount of shares owned.

Income revenue:  In business, revenue is the amount of money that a company actually receives from its activities, mostly from sales to customers. To investors, revenue is less important than profit, or income, which is the amount of money the business has earned after deducting all the business’s expenses.  Revenue growth, as well as income growth, is considered essential for a company’s publicly traded stock to be attractive to investors.

Sales/earnings You go into business to make money. Unless an organisation is a not-for-profit enterprise, its goal is to make money for the owners. In order to make money, the business must have income to pay its employees, utility bills, costs of production and other operating expenses. If a company has cash left over after paying its expenses, it has earnings. Earnings are a company’s net profit.  The nature of a business defines how it makes earnings. All businesses generate income by providing either goods or services to clients

Profits:  Revenues – Expenses = Profit.  So, to increase profits you must raise revenues, lower expenses, or both.  This checklist is a series of questions with comments to help you analyse your profits.

A cash-flow budget records the cash you expect to receive and pay out over a period of time, so it:

  • helps you understand and plan for likely peaks and troughs in your cash flow
  • gives you important benchmarks/indicators of what you want to achieve
  • allows you to make informed decisions when planning additional expenditure
  • shows your bank you’re managing your cash flow, and whether you can afford additional borrowings.

There are various factors to consider when preparing your cash-flow budget, including the time period. This depends on the size of your business, but it’s common to prepare a6-month or 12-month cash-flow budget.

A six-month cash flow budget minimizes the amount of uncertainty involved in the budget. It also predicts future events early enough for you to take corrective action. However, if you’re applying for a loan, you may need to create a cash flow budget that extends for several years into the future, as part of the application process.

The primary purpose of using a cash flow budget is to predict your business’s ability to take in more cash than it pays out. This will give you some indication of your business’s ability to create the resources necessary for expansion, or its ability to support you, the business owner. The cash flow budget can also predict your business’s cash flow gaps — periods when cash outflows exceed cash inflows when combined with your cash reserves. You can take cash flow management steps to ensure that the gaps are closed, or at least narrowed, when they are predicted early. These steps might include lowering your investment in accounts receivable or inventory, or looking to outside sources of cash, such as a short-term loan, to fill the cash flow gaps.

Preparing a cash flow budget involves four steps:

  1. preparing a sales forecast
  2. projecting your anticipated cash inflows
  3. projecting your anticipated cash outflows
  4. putting the projections together to come up with your cash flow bottom line

Developing a format

Set up a worksheet that includes all your receipt and payment transactions, with appropriate columns for the number of months you’re budgeting for. The procedure for working out your cash-flow budget is:

  1. take your beginning cash balance
  2. add your budgeted cash inflows
  3. deduct your budgeted cash outflows.

The result will be your budgeted cash balance.

Improve your cash flow

If it feels like your cash only flows in one direction – out – these cash management basics can help. Even without a cash-flow budget, they can work to your advantage.


Accelerate the flow of cash from your customers
Credit policy Review a customer’s credit history before you extend credit on a sale.

Consider whether you can reduce your trading terms.

Ensure you follow up overdue customer payments swiftly and effectively.

Billing procedure Ensure your invoices show all the information your customers need. Set them out so they’re easy to pay.

Issue invoices promptly



Deposits Consider customer deposits prior to sale.
Shipping and handling Reduce the time from customer order to delivery.
Borrowings Consider factoring your customer invoices to speed up the collection process.


Delay your cash outflows
Your suppliers’ credit policies Talk to suppliers to obtain maximum credit terms when setting up a trade account.
Credit cards Use your credit card to take advantage of interest-free periods and delay your payment.
Delay payment If you have a cash shortage, contact your supplier and ask for additional time to pay. You may be surprised at the support you receive.
Other ways to help your cash flow
Stock on hand Holding excessive stock keeps vital cash out of the business. Review your stock levels to ensure you hold stock for the least amount of time between buying and selling.

Accelerate your cash flow with a special promotion.

Review slow-moving stock to see if you can either return it to your supplier for a credit, or sell it at a discount to create cash flow.

Profit margins Review your profit margin to ensure you get the best profit.

Review your prices and consider an increase.

Review your suppliers’ prices to ensure competitiveness.

Overheads Review your overheads to identify any costs you can reduce, or eliminate.
Borrowings Get additional funding from your bank, or credit institution. Your cash-flow budget should help identify in advance what your future cash needs will be.
Owners’ contributions Owners can contribute additional capital to the business.
Owners’ salaries Reduce owners’ salaries or drawings from the business.
Assets Review your other business assets to identify non-core assets you can sell to inject cash into your business.

 Other options

If you’re still having trouble with your cash flow, consider the following.

Review your cash-flow budget

  • Review your actual cash flow for one month and compare it with your cash-flow budget. Identify any gaps between the results you achieved in the month under review against the budget you developed for the month.
  • Develop strategies to manage any areas of concern.
  • Review your actual cash flow for the three months prior to the budget period so you understand your cash flow better. Review your cash flow budget to check your expectations are reasonable.

Get advice

Your accountant should be able to help you prepare a cash-flow budget. If you’re the leader of a team, you may find it beneficial to work through any cash-flow problems, or opportunities with your team. Consider whether you need assistance from your accountant in managing your relationship with your creditors.

 2.3 A cash flow forecast is created in accordance with recognised processes and steps.

Why Should You Prepare a Cash Flow Forecast?

