How can firms make profits but be short of cash?

What is the difference between cash and profit?

•          Cash is tangible and deals with money flowing in and out of a business.  Profit is a calculation – Revenue – Expenses

Why can firms have large profits and no cash?  Its due to:-

–        Excessive Drawings / Dividends paid out - not recorded  in the Income Statement so profit is unaffected but the firms cash down when paid out

–        Lots of prepayments of expenses – deduct from the expense so profit technically increases but cash goes down

–        Paying off loans - cash goes down and since are loans not in the Income Statement profit is not affected

–        Buying Fixed Assets – treated as Capital Expenditure – so depreciated in the Income Statement but cash may go down by the whole amount

–        Lots of Accrued Income – credit sales are  included in the Income Statement which increases profit but the firms has not yet got the cash)

–        To evaluate this you could mention that, in the short term cash is required to survive but in the longer term profits will need to be generated.

Application tip

·         Always apply to the scenario – quote examples!

·         If asked to calculate the effect always say it will increase or decrease by £xxxx.  Never just give the figure – the direction is important!

Manufacturing Accounts

Manufacturing Accounts deal with working out the cost of making products rather than buying them.  The production costs therefore replace the purchases in the Income Statement.  However before we get there we need a separate statement to show the costs involved in making the items.

There are two types of costs in a Manufacturing account

• Direct Costs – related to production
• Raw Materials, Direct Expenses, Direct Labour and Royalties

• Indirect Costs - Costs which are clearly linked to manufacturing but not directly attributable
• Supervisors wages, depreciation of machinery

NB  If it is not to do with manufacturing then put it in the Income Statement!!

Below is an example of a manufacturing account.  Please note we have had to make adjustments for closing inventory of raw materials and work in progress.  These will be used next year.  Work in progress are items which have started being produced but not yet complete.  Think of a loaf of bread fresh out of the over and not yet cut and wrapped!

 What is Factory Profit

Manufacturers want to gauge how efficiently their factory runs

They compare their own manufacturing cost with the cost of ‘buying in’ from another supplier (A ‘make or buy’ decision)

This does not show how profitable the factory is though.  Firms may therefore decide to ‘add in’ a factory profit of a certain percentage.   This increases the manufacturing (or production) cost.

NB Increasing production cost lowers the Gross and Net Profit from Trading.

This enables the manufacturing element of the business to be kept separate from the Retail element – allowing ‘Profit Centres’.

Production Cost                                        £115,500

Add Factory Profit (10%)                          £ 11,550

Transfer Price                                            £127,050

Doing this has therefore increased our production cost to the retail element of the business allowing the manufacturer to show a profit.

Since we added in a Factory profit in the manufacturing account (thus lowering Gross Profit) we must add it back into the accounts in the profit and loss account after Net profit to give a revised Net Profit for the group as a whole.

 A sample Income statement showing this is shown below

Shares and reserves summary & a limited company balance sheet

Limited company accounts- key terminology

Authorised Share Capital

This signifies the upper limit of shares a firm is allowed to sell.  It needs to get the laws changed to sell more than this.

Balance sheet extract

Shares & Reserves

Authorised Share Capital                            £

500,000 x 50p shares              250,000

Issued share capital

The amount of shares that have actually been distributed to shareholders.  This cannot exceed the Authorised Share Capital and is the figure

Balance Sheet extract

Shares & Reserves

Issued Share Capital                             £

400,000 x 50p Shares                      200,000

Nominal Value of a share

The ‘face’ value of each share when first agreed to be sold with company’s house.  The share does not have to be sold at this and they are often sold at a premium.  In the above example it was set at 50p

Market Value of a share

The current market trading price of a share – this is usually higher than the nominal value of a share.  This may change on a regular basis depending upon demand and supply for the share.

Share Premium account

When a share is sold at a higher price than the nominal value (i.e. during a rights or share issue).  If a share with a nominal value of 50p is sold for 70p the remaining 20p of capital goes in the share premium account.  This is a non trading profit and is called a CAPITAL RESERVE.

Revaluation reserve account

When non-current assets are revalued and go up in value the difference goes in here.  If NCA s go up from £2m to £10m (a total increase of £8m) then Capital must go up by £8m because Assets – Liabilities = Capital.  This usually applies to Buildings.  It is a Non trading Profit (like Share Premium) and goes under the Capital Reserves heading!

General Reserve

These are trading profits from normal activities (think Tesco selling groceries) and go under the heading Revenue Reserves.  Sometimes companies transfer reserves from the Retained Earnings (Profit & Loss a/c) to the general reserve.  The value of the business is unchanged – it is a paper exercise.

