Chapter 11

UNDERSTANDING THE BASICS OF ACCOUNTING AND FINANCE, FINANCIAL ACCOUNTING Introduction

Aside from he recognizing the community's needs and identifying the products and services that will satisfy these needs, another goal of an entrepreneur is to earn profit, as well as to find ways on how to increase it. Understanding the basic of Accounting and Finance will help you achieve the said goal. The primary goal of Accounting is to provide quantitative information, primarily financial in nature, wh ich is intended to be use in making economic decision. In the preceding paragraph, we will be discussing the basic s of Accounting and Finance as well as managing the financial aspects and enterprise. These topics are designed to give you a better knowledg e of the recording of business transaction and how will these transaction will be summarized to provide guides in making financial decisions to increase profit.

Objectives y Discuss the functions of a financial manager, user and sources of y

funds, the rules of sound financing and financial record keeping. Be knowledgeable in the analysis of the financial statement, budgeting and cash management, and some of the reasons why business fails

The Role of Finance in an Enterprise

The role of money in the business enterprise can be compared to the function of blood circulating in the human body. Any activity or undertaking involves money or cash. Money is involved in the continuous expense revenue cycle of the business as long as it is operating. Money is needed to purchase the tools and equipment, materials and supplies, and other needs of the enterprise, and to pay for the expenses incurred, such as salary wages of the employees, electric and power bills, rentals, and other expense. On the other hand, when a sale is made, the business receives money in payments for goods, products, or service rendered. Money received will then be used to pay for materials, salaries, and so forth. The flow of money as describe earlier seems simple, but many business have evolved practices that have complicated the process. An example of this is selling goods and services on which payment will be made after 30 to 60 days, while employees have to be paid on time. On the other hand, the manufacturer can obtain some resource directly without paying money immediately.

Figure 3 The Flow of Fund in a Manufacturing Firm

Financial decision
1. 2. 3. 4. 5. contribution from stockholders long-term borrowings purchases of fixed assets purchased of raw materials for purchases of raw materials on

Production decision
6. processing of raw materials into work-in-process 7. payment for direct labor and other manufacturing cost and other than depreciation 8. depreciation charges as determined by depreciation policy Sales, credit and collection: 9. the sales effect 10. credit sales 11. cash sales 12. collection of accounts receivable Financial Decisions: 13. dividend payments 14. payment of interest and prined of long-term payment 15. payments of interest and prined of short-term payments

It can be noted from the illustration that cash can be compared to a reservoir once depleted, it cannot supply the requirements of the other units. This results in interruption of business operations. Even if your business has purchased all necessary manufacturing equipment, but then, it lacks t he cash to buy the raw materials, operations still cannot start. Another requirement is that the reservoir must be big or abundant enough so that it can be distribute to the different units a balanced supply for a smoother and uninterrupted operation . This means that enough provide of money must be maintained to enable business to buy raw materials, process raw materials, sell on credit and collect at a later date, pay salaries and wages of employees and other expenses.

Functions of a Finance Manager

A. Treasurership It involves provision of funds, custody of funds, or the cashier's function, credit and collection, and investment. It is the role of treasurer to see it that there are sufficient funds to provide for all the needs of the various operating units. B. Comptrollership Another function is to see it that the funds are effectively and efficiently utilize. It involves it involves financial planning, accounting records and reports, tax administration, government reporting, and internal control. Financial planning is important because of the funds of the enterprise are limited and must be allocated properly to the bet interest of the business. A financial plan is a course of action for obtaining and using the money that is needed to implement the goal of busines s organization. 1. Establishing objectives. These should be clear and specific to determine their cost or budget. Objectives should be realistic. That is, available resources in terms of human, material, and financial inputs can support them. Otherwise, such objectives are not attainable. Budgeting. A budget is an estimated or project program of expenses and income over a specified future period. Incomes come from estimated sales. Identifying the sources of funds. There are four ways of financing a business enterprise: a) income from sales, b) owner's money and sale shares of stocks, c) borrowing from friends, relatives, and financial institution, and issuing of bonds , and d) sales of some property of the enterprise as a last resort.

