Calculation of Operating Results of a Business Organisation

The stake holders of any organisation are more concerned about the final product of accounting. It is the final accounts of the company. Following two financial statements are most important among them.

• Trading and Profit and Loss account
•  Balance Sheet

Trading profit and loss account is used to calculate the profit or loss of the operational results for the accounting period. The profit calculated in this manner can be shown in two steps. They are,

• Trading profit/ gross profit
• Net profit/loss

 Trading Account
Organisations which are involved in selling goods and services prepare the trading account to calculate the gross profit. It includes two main aspects.

• Sales income
• Cost of sales

Sales Income
Total sales include sales on cash and credit sales. Some of the goods sold on credit may be returned back to the organisation. Goods returned as such will be deducted from the sales of the business. This allows the calculation of net sales to the business.
                                                                                RS
Example : ¤         Cash sales                                  145,000
                           Credit sales                                  68,000
                                                                             213,000
                           Less – Goods returned                    3,000
                           Net sales                                    210,000
Cost of Sales

Following items are considered when calculating the cost of sales.
         Opening stocks          
        Custom duty
        Carriage inwards      
        Purchases
        Closing stocks            
        Purchases returns
The closing stocks of one period become the opening stocks for the next accounting
period.
Example : The accounting period starts on 01/01/20xx and ends on 31/12/20xx. The opening 
                  stock as at  01/01/20xx is Rs.8000. It is the same as the closing stock of Rs. 8000  
                  as at 31/12/20xx.
An organisationwhich starts business activities newly, will not have an opening stock. But in other organisations when the opening stocks are sold it becomes a part of cost of sales for that accounting period.
The opening stock will not be sufficient for sales for a given accounting period. Therefore the organisations have to purchase new stocks. Goods purchased on cash are known as cash purchases while goods purchased on credit will be termed as credit purchases. Some of these credit purchases may have to be returned from time to time. Such purchase returns will be deducted from the total purchases of the organisation. The net amount calculated is called the net purchases.

          Example : ¤              Cash Purchases               78,000 RS
                                            Credit Purchases             46,000 RS
                                                                                   124,000 RS
                                           Less - Purchase returns     4,000 RS
                                             Net Purchases               120,000 RS

When purchases are considered all the expenses that directly relate to purchases have to be considered. There will be a cost of transporting goods to the business which is termed as carriage inwards. Loading charges have to be paid. All such expenses will be included in the cost of sales.
The opening stocks, purchases and related expenses of purchases are included in the cost of goods to be sold. But it is not the cost of sales. To calculate the cost of sales the closing stocks have to be deducted from the cost of goodsto be sold. The remaining stock of the cost of goods to be sold at the end of the accounting period is known as the closing stocks.

Purchase of shares

Investing in shares of companies is one of the formal methods of investment. These trading activities take place at a stock exchange. Investors can buy shares from an initial public offer made by companies and from the secondary market, which is the stock exchange.

The secondary market operations in Sri Lanka are handled by the Colombo Stock Exchange and shares of all the listed companies are traded here. The companies which are registered in the Colombo Stock Exchange are also called the listed companies. The Colombo Stock Exchange manages all the trading activities of the stock exchange and the Securities and Exchange Commission of Sri Lanka regulates all the activities of the Colombo Stock Exchange.
A company can issue two types of shares.

• Ordinary shares
• Preference shares

As an investment method, ordinary shares have a cashable easily market and therefore ordinary shares are more attractive than other types of shares. Ordinary shareholders are treated as the owners of the company and the capital is called the owners’ equity due to the features attached to the ordinary shares.
Ordinary shares
Ordinary share holders of a company are entitled to the following benefits.

• Dividend payments:

Dividends are paid out of the net profit of the company at the discretion of the management. Dividends are not paid out at the periods of not earning net profits but will be paid at a higher percentage when the company earns higher profits. 

• Ownership and management:

Limited companies are managed by the board of directors. The company directors are appointed from the shareholders of the company. Therefore, the shareholders have the opportunity to participate in decision making process of the company.

• Voting rights:

Ordinary shareholders are able to attend the different types of meetings of the company and they enjoy the voting rights at such meetings based on their number of shares holding.

Investment Portfolios
Instead of investing only in one type of asset category, investors can invest in number of assets as a basket of investments. This is called a portfolio of investment. It gives the investor an opportunity to diversify his investments. A portfolio may comprise deposits in banks and other financial institutions, shares and other types of investments. Investing in a portfolio will reduce the various risks inherent to different types of
instruments and ensures stable level of income over the period of time.
Unit Trusts
Unit trusts are trusts build up by the funds received from its unit holders. Unit holders will purchase units from the trust. Since unit prices are comparatively affordable than other types of investments, even small scale investors can invest in unit trusts. The unit trusts are managed by expert professionals in the various investment fields. Therefore, high returns can be expected at comparatively low risks.