 Cash is King!!

It’s like the oil in the engine of a car – no matter how powerful your engine is – if the oil runs dry the engine seizes up. Cash flow is exactly the same, if the cash runs dry the business seizes up, no matter how profitable it may be.

A cash flow forecast shows cash coming in and cash going out during a certain month. This is usually extended to show the Annual Cash flow for the first year of trading.

Normally there are 2 columns for each month of the Cash flow, one is for the forecast and the second is for the actual (once you have started to trade). If the forecast and actual are the same, each month, then there should be no problem and the business should run smoothly. However if the forecast and actual differ then this will prepare you to take steps to address the situation.

Many businesses issue invoices and ask for payment in 15, 30 or 60 days – however not all customers pay on time and, in fact, the average payment time for a 30 day invoice is currently around 84 days!

Preparing a monthly cash flow forecast provides you with the opportunity to show figures, representing revenues and expenses, in the month the business expects to collect and spend the cash. A cash flow forecast does not show sales estimates or overhead expenses averaged across several months.

Used properly, this will provide you with the means to keep your business decision-making on track and your stock purchasing in control. It will also serve as an early warning indicator when your expenditures are running out of line or your sales targets are not being met.

As the manager of your cash, you will have enough time to devise remedies for anticipated temporary cash shortfalls and ample opportunity to arrange short term investments for the business’ temporary cash flow surpluses.

The completed cash flow forecast will clearly show a bank manager (or yourself) what additional working capital, if any, the business may need, and will offer proof that there will be sufficient cash on hand to make the interest payments to support an overdraft (to cover the shortfalls). If the performance projections are realistic, they will also provide support for the feasibility of a loan for an equipment purchase or for a marketing campaign.

Computer spreadsheet programs such as Microsoft Excel, Lotus 123 or any of a variety of full-faceted business software can be very useful for cash flow worksheet development. We have provided full Cash flow Forecast templates on page 2 of the resources part of this web site, These templates have all the formulae already in place and all you have to do is to enter your figures. To go there simply return to the index and click on the downloadable resources section at the top.

Reliable cash flow projections can bring a sense of order and well-being to your business and more calm to your life. The most important tool owners/managers have available to control the financial aspects of their business is the cash flow worksheet.

How Do You Get Started?

Consider your Cash Flow Income

Find a realistic basis for estimating your monthly / annual sales – see Sales Forecasting

For new businesses, the basis can be the average monthly sales of a similar-sized competitor’s operations who is operating in a similar market It is recommended that you make adjustments for this year’s predicted trend for the industry. Be sure to reduce your figures by a start-up year factor of about 50% a month for the start-up months. There are also publications available in libraries and book stores that discuss methods of sales forecasting.

For existing operations, sales revenues from the same month in the previous year make a good base for forecasting sales for that month in the succeeding year. For example, if the trend readers in the economy and the industry predict a general growth of 4% for the next year, it will be entirely acceptable for you to show each month’s projected sales at 4% higher than your actual sales the previous year. Include Notes to the Cash flow to explain any unusual variations from previous years’ numbers.

If you sell products on credit terms or with instalment payments, you must be careful to enter only the part of each sale that is collectible in cash in the specific month you are considering, (cash sales). Any amount collected after 30 days will be termed Debtors and will be shown in the month in which it will be collected.

It is critical to the credibility of your plan that any sales made should only be entered once the cash is received in payment. This is the critical test principle of the cash flow and should be applied whenever you are in doubt as to what amount to enter and when.

Consider your Cash Flow Outgoings

Project each of the various expense categories (that would normally be shown in your ledger) beginning with a summary for each month of the cash payments to trade suppliers (accounts payable). Again, follow the principle that there should not be any averaging or allocating of these stock purchases.

Each month must show only the cash you expect to pay out that month to your trade suppliers. For example, if you plan to pay your supplier invoices in 30 days, the cash payouts for January’s purchases will be shown in February. If you can obtain trade credit for longer terms, then cash payments will appear two or even three months after the stock purchase has been received and invoiced.

An example of a different type of expense is your insurance expenditure. Your commercial insurance premium may be £2400 annually. Normally, this would be treated as a £200 monthly expense. But the cash flow will not see it this way. The cash flow wants to know exactly how it will be paid. If it is to be paid in two instalments, £1200 in January and £1200 in July, then that is how it must be entered on the cash flow worksheet. The exact same principle applies to all cash flow expense items.

Once total cash collections, total cash payments on goods purchased, and any other expected expenses have been estimated for each individual month of operation, it is necessary to link the cash flow status of each month to the cash flow status and activity of the preceding and succeeding months.

Reconciliation of the Cash Income to Cash Outgoings

The reconciliation section of the cash flow worksheet begins by showing the balance carried over from the previous months’ operations. To this it will add the total of the current month’s income and subtract the total of the current month’s outgoings. This adjusted balance will be carried forward to the opening balance of the next month to become the base to which the next month’s cash flow activity will be added and/or subtracted.

The opening balance for any new start business is Zero.

Making the Best Use Of Your Cash Flow

Cash flow plans are living entities and should constantly be modified as you learn new things about your business and your paying customers. Since you will use this cash flow forecast to regularly compare each month’s forecast figures with each month’s actual performance figures, it will be useful to have a second column for the actual performance figures right alongside each of the forecast columns in the cash flow worksheet. As the true strengths and weaknesses of your business unfold before your eyes, actual patterns of cash movement emerge. Look for significant discrepancies between the forecast and actual figures.

