Chapter 5

Financial Management

• Sources of finance and Types of Capital

• Types of Costs
– Profit/Loss calculation
• Breakeven Analysis
• Understanding Financial Statements
• Cash flow planning

1
 Sources of finance
• The adequate provision of finance is needed to start a business
and ramp it up to profitability.
• The assessment of the fund needed by the business
organization should be done in such a way that the total
amount of money available should be neither too low nor too
less.
• The determination of the right amount of capital that can be
used for the current operation of the business and the future
expansion is the very important task. 2
• Investment capital is a valuable commodity. Like
other commodities, the price of capital is
determined by the interaction between demand
and supply.
• The price of capital is the rate of return that the
supplier (the lender or investor) experts from their
investment..

3
 Cont…

• The major supplies of capital include the

following
– Personal capital
– Informal investors
– Borrowing
– Retained capital
– Different business angles
– Issuing shares
– Commercial Partnership
– Government
4
 TYPES OF CAPITAL REQUIRED
• Capital refers to be the total investment of a company of firm in
money, When the business assesses it capital requirement, it must
consider the need for current asset capital and fixed asset
capital.

1. Current asset capital

• Current assets are part of business capital that are used for the
current business operations

– Cash:

– Inventor

– Receivables: 5
 Cont…
2. Fixed asset capital

– Fixed assets are relatively permanent assets that are used for long period of

time.

• The types of fixed assets needed in a new business may include the following

– Long-term tangible resources in operation. The distinguishing characteristics

of assets in this category are that they are tangible (have physical substance) and

are held for productive use in business operations. Examples building,

machinery, equipment, land etc.

– Intangible fixed assets – Such as patents, copyrights, trademarks, and

goodwill. Many newly established firms have no intangible fixed assets.

– Fixed security investment: - such as stocks of subsidiaries, pension funds and

contingency funds. In most cases, a new business has no fixed security. 6

 Fixed
Fixed and
and Variable
Variable costs.
costs.
Types of costs
Fixed
Fixedcosts
costsremain
remainconstant
constantin
intotal
total(not
(notper
per
unit)
unit)regardless
regardlessofofthe
thevolume
volumeofofproduction
production
or
orsales,
sales,over
overaarelevant
relevantrange
rangeof
ofproduction
production
or
orsales.
sales.
Rent
Rent andand salaries
salaries are are typically
typically
fixed
fixed costs
costs

Variable
Variablecosts
costsfluctuate
fluctuatein
intotal
total(not
(notper
perunit)
unit)
as
asthe
thevolume
volumeofofproduction
productionororsales
sales
fluctuates
fluctuates
Direct
Direct labour
labour costs,
costs, Direct
Direct
material
material costs
costs used
used in
in
production,
production, and
and sales
sales
commissions
commissions are are examples
examples of of
variable
variable costs.
costs. 7
 Example: Cost items of a dress making factory

COSTS FIXED VARIABLE

Wages for the seamstress
Telephone

Salary for the secretary / receptionist

Water and electricity

Rent for the factory building
Maintenance contract on the
machines
Raw material costs

8
 Elements of Cost Examples:
Examples: Indirect
Indirect materials
materials and
and indirect
indirect labor
labor

p
p lleess
m
EExxaam Materials used to Wages paid not
Example: support the directly involved in
production process. production work.
Example: The tires installed in an
Wages paid to automobile Examples:
Examples: maintenance
automobile lubricants and workers, janitors
assembly workers cleaning supplies and guards.
Direct
Direct
Materials
Materials
Direct
Direct Manufacturing
Manufacturing
Labor
Labor Overhead
Overhead

Other
Adminis
Costs
trative
Costs

All executive,  Selling and

organizational, distribution
and clerical  Rent
costs. The Product 9
 Utilities
10
11
 Calculate:
• 1. The Variable cost, Fixed costs and total costs per
month at full capacity

• 2. The profit / loss that the business will make from this
order.

12
 THE TAILOR SHOP of Wro Addis - COST STRUCTURE

Cost (ETB)
per month

[(Cloth 2x150ETB)+ 2.5 dresses per day x

Direct material & (Button 20x5ETB) +(Belt 20days= 50dresses per [2*150+20*5
expenses 1x50 ETB)] per unit month +1*50]*50 = 22500
Variable cost 22,500
[amount x int. rate x years]/month = [ETB 30,000 x 12 % x
Monthly interest 1]/12 = 300
Depreciation: ETB 24,000 ÷ 60 months = 400
Auxiliary materials & packaging 700
Maintenance / repairs 200
Administration cost 400
Salaries (regular salaries in production) 2000
Salaries (Wro Addis) 3000
Rent 2500
Utilities 400
Selling expenses 600
Total Fixed Cost 10,500
Total cost (Variabl+ fixed) 33,000 13
 Profit / loss Calculation
revenue:
50 dresses per month x ETB 700.00 each = ETB 35,000 per month

SALES ETB 35,000

- Cost of production ETB 22,500
= Contribution ETB 12,500
- Overheads (fixed costs) ETB 10,500
= NET PROFIT ETB 2,000 14
 Cont…