Purchases of assets

With the interest rates declining environment, individuals and institutions prefer to invest in properties as a method of investment. Since there is a downward trend in the value of money, the demand for properties is increasing. Assets can be grouped as follows.
¯ Fixed assets
¯ Movable assets
Fixed assets
Fixed assets are the assets that cannot be physically moved from place to place. As a method of investment, there is a higher tendency to acquire fixed assets, specially in lands. This is mainly due to scarcity of land as a resource and its unlimited use of economic life. Therefore, high capital gains are expected by investing in lands. In addition to this, investments in buildings are also an attractive method of investments. However, the economic life time of buildings is limited and it is a depreciable asset in nature.
Moveable assets
Another investment option available is to invest in moveable properties. Moveable assets are the assets which are not fixed to a fixed asset and physically moveable in nature. Investment on gold jewelery is another attractive method of investment due to following reasons.

• The increasing price movement pattern
• The ability to sell/pawn them any time and to convert into cash

In addition to gold jewelery , investments are also made in precious stones such as diamonds, gems and other antique assets.

Types of formal investment

Some types of formal investment are as follows.

• Deposits
• Purchases of assets
• Purchase of shares

Deposits
Deposits are accepted by the banks and other financial institutions registered in the Central Bank of Sri Lanka. This is a very popular form of investment among small scale investors. Financial institutions have introduced various types of deposit products with numerous other benefits built into deposits to attract
depositors. Some of these deposit products are as follows.
i. Savings Deposits
ii. Time/Fixed Deposits
iii. Certificates of Deposit

• Savings Deposits

Savings are made with the intention of earning an interest and to withdraw money as and when required. This is a very feasible form of investment to any scale of investor due to following reasons.

• It is comparatively easy to open a savings account
• Deposits can be made at any time during the working hours
• Convenient physical arrangements made by the financial institutions

Example : - Post offices
                  School Co-operative societies and other school banks
                  Co-operative Rural Banks
                  Commercial Banks
                  Non banking other financial institutions

• ¯ Ability to withdraw funds anytime

Time/Fixed Deposits
A fixed amount will be invested at a fixed rate over a fixed term and this is called a fixed deposit. If the fixed deposit is withdrawn before the maturity date, the agreed interest might not be paid. Interest may be withdrawn before the maturity of the fixed deposit in frequencies such as monthly, quarterly, bi annually and annually or may be withdrawn fully at the maturity together with the capital amount. The interest
rates will vary according to the tenor and the value of the deposit. The following benefits can be enjoyed in investing in fixed deposits.

• Receiving the interest at the end of the term at the agreed rate
• A higher interest than savings will be paid on fixed deposits
• The longer the tenure of the deposit, the higher the interest rate on the deposit

Certificate of Deposits (CDs)
Certificate of deposits can be made over a fixed term at a bank or at another financial institution. CDs will also earn a higher interest than savings and the tenor of CDs are generally one year. In addition to the interest, various other gifts will be given to depositors on drawings.

Evaluation of different modes of investment

Organizations have to carry out their business activities in a very dynamic and complex environment. At the same time, the opportunities available for investments are numerous and wide. Placing excess funds available with individuals and organizations in various instruments with the intention of earning income can be defined as an investment. One mode of classifying the investments is the tenure of the investment. Therefore,
investments can be categorized as follows considering the tenure or maturity.

• Short term investments
• Long term investments

Short term investments are the investments with maturity period less than one year. Other investments that have a maturity period of more than one year are categorized as long term investments.

Another method of classifying investments is the legal form of investments. Accordingly,
investments can be categorized considering its legal form as follows.

• Formal investments
• Informal investments

In the following sections, we will be focusing more on the formal methods of investments. This does not mean that informal types of investments are not popular among investors. Investment methods that do not have an acceptable legal basis can be grouped as informal methods of investments. Investing in Seettu, deposits made at different places expecting higher interest rates are few examples of informal types of investments. The absence of legal acceptance and the potential risk of defaulting are the key factors to be considered before deciding in investing in informal methods of investments.
In contrast, the formal methods of investments are carried out by organizations with acceptable legal basis and are effectively monitored by another Government regulatory body.
At present, investors tend to make investments in the formal methods of investments
due to following reasons.

• Acceptable legal basis
• Low risk of default the capital deposited
• Low risk of default the interest due
• Other non-financial benefits

Varoius avenues of investment

 

Selection of financial sources 2

• Ability to repay

It is required to be vigilant about the movements and patterns of the cash flow of the company. Therefore, the income earned on operating activities that are funded by the borrowed funds should be adequate to meet capital and interest repayments on time. Failure to do so will cause numerous problems to the organization.

