Task 1
Explain the nature and role of accounts. You need to also explain why James and Rebecca need to produce accounting information in order to make financial decisions.
Answer
Accounting is the process of identifying, measuring and reporting economic information to the owners of business and all interested parties (Joel, 2008). Business transactions have financial implication on a business in both short term and long term (Frank & Allan, 2005). Some of the transactions are sale or purchases of fixed assets or current assets, paying of business expenses, and settling current liabilities among other business transactions. Accounting involves identifying, measuring and reporting the business transactions in accordance with generally accepted accounting principles (GAAPS). The following are the generally accepted accounting principle full disclosure, revenue recognition principle, matching principle, cost principle and going concern. It is therefore important for them to prepare income statement, balance sheet and cash flow statement. This will enable them to precisely measure the net profit, know the business net worth and availability of cash to settle business obligations.
Income statement
Income statement is also known as profit and loss account. It shows all the income earned against the total business expense incurred and accrued in a given business period. The income includes revenues received in respect to goods and services provided by a firm. On the other hand, the expenses include all expenditure incurred with respect to the business e.g. wages, electricity bills e.tc. All expense to be associated with the earned net profit must be considered.
James and Rebecca need to prepare this accounting document so that they can precisely know the amount of profit earned over the accounting period. In addition, to measure the amount of expenditure and all income associated with the realized net profit. Moreover, information regarding the expenditure will help them to identify which expense need to be minimized or even eliminated so as to maximize profit.
Balance sheet
It is prepared as at a specific date to show the net worth of a firm and the following items appear in a balance sheet; current assets, non current assets, current liabilities, non current liabilities and capital. All non current assets are prepared according to historic principle less depreciation.
Assets
These are the resources which are owned by an organization. They can either be current or non current assets. They are bought using owners capital or borrowed capital. Examples of non current assets include buildings, office furniture and fittings among others, while current assets include cash and debtors etc.
Liabilities
These are either short or long-term obligations of a business arising from past transaction. Therefore, the business should pay its liabilities when they are due in order to maintain its credit worthiness. Long term liabilities compose the borrowed capital base of a business. An example of a Long term liability is mortgages.
Capital
Capital this is the contribution made by James and Rebecca when starting the business or borrowed capital obtained from banks and other financial institutions. Owners’ capital can be contributed through giving out money or any asset to enable the business to carry out its activities. The importance of preparing balance sheet is to enable the partners to know the net worth of the business as well as total current asset, liabilities and long term assets and liabilities.
Cash flow statement
Cash flow statement shows movement of cash in the organization. In addition, it helps to show the amount used to settle a debt as well as income received (Karl, 2005). It can help James and Rebecca to be able to know whether they have enough money to buy stock and meet current liabilities. Therefore, if at all they realize that that they will have cash shortage, then they will arrange for external financing. Generally, accounting information prepared and presented in the correct format will enable them to make informed business decisions. Only items which cause increase or decrease in cash should be included in cash flow statement therefore depreciations and other related transactions cannot be included.
Task III
Net Profit Margin=
Net Profit Margin for 2007==0.871
Net Profit Margin for 2006==0.16
The net profit margin is reasonable and it has increased, meaning that the business has been able to control its operating expenditure thus indicating increase in profitability (Frank & Allan, 2005).
Gross Profit Margin=
Gross Profit Margin for 2007==0.7104
Gross Profit Margin for 2006 == 0.869
The gross profit margin is reasonable, but, to make a precise decision on whether the pricing is reasonable the gross profit margins of several firms in the same industry must be considered. This is because the gross profit margin is mainly determined by the selling price.
The business sales have increased due to the fall of gross profit margin. This is attributable to decrease in selling prices. Moreover, fall in the selling price increases the demand of business products thus increasing sales.
Average settlement period For Debtors= *365
Average settlement period For Debtors 2007=*365=62.78 days
Average settlement period For Debtors 2006=*365=31.56 days
The ratio indicates that debtors had more than two months to settle their dues in 2007, while they had around one month in 2006 to pay. This might have led to increase of sales because more customers had an option of increasing their consumption and paying it in the future. Consequently, this may lead to obtaining external financing to finance purchases or alternatively increase credit settlement period as well. This ratio must be compared to there ratios from other firms in the same industry so as to make proper business decision where appropriate.