MARK-UP % = (Contribution ÷ Production Cost) x 100

= (ETB 12,500 ÷ ETB 22,500) x 100
= 55.5 %

Contribution % = (Contribution ÷ Revenue) x 100

= (ETB 12,500 ÷ ETB 35,000) x 100
= 35.7 %

NET PROFIT % = Net Profit ÷ Revenue x 100

= ETB 2,000 ÷ ETB 35,000 x 100
= 5.7 %

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 Break-even Analysis
• “A firm Breaks Even if it doesn’t make a profit or a loss”

• In other words profit = 0

• Total Revenue = Total Costs

• Total Revenue (TR)= Price per unit x Number of units sold

• Used to evaluate whether the organisation will be able to cover costs (break even) at
a particular price
Uses of break- even analysis
• It enables a business organization to:

– Measure profit and loss at different levels of production and sales

– To predict the effect of changes in price of sales

– To analyse the relationship between fixed cost and variable cost

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– To predict the effect on profitability if changes in cost and efficiency
 Sales Revenue
Profit at full capacity

Total Costs
If margin of safety
is positive,
BE production is
Variable Costs
above break even.
margin
Safety
If margin of safety
Costs and
revenue

is negative,
Fixed Costs
production is
below break even.
0
Break-even Current Full Output
Output Capacity
point

Margin of safety is the amount by which the sales level

exceeds the break-even level. If sales drop below this level, a
loss will occur.
Cont…

• The fundamental accounting equation

Profit = Revenues - Costs
Revenue = SP*units sold

SP = selling price
Costs = FC + VC(units manufactured)
FC = fixed cost
VC = unit variable costs.
• We are assuming that units manufactured equal units
sold
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What if we want to know how much product
we must sell to break even?

The breakeven point is the point where profit is zero,

so Profit /Loss = 0 = Revenue - Cost
= SP*units sold - FC - VC*units sold
= (SP - VC)*units sold - FC
units sold = FC/(SP - VC)

We will call units sold at  Profit /Loss = 0: BEunits

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 Breakeven revenue

Breakeven units (BEunits) * SP, or

SP * BEunits = SP*(FC/CM)

Breakeven revenue = FC/(CM/SP)

CM= Contribution margin = Revenue - Variable costs

Some variable costs are manufacturing costs, but some
may be non-manufacturing costs. None are fixed costs.

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 Break even analysis

The calculation is as follows:

• Break- Even in unit =

• Break-Even in Birr =

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• Example
• A small street side cafe offers fresh traditional coffee to the
general public. Total variable costs per coffee (including coffee
beans, water, firewood, sugar) amount to ETB 1.60 per cup. The
cafe has fixed costs per week of ETB 360.00, being the rental of
the place. The selling price is ETB 4.00.
Solution
– From the problem
– Total Fixed costs =360ETB/week and
– Total Variable costs =1.6ETB / cup
– sales price = 4ETB/cup
• Calculate
• The number of units to break-even
• break-even revenue and the profit / loss that the business will make
• The diagrammatic presentation of the break – even analysis.

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• Break- Even in unit = [fixed costs / (Sales-variable cost)]
• =[360/ (4-1.6)]= 150 units
• Therefore, the business must sell 150 cups of coffee (per week!) in order to
break-even. Let us put it to the test:
• Sales 150 x ETB 4.00 = ETB 600
• Variable costs 150 x ETB 1.60 = ETB 240
• Fixed costs = ETB 360
• Profit / loss = Sales- (fixed + variable) costs =600-(360+240) =0

• Break-Even Revenue =

= (360/[ (4-1.6)/4] = 600 or 150*4=600

• Once break-even point has been reached, a business enjoys greater

flexibility when setting prices or offering discounts.
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DIAGRAMMATIC PRESENTATION

Margin of
Safety

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 Margin of Safety (MoS)

• Is if a firm is producing AND selling more than the

break even level of output then a profit is being made
• This is effectively a “safety net”, and can be calculated
as:
• Actual Sales - Break Even Level
• From the previous example (coffee house)
• If Actual sales =300 units/week
• Break Even level= 150 units/week
• MoS= 300-150=150 units /week

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 Calculation of Break-Even

Fixed costs $90,000

Unit selling price $25
Unit variable cost $15
Unit contribution margin $10

Break Even sales (units) = $90,000/10= 9000 units

Contribution margin ratio =Unit CM/ Unit Selling price 26

 Break-Even Example: Bamboo Chair Maker

Per month data

• Selling price per unit ETB 750

• Manufacturing cost per unit ETB 450
• Maximum capacity (chairs per month) 60 units
• Fixed costs (including rent, fixed salaries) ETB 6,000

1. Observe the number of units to break-even.

2. What is the break-even % of production capacity?

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 Computing Multiproduct Break-Even Point

• Unit contribution margin is replaced with

contribution margin for a composite unit.
• A composite unit is composed of specific numbers of
each product in proportion to the product sales mix.
• Sales mix is the ratio of the volumes of the various
products.