• Costs of financing

Various costs have to be incurred from initial stage of fund raising to the final repayment. Few of these costs are costs on documentations, advertising, legal fees, stamp charges etc. In addition to these costs, the borrower has to meet capital, interest/dividend repayments periodically on time depending on the
types of the borrowing. Therefore, it is essential to analyze the costs and benefits of financing a particular financial requirement.

• The nature of the business organization

All the financing sources are not accessible to all the types of business organizations. For example, a sole proprietor and a partnership cannot raise funds by issuing ordinary shares to the public. Therefore, an organization should always select the best and the authorized sources to fund its financial requirements
without going for easily accessible unauthorized sources of financing.

• Period of time given to repay

Certain funding should be repaid within one year whilst some other funding allows them along period of time to repay. If the repayable time is shorter the monthly installment of paying back is higher. Then a considerable amount of the income has to be paid back as installments. It may be a hindrance to the improvement and existence of a business. If the repayable time is longer such inconveniences may not occur.

• The nature of the business activities

When funding, it is essential to understand the nature of the business that the company carries out. For example, the source of funds available for a grocery shop owner may not be appropriate for a wholesale dealer mainly due to the differences in their nature of the business.  

Accordingly, the optimum source of funding for the organisation should be selected after careful evaluation of the various factors affecting the decision. This provides much comfort, profitability and liquidity conditions for the organisation.

Selection of financial sources 1

In selecting the best method of financing for an organization, the following factors should be considered. It is important to select the most economical and appropriate source of financing.Therefore let us consider some important factors in selecting sources of financing.

• The nature of the requirement 

• Costs of financing

• Collateral requirements 

• The nature of the business organization

• Terms and conditions imposed 

• Tenure of the facility on the borrower

• Flexibilities in obtaining the facility

• The nature of the business activities

• Ability to repay

 

•  The nature of the requirement

It is required to identify the exact requirement that is to be financed. Short term financial requirements should be financed by short term means whilst long term financial requirements are financed from long term means.

• Collateral requirements

It is required to produce securities/ collateral in obtaining loans specially from banks and other private sector institutions. Generally, the most of securities are lands, buildings and other types of fixed assets. The ability to produce acceptable securities will enhance the ability to meet financial requirements.

• Terms and conditions imposed on the borrower

Lending institutions will impose different terms and conditions on the operations of the business. Sometimes, the lending institution can order the borrower to cease the use of the mortgaged property and recover the loan if the borrower defaults in paying interest and/or capital on time. In addition to this, the lending
institution can charge a penal rate on defaults or delays in meeting these requirements.

• Flexibilities in obtaining the facility

The documentation requirements and the processes that the borrower has to go through in obtaining the loan is also an important factor to be considered. In this process, it is required to produce various documents, guarantees etc. The time taken for these activities varies from one lending institution to another.

Evaluation of financial sources 2

Issuing shares
Shares are issued by the limited companies as the main source of capital. The capital of the company will be divided into number of small units and will be sold the ownership of the company to the persons who purchase the shares.
Shares issued by a company can be classified into two broad categories such as
ordinary shares and preference shares.
Ordinary shares
Ordinary shares are issued without specifying a particular dividend payout percentage. Dividends will be declared based on the annual operational profit of the company. Ordinary share capital is a form of long term capital. (equity share capital)
Preference shares
Preference shares are issued specifying the dividend payout percentage. As a source of finance, the issue of ordinary shares will give the following benefits to the business.

• The ability to raise more funds

            Limited liability companies can invite the general public to subscribe for share
            issues and thereby raise higher amount of capital.

• Long term nature of the capital

            Share capital can be retained until the liquidation of the company as it is paid out at last.

•  No interest is paid

           Interest is not paid for capital raised by issuing ordinary shares. Although
          dividend is paid, it is subject to the operational performances of the company.
          Therefore, there is no committed cost of capital as other loans.

• Enhances the transparency of business operations

          It is legally required to publish financial information of the limited liability
          companies as at stipulated period of time by different statutes. Since the financial
          information is published periodically and they are subject to audit, the investor
          awareness of these companies is comparatively higher than other companies.

Accordingly, by evaluating different financial sources, it is possible to identify the most appropriate and economical source of financing for the company.

