Help with Financial Management

EAR MODULE 661 BUSINESS ADMINISTRATION I: FINANCIAL MANAGEMENT

READ THIS BEFORE YOU DO ANYTHING ELSE! 1. TUTORIAL INTRODUCTION Welcome to studying with Business Management Training College! We trust that you will find your studies towards this qualification rewarding. It is very important that you work through the study material in each guide and in the prescribed text books, as this will prepare you for the assignments at the end of each Module. In order to complete the Qualification you need to be found competent against all the Assessment Criteria of the Topics in this Module. 2. HOW DOES THIS MODULE WORK? Chapters start with a title followed by the lessons for that chapter. At the beginning of every chapter is a list of the outcomes for the particular chapter. YOU ARE NOT REQUIRED TO ANSWER THESE STATEMENTS. We are only informing you of WHAT you will learn and be assessed on in this module. The study guide fulfils the purpose of a tutor, and will effortlessly guide you through the

training material. Each lesson teaches you about a specific topic. Make sure you understand the topic of the lesson before you proceed to the next lesson. If at any time you require assistance, please contact one of the study advisors at BMT College who will promptly assist you with any queries. REMEMBER: IT IS IMPORTANT TO STUDY AND WORK THROUGH ALL THE LESSONS IN THIS GUIDE BEFORE ATTEMPTING THE ASSIGNMENT. IF YOU UNDERSTAND THE WORK IN THIS GUIDE, THE ASSIGNMENT WILL BE EASY. 2

STUDY INSTRUCTIONS 3. ICONS USED IN THIS MANUAL LESSON 1 Indicates the start of a new lesson Indicates the start of a Chapter (also top left of STUDY chapters) Usually an explanation or definition of a specific word or concept Examples of a specific topic or concept Important information. Take a break from your studies! Making notes while you study is very important. Spaces have been allocated throughout this manual for this purpose Indicates self assessment and self assessment answer section THESE SHOULD NOT BE SUBMITTED FOR ASSESSMENT Outcomes for this Module (What you will learn) Steps to be followed in order to complete/execute/do a specific action or task. No prescribed textbook for this module 3

READ THIS BEFORE YOU DO ANYTHING ELSE! HOW TO COMPLETE YOUR ASSIGNMENT 4. COMPLETING THE QUESTIONS:  Answers to review questions must preferably be typed as this eliminates the possibility of an assessor marking the answers incorrect due to the illegibility (unclearness) of the handwriting.  You need to complete ALL the formative questions. Unless the College granted you RPL exemption from that topic or subject, you need to do all the questions. If you do not understand a question, phone or e-mail your assessor to get assistance. ALL questions need to be completed in order to be found competent.  Each question must be marked clearly. The question numbers must not be placed in the left margin but at the top of the answer. Question 1.1 An example of a breakfast cereal is Kellogg’s.  Only attempt the summative assignment after you successfully worked through the module and completed all the formative questions for the particular module/s.  Diploma learners are required to complete a Summative assignment on completion of a subject (provided in the yellow assignment covers).  Use single sheets, front side only. (Double pages must be cut loose on the sides)  Learners who received exemption from certain topics or subjects through RPL (recognition of prior learning) must attach the official letter from the College stating the exempted topics or subjects. 5. SUBMITTING YOUR FORMATIVE AND SUMMATIVE ASSIGNMENTS:  Make sure your name, surname and student number is on every page.  Place the answers to your formative assessment inside the BLUE Formative Assignment

cover provided.  Place the answers to your summative assignment inside the YELLOW Summative Assignment cover provided.  Use a file binder and bind the cover around your answer sheet.   Always keep a copy of your assignment (should your assignment be lost in the post) as the BMTC can take no responsibility for assignments lost in the post.  Only summative assignments must be certified under oath (at any police station or post office) to be the original work of the candidate.  Only the original certified answers will be accepted for assessment. 4 STUDY INSTRUCTIONS  No photocopied, faxed, e-mailed or any other than the original certified answers will be accepted for assessment.  PLEASE NOTE: You can only submit the Formative Assignment once! That means, you only have one attempt for the formative assessment. If you fail the formative you need to make up the marks in the summative. You have three attempts to pass the summative assignment successfully. 6. RESULTS OF YOUR FORMATIVE AND SUMMATIVE ASSIGNMENT:  Your formative and summative assignment results will be outlined in a results letter at the end of each module.  Your formative assessment will count 25% toward your final result for the module and your summative assessment will count 75% of your final result for the module.  To pass and to be advanced to the next module, you need a final result of 50%.  If you do not obtain a pass mark of 50%, you will be required to re-do sections of the summative assignment where you did not obtain a successful result.  Even though your progress will be followed by a study advisor, it will not be possible for the assessor to comment on each answer you submitted. This preventative measure is taken to

eliminate irregularities of sharing memorandum answers with fellow students.  7.  The Assessment Appeals Form need to be submitted to the College. Assignment (tests) structure for the 1st year of the Diploma qualification Study Formative Summative Next Action from the college? Process STUDY COMPONENT 1 Management Principles (a) College will mark module 1 NO SUMMATIVE DUE Step 1 Complete and submit formative assignment and posts after module 1 Module 1 questions module 2. Management Principles (b) College will mark module 2 NO SUMMATIVE DUE Step 2 Complete and submit formative assignment and posts after module 2 Module 2 questions module 3. College will mark module 3 Management Principles (c) Complete and submit the formative and summative of Complete and submit Step 3 summative assignment on component 1. Learner receives Module 3 Module 1, 2 and 3. results of component 1. The College formative questions

posts module 4. STUDY COMPONENT 2 Business Admin (a) College will mark module 4 NO SUMMATIVE DUE Step 4 Complete and submit formative assignment and posts after module 4 Module 4 questions module 5. Business Admin (b) College will mark module 5 NO SUMMATIVE DUE Step 5 Complete and submit formative assignment and posts after module 5 Module 5 questions module 6. College will mark module 6 Business Admin (c) Complete and submit the formative and summative of Complete and submit Step 6 summative assignment on component 2. Learner receives Module 6 Module 4, 5 and 6. results of component 2. The College formative questions posts module 7. STUDY COMPONENT 3 Entrepreneurship (a) College will mark module 7 NO SUMMATIVE DUE Step 7 Complete and submit formative assignment and post after module 7 Module 7 questions module 8. Entrepreneurship (b) College will assess module 8 Complete and submit the

Complete and submit formative and summative of Step 8 summative assignment on Module 8 component 3. Learner receives Module 7 and 8 formative questions results of component 3. END OF 1ST YEAR

STUDY PLANNER Expected Suggested

time of Type REF Heading/Description Duration completion (in hours) (learner to complete) CHAPTER 1 - INTRODUCTION TO FINANCIAL MANAGEMENT Lesson 1.1 Financial Management Defined 4 Lesson 1.2 Basic Financial Concepts 3 CHAPTER 2 - BASIC FINANCIAL ACCOUNTING AND STATEMENTS Lesson 2.1 Recording Transactions 2 The Effect of Transactions on the Financial Lesson 2.2 3 Position of the Enterprise Lesson 2.3 Balancing the Accounts of the General Ledger 3 Lesson 2.4 Preparing and Controlling Budgets 2 Lesson 2.5 The Income Statement 3 Lesson 2.6 The Balance Sheet 3 CHAPTER 3 - BASIC BUSINESS CALCULATIONS Lesson 3.1

Recording Transactions 4 Lesson 3.2 Calculating Interest 2 Lesson 3.3 Financial Ratios 3 Formative Complete formative answer sheet (Blue Cover) 2 Summative 2 Summative assignment about module 4-6 4

TEAM SUPERVISOR CHAPTER 1 INTRODUCTION TO FINANCIAL MANAGEMENT IN THIS CHAPTER:  LESSON 1.1 : FINANCIAL MANAGEMENT DEFINED  LESSON 1.2 : BASIC FINANCIAL CONCEPTS AT THE END OF THIS CHAPTER YOU WILL BE ABLE TO: 1. Define and explain financial management as a concept 2. Explain the general objectives of financial management 3. Explain the main tasks of financial management 4. Explain the meaning of a number of important financial management concepts (capital, profitability, liquidity, solvency, assets, liabilities, income, expenditure and transactions)

LESSON 1.1 LESSON 1.1 FINANCIAL MANAGEMENT DEFINED In this Lesson: Financial Management is concerned with acquiring the necessary resources to ensure the most advantageous financial result to the business over the short and long term. It has to ensure that the business makes best use of its financial resources. The primary financial objective of any business is to gain maximum return on the capital invested in the business. Financial managers want to achieve the highest possible profitability or net income on the capital available. The secondary objectives of financial management all contribute in the end to the primary objective of maximising profitability. CONCEPTS AND VOCABULARY TERMS YOU NEED TO UNDERSTAND:  Financial management: The planning, directing, monitoring, organising, and controlling of the monetary resources of an organisation.  Liquidity refers to a company’s ability to keep making all necessary payments regularly and on time. 9

FINANCIAL MANAGEMENT DEFINED 1. FINANCIAL MANAGEMENT DEFINED 1.1 DEFINITION OF FINANCIAL MANAGEMENT Financial management can be defined as the responsibility to:  Acquire the necessary resources to ensure the most advantageous result to the business over the short and long term

 Make sure that the business makes best use of its financial resources Financial Management is about the analysis of financial variables to ensure the maximum utilisation of capital and the maximum attraction of capital to finance the utilisation. 1.2 THE GENERAL OBJECTIVES OF FINANCIAL MANAGEMENT PRIMARY OBJECTIVE The primary financial objective of any business is to gain maximum return on the capital invested in the business. Financial managers want to achieve the highest possible profitability or net income on the capital available. SECONDARY OBJECTIVES The secondary objectives all contribute in the end to the primary objective of maximising profitability. They are:  Use limited resources as well as possible Available capital must be used as effectively and profitably as possible.  Maintain a healthy position of liquidity A healthy position of liquidity often means the difference between growth and success on one hand, or failure on the other hand. If a business is in a situation where it can no longer make compulsory payments in the short term, the business will fail if the problems cannot be overcome. 10 LESSON 1.1 An effective working capital cycle tries to free capital that is tied up in working capital (such as stock and debtors) as quickly as possible to allow this capital to be used for other needs like paying creditors.

 Maintain a positive cash flow To ensure that the business always has enough money to pay what it needs to pay at any given time, it needs to:  Collect debt as soon as possible.  Eliminate unnecessary stock and do not overstock.  Eliminate products that are not profitable.  Lease fixed assets such as buildings, delivery vehicles and computer equipment instead of buying them.  Use discounts offered by suppliers (e.g. bulk discounts).  Keep operating costs as low as possible.  Regularly (at least once a month) draw up a cash budget. It allows you to make suitable provision for possible shortages of cash and to know when cash will be available.  Negotiate the best loan conditions and interest rates from financial institutions. Lower interest rates mean lower cost of capital and therefore more profit. A business must be able to make interest payments on borrowed capital regularly and on time. It must be able to keep to the terms and conditions of the loan.  Implement an effective budgeting system. 1.3 THE TASKS OF FINANCIAL MANAGEMENT 1.3.1 DRAW UP AND MAINTAIN A FINANCIAL POLICY Formulate guidelines according to which financial activities must be conducted. This will also assist in decision-making, e.g. guidelines according to which you will grant credit, determine product prices, value stock and calculate depreciation. Keep to the guidelines that have been formulated.