For example, if the business’ actual figures are failing to meet your cash revenue forecast for three months running, this is an unmistakable signal that it is time to revise the year’s forecast. It may be necessary to delay the stock purchase plan, or apply to the bank to increase the upper limit of your overdraft. Approaching the bank to increase an operating loan should be done well in advance of the date when the additional funds are required. Do not leave cash inflow to chance.

Designing a Cash Flow Worksheet

There are a variety of ways a cash flow forecast could be structured.

Your general format should allow a double width column along the left side of the page for the account headings, then two side by side vertical columns for each month of the year beginning from the month you plan to open (e.g. the first dual column might be labelled April Forecast and April Actual etc.).

From there, the cash flow worksheet breaks into three distinctive sections. The first section (at the top left portion of the worksheet, starting below and to the left of the month names) is headed Cash Income (or Cash In). The second section, just below it, is headed Cash Outgoings (or Cash Out). The final section, below that, is headed Reconciliation of Cash Flow.


Pre Start Jan F/C Jan Act Feb F/C Feb Act Mar F/C Mar Act
Cash In 700 1200 1600
Loans 1000
Total In 1000 700 1200 1600
Cash Out
Materials 500 200 400 600
Drawings 200 200 200
Vehicle Running 100 50 50 50
Office rent 100 100 100 100
Insurance 200 200
Telephone 50 20 20 20
Total Out 950 570 770 1170
Opening Balance 0 50 180 610
Total In/Out 50 130 430 430
Closing Balance 50 180 610 1040

Cash flow Headings and Inclusions

Possible “Cash Income” sub-headings:

  • Cash Income
  • Cash Sales from main product lines
  • Cash Sales from auxiliary product lines
  • Cash from Services Provided
  • Debtors
  • Sale of Fixed Assets
  • Other Operations Cash Income
  • Total Incomings

Possible “Cash Outgoings” sub-headings:

  • Cash Outgoings
  • Cash Payments to Trade Suppliers of main product lines
  • Cash Payments to Trade Suppliers of auxiliary product lines
  • Owners Drawings
  • Full-time Salaries and Wages
  • Part-time and Casual Salaries and Wages
  • Sales Commissions and/or Royalties Paid
  • Cash Dividends Paid
  • Advertising and Promotion Expense Paid
  • Stationery
  • Professional Fees Paid (legal, audit, courses and consulting)
  • Business Licenses Registrations and Permits Paid
  • Patents, Trademarks and Distribution
  • Agreement Fees Paid
  • Rental of Premises Payments
  • Rental (or lease) Payments for Equipment and Furnishings
  • Other Rental Payments (including vehicles)
  • Motor Vehicle Expenses Paid
  • Insurance Premiums Paid (premises, equipment, vehicles)
  • Repair and Maintenance Expenses Paid (premises, equipment, vehicles)
  • Utilities (electric, gas, and water) Payments
  • Communications (telephones, data line and fax) Payments
  • Postal (mail, courier, telegrams, etc.) Expense Payments
  • Cash Payments on Store/Office Supplies
  • Other Business Expenses (not elsewhere listed)
  • Interest (and Principal) Payments on Term Loans/Mortgages
  • Interest Payments on Overdraft
  • Bank Charges
  • VAT Payments
  • Council Tax Payments (property etc.).
  • Total Outgoings.

Possible Reconciliation of Cash flow sub-headings:

  • Reconciliation of Cash Flow
  • Opening Cash Balance
  • Add: Total Cash Revenues
  • Deduct: Total Cash Disbursements
  • Surplus or Deficit on this Month’s Operations
  • Closing Cash Balance (to be carried forward to next month).
2.4  A cash flow forecast is used in order to determine a working capital for a business.

             What Does Working Capital Mean?

A measure of both a company’s efficiency and its short-term financial health. The working capital ratio is calculated as:

Positive working capital means that the company is able to pay off its short-term liabilities.  Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

Also known as “net working capital”, or the “working capital ratio”.

Investopedia explains Working Capital

If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy.  A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.

Working capital also gives investors an idea of the company’s underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company’s obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company’s operations

Working capital management decisions are therefore not taken on the same basis as long term decisions, and working capital management applies different criteria in decision making: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the more important).

  • The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm’s ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.)
  • In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm’s shareholders. As above, firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.


Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital [13]. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

  • Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
  • Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).
  • Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
  • Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring”.
 2.5 Bank statements are interpreted for reconciliation with the cash book.

A company’s general ledger account Cash contains a record of the transactions (checks written, receipts from customers, etc.) that involve its checking account. The bank also creates a record of the company’s checking account when it processes the company’s checks, deposits, service charges, and other items. Soon after each month ends the bank usually mails a bank statement to the company. The bank statement lists the activity in the bank account during the recent month as well as the balance in the bank account.

When the company receives its bank statement, the company should verify that the amounts on the bank statement are consistent or compatible with the amounts in the company’s Cash account in its general ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement, bank statement reconciliation, bank reconciliation, or doing a “bank rec.” The benefit of reconciling the bank statement is knowing that the amount of Cash reported by the company (company’s books) is consistent with the amount of cash shown in the bank’s records.