2.

3.

Uses and Sources of Funds

Uses of Funds "Funds" refers to money, or its equivalent, which is used in obtaining and bringing together resources for the attainment of your business objectives. Funds are used to obtain resources, which are referred to as assets. Assets can be classified as current or working capital, which are used in the day-to-day operations of the business, or fixed assets, which will be used by the business for a long time, usually for more than one year. To illustrate these two types of fu nds or assets, let us consider a T-shirt printing business. The silk screen frames, stapling machine, cutting knives, painting brushes, and working table are to be used in the business on a long term basis possibly, for a number of years, and are called fi xed assets. While textile paint, thinner, lacquer, worker's wages, and rental are the current assets, they need to be replaced or repurchased weekly, monthly, or as the need arises.

Sources of Funds Sources of funds coming from owners can be identified according to the type of business ownership. When it is a sole proprietorship or the money comes from one person only, this amount is called capital owner's capital, or owner's equity. If it is a partnership, there are several contributors of money, and these funds are called partner's capital. Corporations, on the other hand, issue shares of stock to people who contribute and become owners of the enterprise. The money they put into the corporation is called stockholder's equity. Funds that are borrowed are known as liabilities. Current or shortterm liabilities/financing are to be paid within a year or less, while longterm liabilities/financing are to be repaid for a period of more than one year. There are government and non -government organization that extend both financial and technical assistance to small entrepreneur. We have the Philippine National Bank(PNB), Development Bank of the Philippines(DBP), and Land Bank of the Philippines(LBP). They h ave their own programs for small and medium-scale enterprise. In this case of NGO's there are numerous organizations that extend financial assistance to small enterprises, such as the Meralco Foundation, the Philippine Business for Social Progress, and others. Foreign governments, through their embassies, and international organizations likewise, have their assistance programs for micro and small businesses. Here are some sources of funds:
1. Short-term financing (one year or less) Trade Credit. Goods are delivered to retailers on consignment basis. This means they have to pay the goods within 30 -90 days. Such credit lines applied to retailers with good reputations or established business relations. Promissory notes. This is written pledge by a borrower to pay a certain sum of money to a lender at a specified future date. Such loan entails an interest. Unsecured bank loans. Commercial banks grant unsecured short -term loans to their customers at interest rates that vary in accordance with their credit ratings. Borrowers with high credit ratings get lower interest rate. Commercial paper. This is a short-term promissory note issued by big corporation. Commercial paper is secured by the reputation of the issuing corporation. There is no collateral involved. Big firm with an excellent credit reputation can be easily raise the large amount of money from financial institutions.

2. long-term financing(more than one year)

y Loans. Many firms finance their long-range activities from loans

borrowed from banks and other financial institution. These require collateral such as land, equipment and machinery. Terms of payment are indicated in a loan agreement. Stocks. This is a certificate of ownership. A stock is classified as a common and preferred. Holders of common stock can elect directors and can decide major corporate actions. In these cases of preferred stockholders, they have no voting rights. But they have a priority in claiming of profits and assets of the corporation. In general, only established corporations and sell additional shares of stocks to the public to finance their business projects. Bonds. This is a certificate of indebtedness. It pledges to repay a specific amount of money with interest. Such certificate indicates also a maturity date. Big corporations issue bonds to raise fund for their business activities. Bondholders have the first to claim on the assets of the issuing corporation in case it gets bankrupt. Bonds are classified as debenture bonds (supported only by the reputation of the issuing corporations), mortgage bonds (secured by the assets of the issuing corporation), and convertible bonds (can be exchanged with shares of common stocks).