1.3.2 DRAW UP FINANCIAL STATEMENTS A proper record-keeping system that will provide the accountant / bookkeeper with all the necessary source documents to draw up financial statements must be maintained. 11

FINANCIAL MANAGEMENT DEFINED 1.3.3 DO FINANCIAL ANALYSES (FOR PLANNING AND CONTROL) With a financial analysis you investigate the financial position of your business. This information allows you to apply financial control and to determine to what extent the actual performance of your business meets the objectives you have set for it. Problem areas can be identified and corrective action can be taken when necessary. For example businesses normally loose money for one of two reasons: A) Poor profits High expenses; high administrative costs, advertising costs, staff costs and fixed expenses. Poor gross profit; incorrect purchasing and receiving, incorrect storage and control and inefficient production. Overcoming the problems of poor profits:  High expenses High admin costs: Keep good record of costs and eliminate unnecessary costs. High advertising costs: Only advertise if benefits from advertising will outweigh the costs. High staff costs: Cut down unnecessary wages. Regulate staff meals and privileges. Clean and mend uniforms regularly. Avoid overtime. High fixed expenses: Avoid purchases on lease terms. Renegotiate terms regularly.  Poor gross profit Incorrect purchasing and receiving: Check quantity and quality of goods before paying for them. Choose suppliers carefully to ensure good quality at reasonable price. Incorrect storage and control procedures: Keep cold-rooms and equipment well maintained. Do not over-order. Inefficient production: Keep portion sizes at a reasonable level and monitor complaints from guests. Correct any problems as soon as possible. B) Low turnover This is normally caused by Ineffective management and/or external factors. Overcoming the problems of low turnover:

Ineffective management: More training for managers. Obtain more feedback from guests. External factors: Keep up with changes and events in your micro (internal), macro (PEESTL) and market environments and adapt as soon and effectively as possible. 1.3.4 MAKE CREDIT EVALUATIONS AND COLLECT DEBTS  Judge the creditworthiness of customers who want to buy on credit.  Decide on what terms credit will be granted.  Credit sales mean additional administration and costs.  Debts must be collected effectively and on time because delays can have a negative effect on your cash flow and liquidity. 1.3.5 DEAL WITH TAXES AND INSURANCE OF THE BUSINESS Make provision for paying VAT and Income tax to the SA Revenue services (SARS). 12

LESSON 1.2 LESSON 1.2 BASIC FINANCIAL CONCEPTS In this Lesson: As a manager you should be familiar with the basic financial concepts to be able to know exactly what is referred to when, for instance the financial manager refers to the liquidity of the business or the income statement or balance sheet. It is important that we understand the key aspects and terms of finance. 1. BASIC FINANCIAL CONCEPTS 1.1 FINANCE

Finance is the art of raising, managing, and making money. It is a process that involves three essential steps:  Assessing the financial health of the company  Using the information to plan for future performance  Executing the plan 1.2 CAPITAL Capital structure The capital structure represents the long-term financing of the firm, represented by long- term debt, preferred stock and common equity (consists of capital and retained earnings). Capital structure is distinguished from financial structure, which includes short-term debt plus all other accounts. Capital refers to the money available to the business for the purchase of goods and services with a view to generating an income for the business. 13

BASIC FINANCIAL CONCEPTS  Fixed capital The capital used to obtain assets such as land, buildings, machinery and equipment.  Operating or working capital Money used to acquire current assets such as stock or financing debtors.  Short-, medium- and long- term capital

 Short-term capital: Capital that is usually available for a period of between one and three years; in most cases less than one year  Medium-term capital: Capital usually available for a period between one and five years.  Long-term capital: Capital usually available for a period longer than five years (10, 15 and even 20 years).  Owners’ capital or equity The capital made available by the owner/s of the business.  Outside (borrowed, loaned or foreign capital) The part of the capital lent or provided to the business by external institutions (investors, suppliers, commercial banks and other financial institutions) at a certain price (interest). 1.3 PROFITABILITY Profitability refers to the relationship between the net income earned over a certain period, and the capital used in that period to generate income. Profitability is calculated as a percentage: Net income earned X 100% Total Capital employed 1.4 LIQUIDITY A business will incur certain expenditure in the process of making an income. Payments must be made to suppliers, interest must be paid to financial institutions and salaries/wages, rental, water and electricity must be paid. Liquidity refers to the company’s ability to keep making all these payments regularly and on time.

14 LESSON 1.2 1.5 SOLVENCY The ability of a business to pay off its debt at any given time, even if all its activities should stop, is known as the solvency of the business. Total assets must cover total liabilities of the business (liabilities are what the business owes to its creditors and suppliers and suppliers of capital). This means in fact that the business’s total assets must at least equal or exceed its total liabilities. When the business’s total liabilities exceed its total assets, the business is technically insolvent. 1.6 ASSETS Assets refer to all the economic resources that an enterprise owns. In an accounting environment, an asset is something that an entity has acquired or purchased, and that has money value (its cost, book value, market value, or residual value). An asset can be: (1) something physical, such as cash, machinery, inventory, land and building, (2) an enforceable claim against others, such as accounts receivable, (3) right, such as copyright, patent, trademark, or (4) an assumption, such as goodwill. Assets shown on their owner's balance sheet are usually classified according to the ease with which they can be converted into cash. See also intangible assets and tangible assets FOUR TYPES OF ASSETS TO BE FAMILIAR WITH: 1.6.1 Fixed assets (intangible)

These are assets that confer rights, ex. goodwill, franchise fees, patents, special licences, brands, copyrights, etc. 1.6.2 Fixed assets (tangible) These are items that are purchased to facilitate the running of the business. They are not purchased for resale, ex. land, buildings, plants and machinery, fixtures and fittings, office machines, furniture, vehicles, etc. 15

BASIC FINANCIAL CONCEPTS 1.6.3 Investments When a business has spare cash that the owners do not want to put into their trading operations, they may decide to invest that money into other trading profit earning investments or ventures; investments in other businesses, long-term deposits, shares in listed companies, etc. If the investment is of a long-term nature it will be shown separately on the balance sheet under fixed assets. Short-term investments for quick profits will be shown as a current asset. 1.6.4 Current assets These are the trading assets of the business. They are part of the working capital. Typical current assets are: stock of raw materials, stock of finished goods, work in progress, prepaid expenses and deposits, cash on hand and at bank and outstanding debtors. 1.7 LIABILITIES Liabilities refer to all money owed by the enterprise to other people or businesses. A liability legally binds an individual or company to settle a debt. When one is liable for a debt, they are responsible for paying the debt or settling a wrongful act they may have committed. In the case of a company, a liability is recorded on the balance sheet and can include accounts payable, taxes, wages, accrued expenses, and deferred revenues. Current liabilities are

debts payable within one year, while long-term liabilities are debts payable over a longer period. THREE TYPES OF LIABILITIES: 1.7.1 Owner’s equity  Amounts invested in the business by owners: share capital and loan accounts.  Accumulated profits. In the case of a Company or CC, these profits may be  distributable (dividends) or non-distributable (reserves). Equity is a stock or any other security representing an ownership interest. On a company's balance sheet, the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). 1.7.2 Long term liabilities Amounts the business borrowed from financial institutions and other businesses or individuals. The loans are repayable over long periods of time. 16 LESSON 1.2 1.7.3 Current liabilities The trading liabilities of the company that form part of the working capital; creditors, bank overdrafts, taxes, etc. 1.8 INCOME The amount of money or its equivalent received during a period of time in exchange for labour or services, from the sale of goods or property, or as profit from financial investments. Income is simply the event that results in money flowing into the business. EXAMPLES OF INCOME: Sales

Services rendered (such as an accountant’s services, doctor’s services, a plumber’s services, etc.) Interest received Rent received Each one of these things above represent some sort of event that occurs (like a sale being made), which results in money flowing into a business. Two basic types of income:  From trading or service operations: Sales, commissions, etc.  From other sources: Interest received, dividends, profit on sale of fixed assets, etc. 1.9 EXPENSES Payment of cash or cash-equivalent for goods or services, or a charge against available funds in settlement of an obligation as evidenced by an invoice, receipt, voucher, or other such document. TWO BASIC TYPES OF EXPENSES: 1.9.1 Fixed overhead expenses. These are expenses that must be paid whether the business is trading or not. They are not directly related to sales or manufacturing, ex. rental of administrative offices, receptionist’s and accountant’s salaries, telephone and electricity expenditure. 17

BASIC FINANCIAL CONCEPTS 1.9.2 Variable expenses Expenditure directly related to the manufacturing or sales processes of a company, ex.

materials used, labour, depreciation on machines, etc. 1.10 TRANSACTIONS A transaction is classified as an agreed upon transfer of value from one party to another, ex. sale or purchasing of goods. In an enterprise, all transactions must be recorded, classified and summarised to provide information on which owners, managers and investors can base their decisions and actions. In accounting, any event or condition recorded in the book of accounts is a transaction. This information is normally communicated by means of financial reports such as the balance sheet (financial position) and the income statement (financial result). We obtain essential information from accounting records, such as: Sales Total sales figures by day, week, month and year should be available and these sales should also be broken down into departments, products or type of merchandise, if applicable. These divisions of sales are necessary to determine the profitability of each department or line and to make decisions about it. Operating expenses Information is needed for all types of expenses. Retailers may classify their expenses as selling expenses and general expenses. Factory’s expenses may be classified as manufacturing, selling and general expenses. Accounts receivable Records of total cash sales and total sales on account must always be available. Accounts payable Records of every debt incurred must be available and the total debts outstanding at any time must be easily accessible. Inventory

Regular information on the total inventory must be available. Payroll records Payrolls include records of weekly wages, monthly cheese to employees, pension fund contributions, PAYE, etc. 18

LESSON 1.2 NOTES:

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TEAM SUPERVISOR CHAPTER 2 BASIC FINANCIAL ACCOUNTING AND STATEMENTS IN THIS CHAPTER:  LESSON 2.1 : RECORDING TRANSACTIONS 

LESSON 2.2 : THE EFFECT OF TRANSACTIONS ON THE FINANCIAL POSITION OF THE ENTERPRISE  LESSON 2.3 : BALANCING THE ACCOUNTS OF THE GENERAL LEDGER  LESSON 2.4 : PREPARING AND CONTROLLING BUDGETS  LESSON 2.5 : THE INCOME STATEMENT  LESSON 2.6 : THE BALANCE SHEET AT THE END OF THIS CHAPTER YOU WILL BE ABLE TO: 1. Describe how financial transactions are recorded 2. Explain the double-entry system in accounting 3. Explain the accounting equation 4. Explain the effect a transaction will have on the financial position a business 5. Name and explain the function of all the main documents involved in recording and summarising transactions (source documents, journals, ledger, financial statements) 6. Balance a general ledger account 7. Classify general ledger accounts into asset, liability, income or expenditure accounts 8. Prepare a pre-adjustment trial balance for a small business/department 9. Discuss the importance of budgets 10. Explain why budgets are drawn up 11. Describe the stages that have to be completed in sequence to prepare a proper budget 12. Explain terminology associated with budgeting 13. Identify various types of budgets and briefly explain them 14. Prepare a sales budget for a small business/department 15. Prepare a production budget for a small business/department 16. Prepare an income statement for a small business/department 17. Utilise information from an income statement to calculate the breakeven point, maximum discount, and mark -up % for a business 18. Prepare a balance sheet for a small business/department

LESSON 2.1 LESSON 2.1 RECORDING TRANSACTIONS In this Lesson: Before any transaction can be transferred to the financial statements, it has to be summarised, organised and recorded. Every transaction has an effect on the financial position of the enterprise. Transactions must be classified, recorded and summarised to show its effect on the financial position of the business. 1. RECORDING TRANSACTIONS 1.1 TRANSACTIONS In general, everything a company does results in a transaction, including things that take place between the business and:  Customers, who buy products and services sold by the business  Employees, who are paid wages and provided benefits  Vendors, who sell services, equipment, and supplies to the business  Government agencies, who collect taxes from the business  Sources of equity capital (investors or owners who put money in and take it out of the business)  Sources of debt capital (banks and lending institutions) Accounting guidelines govern how businesses record transactions. They also dictate the design of the recordkeeping system that a business uses and how reports are prepared, based on the information gathered and put into the system.