Because most companies write hundreds of checks each month and make many deposits, reconciling the amounts on the company’s books with the amounts on the bank statement can be time consuming. The process is complicated because some items appear in the company’s Cash account in one month, but appear on the bank statement in a different month. For example, checks written near the end of August are deducted immediately on the company’s books, but those checks will likely clear the bank account in early September. Sometimes the bank decreases the company’s bank account without informing the company of the amount. For example, a bank service charge might be deducted on the bank statement on August 31, but the company will not learn of the amount until the company receives the bank statement in early September. From these two examples, you can understand why there will likely be a difference in the balance on the bank statement vs. the balance in the Cash account on the company’s books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may need adjustment in order to report the true amount of cash.

After you adjust the balance per bank to be the true balance and after you adjust the balance per books to also be the same true balance, you have reconciled the bank statement. Most accountants would simply say that you have done the bank reconciliation or the bank rec.

Bank Reconciliation Process

Step 1. Adjusting the Balance per Bank

We will demonstrate the bank reconciliation process in several steps. The first step is to adjust the balance on the bank statement to the true, adjusted, or corrected balance. The items necessary for this step are listed in the following schedule:


Step 1. Balance per Bank Statement on Aug. 31, 2009
     Add: Deposits in transit
     Deduct: Outstanding checks
     Add or Deduct: Bank errors
 Adjusted/Corrected Balance per Bank

Deposits in transit are amounts already received and recorded by the company, but are not yet recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the bank’s night depository at 10:00 p.m. on August 31. The bank will process this deposit on the morning of September 1. As of August 31 (the bank statement date) this is a deposit in transit.

Because deposits in transit are already included in the company’s Cash account, there is no need to adjust the company’s records. However, deposits in transit are not yet on the bank statement. Therefore, they need to be listed on the bank reconciliation as an increase to the balance per bank in order to report the true amount of cash.

  • A helpful rule of thumb is “put it where it isn’t.” A deposit in transit is on the company’s books, but it isn’t on the bank statement. Put it where it isn’t: as an adjustment to the balance on the bank statement.

Outstanding checks are checks that have been written and recorded in the company’s Cash account, but have not yet cleared the bank account. Checks written during the last few days of the month plus a few older checks are likely to be among the outstanding checks.

Because all checks that have been written are immediately recorded in the company’s Cash account, there is no need to adjust the company’s records for the outstanding checks. However, the outstanding checks have not yet reached the bank and the bank statement. Therefore, outstanding checks are listed on the bank reconciliation as a decrease in the balance per bank.

  • Recall the helpful tip “put it where it isn’t.” An outstanding check is on the company’s books, but it isn’t on the bank statement. Put it where it isn’t: as an adjustment to the balance on the bank statement.

Bank errors are mistakes made by the bank. Bank errors could include the bank recording an incorrect amount, entering an amount that does not belong on a company’s bank statement, or omitting an amount from a company’s bank statement. The company should notify the bank of its errors. Depending on the error, the correction could increase or decrease the balance shown on the bank statement. (Since the company did not make the error, the company’s records are not changed.)

Step 2. Adjusting the Balance per Books

The second step of the bank reconciliation is to adjust the balance in the company’s Cash account so that it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the following schedule:


Step 2.  Balance per Books on Aug. 31, 2009
     Deduct: Bank service charges
     Deduct: NSF checks & fees
     Deduct: Check printing charges
     Add: Interest earned
     Add: Notes Receivable collected by bank
     Add or Deduct: Errors in company’s Cash account
 Adjusted/Corrected Balance per Books

Bank service charges are fees deducted from the bank statement for the bank’s processing of the checking account activity (accepting deposits, posting checks, mailing the bank statement, etc.) Other types of bank service charges include the fee charged when a company overdraws its checking account and the bank fee for processing a stop payment order on a company’s check. The bank might deduct these charges or fees on the bank statement without notifying the company. When that occurs the company usually learns of the amounts only after receiving its bank statement.

Because the bank service charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the service charges will have to be entered as an adjustment to the company’s books. The company’s Cash account will need to be decreased by the amount of the service charges.

  • Recall the helpful tip “put it where it isn’t.” A bank service charge is already listed on the bank statement, but it isn’t on the company’s books. Put it where it isn’t: as an adjustment to the Cash account on the company’s books.

An NSF check is a check that was not honored by the bank of the person or company writing the check because that account did not have a sufficient balance. As a result, the check is returned without being honored or paid. (NSF is the acronym for not sufficient funds. Often the bank describes the returned check as a return item. Others refer to the NSF check as a “rubber check” because the check “bounced” back from the bank on which it was written.) When the NSF check comes back to the bank in which it was deposited, the bank will decrease the checking account of the company that had deposited the check. The amount charged will be the amount of the check plus a bank fee.

Because the NSF check and the related bank fee have already been deducted on the bank statement, there is no need to adjust the balance per the bank. However, if the company has not yet decreased its Cash account balance for the returned check and the bank fee, the company must decrease the balance per books in order to reconcile.

Check printing charges occur when a company arranges for its bank to handle the reordering of its checks. The cost of the printed checks will automatically be deducted from the company’s checking account.

Because the check printing charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the check printing charges need to be an adjustment on the company’s books. They will be a deduction to the company’s Cash account.

  • Recall the general rule, “put it where it isn’t.” A check printing charge is on the bank statement, but it isn’t on the company’s books. Put it where it isn’t: as an adjustment to the Cash account on the company’s books.

