ILM Level 5 Certificate in Management

Understanding Financial Management

Understanding Financial Management

Contents / Page No.
Unit Objectives / 2
A general introduction to finance / 3
Accounting at its most simple / 3
Accounting and financial reporting standards / 4
Accounting policies / 5
Depreciation / 6
Financial Objectives / 8
The Business Cycle / 9
Sources of funds / 11
The key financial statements: / 13
The profit and loss account / 14
The balance sheet / 21
The cash flow statement / 28
The Cash Flow Forecast / 29
Monitoring and controlling the cash flow / 31
The Finance Function / 33
Financial evaluation using ratio analysis / 34
Financial and management accounting / 41
The budgetary process and budgetary control / 42
Flexed budgets / 43
RASCAL / 46
The Budget Setting Cycle at Loughborough / 48
The balanced scorecard / 49
Financial Governance in Loughborough University / 51
Summary / 55

Unit Objectives

This unit will help you develop your knowledge and understanding of finance at Loughborough, the value of management accounting and the process of budget setting and control.

The aim of this unit is to provide you with an understanding of the basic finance terminology used in accounting and also at Loughborough University. The unit is run in conjunction with the finance team and is specifically designed to help you to understand more about Finance at Loughborough. This unit is also followed up by Making a Financial Case, which will help you to understand how a financial case is put together here at Loughborough.

By the end of this unit, you will be able to:

  • Understand finance within the context of Loughborough University
  • Understand the role and value of management accounting
  • Understand budgets for the management of your area of operation

The unit will covers areas such as:

  • accounting documentation, such as balance sheets, profit and loss accounts, income and expenditure accounts and cash flow statements
  • financial performance measures at Loughborough
  • cash, profit and cash flow forecasting
  • sources of finance and funding within the Higher Education Sector and at Loughborough, and their characteristics
  • Loughborough’s stakeholders and financial expectations
  • financial performance indicators and their role in achieving objectives

and on budgets:

  • the role of the management accountant
  • the nature and purpose of financial and non-financial budgets
  • methods of preparing budgets
  • budgetary techniques for controlling operations
  • how variances are calculated and used to analyse extent, source and cause of budgetary deviation
  • techniques for monitoring and controlling costs

A General Introduction to Finance

Accounts, finance and financial information are all central to business decisions. But what is the basis upon which this information is compiled? Managers who are not specialist accountants need to know something of the basics of the management information contained within a set of accounts/financial reporting statements. This will enable you to communicate with the financial experts within the organisation and those outside, who may otherwise take advantage of your naivete in this discipline.

This unit is designed for managers who are not financial specialists but who need to be able to interpret financial information for decision-making purposes. You need to be able to:

  • Identify financial trends
  • Interpret and analyse financial information and evaluate its significance to day-to-day operational decisions

Accounting at its most simple

Take a local club. They will prepare their accounts on the basis of cash received and paid out. They make up a cash book or may produce their accounts straight from bank records. They are unlikely to produce a balance sheet but will prepare an income and expenditure statement in a list format.

As soon as an organisation starts to use any form of accounting ledger they will start using a double entry book keeping system. This is where the accounts start to add to zero. Basically, every action will have two balanced effects. If I purchase a chair for £100 two things result. I have a chair and I don’t have a £100. The two parts of the transaction are recorded on a trial balance. These form the debit and credit entries relating to this transaction.

Debits – assets, expenditure, surpluses / profits

Credits – liabilities, income, deficits / losses

A positive balance in your bank account is a good thing. This shows as a debit. Consequently, all accounting systems everywhere show income as a negative number!

As an organisation gets bigger and more complex, more rules have to be followed when preparing a set of accounts.

Accounting and Financial Reporting Standards

The aim of a set of Financial Statements is not to be absolutely correct. It is to give a true and fair view of an organisations financial position.

There are many users of a set of accounts. In a free market economy such as the UK, common sense dictates the need to have uniform financial reporting standards. A common vocabulary, uniform accounting methods, and full disclosure in financial reports are the goal of the accounting profession. The most important financial statement and financial reporting standards and rules are called ‘generally accepted accounting principles’ (GAAPs). UK GAAP, is the overall body of regulation establishing how company accounts must be prepared in the United Kingdom. These provide a framework to measure profit, and to value assets and liabilities, as well as what information should be disclosed in those financial statements published for use outside the business. Without these principles it would be chaos and literally impossible to compare the financial reports of companies. We will discuss these further.