Before any transaction can be transferred to the financial statements, it has to be summarised, organised and recorded. Every transaction has an effect on the financial position of the enterprise. 21

RECORDING TRANSACTIONS Transactions must be classified, recorded and summarised to show its effect on the financial position of the business. For example: When you sell a stock item:  There is a change in stock.  There is a change in cash or debtors. When you buy stock to resell:  There is a change in stock  There is a change in cash or creditors This bookkeeping or recording phase provides the information on the financial position and the financial result of the enterprise that can be used to compile balance sheets and income statements. All transactions are recorded in two separate accounts. There is an account for each asset, liability and equity item. There also is an account for each income and expense item. All these accounts are classified and grouped together in the general ledger.

Income and expenses affect the equity and are therefore referred to as nominal accounts. The nominal accounts provide the information for the income statement while the asset, liability and equity accounts provide information for the balance sheet and statement of changes in equity. The accounts in the general ledger are basically in the form of a “T” and are often referred to as T-accounts. A DEBIT (Dt) and CREDIT (Ct) system is used. The ledger page is divided in two and debits are entered on the left hand side and credits on the right hand side. When we enter something on the left side of the account, this is known as debiting the account. A debit entry is put through or the account is debited. When we enter something on the right side of the account, it is known as crediting the account. A credit entry is put through or the account is credited. A debit amount on one ledger account must have an equal credit on another ledger account. For every debit entry there always must be a credit entry of a corresponding amount. This is known as the double-entry system or double entry accounting. 22 LESSON 2.1 DOUBLE ENTRY ACCOUNTING This is the method used by most businesses and preferred by accountants. With this method, every valid entry or transaction must involve two (or more) accounts. (In fact, most accounting software packages will not allow you to post a single entry transaction!) Both sides – the debit and the credit – of the transaction must balance and this ensures that all financial statements balance. For example, let’s say that the business buys a R2, 000 computers on credit. The company’s assets go up by R2, 000 (the debit) but the liabilities also go up by R2, 000 (the credit). As this is paid, assets (cash) decrease as payments are made and the liability goes down by the same amount

Some notes about recordkeeping:  Rand signs are typically not used in journals or ledgers, but should be placed in financial reports and statements (even if it is on the first line only).  Commas (to show thousands of dollars) are not required in journals or ledgers but should be placed in financial reports and statements for clarity.  Dashes or blank spaces can be used to indicate zeroes. 1.2 THE ACCOUNTING EQUATION The financial position of an enterprise can be expressed as follows: DEBIT BALANCES = CREDIT BALANCES OR ASSETS = INTERESTS (FINANCING) OR ASSETS =

LIABILITIES + EQUITY A debit balance can only be one of two things: an asset or an expense. A credit balance can only be one of two things: an income or a liability. 23

RECORDING TRANSACTIONS The accounting equation can therefore also be written as follows: How money is applied (Dt) = Where money comes from (Ct) Assets + Expenses (Dt) = Liabilities + Income (Ct) Dt ASSET (e.g. Bank) or EXPENSE Account (e.g. Rent paid) Ct Decrease (-)  An asset account is increased by an entry on the debit side and decreased by an entry on the credit side.  The amount of an expense account is also increased by entries on the debit side and decreased by entries on the debit side. Dt LIABILITY (e.g. Creditor) or INCOME (e.g. Sales) Ct

Decrease (-) Increase (+) • Liabilities and the capital account are increased by entries on the credit side and decreased by entries on the debit side. • The amount of an income account is increased by entries on the credit side and decreased by entries on the debit side. 1.3 LEDGER ACCOUNTS The ledger account is also known as the T-account as it has the form of a T. The title is being written on the horizontal line and transactions are entered on the left side (debit side) and right side (credit side) of the vertical line: Cash Account Debit side Credit side 24 LESSON 2.1 Balance: The balances of certain accounts increase when debited, while the balances of other accounts increase when credited. The reason for this is found in the basic accounting comparison: Assets= Ownership interest + Liabilities

 The balance of an account is the difference between the total money value of the debit and credit entries on an account.  The balance of an account normally appears on the same side as the side on which the element appears in the accounting comparison.  The balance of an account increases with the entry of an amount on the same side as the side on which the element appears in the accounting comparison.  The balance of an account decreases with the entry of an amount on the opposite side as the one on which the element appears in the accounting comparison. Asset accounts Asset accounts are on the left side (debit side) of the comparison. The balance of the asset account is usually a debit balance and increases with entries on the debit side and decreases with entries on the credit side. Liability accounts Liability accounts are on the right side (credit side) of the comparison. The balance of the liability account is usually a credit balance and increases with entries on the credit side and decreases with entries on the debit side. Ownership interest (Owner’s equity / Capital) Ownership interest appears on the right side (credit side) of the comparison and therefore the balance will increase with further entries on the credit side and decrease with further entries on the debit side. Income items: These items will increase ownership interest and therefore income accounts will have credit balances and will increase with entries on the credit side and decrease with entries on the debit side.

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RECORDING TRANSACTIONS Cost items These items will decrease ownership interest and therefore cost accounts will usually have debit balances that will increase with further entries on the debit side and decrease with further entries on the credit side. This proposition can schematically be presented as follows: Assets = Ownership interest + Liabilities DT Asset accounts CT DT Capital CT DT Liability Accounts CT + - - + - + - Increase

- Increase on - Increase on on Debit Credit side Credit side side Decrease on Decrease on Decrease on Credit side Debit side - Credit Debit side - Credit - Debit balance balance balance Income accounts - +

- Decrease - Increase on Debit side on Credit side - Credit balance Cost Accounts + - - Increase Decrease on on Debit Credit side side (because it is a decrease in ownership interest)

- Debit balance 26

LESSON 2.1 NOTES:

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RECORDING TRANSACTIONS NOTES:

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LESSON 2.2 LESSON 2.2 THE EFFECT OF TRANSACTIONS ON THE FINANCIAL POSITION OF THE ENTERPRISE In this Lesson: Every transaction has an effect on the financial position of the enterprise. A transaction always affects two accounts. The accounting equation can be used to analyse these effects. 1. THE EFFECT OF TRANSACTIONS ON THE FINANCIAL POSITION OF THE ENTERPRISE 1.1 ANALYSING THE EFFECTS Every transaction has an effect on the financial position of the enterprise. Transactions must be classified, recorded and summarised to show its effect on the financial position of the business. A transaction always affects two accounts. The accounting equation can be used to analyse these effects.

29

RECORDING TRANSACTIONS The following example will illustrate this principle: Pamela starts a bakery. During the first month of business: 1. She opens a bank account for her business in the name of Pamela’s delicatessen and Deposits R25 000 into it. This is her initial capital investment or equity. 2. She purchases an oven for R20 000 on credit from Hellfires Pty Ltd. 3. She purchases consumable inventory for R2000. 4. She supplies snacks of R2000 on credit to Yuppie Foundation. 5. The bakery consumes R1000 of consumable inventory. Assets (R) + Expenses Liabilities (R) +Equity (R) Bank Debtors

Equipment Consumables = Creditors Equity 1 +25 000 = +25 000 2. +20 000 = +20 000 3. – 2 000 +2 000 = 4. +2 000 = +2 000 5. -1 000

= - 1 000 +23 000 +2 000 +20 000 +1 000 = +20 000 +26 000 R46 000 = R46 000 1. The cash in the bank is an asset for the business, but it owes this amount to the owner. 2. The oven is an asset for the business, but it owes this amount to Hellfires Pty Ltd. 3. Because the business paid cash from the bank, the bank asset decreases, but at the same time the consumable inventory asset increases by the same amount. When the Inventory is consumed, the cost of the consumption will represent an expense and the consumable asset as well as equity will decrease with the same amount (see 5.) 4. This represents an income for the business. Since the business belongs to the owner, the income also belongs to her. It therefore increases the equity. 30 LESSON 2.2 5.

The consumed inventory represents an expense that decreases equity and the inventory at hand. If the Yuppie foundation pays their debt, the net profit for this period the difference between the income (R2000) and the expenditure (R1000). The profit belongs to the owner. Examples of how accounts are influenced by transactions: TRANSACTIONS ACCOUNT DEBITED ACCOUNT CREDITED The owner deposits capital Bank Equity/capital Sell goods for cash Bank Goods/stock Sell goods on credit Debtors Goods/stock Debtor makes payment Bank Debtors Buys goods for cash Goods/stock Bank Purchas goods on credit Goods/stock Creditors Pay creditor Creditors Bank 1.2 BASIC ACCOUNTING BOOKS AND STATEMENTS

1.2.1 SOURCE DOCUMENTS  Receipts  Sales invoices  Delivery notes  Invoices from creditors  Delivery notes from creditors  Cash register slips  Petrol and tollgate slips  Stock received notes  Stock requisition notes  Bank statements and vouchers  Other proof of expenditure or income depending on type of business. 31

RECORDING TRANSACTIONS 1.2.2 JOURNALS

Journals are the prime books of entry and are entered from the source documents. They are diaries of the day-to-day transactions of the business:  Sales journal; records all sales whether cash or credit.  Purchases journal; record of all purchases on credit.  Cash book; accurate record of bank account – payments and receipts.  Petty cash book; minor cash expenditure.  Journal; to make adjustments in the ledger. 1.2.3 LEDGERS Ledgers are called the secondary books of account and are entered from the journals. They summarise and categorise the information entered in the journals:  General ledger or private ledger.  Debtor’s ledger; record of all customers who owe you money and buy on credit – separate account for each debtor.  Creditors ledger; exact information on all the suppliers who supply you on credit basis and who you owe money to – separate account for every creditor.  Fixed assets register. The number of accounts needed in the ledger will depend on the nature and size of the business, but the following accounts must always be opened:  Assets  Liabilities  Owner’s equity  Initial capital invested  Income accounts  Cost accounts

1.3. RECORDING TRANSACTIONS IN THE LEDGER A separate account must be opened for each asset, liability and ownership interest item. The collective noun for all these accounts is the ledger. The proportionality of the basic accounting comparison is being maintained in the ledger and therefore the total of the debit balances in the ledger equals the total of the credit balances in the ledger. 32 LESSON 2.2 The accounting system is based on the following approaches:  Every transaction influences at least two items in the accounting comparison (or in the accounts).  The influence of every transaction must be reproduced in terms of money.  The accounting comparison must balance after the reproduction of the influence of each transaction. Before a transaction can be put on record, it must be analysed as follows: a) Determine which asset or interest items are being influenced b) Application of the tenets of debit and credit. Example The following transactions of CJ Smit, an attorney, are being used to illustrate the recording of transactions in the ledger accounts: 2011 September 1:

CJ Smit opened a bank account for his legal practice, Smit and Kie by investing R50 000 from his private sources in the practice. a) The asset “Cash” increased with R50 000 and to increase an asset the Cash in Bank must be debited. Dt Cash in Bank Ct 2009 Sept: 1 Capital: CJ Smith R50 000 b) Ownership interest coming into being (increased) with R5 000; to increase an interest the interest account must be credited. Dt Capital: CJ de Wet Ct 2009 Sept: 1 Capital: CJ Smith R50 000 33

RECORDING TRANSACTIONS September 2:

The firm pays R8000 for rent for September for the use of the practice’s offices. a) The cost item “Rent Pay” originates (increased) with R8000. This item is a decrease of the ownership interest. To increase a cost item the Rent Pay must be debited. Dt Rent Pay Ct 2009 Sept: 2 Cash R8 000 b) The asset “Cash in Bank” decreased with R8000 because of the payment. To decrease the asset, the Cash in Bank must be credited. Dt Cash in Bank Ct 2009 2009 Sept: 1 Capital: CJ Smit R50 000 Sept: 2 Rent R8 000 September 3: The firm buys office equipment with a value of R16 000 for cash. a) The asset “Office Equipment” increased with R16000. To increase the asset, the Office Equipment must be debited.