Interest earned will appear on the bank statement when a bank gives a company interest on its account balances. The amount is added to the checking account balance and is automatically on the bank statement. Hence there is no need to adjust the balance per the bank statement. However, the amount of interest earned will increase the balance in the company’s Cash account on its books.

  • Recall “put it where it isn’t.” Interest received from the bank is on the bank statement, but it isn’t on the company’s books. Put it where it isn’t: as an adjustment to the Cash account on the company’s books.

Notes Receivables are assets of a company. When notes come due, the company might ask its bank to collect the notes receivable. For this service the bank will charge a fee. The bank will increase the company’s checking account for the amount it collected (principal and interest) and will decrease the account by the collection fee it charges.  Since these amounts are already on the bank statement, the company must be certain that the amounts appear on the company’s books in its Cash account.

  • Recall the tip “put it where it isn’t.” The amounts collected by the bank and the bank’s fees are on the bank statement, but they are not on the company’s books. Put them where they aren’t: as adjustments to the Cash account on the company’s books.

Errors in the company’s Cash account result from the company entering an incorrect amount, entering a transaction that does not belong in the account, or omitting a transaction that should be in the account. Since the company made these errors, the correction of the error will be either an increase or a decrease to the balance in the Cash account on the company’s books.

Step 3. Comparing the Adjusted Balances

After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step 2), the two adjusted amounts should be equal. If they are not equal, you must repeat the process until the balances are identical. The balances should be the true, correct amount of cash as of the date of the bank reconciliation.


Step 4. Preparing Journal Entries

Journal entries must be prepared for the adjustments to the balance per books (Step 2). Adjustments to increase the cash balance will require a journal entry that debits Cash and credits another account. Adjustments to decrease the cash balance will require a credit to Cash and a debit to another account.

 Activity 5

Study a banking statement and make notes of your observations.

Unscramble the words in your Workbook.

3.  Apply an accounting system to manage a new venture.

 3.1     An explanation is given of how an accounting system is applied in a new venture.

Proper bookkeeping is important to sustaining and expanding a business. Without it, you run the risk of hitting cash flow crunches, wasting money, and missing out on opportunities to expand. When you are devising or revising your bookkeeping routine, remember that the purpose of bookkeeping is to help you manage your business and to enable tax agencies to evaluate your business activity. As long as your bookkeeping achieves both of these objectives, it can – and should – be as simple as possible.

The general guidelines here outline what you must take care of and provide ideas for how to keep your books in an orderly manner. But before making any decisions regarding bookkeeping, check with your accountant or tax preparer because bookkeeping needs vary dramatically by business.


Many small business owners choose to use software to keep track of various aspects of their business, and resources are provided here to help you institute computer automation. The key to taking full advantage of bookkeeping software is to determine if it saves you time and frees you up to concentrate on running your business. In many cases it will, but be careful not to fall into the trap of wasting time setting up computer bookkeeping that could be more efficiently handled on paper. The paper bookkeeping forms mentioned here can be obtained from most stationary stores.

Some bookkeeping functions are best relegated to an accountant. While it is essential to retain a thorough knowledge by reviewing your books frequently, an accountant or bookkeeper can free you up to concentrate on expanding your business. Even a bookkeeping task that takes only a few hours a week may be better relegated to someone else if that time can be better spent

Revenues and Expenses

Your business will use either a Revenue and Expense Journal or a Ledger to keep track of how much money is going out, where it is going, and what is coming in.

A Revenue and Expense Journal is used by most small businesses and is single-entry accounting — recording receipts and expenditures only. Double entry accounting involves a ledger and necessitates that each activity be recorded as a debit and a credit on your books. In the past it was thought that all businesses needed to use the more cumbersome method of double-entry, but the single entry system is now used for many small business owners. Single-entry accounting can be kept on paper or computer. Programs that perform single-entry accounting include Quicken by Intuit and Microsoft Money among many others.

A ledger is used to record every transaction twice based on the idea that each transaction has two halves that affect your business. For example, if you sell an item, your books would reflect a decrease in inventory (a credit) and a inflow of payment (debit). If you use double-entry accounting you may want to use a computer program or a bookkeeper to keep your ledger up to date. If you allow anyone else to keep your books be sure you review them regularly. Programs that do double-entry bookkeeping include: M.Y.O.B by Teleware, Peachtree Accounting by Peachtree Software, and Quickbooks by Intuit.


Your accountant can advise you on which type of recordkeeping you should choose. Also consult your tax advisor about whether you should use a cash or accrual-based

Cash Expenditures

Cash spent in your business needs to be accounted for if you want to record all business expenses in a given year. There are at least two ways to do this: write yourself reimbursable checks or keep a petty cash record.

If you choose to pay yourself back with a check, simply keep track of all cash receipts and total them weekly, biweekly or monthly, depending on your volume of expenses. Keep a log of each category of expense, for tax purposes and write yourself a check for the total. Write cash reimbursable in your check register to differentiate this from taxable income. Alternatively, you can keep a petty cash record by writing a check to petty cash and keeping a log of each expense paid out of petty cash.

Inventory Records

Keeping on top of your inventory records will enable you to prevent pilferage, keep inventory holdings to a minimum, and track buying trends, among other things.