The regulatory framework in the UK includes the Companies Act 2006, Financial Reporting Standards (FRS) and Statements of Recommended Accounting Practise (SORP) . There is a specific SORP for HE ‘Accounting for Further and Higher Education’ which deals with grants given for specific purposes. Around the University, you may hear reference to FRS 17 Retirement benefits, which governs how we account for our liabilities in relation to the Leicestershire Local Government Pension Scheme.Public limited companies (PLCs) are required by law to have their accounts independently audited, thereby protecting the interests of external investors.

The University is also a charity and is regulated by the Charities Commission through HEFCE.

All of these are currently under review. For financial periods starting after 1st January 2015 (i.e. for the financial year 2015/16 for the University), these will be changed. Four new FSR’s are being introduced. FSR 100 is an enabling statement; FRS101 allows for reduced disclosure but cannot be used by charities. FRS102 governs how we will prepare our accounts and FRS 103 is only applicable to insurance accounting. These will have a fundamental impact. They will change how we treat certain income streams and how we need to account for the USS Pension Scheme. They will also require that we collect data on unused annual leave at 31st July each year.

Accounting Policies

Fundamental to the preparation of financial statements of a business are certain accounting principles. These concepts are recognised internationally and are designed to make accounting information more meaningful.

The going concern concept: means that the financial statements are prepared on the basis that the business will continue to exist for the foreseeable future.

The prudence concept: means that the financial statements contain income and profits only when realised rather than when anticipated. However, they contain all possible and potential costs or losses. If in doubt ‘overstate losses and understate profits’.

The accruals concept: requires that expenses and income be accounted for when they are incurred or invoiced and not when the money changes hands. This concept specifically means that the profit and loss account does not show the cash flow of the business.

The consistency concept: requires the same treatment for similar items to allow proper comparison of accounts for different years

Financial Statements are prepared using the concept of a true and fair view – they may not be 100% accurate but the give the right impression!

Depreciation

One of the issues arising from the application of these principles is depreciation. Most fixed assets reduce in value over their lifespan. Think of your own personal assets, eg. car, television, stereo system and so on. These will almost certainly not be worth now what you paid for them originally. For most assets, it is a downward trend.

The organisation’s accountant will calculate a reduction in the value of each of your fixed assets over the accounting period. S/he will then:

  • deduct depreciation from the value of the fixed assets in the balance sheet for the period (normally 12 months)
  • charge it as an expense in the Profit and Loss Account

Depreciation is normally calculated in one of two ways:

1.the straight line method

2.the reducing balance method

1.The Straight Line Method: takes the original cost of the asset and deducts the same fixed amount each year, eg.

  • A machine costs £10,000
  • There is no expected residual value at the end of its forecast 5 year lifespan. (Residual Value means how much the asset will be worth and for how much it is expected to be sold at the end of its useful life within the business.)
  • Depreciation will be £2,000 per year leaving a residual value of £0.

Year / Cost
£ / Accumulated Depreciation
£ / Book Value
£
1 / 10,000 / 2,000 / 8,000
2 / 10,000 / 4,000 / 6,000
3 / 10,000 / 6,000 / 4,000
4 / 10,000 / 8,000 / 2,000
5 / 10,000 / 10,000 / 0

If you plotted the book value in a graph then it would look something like the following:


2. The Reducing Balance Method: takes the original cost of the asset and reduces it by a fixed % each year

This method is used where the asset is expected to depreciate more heavily in the earlier years of its use.

Activity:

  • A new vehicle costs £12,000
  • It is decided that it will depreciate at a rate of 25% per year

Year / Cost
£ / Accumulated Depreciation
£ / Book Value
£
1 / 12,000 / 3,000 / 9,000
2 / 12,000 / 5,250 / 6,750
3 / 12,000
4 / 12,000
5 / 12,000 / 2,847

If you plotted the book value in a graph then it would look something like the following:

Summary

Depreciation matches the economic benefit of an asset to the period in which it is in use. The method and rate adopted for charging depreciation should reflect the nature and use of the asset.

Financial Objectives

Why are we in business? – a relatively easy question for a business, a much harder question for the University.

For a business, “To make money” is the easy answer to the question. This is true in that those who participate in a business enterprise do so in the hope of increasing their wealth – the common measure of which is money. But it is inadequate, because no business has an automatic right to increases in wealth. Any increases are as a result of customers wanting the product or service that the business is providing. Every business must therefore have both marketing and financial objectives and these are inextricably linked.

Considerable controversy exists as to what the financial objectives of a business are or should be. Some of the options include:

  • maximisation of profit
  • maximisation of return on capital employed
  • survival
  • security
  • long-term stability
  • growth
  • maximisation of shareholders’ wealth

Clearly it is too simplistic to say that the only objective of a business is to maximise profits. Another goal could be security; the removal of uncertainty regarding the future may override the pure profit motive.