Average settlement period for creditors=*365
Average settlement period For Creditors 2007=*365=263 days
Average settlement period For Creditors 2006 =* 365 = 205.2 days
The average settlement period for creditors shows that the time taken by the business to settle debt in 2006 was 205 days, while in 2007 was 263 days. This means that in 2007, it took the business almost a year to pay back its suppliers. As a result, this may tarnish the business name if left unchecked or if the credit is delayed without suppliers consent. However, the increase in credit period gives an indication that suppliers are identifying the business as reliable in paying debts hence allowing it to acquire credit and pay back after a year.
Current Ratio=
Current Ratio for 2007 = = 1.04
Current Ratio for 2006==3.36
The current ratio of both years is more than one indicating that the business can meet its current liabilities as they fall due. The current ratio has fell from 3.36 in 2006 to 1.04 in 2007 indicating that fewer current assets are available for paying creditors. The fact that stock does not form a major percentage of the current asset is an indication that the business may not need to sale so as to settle its debts.
Gearing Ratio
Equity Ratio for 2007 === 0.5
Equity Ratio for 2006== 0
In 2006, all the business assets were financed through shareholders contribution unlike in 2007. About half of assets in 2007 were financed through a loan. Such swift increment in gearing ratio is risky because if the business fails to repay the loan it may plunge into insolvency.
Task 4
Discuss and evaluate the possible procedures and processes that James and Rebecca could put in place to better control their working capital.
Answer
Working capital is composed of current assets and current liabilities. Certain process and procedures should be followed to ensure that current capital is taken care of, I.e. effective control. Firstly, to control stock, they should ensure that all stock purchased is recorded immediately to avoid cases of theft or lack of accountability. Moreover, they can use LIFO process for all goods which are perishable or whose value may fall with time. In addition, maximum and minimum stock levels should be calculated to avoid holding excess stock which increases the storage cost or running short of stock (Frank, & Allan, 2005). All stock issued should be recorded and stock taking should be done when necessary to avoid cases of theft. This calls for effective documentation of all stock records. However, economic order quantity should be calculated to decrease cost of ordering stock.
Secondly, to control cash and bank accounts, a cash book should be kept. However, they should make sure that all cash received is banked immediately to ensure money security. In addition, cash book should be reconciled with bank statement. Moreover, excessive liquid cash should be used to buy stock or shares which are easily disposable to make optimal use of this current asset or can be invested in projects which can be easily converted into cash. Creditors should be paid through checks, while debtors should be encouraged to make payments through the bank and provide deposit slips as proof of payment. This will make sure that money is safely handled.
Thirdly, total debtors and total creditors accounts should be kept. This will make sure that no worker can receive payment from a debtor and fail to record. It will also ensure that any errors regarding debtor or creditors are recognized and corrected in time. The company should ensure that it has effective debt policy i.e. they should ensure that before any credit sale is made the buyer should prove his or her credit worthiness. To avoid tarnishing the business image they should ensure that they pay all their credit purchases within the agreed period. This can be enhanced by keeping cash flow statement to ensure that they arrange for different sources of cash before they run short of the current asset.
Task 5
How the budget can be used
The budget can be used as an indicator of revenues and costs associated with any business activity to be carried out by the firm. It makes sure that no activity which is not within the interest of the business is financed. In addition, enough funds will be set aside for required business activities to avoid unnecessary monetary shortages for important business projects. Unexpected monetary shortage may lead to slowing down of a project or arranging for expensive alternative ways of financing the project.
Budgeting calls for the justification of any project which needs financing. This makes sure that only most profitable projects are financed to avoid possibility of blind investing. Moreover, the budget will enable them to effectively monitor and control all business projects i.e. use it for appraisal purposes. This will ensure that projects are initiated and completed within the required frame work. In addition, it makes sure that any diversion between actual and projected amounts can be scrutinized and justified.