If you sell a large number of small-ticket items — for example, as in a stationary store — you might want to use a computer system to track inventory or tie your computer system into your sales by having a POS (point of sale) inventory system. If you sell larger ticket items you may be able to do it yourself on paper.

The crucial inventory information you need to capture is: date purchased, stock number of item purchased, purchase price, date sold, and sale price.

Accounts Receivable

If your products or services are paid for at time of delivery, you will not need an accounts receivable tracking system. However, if you provide services or products for which people pay you at a later date, your accounts receivable records keep track of what is owed to you. You can monitor accounts receivable by holding on to a copy of all invoices sent out or by keeping an accounts receivable record. Either way, the information you need to capture includes: invoice date, invoice number, invoice amount, terms, date paid, amount paid, and the name of the entity being billed.

Many software programs are available to help you generate invoices and track hours and expenses incurred for each client. These programs can save hours of time for a business owner and create professional-looking invoices. But, according to Ed Slott, author of “Your Tax Questions Answered”, (Plymouth Press) keeping your accounts receivable on computer is sensible if it enables you to collect payment more quickly or get a better handle on where your money comes from. Otherwise a paper system is very effective. Software programs that will create invoices or track hours include: Quick Invoice by Intuit software; Time slips and Win Invoice by Good Software; and Perform Pro Plus from Delrina.

Accounts Payable

Accounts payable are debts owed by your company for goods and services. Keeping track of what you owe and when it is due will enable you to establish good credit and hold onto your money as long as possible.

Business owners with few accounts payable items use accordion file folders labelled with dates to keep track. Other small firms simply pay bills twice per month and keep all bills in a “To Pay” folder. Larger companies use accounts payable paper records organized by creditor. Regardless of the system you choose, you should retain the following information about accounts payable: invoice date, invoice number, invoice amount, terms, date paid, amount paid, balance (if applicable), and clients names and address.

3.2 An accounting system is established for a new venture.

When a small business is established, the number of activities are normally few. The entrepreneur is thus able to handle the bookkeeping himself. Depending on the entrepreneur’s educational background, this makes particular demands on an individual. An entrepreneur should delegate record-keeping to a suitable person as soon as possible, as it may detain him from other important tasks.

The small business man can make use of the following financial systems:

  • Petty cash book – To keep record of all cash payments
  • Cash book – To keep record of all cash received, deposits, cheque payments, debit orders, banking costs and levies.
  • Purchase journal – To keep record of all credit purchases.
  • Sales journal– To keep record of all credit sales
 3.3 The accounting system is monitored for effectiveness.

 It is always advisable for a small business to monitor its cash flow, but never more so than during an economic crisis. Knowing where your money is going and what payments are still outstanding will give business owners a clear overview of their companies’ current statuses.

In times of economic unrest, small business owners should keep an eye on the financial short term. By decreasing the credit cycle as much as possible, they will be more prepared for unexpected events. An accounting system can help business owners to prevent unforeseen financial occurrences from affecting their companies in the long term

3.4 Taxation requirements are catered for in the accounting system of the new venture.

The imposition of taxation is essential in order to provide the community with certain services and to bring in a more equal distribution of wealth between individuals in a country.

The accounting and financial systems of a business must be adequate to enable the responsible taxpayer to complete the tax return accurately. The financial system must ensure that the necessary books and records required by the receiver of revenue, are available from an investigation of the tax return.

The following periods are required for the safekeeping of books and records:

  • Founding documentation of a company, close corporations and partnerships. Minute books.
  • Period of 15 years. Financial statements, accounting records and books, including supporting schedules.
  • Period of 6 years . Paid cheques.
  • Period of 5 years. Tax returns and assessments, salaries and wage registers, sales and purchasing invoices, bank statements, stock inventories, VAT records, other supporting documentary evidence.

 4. Analyse an income and expenditure statement.

 4.1 An explanation is given of how income and expenditure statements are applied in terms of their purpose.

 A company’s income and expenditure statement is a record of its earnings or losses for a given period. It shows all of the money a company earned (revenues) and all the money a company spent (expenses) during this period. It also accounts for the effects of some basic accounting principles such as depreciation.

The income statement is important because it’s the basic measuring stick of profitability

What are income statements used for?:

You use an income statement to track revenues and expenses so that you can determine the operating performance of your business over a period of time. Small business owners use these statements to find out what areas of their business are over budget or under budget. Specific items that are causing unexpected expenditures can be pinpointed, such as phone, fax, mail, or supply expenses. Income statements can also track dramatic increases in product returns or cost of goods sold as a percentage of sales. They can also be used to determine income tax liability

 4.2 Sources of income and expenditure statements are identified for a new venture.
 Activity 6

 Complete the table in your workbooks to indicate the sources of income and expenditure for your own venture.

4.3 Income and expenditure statements are evaluated to determine the financial viability of new venture.

You can gain valuable insights into companies by making sense of their financial statements. Let’s review the income statement, sometimes called the statement of operations.

The income statement summarizes sales and profits over a period of time, such as three months or a year. It usually offers information for the year-ago period, too, so you can compare and spot trends

 Group Activity 7

Groupwork – Each group needs to study a different income and expenditure statement. Feedback will be given to the other groups on the financial viability of the enterprise

 4.4  An income and expenditure statements is created for a new venture.
Activity 8

Create an income and expenditure statement for your own business

5. Analyse a balance sheet.

 5.1  An explanation is given of the purpose of a balance sheet with reference to how often a balance sheet is necessary.

The balance sheet is one of the most important financial statements of a company. It is reported to investors at least once per year. It may also be presented quarterly, semi-annually or monthly. The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities), and the value of the business to its stockholders (the shareholders’ equity). The name, balance sheet, is derived from the fact that these accounts must always be in balance. Assets must always equal the sum of liabilities and shareholders’ equity.