Evaluation of financial sources

As discussed, the business organizations can finance their financial requirements from various sources of finance. Each of these sources should be carefully evaluated before selecting as the source of finance.
Bank loans
Bank loans are a formal type of sources of funding. The bank may impose certain terms and conditions on the borrower to make sure that the loan is repaid promptly. Bank loans can be obtained comparatively at low rates. The bank will charge different interest rates from different borrowers considering their financial stability, nature of the business and other factors that the bank may consider important. In certain instances, the bank will grant loans on less condition considering the economic priorities of the country. Accordingly, bank loans are considered as a reliable source of finance.
Selling properties/renting out/pawning
A business organization can use its own properties to fund different requirements. If there are excess or unutilized assets, the company can sell them out or rent/ lease them out and fund the requirements. This method of financing enables the organization to meet the financial requirements at low cost and comparatively
easily since the company uses some existing assets.
Personal loans
This is one of the informal methods of financing. Although personal loans are subject to higher interest rates, the ability to obtain loans with less documentation requirements and with no guarantors, these loans are
comparatively an attractive method of financing.

Sources of finance

Various financial requirements of an organization are funded by different sources of finance. Accordingly,
i. Long term investments can be financed by long term sources
ii.Short term investments can be financed by short term sources
Therefore, it signifies that there is a relationship between the term of the investment and the term of the sources of financing.

Identifying the source of finance according to the nature of the
organisation
There are different forms of business organisations. Whilst some organisations have access to wide range of sources of financing, other organisations may find it difficult to finance their requirements. The higher the access to different sources of financing the higher the growth potential of the organisation.

Sole proprietorship
Savings of the proprietor, pooled money from family members and close relations
are the key sources of financing of a sole proprietor. Most of these funds are
interest free. Sole proprietor has the access to the personal loans, banking loans
and overdraft facilities too.
Partnerships
The main source of finance is the capital invested by partners of the partnership. The capital invested by different partners is agreed at the time of formation of the partnership. In addition to the capital invested, the partnership can also borrow funds from its partners. Partnerships also have the access to banking and other
financial system and obtain loans. Thus you will be able to understand that partnerships have comparatively more ability to find source of finance than sole proprietorships.
Limited liability companies/Listed companies
Limited companies have access to a wide range of sources of funding than other forms of business organizations. They can
¯ Issue shares
¯ Issue debentures
¯ Obtain mortgaged loans
¯ Obtain Bank loans
¯ Obtain loans from non banking corporative sector
¯ Enter into leasing and Hire purchase contracts etc
Co-operative societies
Membership fees paid by the members of the society are the main source of funds of the co-operative societies. In addition to member fees, they have the access to bank loans, corporate loans and Government grants.
Public enterprises
The businesses which are maintained and controlled by the Government, provincial councils, local authorities and other Government institutions fall into public enterprise category. The main source of finance of public enterprise is the Government grants. In addition to this, certain local public enterprises have been permitted to issue shares to the public for its financial requirements.

Financial requirements of business organisations

At present, people have complex needs and wants. In this context, it is important to study the various market conditions and identify different business opportunities available. Selection of sources of finance for an organization and invest them profitably should be carefully decided. In this section, we will identify various types of financial requirements of an organization.

i. Initial capital requirements
   It is required to buy assets and incur certain expenditures when starting up a new business.
   Therefore, funds  are required to finance initial capital requirements of a company for
    properties,equipment, furniture, buildings etc.
ii. Business expansion requirements
     Funds are also required for business expansion activities. The company may require opening
     of new  departments or branches for which the company has to invest in more equipment,
      furniture, buildings etc.
iii. Acquisition of other businesses
     Funds may also be required in financing acquisition of another operating business as a strategic
      move. For example, a furniture shop owner may acquire a carpentry workshop. This will help
      him in supplying materials, opening another sales outlet etc.
In addition to the above mentioned basic needs, following requirements too, play an important role.

• To carry out day-to-day activities

                 Example : ¤ For purchasing stocks
                 For Sundry expenses

• To face unexpected incidents

              Example : ¤ Getting unexpected orders
              Bad debts

It is clear that a business organization may find different types of financial requirements in carrying out its business operations. On the other hand, there can be different types of investment objectives also.
Accordingly, the financial requirements of an organization can be discussed under two main categories based on time.
01. Financial requirements to meet long term investment opportunities
      Long term financial requirements are to invest in assets which are long term in
      nature such as acquisition of lands, buildings, properties etc. These are called
      long term financial requirements.
02. Financial requirements to meet short term investment opportunities Short term financial
       requirements are to meet financial requirements of carrying
       out day-to-day activities such as paying salaries and wages, insurance premium,
       traveling charges, electricity, taxes, settling trade debts etc.
The above financial requirements may vary from organization to organization depending on their nature and size of the organization. For example, there can be more short term financial requirements for a grocery shop whilst there can be more demand for long term financial requirements for a construction company.