Dt Office Equipment Ct 2009 Sept 3: Cash R16 000 b) The asset “Cash in Bank” decreased with R16000. To decrease an asset the Cash in Bank must be credited. Dt Cash in Bank Ct 2009 2009 Sept 1: Capital: CJ Smith R50 000 Sept 2: Rent: R8 000 Sept 3: Equipment R16 000 34 LESSON 2.2 September 6: Waltons Stationery provides stationery and printing for the value of R2500 on credit. a) The cost item “Stationery ad Printing” decrease the Ownership Interest with R2500. To decrease the Ownership Interest the Stationery and Printing must be debited.

Dt Stationery and Printing Ct 2009 Sept: 6 Waltons Stationery R2 500 b) Creditors increased with R2500. To increase the creditors, Waltons Stationery (a creditor) must be credited. Dt Waltons Stationery Ct 2009 Sept: 6 Stationery & Printing R2 500 September 12: Smit & Kie receive R5000 for legal services rendered. a) The asset “Cash in Bank” increased with R5000. To increase an asset, Cash in Bank must be debited. Dt Cash in Bank Ct 2009 2009 Sept: 1 Capital CJ Smit R50 000 Sept: 2 Rent R8 000 Sept: 12 Fees R 5 000 Sept: 3 Equipment R16 000 b) The ownership interest increased with R5000. To increase ownership interest, “Fees” must be credited. Dt Fees Ct 2009 Sept: 12 Cash R5 000

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RECORDING TRANSACTIONS September 18: Smit & Kie completed legal work for ABC Limited and debited their account with R10 000. a) The asset “ABC Limited” (a debtor) increased with R10 000. To increase the asset, ABC Limited must be debited. Dt ABC Limited Ct 2009 Sept: 18 Fees R10 000 b) Ownership interest increased with R10 000. To increase Ownership Interest, fees must be credited. Dt

Fees Ct 2009 Sept : 12 Cash R 5000 Sept : 18 ABC Limited R10 000 September 25: Pay salaries of R10 000 for the month a) The cost item “Salary” decreased the ownership interest with R10 000. To decrease the ownership interest, “Salary” must be debited. Dt Salary Ct 2009 Sept: 25 Cash R10 000 b) The asset “Cash in Bank” decreased with R10 000. To decrease an asset, “Cash in Bank” must be credited. Dt Cash in Bank Ct 2009 2009 Sept: 1 Capital : CJ Smit R50 000 Sept : 2 Rent R 8000

Sept 12 Fees R 500 Sept : 3 Equipment R 16000 Sept : 25 Salary R10 000 36 LESSON 2.2 September 28: CJ Smit withdrew R5000 from the firm’s bank account for his own use. Withdrawal by the owner decreased his interest in the enterprise with R5000. To decrease the ownership interest “Withdrawal: CJ Smit” must be debited. Dt Withdrawal : CJ Smit Ct 2009 Sept: 28 Cash R5000 b) The asset “Cash in Bank” decreased with R5000. To decrease the asset, cash in bank must be credited. Dt Cash in Bank Ct 2009 2009 Sept 1: Capital : CJ de Wet R 50 000 Sept : 2 Rent

R 8 000 Sept 18 : Fees R5 000 Sept : 3 Equipment R16 000 Sept 25 Salary R10 000 Sept 28 Withdrawal: CJ Smit R 5 000 September 29: Pay R1500 on account to Waltons Stationery a) A liability (creditor) decreased with R1500. To decrease the liability, Walton Stationery must be debited. Dt Waltons Stationery Ct 2009 2009 Sept: 29 Cash R1 500 Sept: 6 Stationery & Printing R2 500 An asset “Cash in Bank” decreased with R1500, therefore “Cash in Bank” must be

credited. Dt Cash in Bank Ct 2009 2009 Sept 1 : Capital : CJ Smit R50 000 Sept : 2 Rent R8 000 Sept 18 : Fees R5 000 Sept : 3 Equipment R16 000 Sept 25 Salary R10 000 Sept 28 Withdrawal : CJ Smit R5 000 Sept 29 Waltons stationery R1 500 Stationery R 1500 37

RECORDING TRANSACTIONS September 30: Received payment of R2500 from ABC Limited a) An asset “Cash in Bank” increased with R2500. To increase the asset, the account must

be debited. Dt Cash in Bank Ct 2009 2009 Sept 1 : Capital : CJ Smit R50 000 Sept : 2 Rent R8 000 Sept 18 : Fees R5 000 Sept : 3 Equipment R 16 000 Sept 30 : ABC Limited R2 500 Sept 25 Salary R10 000 Sept 28 Withdrawal R5 000 Sept 29 Waltons Stationery R1 500 b) The asset, debtors decreased with R2500. To decrease the asset, ABC Limited must be credited. Dt ABC Limited Ct 2009 2009 Sept 18 : Fees R10 000 Sept : 30 Cash R2 500 38

LESSON 2.2 NOTES: 39

BALANCING THE ACCOUNTS OF THE GENERAL LEDGER LESSON 2.3 BALANCING THE ACCOUNTS OF THE GENERAL LEDGER In this Lesson: During the recording process both the debit side and the credit side of an account is used. All amounts on the one side of the account are increases, which must be added. All amounts on the opposite side are decreases, which must be subtracted. The different between the total debits and the total credits on an account is known as the balance on the account. When the total debits on an account exceed the total credits, the balance is a debit balance and when the credits exceed the debits, it is a credit balance. 1.1 THE BALANCE ON AN ACCOUNT IS CALCULATED AS FOLLOWS: 1) Add the debit side on an account and write the total in, in pencil. 2) Add the credit side of an account and write the total in, in pencil. 3) Subtract the smaller total from the bigger total. The “difference” which is calculated, is the balance of the specific account. This balance is written on the side of the account with the smaller total. 4) The totals of the account are now inserted. After the inserting of the balance as described in (3), the totals of the debit and credit sides must be in harmony. 5) The balance, which is written above the totals in (4), must now be transferred to the opposite side from which it was inserted in step 3 and be written under that side’s total. This

represents the balance at the beginning of the new month’s transactions. 40 LESSON 2.3 The balance of the Cash in Bank account will be calculated as an example: DT CASH IN BANK CT 2009 2009 Sept 1 Capital : CJ Smit 50 000 Sept 2 Rent 8 000 Sept 15 Fees 5 000 Sept 3 Equipment 16 000 Sept 30 ABC Limited 2 500 Sept 25 Salary 10 000 Sept 28 Withdrawal: CJ Smit 5 000 Sept 29 Waltons Stationery 1 500

(1) total debit side in pencil 57 500 (2) Total credit side in pencil 40 500 DT CASH IN BANK CT 2009 2009 Sept 1 Capital : CJ Smit 50 000 Sept 2 Rent 8 000 Sept 15 Fees 5 000 Sept 3 Equipment 16 000 Sept 30 ABC Limited 2 500 Sept 25 Salary 10 000 Sept 28 Withdrawal: CJ Smit 5 000 Sept 29 Waltons Stationery 1 500 (3) Insert balance Sept 30 Balance 17 000 as calculated 57 500 57 000 4) Add totals of debit and credit side

2009 Oct 1 Balance 17 000 41

BALANCING THE ACCOUNTS OF THE GENERAL LEDGER 1.2 CLASSIFICATION OF GENERAL LEDGER ACCOUNTS All accounts must be classified as an asset, liability, income or expense account. The following are some examples of this classification. The classification will have an effect on whether the account will be debited or credited. Remember that all Income and Liability accounts will always have a Credit balance (Use the acronym, CIL to remember: Ct = Income and Liability accounts) and all Asset and Expense accounts will always have a Debit balance (Use the acronym DAE to remember : Dt = Assets and Expense accounts). ACCOUNT NAME ASSET LIABILITY INCOME EXPENSE

Positive bank balance  Telephone expenditure  Land and buildings  Wages  Petty cash  Sales  Advertising expenditure 

Stationery (in store room)  Loan from bank  Vehicle  Rental expenditure  Water and electricity  Discounts given  Deposit for municipal account  Postage

 Debtors  Creditors  Bank overdraft  42 LESSON 2.3 1.3 THE PRE-ADJUSTMENT TRIAL BALANCE After the recording of all the transactions in the ledger, the arithmetical accuracy of the recording must be tested, to determine whether the total debits equal the total credits. This is being done by determining the balances of each account as already explained. At the end of a specific period, all accounts in the ledger will either have a debit balance or a credit balance or a nil balance. A list of these balances is called a trial balance. Because

every debit entry has an equal credit entry, the total of the debit balances has to equal the total of the credit balances. If this is the case, the double-entry principle has been applied correctly. It does however not mean that no mistakes were made during the recording phase. The following errors will not be revealed by the trial balance:  Items posted to the correct side of the ledger but to the wrong account.  Entries that are completely omitted (not recorded at all).  Errors on one side of ledger that are compensated by errors on the other side if the ledger. A trial balance can be compiled by taking all the balances from the accounts in the general ledger and transferring them to the correct columns in a table. This is called the pre- adjustment trial balance because no changes have been made to it. Example: Pre-adjustment trial balance of Hamburger Den at 30 April …. ACCOUNT DEBIT CREDIT Bank R18 000 Consumables (inventory) R2 000 Equipment R30 000 Capital R20 000 Sales R8 000 Creditors R30 000 Debtors R5 000

Consumables (used) R2 000 Salaries R1 000 Total R58 000 R58 000 43

PREPARING AND CONTROLLING BUDGETS LESSON 2.4 PREPA REP RING AND CONTROLLING BUDGETS In this Lesson: A budget can be defined as a written document that expresses management’s goals and forecasts in financial terms for a specific future period. It is a financial plan for a future period. Budgeting is an important technique for all businesses. Budgets are based on forecasts of future events. Although forecasts are only guesses as to what may happen in the future, they help organisations to base their guesses on the most reliable information available at that specific time. In order for a budget to be drawn up effectively, certain stages have to be completed in sequence. 1.1 INTRODUCTION Control is the process that enables management to see to it that the actual activities are in harmony with planned objectives. This requires concerted effort.