Retained Earnings

These are profits made from normal trading activities accumulated over the years. If a company makes a profit it rises by that amount and if it makes a loss it falls by that amount.  It is a Revenue Reserve as it comes from trading profits!

NB All reserves are not money.  They simply highlight where the funds have come from to make it worth what it is! Money is in the bank usually!!!

Below is a sample of a Limited Companies Balance sheet

Bad Debts and Provision for Doubtful Debts

Bad Debts and Provision for Doubtful Debts

 

Note: Bad Debts and Provision for Doubtful  Debts are not the same thing

Bad Debts

A bad debt is a debt owing to a business that it considers will never be paid

If a firm has trade receivables to the total of 10,000 from a number of peoples accounts some of these could become bad (not collectable).  These must then be written off and the company must accept the loss

Therefore you should: -

DEBIT bad debtors written off account

CREDIT the trade receivables account

with the relevant amount to be written off.

At the end of the year you should

DEBIT        The Income Statement

CREDIT     Bad Debts (written off) Account

With the total bad debts account written off as a company expense

This is in line with the concept of prudence which suggests that bad debts should be recognized as they arise.

Provision for doubtful debts

 

This is allowing for (hence the term provision) some of your trade rerceivables not paying their bills.  The firm will usually choose a specific percentage of trade receivables based on previous experience, which can vary from business to business (you may think of banks and hire purchase companies which may use a higher figure).

 

This procedure comes after writing off bad debts

 

For example

 

Trade Receivables                                   ₤10,000

Bad Debts                                                 ₤200

                                                                   ₤ 9,800

Provision of 2%                                        ₤    196 

Balance sheet final total                          ₤ 9604

The ₤196 is then

Debit                    Income Statement (as an expense called provision for doubtful debts)

Credit                   Provision for bad debts account

In the balance sheet it is then deducted as follows

Balance Sheet of Nial Satis as at 31/12/2003

Current Assets                                ₤                           ₤                           ₤

          Stock                                                                                        10,000

          Trade Receivables               9800

Less prov for bad debts                   196

                                                                             9,604

Prepayments                                                      1,000        

Cash                                                                    2,500

Bank                                                                    9,950

                                                                                                             33,054

Adjustments to the Provision for Bad Debts

Once a provision has been created the only adjustments needed are due to

·        Policy change in provision (increase or decrease in percentage)

·        Arithmetic adjustment in trade receivables total (this is quite likely each year)

When this happens the amount of the provision may increase or decrease.

An increase in provision for bad debts is recorded as follows

DEBIT        the difference (new provision minus old one) to Income Statement *

CREDIT     provision for bad debts

* Note : In the Income Statement this is recorded as an increase in provision for bad debts and listed in expenses

For the balance sheet the amount of the new increased provision is shown (i.e. the larger amount)

An decrease in provision for bad debts is recorded as follows

Debit the difference (old provision minus new one) to provision for bad debts

Credit the Income Statement (this is recorded as reduction in provision of bad debt account under income)

For the balance sheet the amount of the new provision is shown (i.e. the smaller amount)

 

Minimising the risk of bad debts

It is appropriate to look at ways in which businesses selling on credit can minimise the risks. The following are some of the procedures that can be followed:

·        When first approached by an unknown business wishing to buy goods on credit. the seller should ask for two references.  One of these should be the buyer's bank, and the other a trader with whom the buyer has previously done business.

·        The seller, before supplying goods on credit, should take up both references and obtain satisfactory replies.

·        Once satisfactory replies have been received, a credit limit for the customer should be established, and an account opened in the sales ledger. The amount of the credit limit will depend very much on the expected amount of future business - for example, £1,000 might be appropriate. The credit limit should not normally be exceeded - the firm's credit controller or financial accountant will approve any transactions above the limit.

·        Invoices and month-end statements of account should be sent out promptly; invoices should state the terms of trade, and statements should analyze the balance to show how long it has been outstanding, e.g. 'over 30 days, over 60 days, over 90 days' - computer produced statements can show this automatically.

·        If a customer does not pay within a reasonable time, the firm should follow established procedures in' order to chase up the debt promptly. These procedures are likely to include 'chaser' letters, the first of which points out that the account is overdue, with a later letter threatening legal action. Whether or not legal action is taken will depend on the size of the debt - for a small amount the costs and time involved in taking legal action may outweigh the benefits of recovering the money.