The balance sheet is the fundamental report of a company’s possessions, debts and capital invested. Before investing in any company, an investor (or the bank manager) can use the balance sheet to examine the following:

Can the firm meet its financial obligations?

How much money has already been invested in this company?

Is the company overly indebted?

What kind of assets has the company purchased with its financing?

These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides many clues to a firm’s future performance. Once you completely understand the balance sheet, making informed investment decisions should be much easier for you.

The concept behind the balance sheet is very simple. In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners’ capital (shareholders’ equity). Therefore, the following equation must hold true:

Assets = Liabilities + Shareholders’ Equity

Total Liabilities R30,000
Shareholders’ Equity R50,000
Total Assets R80,000
5.2 The liabilities in a balance sheet are classified in terms of long-term and current liabilities.

 Liabilities are obligations a company owes to outside parties. They represent rights of others to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees. On the balance sheet, liabilities are generally broken down into current liabilities and long-term liabilities.

Current liabilities are those obligations that are usually paid within the year, such as accounts payable, interest on long-term debts, taxes payable, and dividends payable. Because current liabilities are usually paid with current assets, as an investor it is important to examine the degree to which current assets exceed current liabilities.

The most pervasive item in the current liability section of the balance sheet is accounts payable. Accounts payable are debts owed to suppliers for the purchase of goods and services on an open account. Almost all firms buy some or all of their goods on account. Therefore, you will often see accounts payable on most balance sheets.

Long-term debt is a liability of a period greater than one year. It usually refers to loans a company takes out. These debts are often paid in instalments. If this is the case, the portion to be paid off in the current year is considered a current liability.

Uses of the Balance Sheet

The balance sheet has many important uses. Lending agencies use balance sheets to evaluate the financial position of most loan applicants. The balance sheet statement can also be extremely useful to the owner of the business. Comparison of balance sheets over time will show how much the business net worth is increasing or decreasing. A balance sheet can also be used by the owner of a business to support a request for borrowed funds.

The balance sheet gives information on how best to meet liabilities. If liabilities are due in a short time, cash will be needed to pay them. If the sale of current assets will not raise sufficient funds and the loan cannot be renewed, then a long-term loan may need to be negotiated on the basis of long-term asset values.

Comparison of total current assets to total non-current assets helps determine if too much or too little capital is tied up in permanent investments. A farm business, consisting primarily of non-current assets, has less flexibility than one that has sufficient current assets. Some flexibility in the business should be maintained. A balance sheet provides the information for making these comparisons.

What is a Balance Sheet: Example

Pretend that you are going to apply for a loan to put a swimming pool into your backyard.  You go to the bank asking to borrow money, and the banker insists that you give him a list of your current finances.  After going home and looking over your statements, you pull out a blank sheet of paper and write down everything you have that is of value [your checking and savings account, mutual funds, house, and cars].  Then, at the bottom of the sheet you write down all of your debt [the mortgage, car payments, and your student loan].  You subtract everything you owe from all the stuff you have and come up with your net worth.

Congratulations, you just created a balance sheet.

For every business, there are three important financial statements you must look at; the Balance Sheet, the Income Statement, and the Cash Flow Statement.  The balance sheet tells investors how much money the company has, how much it owes, and what is left for the stockholders.  The cash flow statement is like a business’ checking account; it shows you where the money is spent.  The income statement is a record of the company’s profitability.  It tells you how much money a corporation made (or lost).

Every balance sheet must “balance”.  The total value of all assets must be equal to the combined value of the all liabilities and shareholder equity (i.e., if a lemonade stand had R10 in assets and R3 in liabilities, the shareholder equity would be R7.  The assets are R10, the liabilities + shareholder equity = R10 [R3 + R7]).

A basic balance sheet.

Assets = Liabilities + Shareholders’ Equity

The following balance sheet is arranged vertically starting with assets and then proceeding to detail liabilities and shareholders’ equity. Note that the balance sheet gives a snapshot of the assets, liabilities and equity for a given day. In our case, that is December 31. Often a balance sheet shows information for two successive periods as the one below. This gives the investor a better perspective of the company’s operations by showing areas of growth.

Pete’s Potato & Pasta, Inc.

Balance Sheet Ending December 31st

1998 1999
Current Assets
Cash and cash equivalents R10,000 10,000
Accounts receivable 35,000 30,000
Inventory 25,000 20,000
Total Current Assets 70,000 60,000


Fixed Assets
Plant and machinery R20,000 20,000
Less depreciation -12,000 -10,000
Land 8,000 8,000
Intangible Assets 2,000 1,500
TOTAL ASSETS 88,000 79,500


Accounts payable R20,000 15,500
Taxes payable 5,000 4,000
Long-term bonds issued 15,000 10,000


Common stock R 40,000 40,000
Retained earnings 8,000 10,000



As you can see, total liabilities and shareholders’ equity equals total assets.

The basic financial statement reveals what a company owns, what a company owes to others, and the investments its owners made. It details how a company finances its operations and what assets the company has acquired with this financing.