Rule of Sound Financing

In borrowing, you must be careful not to overlook the financial structure of your business. Ideally, the 40:60 equity ratios must prevail. What does this ratio mean? Its means that only 40% debt and 60% equity must finance your business. For example, if you need P100, 000 to s et up your business, only P40, 000 must be borrowed (debt) and the rest or P60, 000 must come from your own contributions (equity). This 40/60 ratio is recommended in order to:

y provide for future borrowings when the business will expand; or y Meet changing circumstances and situations.
Firms with higher debt/equity ratio saddled with high loan and interest payments. This situation put the firm at a disadvantage, especially when it competes with the other businesses without a similar debt burden. In addition to the debt/equity requirement, you must comply with the following rules that your firm will have a sound financial structure:

y Fixed assets and working capital requirements during normal

operations must be financed from the owner's equity and long -term liabilities. Short-term requirements, like additional working capital needed during peak seasons (Christmas, school opening, and other special occasion ), must be funded from sources that offer short -term loans like trade

credits (30,60,90 days), short -term bank loans (two or three months) pawnshops(three months), friends, relatives, and family members. In summary, short-term capital requirements must be financed by short term loans. Owner's equity and/or long -term loans must finance long-term capital requirements.

Working Capital Management

Working capital is concerned with the day -to-day financial operations of a business and the problem of ensuring that there is enough cash in the firm to be able to pay what is owed and still continues to trade. Working capital is current assets less current liabilities. How does working capital work? A firm buys a quality of goods that it intends to sell later on at a profit. Thus, its cash falls, but it has stock in hand. The goods are subsequently sold on c redit term at a profit. Further purchases are made, but the firm may not pay for these purchased immediately. It may hold onto the invoice, especial ly if it is a little short of cash. Eventually, the customers pay up and the firm can use the cash to pay what it owes, and be able to buy even more goods. Why is there a problem? The firm may not be able to get its hand on enough cash when the supplier asks for payment. High stock levels (including working progress), low profit margins, and a fast sales rat e of growth often compound the problem.
The Accounting Equation. Stocks + debtors + cash = creditors + borrowings + equity capital. Therefore, if you wish to buy more stock, or you put in more equity.

If your customers do not pay up (i.e. there is an i ncrease in debtors), you cut stocks, or you put more money in.

Financial Records and Reports

Some businesses fail because the owner or manager was unable to keep track on how the business performed. They may have failed to notice such deficiencies like heavy operating expense, inadequate sale volume or selling below break-even, high level of receivable (difficulty in collecting), excessive fixed assets. These failures could have been avoided, if the owner kept adequate the financial records. Thus, a bu siness owner needs to have a proper training, not only in record keeping, but also in analyzing these documents for management and control purposes.

In managing the finances of an enterprise, you have to make sound and timely decisions on the fund allocation of the different operating units, and the sources from which the funds would be taken. To be effective, your decision must be based on reliable and up -to-date information. To do this, you, as an entrepreneur, need to maintain records of all the transactions the enterprise has made. These transactions represent your enterprise's operations and affect its financial status.

Financial Record Keeping

The recording of the transaction within the business is referred to as bookkeeping. The records are called book of accounts. The effects of the transactions are drawn out from the books of accounts and summarized in a report called income statement or profit and loss sheet. The whole system of recording and interpreting the result of the business transaction is called accounting. Thus, the system is referred to as the accounting system and the outputs are accounting records and reports. The flow of recording busines s transactions is as follows: Transaction occur daily (cash, sales, cash disbursements, credit sales) Proper supporting documents are prepared. Debits and credits are recorded in the journals Summary totals are posted on the ledger Preparation of the balan ce sheet and income statement (profit and loss statement) The features of good accounting system are as follows simple to understand; flexible and adaptable to changing needs; inexpensive to operate; little time to operate; and handy and convenient to use.

y y y y y

y y y y y

Book of Accounts
An enterprise would need the following book of accounts:

y Journal
The journal is a chronological record of the business transactions of the enterprise. It is also referred to as the book of original entry. The entries show the effect of the transactions on the different item in the balance sheet.

Date 10/10

Sample Forms of General Journal Account and Ref. Debit explanation Cash 11 10,000 Sales 41 Cash sales of the day Office equipment Cash Purchase desk calculator 16 11 3,000

Credit

10,000

10/11

3,000

10/11

Salary and wages Cash Payment of salaries for the week ending October 11

51 11

14,000

14,000

10/11

Office Equipment Accounts receivable Purchased from AJ electronics (1) computer unit on account

16 21

35,000 35,000

Entries in the general