Standards must be set, and performance must be watched. If necessary, corrective steps must be taken to ensure that the enterprise resources are utilised as effectively as possible. A budget can be defined as a written document that expresses management’s goals and forecasts in financial terms for a specific future period. It is a financial plan for a future period. 1.2 REASONS WHY A BUDGET IS DRAWN UP  It creates a formal framework for an enterprise to make forecasts and set goals.  Budgets are instruments for management and staff to evaluate whether goals have been achieved. They aid financial control by comparing actual results with budgeted results.  Budgets assist in the process of financial planning. In the budgeting process, the capital requirements of the enterprise are determined. It allows the enterprise to make provision for its financial needs at an early stage. 44 LESSON 2.4  It creates cost awareness among staff. Budgets are used to control costs in an enterprise and limit them to a minimum.  It co-ordinates the enterprise’s goals and unifies them to achieve goals. It contributes to the optimum use of resources at the disposal of the enterprise.  The enterprise has the opportunity to take into account external factors such as competition and economic cycles that may influence financial planning.  It is a good indication of the enterprise’s performance and is used to assist in the application of financial control. Budgeting is an important technique for all businesses. Budgets are based on forecasts of future events. Although forecasts are only guesses as to what may happen in the future, they help organisations to base their guesses on the most reliable information available at that specific time. In business, forecasts are generally referred to as budgets, though the term projection may also be used. Forecasts are made of both the income that the business expects to earn and different types of expenditure that the business is to undertake.

Financial accounting and cost reporting systems are important in assessing how a business has performed in the past. However, looking at past results alone is not sufficient to enable managers to run a business efficiently. The success of a business depends on the ability of the managers to formulate polices and strategies effectively, to plan and control the operations of the business, to co-ordinate the use of the resources of the business and to make decisions. One of the most important tools used in this process is the budget. 1.3 BUDGETING PERIODS Budgets are drawn up a reasonable time before the end of the financial year to be ready for the following year to which they will apply. It takes place by collecting and processing the necessary information from various components. All information in budgets must be based on challenging but realistic goals. Thorough research must be done on existing situations. A budget will only work if all interested parties in the enterprise are consulted in the process and their inputs are also processed. When a budget is reasonable and realistic it will motivate staff to attempt to comply with it. Unrealistic and unreasonable budgets will have a negative effect on staff. 1.4 INTERNAL AND EXTERNAL FACTORS THAT IMPACT ON A BUDGET 45

PREPARING AND CONTROLLING BUDGETS In most enterprises, one or more factors exist which limit the activities of the enterprise as a whole. If this were not the case, all the enterprises in the country would theoretically experience unlimited growth. Examples of such limiting factors are:  The supply of the product is limited; therefore purchases are limited (external).  The demand for the product is limited; therefore sales are limited (external).

 The funds of the enterprise are limited; therefore neither too much stock can be kept nor can too much credit be allowed (internal).  There are many competitors in the same industry (external). 1.5 BUDGET STAGES The budget promotes involvement, co-operation and co-ordination between the often isolated departments of the organisation. It forces departments to acknowledge their mutual dependency on one another. In order for a budget to be drawn up effectively, certain stages have to be completed in sequence: Stage 1 Communicating details of the budget policy This information may be planned changes in the sales mix, the expansion or contraction of certain activities, important guidelines that govern the preparation of the budget, ex. price and wage increases, expected changes in productivity and expected changes in industry demand and output. Stage 2 Determining factors that restrict output As discussed above, various limitations exist. Prior to the preparation of the budgets, it is necessary for top management to determine the factors that restrict performance. Stage 3 Preparing the sales budget If sales demand is the factor that restricts output, the sales budget is the most important plan in the annual budgeting process. Sales budgets are typically based on estimated sales demand. Stage 4 Initial preparation of departmental budgets Initial budgets should be done by the managers responsible for meeting the budgeted performance. It should be done using the bottom up process. This means that the lowest level of

management is the source of the budget that is passed up to higher levels for approval. 46 LESSON 2.4 Stage 5 Negotiating budgets Once budgets are completed at lower management or departmental level, it is passed up to higher levels of management, who may adjust certain aspects. This phase merely represents the adjustment of budgets at higher levels of management. Stage 6 Co-ordination and review of budgets This phase represents the acknowledgement of any adjustments made in the previous phase, and how these adjustments affect the budgeting process. Stage 7 Final acceptance of the budget When all budgets are in harmony with each other, they are summarised into a master budget. Stage 8 Budget review The budget should be analysed at regular interviews. This means that comparisons between actual results and budgeted results are made. This process will assist in determining the accuracy of the budgets. Any changes can be made to obtain better results when subsequent budgets are to be prepared. 1.6 BUDGET TERMINOLOGY In order to understand the budgetary process, it is important to become familiar with the

terminology associated with budgeting: 1.6.1 COST It is necessary to examine cost not only by their nature (material, labour, overheads) but also by their behaviour in relation to changes in the volume of sales. Using these criteria, four kinds of cost may be identified:  Fixed costs; these costs remain fixed irrespective of the volume of sales, for example rent, rates, insurance.  Semi-fixed costs these are costs that move in correlation with, but not in direct proportion to the volume of sales (ex. fuel costs, telephone, laundry). Semi-fixed costs contain a fixed and variable cost element, ex. the charge for the telephone 47

PREPARING AND CONTROLLING BUDGETS line and a variable cost depending on the number of calls made.  Variable costs; these are costs that vary in proportion to the volume of sales, ex. food and beverage costs.  Total costs; this is the sum of the fixed costs, semi-fixed costs and variable costs. 1.6.2 PROFIT There are two main kinds of profit:  Gross profit = total sales – cost of materials.  Net profit = total sales – total costs (material +labour + overhead costs). 1.6.3 BREAKEVEN POINT

The term break-even point may be defined as that volume of business where the total costs are equal to the sales and where neither profit nor loss is made. 1.6.4 VARIANCE ANALYSIS Variance analysis is an activity that allows management to compare the actual performance during a specific period against its budgeted expectations in the same period. To use variance analysis effectively, determine why the variance occurred. Identify the causes of unfavourable variances and suggest remedies to prevent them. 1.7 BUDGET LIMITATIONS Although budgets are useful and valuable, one must keep in mind that they do have certain limitations. These limitations include:  The given information used to prepare budgets is obtained from estimates.  Budgets are never perfect because they have to adapt continuously to changing circumstances.  The implementation of a budget and the control over the activities are subject to the fallibility of man. 48 LESSON 2.4 1.8 BUDGET CONTROL In any enterprise it is the responsibility of management to plan the future activities of the enterprise and to exercise control over these activities so that the planned objectives are met.

The control process can be divided into three phases, namely:  Setting standards or measures.  Measuring reality and judging it against the given measures or standards.  Corrective action when the reality deviates from the plan. The budget remains one of the best planning and controlling mechanisms the organisation can make use of, but then it must be established and used in a responsible and scientific manner. A very good management information system is necessary to do planning and controlling. 1.9 TYPES OF BUDGETS There are many types of budgets available as financial control tools within the business: 1.9.1 Project budgets are budgets drawn up for specific tasks or projects to be undertaken (ex. if a company wishes to open up another branch) and will no longer be valid once the project is completed. 1.9.2 Capital budgets are concerned with general office buildings, extensions of the factory building, installation of new machinery and equipment as well as new vehicles. 1.9.3 Cash budgets. The enterprise always needs cash and the amount needed will vary from month to month, depending on the monthly cash income and payments. 1.9.4 Departmental budgets are prepared when individual departments may need to make separate budgets to add to a master budget, e.g. sales, purchases, human resources, advertising, etc. 1.9.5 Operating budgets. These are concerned with the day-to-day income and expenditure of an establishment and include sales, cost of sales, labour, maintenance, etc. 1.9.6 Zero-based budgets. In this approach to budgeting the results of the previous 49

PREPARING AND CONTROLLING BUDGETS year’s budget are not taken into account. The budgeting process begins afresh every year. This enables the organisation to look at its activities and prioritise from a fresh angle every year. The budget figures of the past play no role in the allocation of funds and every manager must state his case again and give the necessary motivation for his department’s budget request. 1.10 THE MOST IMPORTANT BUDGETS THE SALES BUDGET Sales forecasts determine the starting point of the sales budget. It is regarded as the most important budget because many other budgets are influenced by it. The formula for determining expected sales is: Expected sales = expected number of units sold x unit price Example of a sales budget: ABC Traders  They sell doormats and estimate that 3000 units will sell in the first quarter.  Sales will increase by 500 units per quarter thereafter.  Their selling price for the door mats is R60 per unit. SALES BUDGET FOR ABC TRADERS 1 2 3 4 Year Expected sales 3 000 3 500 4 000 4 500

15 000 Unit price X R60 X R60 X R60 X R60 X R60 Total: quarter R180 000 R210 000 R240 000 R270 000 R900 000 PRODUCTION BUDGET It has now been determined how many units you are expected to sell, thus the units you must manufacture can now be determined, bearing in mind that you already have some stock on hand. The calculation should be done as follows: Expected sales figure Minus Opening stock Plus Final stock = Expected number of units to manufacture. 50

LESSON 2.4 Complete the following production budget PRODUCTION BUDGET FOR ABC TRADERS 1 2 3 4

Year Expected sales 3 000 3 500 4 000 4 500 15 000 Less opening stock (450) (525) (600) (675) (450) Total Plus closing stock 525 600 675 750 750 Number of units to be produced CASH BUDGET The cash budget is the main concern in the enterprise; it is an important result obtained from drawing up other budgets. Expected cash flow is determined to assist management to make provision for cash shortages and to consider the necessary financing possibilities. Example: ABC Traders has collected the following information for you in respect of their cash budget:

 The bank should show a positive balance of R40 000 at the beginning of the year  An investment of R4 000 will be sold for cash in the second period  Purchases of all current costs are spread evenly over the quarters  Direct labour costs are settled in the period incurred  Management wants to purchase a new truck for R133 000 in the second quarter  The enterprise pays tax monthly in equal instalments  Loans are paid in the first quarter when there is sufficient cash. 51

PREPARING AND CONTROLLING BUDGETS CASH BUDGET FOR ABC TRADERS 1 2 3 4 Cash balance 40 000 22 550 5 900 13 050 Debtors and cash 173 000 198 000 228 000

258 000 Sales of investment 4 000 Total receipts 213 000 224 550 233 900 271 050 Expenditure Less: payments Direct material 15 125 17 625 20 125 22 585 Direct labour 47 105 49 805 52 505 91 500 Rent paid 14 000 14 000 14 000 14 000 Telephone 1 400 1 400 1 400 1 400 Salaries 11 200 11 200 11 200 11 200 Repairs and maintenance 1 120 1 120 1 120

1 120 Marketing 14 000 14 000 14 000 14 000 Purchase of vehicle 133 000 Interest paid 8 750 8 750 8 750 8 750 Current costs 76 500 76 500 76 500 76 500 Tax 1 250 1 250 1 250 1 250 Total payment 190 450 328 650 200 850 242 305 Surplus/deficit 22 550 (104 100) 33 050 28 745 Financing - loans 110 000 - payments

(20 000) (10 000) Closing balance 22 550 5 900 13 050 18 745 52

LESSON 2.4 NOTES:

53

THE INCOME STATEMENT LESSON 2.5 THE INCOME STATEMENT In this Lesson: In any business, income is generated and expenditure is incurred when generating that income. The record of the income and expenditure is called the Income Statement or a profit and loss statement or operating statement. This is a summary of the income and expenses of a business during a certain period: monthly, quarterly, or annually. If the company has more income than expenses for a certain period it has net income - a profit. If the expenses exceed income, the company has a net loss. 1.1 INTRODUCTION An income statement is a record of all income and expenditure that the enterprise conducted in the year or period under review. The income statement can be used to provide the comparison between actual results and expected (budgeted) results. It is essential that any business regularly compile an Income Statement because it gives management an overview of what is happening in the business. If expenditure exceeds income, the business makes a loss. If income exceeds expenditure, the business makes a profit. Income statements should at least be compiled on a monthly basis, annually and when doing projections for the year ahead.

