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LO4- Using financial information to check the financial health of business…
LO4- Using financial information to check the financial health of business.
4.1 financial terms used to check health
Business costs
Opportunity cost- a benefit, profit or advantage that must be given up to acquire or achieve something else.
Costs- expenses a business has to pay when producing and supplying products
depreciation- the cost of an asset consumed over its useful life.
Variable costs: costs that vary directly with level of output.
Ie direct labor (cost of employees producing), raw materials, packing costs.
Fixed costs: costs that have to paid even if the business sells nothing
ie. rent, office salaries, advertising, insurance, depreciation
Revenue: money earned from selling output by the quantity sold at the price it sells for over an amount of time
Revenue= selling price x quantity sold
Cash flow: all money moving in and out a business
inflows: cash received from selling, loan receipts, commission received, rent received
outflows: wages, insurance, payments to suppliers, loan interest.
Net cash flow: difference between money coming into business and money going out of business
Profit left after paying total costs can be used to reward owners, invest in future growth or save for contingency.
Loss: made when business revenue doesn't cover costs. losses are eliminated through reducing costs and increasing revenue
if business cannot pay expenses its insolvent.
By using a cash flow forecast, businesses can plan ahead and identify where to put more funding.
Break even: where level of sales allows total cost to equal total revenue- the business makes no profit or loss.
at break even point the business can work out: how many sales and at which price are needed to cover all costs, how changes in sales will effect profits.
At break even it can be assumed: all output is sold, business only makes one type of product.
If business is making profit, it is above break even point
Margin of safety
How far output can fall before business begins to make a loss it= actual output- breakeven output
4.2 How to calculate profit/loss and breakeven point/output
Profit= revenue- costs
Break even point= fixed costs /(selling price- variable costs)
gross profit= revenue - cost of sales
net profit= gross profit - expenses
total cost= fixed cost + variable cost
total revenue= price x quantity
total variable cost= cost per unit x amount of units
net cash flow= inflow- outflow
4.3 How to interpret financial statements
income statement: shows revenue and expenses a business have received and paid in a period of time, therefore showing the profit.
income statements over several years can be compared to analyze revenue, cost of sales and expenses over the time.
Statement of financial position: represents the businesses health at the given moment. total assets must equal total liabilities and owners equity. the two sides must always balance.
It give info about financial health, and is split into sections:
Assets- resources owned by the business.
Current assets- used by business operations and usually used to create cash in under 12 months before being finished with use.
noncurrent assets- acquired for use in business for over 12 months ie vehicles, premises, machinery
Liabilities- represent debts owed by business
non current liabilities- debts that are due after one year (long-term finances) ie long term bank loans, mortgages, debentures.
current liabilities- debts owed within one year that come on a day to day basis ie bank overdraft, trade payables or corporation tax
Equity- (capital) describes how much the business is worth, how much it owns and how much the owners have invested in the business.
Cash flow forecast and statement
Cashflow forecast: report that predicts future cash inflows and outflows per month, made up of: receipts, payments + net cash flow (difference between receipts and payments to show how much money is left at the end of the month)
The closing balance from one month will be the opening balance for the next month.
The forecast doesn't inform about profits but helps the business to: prevent problems they predict, plan how to use excess cash, plan burrowing.
Cash flow forecast should be compared with actual cash flows to resolve any potential problems ie:
By holding less inventory within the business
Improving credit control.
Increasing sales
Selling non-current assets ie computers or vehicles
By reducing costs.