The key to understanding the balance sheet is in the most basic and fundamental of all accounting equations: Assets must equal liabilities plus shareholders’ equity.

Activity 9

Draw up a balance sheet for your business. Include the balance sheet in your portfolio of evidence.

 5.3  Assets and liabilities are determined in a new venture context.

Assets are economic resources that are expected to produce economic benefits for its owners. Assets can be buildings and machinery used to manufacture products. They can be patents or copyrights that provide financial advantages for their holder. Let us begin with a look at a few of the important types of assets that exist.

Current assets are assets that are usually converted to cash within one year. Bondholders and other creditors closely monitor a firm’s current assets since interest payments are generally made from current assets. They include several forms of current assets:

Cash is known and loved by all. It is the most basic current asset. In addition to currency, bank accounts without restrictions, checks and drafts are also considered cash due to the ease in which one can turn these instruments into currency.

Accounts receivable represent money clients owe to the firm. As more and more business is being done today with credit instead of cash, this item is a significant component of the balance sheet.

A firm’s inventory is the stock of materials used to manufacture their products and the products themselves before they are sold. A manufacturing entity will often have three different types of inventory: raw materials, works-in-process, and finished goods. A retail firm’s inventory will generally  consist only of products purchased that have not been sold yet.

Long-Term Assets

Long-term assets are grouped into several categories. The following are some of the common terms you may encounter:

Fixed assets are those tangible assets with a useful life greater than one year. Generally, fixed assets refer to items such as equipment, buildings, production plants and property. On the balance sheet, these are valued at their cost. Depreciation is subtracted from all except land. Fixed assets are very important to a company because they represent long-term liquid investments that a company expects will help it generate profits.

Depreciation is the process of allocating the original purchase price of a fixed asset over the course of its useful life. It appears in the balance sheet as a deduction from the original value of the fixed assets.

Intangible assets are non-physical assets such as copyrights, franchises and patents. To estimate their value is very difficult because they are intangible. Often there is no ready market for them. Nevertheless, for some companies, an intangible asset can be the most valuable asset it possesses.

Remember that every company will have different assets depending on its industry. However, it is important to know and understand the major accounts that will appear on most balance sheets.

 Activity 10

 Complete the column in you handbooks to indicate the current assets and liabilities of your business.

 5.4  A balance sheet is evaluated in terms of equity and/or financial net worth.

The analysis of a balance sheet can identify potential liquidity problems. These may signify the company’s inability to meet financial obligations.  An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet. The balance sheet is the basic report of a firm’s possessions, debts and capital. The composition of Current Ratio Acid Test (or Quick Ratio) Working Capital, Leverage will vary dramatically from firm to firm.

Shareholders’ equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders’ equity generally reflects the amount of capital the owners invested plus any profits that the company generates that are subsequently reinvested in the company. This reinvested income is called retained earnings.

 5.5 A balance sheet is drawn up for a new venture. 

See activity under 5.1

6. Make a financial decision based on financial statements.

The Financial statement is the concise product of a detailed examination of a person’s financial situation that has two main purposes.

  1. Budgeting tool for clients – The process of compiling a Financial Statement is the prime vehicle through which money advisers assist clients to assess their income and expenses. They can be useful to clients as a budgeting aid.
  2. Summary of Financial Situation – As a summary of a detailed examination of the client’s financial situation, financial statements often form the basis of negotiation. For example, creditors and courts use financial statements in making decisions on proposed offers of payment.

Financial Statements aim:

  • to accurately reflect a persons financial situation
  • to provide sufficient details to enable a creditor or court to make a decision on a proposed offer of payment.
  • to convey that information in a clear and concise manner
6.1  Recommendations are made on how to improve the financial ratios of new ventures.

Financial ratios are calculated from one or more pieces of information from a company’s financial statements. For example, the “gross margin” is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial analyst an excellent picture of a company’s situation and the trends that are developing.

A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of 25% is meaningless by itself. If we know that this company’s competitors have profit margins of 10%, we know that it is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for example, has been increasing steadily for the last few years, this would also be a favourable sign that management is implementing effective business policies and strategies.

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company’s finances and operations. An overview of some of the categories of ratios is given below.

  • Leverage Ratios that show the extent that debt is used in a company’s capital structure.
  • Liquidity Ratios that give a picture of a company’s short term financial situation or solvency.
  • Operational Ratios that use turnover measures to show how efficient a company is in its operations and use of assets.
  • Profitability Ratios that use margin analysis and show the return on sales and capital employed.
  • Solvency Ratios that give a picture of a company’s ability to generate Cash flow and pay it financial obligations.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by the GIGO law of “Garbage In…Garbage Out!” A cross industry comparison of the leverage of stable utility companies and cyclical mining companies would be worse than useless. Examining a cyclical company’s profitability ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of fundamental changes in a company’s situation or prospects would predict very little about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would tell very little about the prospects for this company.

Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the “downside” risk since they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a company’s financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that will accrue to the shareholder.

Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions from the same ratio analysis.

“As in all things financial, beauty is often in the eye of the beholder. It pays to do your own work!”

 6.2 The financial strengths and weaknesses of own venture are analysed in order to make suggestions to improve income and reduce costs.
Activity 11

Do a SWOT analyses on the financial strengths and weaknesses of your own venture. Write a paragraph on how to improve the ratios of your own business in the space provided in your workbooks.