54 LESSON 2.5 1.2. DRAWING UP AN INCOME STATEMENT THE PRINCIPLES OF DRAWING UP AN INCOME STATEMENT: Sales generate income. From this income, the following must be paid:  Materials / Stock  Overheads or operating expenses  Labour The income statement can therefore be divided into a trading section and a profit and loss section. The trading section determines how much gross profit was made – how much profit the business made from buying goods at one price and selling it at a higher price. The “cost of sales” amount represents the cost of the goods sold before deducting the fixed overheads, selling and administrative expenses. The profit and loss section comprises of all other income (other than sales) and all other expenses. Other income is added to the gross profit and other expenses are subtracted from it. This leaves the business with its net profit before tax which is the figure by which the performance of the business will be assessed. Example of an income statement for a retail business:  Duxbury General Store’s income for December 2010 was R500 000. 

Their opening stock was worth R25 000.  They purchased R275 000 worth of stock during the month of December.  On 31 December they found that they had R 20 000 worth of stock left in their store room.  Their other expenses during December were:  Accounting fees - R5 000;  Advertisements - R 10000;  Bank Charges - R 1500;  Interest on loan - R2 000;  Licenses - R1500;  Postage – R1000;  Rent - R11000;  Salaries - R22000. 55

THE INCOME STATEMENT DUXBURY’S GENERAL STORE INCOME STATEMENT FOR THE MONTH ENDED 31 DECEMBER 2010 Sales R500

000 Less: Cost of sales R280 000 Opening stock R25 000 Add: purchases R275 000 Subtotal: R300 00 Less: closing stock R20 000 GROSS PROFIT R220 000 Less: expenses

R59 000 Accounting fees R5 000 Advertisements R10 000 Bank charges R1 500 Interest on loan R2 000 Licenses R1 500 Postage R1 000 Rent R11 000 Salaries R22 000 - Owner

R10 000 - Shop assistant R8 000 - Cashier R4 000 Stationery R1 000 Telephone R2 000 Water/electricity R2 000 NET PROFIT BEFORE TAX R161 000 Less: Provision for tax (assume 28%) R45 080

NET PROFIT AFTER TAX R115 920 56 © Business Management Training College (Pty) Ltd

LESSON 2.5 1.3 UTILISING INFORMATION FROM AN INCOME STATEMENT BREAKEVEN POINT Now that you know that your business is making a profit, the next step is to calculate exactly what turnover or sales is required to cover all expenses. This is called the breakeven point. To do this calculation, you need to know your total expenditure as well as the gross profit %:

 Total expenses: Add up all actual or envisioned expenses, e.g. R59 000.  Gross profit %: Sales (R500 000) less cost of sales (R280 000) = Gross profit (R220 000) Then divide gross profit by sales X 100 = GP% Gross profit X 100 = R220 000 X 100 = 44% Sales 1 R500 000 Breakeven point = total expenses divided by GP% Example: R59 000 0, 44 (for 44%) = R134 090.90 = Breakeven turnover required. It means that you have to sell or turnover R134 091 to pay for total expenses of R59 000 with a gross profit of 44% for the specified period. BREAK-EVEN CHART The graphic representation of the BEA illustrates the concept as follows: In our examples, the total costs will look like this: (Total costs = fixed costs + variable costs) Total costs

57

THE INCOME STATEMENT

The total costs start at R 100 000. When 0 units are sold, the variable cost is R0 and the fixed cost is R 100 000, bringing the total cost to R 100 000. When 500 units are sold, the variable cost is (500 x R30) = R 15 000 plus fixed cost of R 100 000 bringing the total cost to R 115 000, etc. Total sales will look like this: Total sales The total sales value of 0 units is R0, while the total sales value of R 1 000 units is (R 80 x 1 000) = R 80 000. The total sales value of 500 units is (R80 x 500) = R 40 000, etc. The Break-even chart: The break-even point is the point at which the sales line and the total costs line intersect. Draw a horizontal line from the break-even point (the point where the 2 lines cross) to the vertical axis. The value on the vertical axis at this point is the rand value of the break-even point (R 16 000 in our example). Draw a vertical line from the break-even point down to the horizontal axis. The value on the horizontal axis is the number of units at break-even, which is 2 000 units in our example. The area between the sales and total costs lines, to the right of the break-even point, is the area where a profit is made. The further we move to the right, the higher the profit. 58

LESSON

2.5 The area between the sales and total costs lines, to the left of the break-even point, is the area where a loss is still incurred, as an insufficient number of units are being sold and we are not reaching break-even. DETERMINING MAXIMUM DISCOUNT TO CUSTOMERS Always remember that discount comes from your profit. When you give discount you actually are giving away profit! Example: Sales R500 000 Less cost of sales R280 000 Gross profit R220 000 Less expenses R59 000 Maximum discount you can Net profit before tax R161 000 give in order to break even Maximum discount expressed as a percentage: = Net profit before tax X 100 Sales 1

= R161 000 X 100 R500 000 1 = 32,22% = maximum discount you can give in order to break even. MARK UP % = Gross profit X 100 Cost of sales 1 R220 000 X 100 R280 000 1 = 78, 57% 59

THE INCOME STATEMENT OTHER VALUABLE INFORMATION FROM THE INCOME STATEMENT:  Look for variances between actual results and forecasts. Adjust forecasts to be more accurate.  Good profits do not necessarily mean good cash flow. When you adjust your income and expenditure forecast, you must also adjust your cash flow forecast.  Measure advertising and marketing cost against sales to establish the efficiency of your marketing strategy.  Determine the effects of borrowed money. Interest on loans and leases reduces your profit. The cost of borrowed money may cost you your competitive edge in terms of selling prices. 60

LESSON 2.5 NOTES:

61

THE BALANCE SHEET LESSON 2.6 THE BALANCE SHEET In this Lesson: A balance sheet is drawn up to give a snapshot of the business at a specific time. It includes all the items that contribute to the economic benefit of the business such as assets, loans and cash. It shows what the business owes (liabilities) and what it owns (assets). 1.1 INTRODUCTION The balance sheet gives the assets and liabilities of a business on a particular day at the end of a financial period and follows a fixed format that consists of two sections. The first part

covers the assets of the business and the second section deals with capital, liabilities, equity and loans. 1.2 TOTAL ASSETS This section shows where the Capital was applied. The business could have used the capital to acquire fixed (non-current) assets, current assets or inventory. Current assets are items like Debtors and the money the business has in its bank account. 1.3 EQUITY AND LIABILITIES This section shows how much capital the business has and where it was obtained from. It typically includes items such as capital deposits, accumulated profit/loss, loans/creditors and short term debts (current liabilities). 62

LESSON 2.6 EXAMPLE OF A BALANCE SHEET BALANCE SHEET OF ABC STORES AS AT 28 FEBRUARY 20…. R Non-current assets (fixed 150 200 Current assets:

487 850 Inventory 205 300 Debtors 152 550 Bank balance 130 000 TOTAL ASSETS 638 050 Capital 350 000 Accumulated profit 50 740 Loan (long term) ———- Current liabilities: 237 310 Creditors 120 110

Arrear expenses 117 200 Bank overdraft ———- EQUITY AND LIABILITIES 638 050 1.4. ANALYSING A BUSINESS An annual report typically summarises the company’s fiscal year. The real meat of this report is the financial statements: balance sheet, income statement, cash flow statement, and statement of shareholder’s equity. Each report should have last year’s figures and some comparative numbers for prior years so that users can see the change. If past history isn’t included, ask for it (or at least an explanation of why it isn’t there). 63

THE BALANCE SHEET Here are some other tips for looking at the balance sheet in an annual report:  Look for trends and major changes over the past few years. 

Calculate the current ratio if appropriate.  Compare asset values to similar companies.  Watch for an increase in long-term debt. This could signal trouble.  If most of the assets are made up of profits from previous years, then the bottom line might not be as good as it first appears. Low-Risk Corporations Low-risk corporations typically offer low shareholder returns but have lots of equity. This makes the company more secure and less likely to fail. Its assets exceed its liabilities by a large margin. Banks, insurance companies, and well-established brand names often fall in this category. Financial numbers for a low-risk corporation usually look like this:  70-30 split between current and fixed assets  25% or less of liabilities are current  15% or less of debt is long-term  Shareholder’s equity is around 50-60% High-Risk Corporations These are the companies that take bigger risks, or are in riskier business segments, and (sometimes) can make the big gains under the right circumstances. These companies can offer investors the allure of high returns but you must remember that they therefore have higher risk. Their funding typically comes from outside the business and therefore they have little equity but higher debt. You may see fast growth but you will also likely see a big fluctuation in earnings. Financial numbers for a high-risk corporation usually look like this:  30-70 split between current and fixed assets  25% or more of liabilities are current

 45% or more of debt is long-term  Shareholder’s equity is around 35% 64

LESSON 2.6 NOTES: 65

THE T B EAM ALANCE SUPER S VI HEET SOR CHAPTER 3 BASIC BUSINESS CALCULATIONS IN THIS CHAPTER:

 LESSON 3.1 : WORKING WITH PERCENTAGES AND AVERAGES  LESSON 3.2 : CALCULATING INTEREST  LESSON 3.3 : FINANCIAL RATIOS AT THE END OF THIS CHAPTER YOU WILL BE ABLE TO: 1. Work with percentages. 2. Calculate simple interest and find the value of any of the elements of the formula. 3. Calculate compound interest and find the value of any of the elements of the formula. 4. Explain what a financial ratio is and name the four groups of ratios used to analyse financial statements. 5. Explain and calculate two liquidity ratio figures for a company (current ratio and acid- test). 6. Explain and calculate two activity ratio figures for a company (inventory turn-over rate and debtor’s collection period). 7. Explain solvency ratio’s and calculate the debt ratio for a business. 8. Explain profitability ratios and calculate the profitability of a business (return on total assets) and then also profitability of own capital.

LESSON 3.1 LESSON 3.1 WORKING WITH PERCENTAGES PERCENT AND AVERAG A ES IN BUSINESS In this Lesson: As a manager one has to be able to analyse results and figures.