Why it is necessary to interlink budgets
Business functions are interrelated and intra-related. For example the cash budget should be interlinked with all the other business budgets to smoothen the financing process. In addition, the capital base forms the foundation to be considered in making any budget because it is the main determinant in making any project budget. For example, if the amount put a side to finance anew project id high it means few resources are available for carrying other business functions.
How to prepare a budget
In preparing a budget, one considers the following three factors; variable cost, fixed cost and breakeven point. The variable cost is expected to change with changes of other variables, unlike the fixed costs which stay constant even with changes in variable cost. For example, gross profit may increase without increase in fixed costs. James and Rebecca needs to effectively use fixed sales so as to maximize profit. However, it is important to note that fixed costs stay constant within a given range after which the cost jumps to the next range.
Breakeven point
This is a point at which the business is indifferent i.e. the firm make neither loses nor profits. It gives the level of sales which the business should not fall below otherwise the company would realize a loss. When preparing the budget you determine all fixed and variable costs then, you determine the profit you need to obtain so as to set the selling price (Janet, 2007). To alter the profit level, one either alters the selling price or variable costs.
Differences between zero-based budget and incremental budget
Zero based budgeting requires that any item included in the budget is justified i.e. each item justifies its importance in the budget. It therefore does not put into consideration last year’s expenditure and past experience is not considered in drafting the budget. This means that it is considerably costly and time consuming because a new budget must be drafted annually. Its main merit is that it enhances efficiency and it identifies opportunities to enhance out sourcing (Joel, 2008).
Incremental budget makes use of the previous budget as the key base line for developing a new budget. It allows changes in revising previous year’s budget according to present year’s needs. This makes it easier for management to carry out its planning and budgeting functions.
Benefits of preparing business budget
The budget helps the management of a business to establish and evaluate standards of performance, then work towards attaining both long term and short-term goals. It makes sure that all resources are effectively used. Generally, budget is the main item utilized in management planning function. This is because it lays down the strategies that make it possible for management to monitor projects and evaluate performance over time (Mathur, 2011).
Task 6
Part one
James and Rebecca are thinking of developing their business by purchasing the building next door to build a new gym facility. They need to raise around £75,000 for the venture. Based on the profit and loss account and balance sheet that you have produced for 2007, explain how they could raise the additional capital needed.
Answer
They can obtain a loan from a bank and offer one of the business assets as security. This is possible, though, it will raise gearing ratio and further increase chances of possible default. This may plunge the business into insolvency especially if the new project is not well managed. Therefore, if they choose this method of financing they must calculate the project rate of return. Thus a loan can be a nice way of financing the new project if the expected rate of return is above the interest rate payable.
Alternatively the two partners can increase their capital contribution. This will lead to fall of gearing ratio and decrease possibility of future default of paying interest to loans (Joel, 2008). In addition, they will not be required to provide security for the additional capital. However, this can only be possible if they are able to obtain additional capital from personal savings.
Lastly, the partners can consider including another person as a partner and contribute to the financing of this new project ( Roy, 1997). This does not increase the gearing ratio but it may adversely affect how the partners share profits. The process of admitting the new partner must be followed to the strictly to avoid any cases of misunderstanding among partners.
Part two
Ultimately you should comment on whether, in their current financial position, they should take the risk of securing additional sources of finance.
Answer
The business should not take another risky source of finance. This will lead to increased expense in terms of interest payments and increased gearing ratio. Consequently with increased gearing ratio, as a result of financing the business through external sources, leads to increased possibility of insolvency.
References
Frank, W & Allan, S 2005. Business accounting 1
Janet,W 2007. CMA official learning system fundamentals of management accounting. CMA publishing
Joel, S 2008. Managerial uses of financial information. Spring science for business media
Karl,F 2005. Economic development finance. Sage publication ltd
Mathur,B 2011. Accounting for management. Tata mcgraw private ltd
Roy, D 1997. Foundation of business accounting. Aldel press