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 Cont… Multiproduct Break-Even Point

The resulting break-even formula

for composite unit sales is:

Break-even point Fixed costs

= Contribution margin
in composite units
per composite unit

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 Cont… Multiproduct Break-Even Point

A company sells windows and doors. They sell 4

windows for every door. Fixed costs 900,000

Windows Doors
Selling Price $200 $500
Variable Cost 125 350
Unit Contribution $ 75 $ 150
Sales Mix Ratio 4 1

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 Cont… Multiproduct Break-Even Point

Step 1: Compute contribution margin per

composite unit.

Windows Doors
Selling Price $200 $500
Variable Cost 125 350
Unit Contribution $ 75 $ 150
Sales Mix Ratio
Composite C/M

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 Cont… Multiproduct Break-Even Point

Step 2: Compute break-even point in

composite units.

Break-even point = Fixed costs

in composite units Contribution margin
per composite unit

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 Cont… Multiproduct Break-Even Point

Step 2: Compute break-even point in

composite units.

Fixed costs
Break-even point
=
in composite units
Contribution margin
per composite unit

$900,000
Break-even point
=
in composite units $450 per composite unit

Break-even point
= 2,000 composite units
in composite units
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 Cont… Multiproduct Break-Even Point

Step 3: Determine the number of windows and

doors that must be sold to break even.

Sales Composite
Product Mix Units Units
Window 4 × 2,000 = 8,000
Door 1 × 2,000 = 2,000

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 Multiproduct Break-Even
Income Statement
Step 4: Verify the results.

Windows Doors Combined

Selling Price $200 $500
Variable Cost 125.00 350.00
Unit Contribution $ 75.00 $ 150.00
Sales Volume × 8,000 × 2,000
Total Contribution $ 600,000 $ 300,000 $ 900,000
Fixed Costs 900,000
Income $ 0
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 Break-Even Exercise:
New Wave Technology Inc. manufactures and sells two products,
MP3 players and satellite radios. The fixed costs are $300,000, and
the sales mix is 40% MP3 players and 60% satellite radios. The unit
selling price and the unit variable cost for each product are as
follows:

I. Compute the break-even sales (units) for the overall product,

II. How many units of each product, MP3 players and satellite radios, would be sold
at the break-even point?
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 Disadvantages of Break Even analysis

• It is only a forecast!
• Assumes all products are made AND sold
• Assumes that sales prices are constant at all levels of
output
• Costs may change
• It can only apply to single product or single mix of
products
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• Sales -Cost of sales= Gross profit
• Gross profit /Sales x100=Gross profit margin (%
• Opening stock +Purchases -Closing stock=Costs
of sales

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 PROFIT FORECAST
Profit forecast tells you how much profit/loss
you make in a period

Profit and Loss is also essential in providing

information for Inland Revenue for Taxation
purposes
• A profit forecast should show what level of
profit you expect your
• business to produce at the end of the period.
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 Example: Block Enterprise
Suppose you are the owner of hollow blocks manufacturing enterprise. Hollow
blocks are sold for ETB 850 per 100 blocks. The monthly cost structure of your
enterprise looks the following
Salaries ETB 3,000 per month
Production Labour ETB 50 per 100 blocks
Rent ETB 3,000 per month
Cement, sand and stone ETB 500 per 100 blocks
Machine credit payment ETB 1,000 per month
Delivery costs ETB 50 per 100 blocks
Telephone / Communication ETB 500 per month

Budgeted production and sells (quantities of bricks to be sold)

September October November
Blocks 5,000 6,500 7,000 40
• Prepare a profit forecast, for the months September, October and
November
Hollow Block Making Enterprise - Profit Forecast
September October November
Income from Sales

- Material Cost
- Production Labor
Contribution
Salaries
Rent
Machine Rent
Delivery Expense
Telephone

-Total Expense
Profit Before Tax

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 Sales forecast (profit forecast)
850 birr / 100 unit blocks
Sep. Oct. Nov.
Forecasted sales amount ( units) 5000 6500 7000
Forecasted sales revenue (income) 42500 55250 59500
Description of costs ETB Sep. Oct. Nov.
Salaries 3000/month 3000 3000 3000
Labor cost (Wage) 50birr/100 unit 2500 3250 3500
Rent 3000/month 3000 3000 3000
500
Material (cement, sand.. birr/100unit 25000 32500 35000
Machine credit payment 1000/month 1000 1000 1000
Delivery cost 50birr/100 unit 2500 3250 3500
Communication 500/month 500 500 500
Total cost 37500 46500 49500
PBT =Revenue – total expenses 5000 8750 10000

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 Cash flow
Cash flow is the money that is moving (flowing) in and out of your
business in a month.
Example
Prepare a cash flow forecast for the period September, October
and November of the Yared Hollow Block Enterprise.
During August you produced and sold bricks to the amount of ETB
30,000. All sales are on credit and debtors take one month on
average to pay. However, you pay cash for the materials in the
moment of production. You had ETB 25,000 in the bank at the end
of March.

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 Cash flow

Cash flows OUT Cash flows IN

to buy raw from sales of
materials products

Cash flows OUT

to pay overhead
costs

44