Expressing business data and results in terms of percentages can assist the manager to identify trends and relationships between various variables. Managers have to be able to express changes (increases / decreases) in various business factors such as sales, expenses, profit, etc. over time in terms of percentages. 1.1 WORKING WITH PERCENTAGES The word per cent means out of every century or out of every 100. 25% therefore means 25 out of every 100 or 25/100. If somebody spends 20% of their salary to buy food, it means that he/she spends R20 of every R100 that he/she earns on food. 1.1.1 Converting decimal fractions and / or vulgar fractions into percentages To convert a decimal or a fraction to a percentage, simply multiply it with 100. To convert 0,14 to percentage, multiply with 100 = move decimal comma 2 places to the right = 14% To convert 3/5 to percentage, multiply with 100 = 3/5 x 100 = 300/5 = 60% To convert a percentage to a fraction, simply place it on 100 and loose the % sign: 25% converted to a fraction = 25/100 = 1/4 67

GENERAL CALCULATIONS IN BUSINESS

To convert a percentage to a decimal, divide by 100 = move decimal comma 2 places to the left and loose the % sign: 30% converted to a decimal = 0,30 1.1.2 Express one number as a percentage of another If nine workers were working on a project and two got injured, what percentage got injured? The number of injured workers can simply be represented by 2 out of 9 = 2/9. This fraction can now be converted into a percentage by multiplying it with 100: 2/9 x 100/1 = 200/9 = 22,22% 1.1.3 Applying percentage to a number There are 40 files in a cabinet. If 20% of these files have to be removed, how many files must be removed? We have to remove 20% of 40 files = 20/100 of 40 files “of” means the same as multiply (x) therefore we can express it as 20/100 x 40/1 = 800/100 = 8 files must be removed. (To check if we are correct: We have to remove 8 of the 40 files. 8/40 x 100 = 800/40 = 20%) 1.1.4 Measure percentage change To calculate the percentage increase or decrease, the following formula must always be used:

Change X 100 Original 1 68

LESSON 3.1 Example: Let’s consider ABC stores’ sales figures for June 2010 and June 2011: In June 2010, they sold R150 000 worth of merchandise. In June 2011, they sold R200 000 worth of merchandise. Now let’s calculate the percentage increase in sales from 2010 to 2011: First calculate the amount of change (or difference) in sales from R150 000 to R200 000 = R50 000 The original always refers to the first (oldest) figure (2010 in this case) =

R150 000 Change X 100 = Percentage change Original 1 R50 000 X 100 = R5 000 000 = 500 R150 000 1 R150 000 15 = 33,33% increase in sales 69

GENERAL CALCULATIONS IN BUSINESS The petrol price was dropped from R11, 50 to R10,95 per litre. Calculate the percentage decrease in the price of petrol. First calculate the amount of change (or difference) = R11,50 – R10,95 = R0,55 Using the formula: Change X 100 = Percentage change Original 1 R0,55 X 100 R55 = 4,78% decrease in price R11,50 1 = R11,50

If VAT goes up from 14% to 16%, find the percentage increase. The change in VAT is: 16 – 14 = 2%. The original VAT figure was 14% Change X 100 = Percentage change Original 1 2 X 100 = 100 = 14, 28% increase in VAT 14 1 7 1.2 WORKING WITH AVERAGES When we talk about “average”, we normally mean something or someone that falls somewhere in the middle of a group. The average of a group of numbers is the number that lies somewhere in the middle of this group of numbers. 1.2.1 Calculate the arithmetic mean for decimal values and fractions One type of average is called the “arithmetic mean”. To determine the arithmetic mean, simply add together all the numbers and divide by the number of numbers that were added together: The arithmetic mean of 13, 15, 17, 25 and 30 is: Step 1. Add all numbers: 13+15+17+25+30 = 100

70 LESSON 3.1 Step 2. Now divide by number of numbers (5): 100 ÷ 5 = 20 = arithmetic mean The arithmetic mean for 1/ 1 2, /8 and 3/4 is: Step 1. Add the numbers: ½ + 1/8 + ¾ = 4+1+6 = 11 8 8 Step 2. Now divide by number of numbers (3): 11 ÷ 3 = 11 X 1 = 11 = arithmetic mean 8 1 8

3 24 Calculate the average age of your workforce: You have the following statistics regarding the age of your workers: 3 are 56 years old 5 are 33 years old 2 are 29 years old 3 are 24 years old 2 are 20 years old. Step 1. Add the numbers: 3 x 56 = 168 5 x 33 = 165 2 x 29 = 58 3 x 24 = 72 2 x

20 = 40 15 workers– total age = 503 Step 2. Divide total age (503) by number of workers (15) = 33, 5 years = Average age of workers. 71

GENERAL CALCULATIONS IN BUSINESS 1.2.2 Finding the missing percentage You may sometimes have the average and be asked to calculate one of the amounts making up the average. For example: In total the sales of your store has increased with 60% during the past year. On further investigation you find the following percentage increases in the sales of individual items:  Soccer boots: 70%  Soccer shirts: 40% 

Soccer shorts: 58%  Soccer balls: 65% You can however not find any figures for the increase in your sales of soccer socks. What percentage increase did you experience in the sales of socks? Boots - 70/100 Shirts - 40/100 Shorts - 58/100 Balls - 65/100 Socks - ??/100 Total number of possible increase for all items: 5 x 100 = 500 Average increase in sales for all items = 60% You achieved an average increase of 60/100 of 500 for all items = 300 If you add up the increases for the other items: 70 + 40 + 58 + 65 = 233 = increase for items excluding socks Therefore increase in sales of socks = 300 – 233 = 67% 72

LESSON 3.1 1.2.3 Calculate the average of a group of times in hours and minutes You may be required to find the average of a group of times, especially when you are planning or budgeting for your business. Let’s consider the following example:

Your business delivers fresh products to households on Mondays, Wednesdays and Fridays. On Mondays it takes your delivery people 3 hours and 15 minutes to complete their rounds. On Wednesdays they spend 2 hours and 40 minutes and on Fridays it takes them 2,2 hours. What is the average time that your delivery people spend on the road per week? Step 1. Add up all the times: Monday: 3 hours = 3 X 60 = 180 + 15 minutes = 195 minutes Wednesday: 2 hours = 2 X 60 = 120 + 40 minutes = 160 minutes Friday: 2, 2 hours = 2 X 60 = 120 + 12 minutes = 132 minutes (120 + 0,2 X 60) Total Minutes: = 487 minutes

Step 2. Total number of trips = 3. Therefore average number of minutes = 487 ÷ 3 = 162,33 60 minutes (1hour) goes into 162 minutes 2 times (120 minutes) and 42 minutes remain. Average time is 2 Hours and 42 minutes 73

GENERAL CALCULATIONS IN BUSINESS NOTES:

74

LESSON 3.2 LESSON 3.2 CALCULAT ALCULA ING INTEREST In this Lesson: Interest is the cost of borrowing money. An interest rate is the cost stated as a percentage of the amount borrowed per period of time, usually one year. WHAT IS INTEREST? The prevailing market rate is composed of:  The Real Rate of Interest that compensates lenders for postponing their own spending

during the term of the loan.  An Inflation Premium to offset the possibility that inflation may erode the value of the money during the term of the loan. A unit of money (rand, dollar, peso, etc.) will purchase progressively fewer goods and services during a period of inflation, so the lender must increase the interest rate to compensate for that loss.  Various Risk Premiums to compensate the lender for risky loans such as those that are unsecured, made to borrowers with questionable credit ratings, or illiquid loans that the lender may not be able to readily resell. 1.1 SIMPLE INTEREST Simple interest is calculated on the original principal amount only. Accumulated interest from prior periods is not used in calculations for the following periods. Simple interest is normally used for a single period of less than a year, such as 30 or 60 days. 75

CALCULATING INTEREST Simple Interest = p * i * n where: p = principal amount (original amount borrowed or loaned) i = interest rate for one period n = number of periods

Example 1: You borrow R10,000 for 3 years at 5% simple annual interest. interest = p * i * n = 10,000 * .05 * 3 = 1,500 Example 2: You borrow R10,000 for 60 days at 5% simple interest per year (assume a 365 day year). interest = p * i * n = 10,000 * .05 * (60/365) = 82.1917 1.2 COMPOUND INTEREST Compound is, simply put, single interest plus interest on interest. It is interest which is calculated not only on the capital or principal amount but also the accumulated interest on the amount over the period. Compound interest differs from simple interest in that simple interest is calculated solely as a percentage of the principal sum. The equation for compound interest is: P = C(1+ r/n)nt Where: P = future value C = initial deposit r = interest rate (as a fraction: e.g. 0.06 for 6%) n = number of times per year interest is compounded t = number of years invested

Although the interest may be stated as a yearly rate, the compounding periods can be yearly, semi-annually, quarterly, or even continuously. 76

LESSON 3.2 You can think of compound interest as a series of back-to-back simple interest contracts. The interest earned in each period is added to the principal of the previous period to become the principal for the next period. Example: You borrow R10,000 for three years at 5% annual interest compounded annually: interest year 1 = p * i * n = 10,000 * .05 * 1 = 500 interest year 2 = (p2 = p1 + i1) * i * n = (10,000 + 500) * .05 * 1 = 525 interest year 3 = (p3 = p2 + i2) * i * n = (10,500 + 525) *.05 * 1 = 551.25 Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. Compare this to R1,500 earned over the same number of years using simple interest. The power of compounding can have an astonishing effect on the accumulation of wealth. The table shows the results of making a one-time investment of R10,000 for 30 years using 12% simple interest, and 12% interest compounded yearly and quarterly. TYPE OF INTEREST PRINCIPAL PLUS INTEREST EARNED Simple R46,000.00 Compounded yearly R299,599.22 Compounded quarterly R347,109.87

77

CALCULATING INTEREST NOTES:

78

LESSON 3.3 LESSON 3.3 FINANCIAL RAT A IOS: ANALYSING NAL FINANCIAL STATEMENTS In this Lesson: A financial ration is a comparison of the relation between two sets of values from a financial statement, for example, the relation between current assets and current liability (current ratio). It is important not to look at any ratio in isolation - it must be compared with a norm and assessed together with other ratios. A ratio on its own is not an indication of the success or failure of a business. Financial statements should be analysed with the aid of various financial ratios. Some of the most useful ratios are:  Liquidity ratios – they analyse the business’s ability to meet its commitments regularly and on time  Activity ratios – they investigate the effectiveness of employment of assets to realise sales  Solvency ratios – they determine the ability of a business to pay all its debts at any time 

Profitability ratios – they assess the profitability of a business and calculate the return of capital employed 79

FINANCIAL RATIOS 1.1 LIQUIDITY RATIO FIGURES (CURRENT RATIO AND ACID-TEST) There are two ratios that are generally used to assess the liquidity position of a business – the current ratio and acid-test ratio. 1.1.1 The current ratio The current ratio indicates to what extent the current liabilities (short-term debt) of the business are covered by the current assets. It tells the business whether it has the means to meet its obligations in the short term (liquidity). It shows if the business is able to pay what it owes its creditors. Current ratio = current assets current liabilities The generally accepted norm for the current ratio is 2:1. A lower ratio can mean that the

business will have difficulty meeting its short-term obligations. A weak current ratio can be the result of factors like having too many creditors, cash flow problems or a large bank overdraft. 1.1.2 The acid-test ratio The current ratio is based on the assumption that all current assets could be turned into cash equally quickly. Businessmen will however know that this is often not the case and that it can take longer to turn inventory into cash than it does for an investment in the bank or debtors. The main reason for this longer conversion period is that often the inventory is sold on credit and the debt must first be collected before the cash can be used for payments. For this reason, the acid-test ratio is employed. This ratio excludes inventory and gives a better indication if the business will be able to meet its short-term obligations regularly and on time. Acid-test ratio = current assets – inventory current liabilities The generally accepted norm for the acid-test ratio is 1:1. This means that for every R1 of short-term liability, the business must have R1 of liquid assets that can be converted to cash quickly. A low acid-test ratio can be the result of too much inventory, a lack of sufficient cash resources at a specific moment or many debtors who have already settled their accounts. 80 © Business Management Training College (Pty) Ltd LESSON 3.3 Low current and /or acid test ratios indicate that the business has potential/ possible cash-flow problems. It may experience problems to pay current liabilities such as creditors or maintain an acceptable bank balance. This makes credit providers hesitant about granting additional funding/credit. 1.2 ACTIVITY RATIO FIGURES (INVENTORY TURN-OVER RATE AND DEBTOR’S

COLLECTION PERIOD) This type of ratio gives an indication of how effectively the assets of the business are being used to realise sales. There are a number of activity ratios but for purposes of this course, only two will be discussed: The inventory turn-over rate and the debtors collection period. 1.2.1 The inventory turn-over rate This ratio gives an indication of how many times the average inventory (stock) is realised in sales during a year. A business’s inventory has to turn around a certain number of times to realise its projected sales for the year. Inventory turnover rate = Cost of sales Average inventory The inventory turn-over rate differs from industry to industry and no single norm can therefore be established. The following are examples of industry-specific norms:  Cafés: 8 times  General dealers: 4-5 times  Grocery stores: 6-8 times  Clothing stores: 2-3 times The higher the inventory rate, the less capital the business will need to carry inventory and the capital can be used more frequently during a period to finance new inventory. It can however also be risky to have a too high rate as this can create the danger of inventory shortages when sales suddenly increase.