The mission of the University is to

  • To increase knowledge and understanding throughresearch which is internationally recognised.
  • To provide a high quality international educationalexperience with wide opportunities for studentsfrom diverse backgrounds which prepares ourgraduates for the global workplace.
  • To influence the economic and social development ofindividuals, business, professions and communities
But we work within a set of financial constraints both self-imposed and externally imposed by HEFCE and our lenders.

The Business Cycle

How is a business financed?

When you start a business, there are only two places (legally!) that you can obtain the money from … put in your own money (Share Capital) or borrow it (Loan Capital).

Share Capital is a permanent form of funds i.e. the shareholder is not entitled to their money back, but is, hopefully rewarded with both on-going dividends and capital growth should he sell his shares.

Loan Capital is a temporary form of funding ie the lender will eventually want the return of his investment and meanwhile will expect to be paid interest on his capital.

The relationship between Share Capital and Loan Capital is known as ‘Gearing’. The higher the gearing %, the greater are the risks to shareholders, but the potential to earn greater returns on their investment has to be also be considered. We will do more about gearing when we look at ratio analysis.

Eventually, when the business is operating, there will be another source of funding … the profits that the business retains ie the retained profits. These profits belong to the shareholders and will increase the ‘equity’ within the business. In a business the difference between income and expenditure is termed a profit. In a not for profit entity it is termed a surplus. A profit is available for distribution to the shareholders or for re-investment and in a not for profit organisation the surplus is used for re-investment.

The University has no share capital. It is not a company. It is an exempt charity established by Royal Charter. It does have retained surpluses and it does raise money through loans.

Just as there are, eventually, three sources of funds (Share Capital, Loan Capital and Retained Profits), there are three areas that we can utilise the funds that have been generated:

  • Fixed Assets (eg Land, Buildings, Machinery etc)
  • Working Capital (Stocks, Debtors, Creditors)
  • Investments in other companies

Source of Funds

In considering the appropriate form of funding, the following factors will need to be considered:

  • Cost of servicing ie interest rate and repayment of capital
  • Admin and legal costs of raising finance
  • The tax position in terms of ability to recover interest payments
  • The dilution and control of existing shareholders

From the lenders perspective, the following factors will be important:

  • The return for investing
  • The level of risk attached to the lending
  • The ‘exit route’ in terms of liquidating the debt (if required)
  • The personal tax position of the lenders
  • The degree of control the lender has in terms of the affairs of the business

In terms of risk and return, the more risk attached to the funds, the higher the expected return.

Ordinary Shares (Equity Financing)

This is the most important form of financing. The ordinary (or equity) shareholders are the owners of the business and through their voting rights, exercise control. As owners they also bear the greatest risk. If the business performs badly they will receive low or no dividends and probably a reduction in the market value of their shares. There is no obligation to pay them a dividend. If the business goes into liquidation, they will rank last in terms of repayment (assuming that any funds are left!)

On the other hand, if the business is successful then the rewards, both in terms of income and capital growth, are not limited.

There are essentially 3 ways of raising new equity finance:

  • Retained profits
  • Rights Issue
  • Public Issue

Retained profits are the most important. They represent the dividends forgone by the ordinary shareholders and are the cheapest way of raising finance. Their retention is key to the future growth of the business.

Rights Issues are offers to existing ordinary shareholders to take up additional shares for cash, at a price usually significantly below the market value quoted. The number of shares that an individual shareholder has the ‘right’ to take up depends on the number of shares already owned. If the shareholder does not want to take up the offer, the rights can be sold in the capital market by a non-shareholder. The other option is to let the rights offer lapse, but in this case the shareholder will be worse off financially by this decision.

Preference Shares

These shareholders bear less risk than ordinary shareholders. They usually have the right to the first slice of any dividend paid. The type of preference share eg 5% Preference Share determines their dividend. They are normally ‘cumulative’ which means that if their dividend is not met in the year, the obligation to backdate payment must be met (as well as current year obligations) before ordinary shareholders are considered. Preference shareholders do not normally have voting rights.

Debentures (Loan Stocks)

Many businesses borrow by issuing securities with a fixed interest rate and a pre-stated redemption date. They are typically issued for periods from 10 to 25 years. Some debentures do not have redemption dates and are known as ‘perpetual loan stocks’. They are usually secured against specified assets of the business eg property. A market quotation often exists for debentures so that they can be traded.

Debt

This is not tied in any way to the success or otherwise of the business and has no element of ownership.

The Key Financial Statements

Loughborough University produces Financial Statements for the year to 31st July. The Financial Statements for 2011/12 are 64 pages long.

They comprise

Operating and Financial review – p6 – 33

Statement of Corporate Governance – p35 – 35

Statement of the Responsibilities of Council – p36

Independent Auditors Report – p37