If the rate is too low, it may mean that:  Wrong type of inventory is carried  Out of date inventory is carried  Too much damaged inventory is carried  Too much inventory in general is carried 81

FINANCIAL RATIOS  The sales figures of the business is too low 1.2.2 The debtors collection period Debtors collection period = average debtors x 360 credit sales This rate gives an indication of the average number of days it takes for the business to collect its debts. It enables the business to compare the real collection period with the granted credit period. If big differences occur, the business has to review its credit policies and collection practises. A long debtor’s collection period is an indication of slow and late payments by debtors and has a direct influence on the cash flow of the business and can result in liquidity problems.

1.3 SOLVENCY RATIO The solvency of an enterprise refers to the ability of the business to pay all its debts at any time, even if all its activities are stopped. The business should at all times be able to repay all its debts and therefore its total liabilities must be covered by its total assets. The most useful solvency ratio is the debt ratio. It reflects the extent to which the total liabilities of the business are covered by its total assets. Debt ratio = Total assets Total liabilities The higher the debt ratio, the greater the financial risk of a business. A debt ratio of 2:1 means the business has R2, 00 in assets for each R1, 00 of debt. A debt ratio of 1:1 means that the business is technically insolvent and run a strong risk of liquidation by any of its external capital suppliers. 1.4 PROFITABILITY RATIOS These ratios give us an indication of how profitably the business has employed the available capital in its activities. Businesses try to obtain at least a satisfactory return on their available capital but normally would push to increase the profitability as much as possible. 82 LESSON 3.3 1.4.1 Return on total assets (Profitability) Profitability = Net income before interest and tax x 100

Total assets The profitability of a business should at least exceed the inflation rate and be considerably higher than interest rates 1.4.2 Profitability of own capital This ratio is an indication of the return that the owners of the business have earned on their capital annually. Profitability of own capital = Net income after interest and before tax X 100 Own capital (owner’s interest) 1.5 OTHER IMPORTANT RATIOS There are many other ratios that managers use, for example: Return on equity: Profit margin on sales, leverage ratio, times interest earned and cash flow ratios. Compares the net after-tax profit with the owner’s equity and shows how much the owner of the organisation earned on each rand invested in the business.  Profit margin on sales: Relates the sale of the business’s products to the direct cost of the products.  Leverage ratio: This is the ratio of total sales to equity and it measures the percentage of total funds provided by the owners.  Times interest earned: Measures the extent to which the business is able to pay its interest obligations and the level by which earning can decline without causing financial losses for the financier. 

Cash flow ratios: In order to manage a business’s assets, management needs to comprehend the use and application of cash flow performance indicators. The cash flow statement allows managers to analyse various sources and applications of cash. 83

FINANCIAL RATIOS The cash flow adequacy ratio measures the ability of the business to generate sufficient cash to pay its interest bearing debts, reinvest funds in its operations and distribute dividends to shareholders. The cash position ratio indicates to what extent cash from total activities can finance investment in fixed and financial assets. It assesses the business’s ability to generate cash flow in excess of capital expenditure from operations and other activities. In ratio analysis, it is important to remember ratios must always be compared to benchmarks. Benchmark figures are compiled by taking the average of the best quarter. Benchmarking ensures that trends can be identified and compared with long term goals and standards. Any ratio must be evaluated in the context of all the other associated ratios of the organisation. The usefulness of ratios depends on the skilful application and interpretation. When assessing ratios, it is important that the results are compared with other companies in the same industry or with historic ratios and not to be taken in isolation. What may seem like a poor ratio at first glance may well be normal for that industry and, of course, the reverse applies, in that what may seem a good ratio on its own, could be below average for that industry.

1.6 SOME PRACTICAL RATIO CALCULATIONS For the purpose of our calculations, we will use the balance sheet and income statement of the Swiftgro Company (source: Business Management – A Value Chain Approach) 84 © Business Management Training College (Pty) Ltd LESSON 3.3 Balance sheet as at 31 December 2002 2002 2001 ASSETS Non-Current Assets 389 000 110 000 Property, plant and equipment 379 000 100 000 Intangible assets 10 000 10 000 Investments 20 000 20 000

Current Assets 463 200 185 100 Inventory 252 000 110 000 Trade and other receivables 201 200 70 100 Cash and cash equivalents 10 000 5 000 TOTAL ASSETS 872 200 315 100 EQUITY AND LIABILITIES Capital and reserves 387 300 157 300 Issued share capital 200 000 152 000 Reserves 187 300 5 300 Non-current liabilities Long term loan 180 000 0 Current Liabilities 304 900 157 800 Trade and other payables 278 200 157 800 Bank overdraft 20

000 0 Tax payable 6 700 0 TOTAL EQUITY AND LIABILITIES 872 200 315 100 SWIFTGRO LIMITED Liquidity Ratio (Current ratio) We have already looked at the current ratio (liquidity ratio) earlier on. The liquidity ratio measures the ability of the business to meet its short term financial obligations if current assets are converted into cash in the short term. A good ratio is seen as one where the current assets are twice the value of current liabilities, although it depends on the nature and scope of a business’s activities. 85

FINANCIAL RATIOS Liquidity ratio = Current Assets Current Liabilities = 463 200

304 900 = 1.52 for 2002 and 185 100 157 800 = 1.17 for 2001 This means that for every R1 of current liabilities the company had R 1.52 of current assets to cover current liabilities in 2002. Om 2001 the ratio was R1.17 of current assets for each R1 of current liabilities. This implies that in 2002 the company was in a more favourable position to cover its short-term obligations that it was in 2001. Acid Test The acid test is calculated as: Current assets – stock Current liabilities This ratio measures the ability of the organisation to meet its current liabilities without the most non-liquid item of current assets. In our example, the acid test is: 211 200 304 900 = 0.69 in 2002 and 75 100 157 800

= 0.48 in 2001 86 LESSON 3.3 This means that for every R1 of current liabilities, the business and only 69c of current assets less stock to cover current liabilities. In 2001 the ratio was worse, with only 48c of current assets less stock available to cover current liabilities. Activity ratio This is also known as the asset management ratio. This ratio measures how effectively management uses the business assets, that is the amount of sales generated for every R1 of the assets. The activity ratio is calculated as: Sales Total assets In our example the activity ratio is: 1 200 000 872 200 = 1.38 for 2002 and 620 000

315 000 = 1.97 for 2001. This means that in 2002, for every R1 of fixed assets, R 1.38 of sales was generated. In 2001 the company generated R1.97 of sales for every R1 of assets employed. Debtor’s collection period The average debtor’s collection period is the average length of time that elapses between concluding a sale and receiving the cash. This is calculated as: Debtors x 365 Sales 1 By referring to our previous example: 87

FINANCIAL RATIOS 201 200 x 365 1 200 000

= 61 for 2002 and 70 100 x 365 620 000 = 41 for 2001 This means that the debtor’s turnover in 2002 was nearly six times a year, (365/61) while in 2001 it was nearly nine times (365/41). This indicates that the collection of debtors was substantially better in 2001 than in 2002. The same is true for debtors’ days outstanding, which is a different calculation of the same collection period. In 2001 debtors were outstanding for 41 days, while in 2002 they were outstanding for 61 days. Return on total assets The return on total assets measures the profitability of the business as a whole in relation to the total assets. The figure used in this ratio must be profit before interest and tax, to measure the true effectiveness of the operational management. The reason for excluding interest and tax is that these expenses are not controlled by operational management, but are a result of borrowing and tax legislation. Each asset in a business should earn income. The amount of money earned on an asset should be more than cost of financing that asset. If not, then the assets will cost the business more than the assets produced and the business loses money.

88 LESSON 3.3 Return on total assets is calculated as: = Profit before interest and tax x 100 Total assets 1 By referring to our previous example: = 280 000 872 200 = 32% in 2002 and = 74 600 315 100= 24% in 2001. This means that for every R1 in assets, the company earned 37c in profit before interest and tax in 2002. In 2001 the company earned only 24c for every R1 invested in fixed assets. A sharp increase in profit has occurred from 2001 to 2002. Profitability ratio This ratio measures the profitability of the business. It indicates what percentage of sales

remains as profit for every rand generated from sales. This ratio does not measure how much the business sells, but rather, for each rand earned, what amount remains as profit. This ratio is calculated as: Profit before interest and tax x 100 Sales 1 In our example: = 280 000 1 200 000 = 23% in 2001 and = 74 600 620 000 = 12% in 2001. 89

FINANCIAL RATIOS

This means that for every R1 generated from sales, 23c net profit before interest and tax was earned in 2002. In 2001 only 12c net profit before interest and tax for every R1 of sales was earned. The largest part of the increase in return on assets was due to the profitability ratio. Insolvency Ratio Shareholders’ funds loss Compares a company's losses to its shareholders funds, indicating (in years) the time it will take for the company to become insolvent due to lack of profit, rather than due to cash flow liability. It assumes that the company will continue to make the same losses. Current assets - stock Current liabilities This ratio indicates the ability of a company to pay its debts as they fall due. It is generally considered to be a more accurate assessment of a company's financial health than the current ratio as it excludes stock, thus reducing the risk of relying on a ratio that may include slow moving or redundant stock. Figures of this ratio are lower than the current ratio. Supermarkets can, for example, easily survive on ratios as low as 0.4 with cash being received for goods sold, before the goods are actually paid for. Plant hire contractors would also expect ratios as low as 0.6 to 0.8. Clothing retailers also operate at very low levels, with average figures being between 0.2 and 0.6 and retail as a whole between 0.3 and 0.7. In manufacturing figures between 0.7 and 1.1 are seen as acceptable and for wholesalers 0.7 to 1.0. Construction should operate at between 0.6 and 1.0. 90

LESSON 3.3 NOTES: BIBLIOGRAPHY  Business Management – A Value Chain Approach second edition. Gideon Nieman, Alf Bennet.  Basic Financial Management for Entrepreneurs – Conradie, WM & CMW Fourie  Basic Business Calculations – Prof D Zidel STUDY GUIDE REVIEW AND COMMENTS We are committed to provide the best quality study material to our students. Your contribution and constructive feedback to this regard will be highly appreciated. Student Name: Student Number: Name of Study guide: