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The Circular Flow of Income

Business organisations operate in an economic
environment which shapes, and is shaped by, their
activities.
economic activity is concerned with flows of
resources, output, income and expenditure.
a model of the circular flow of income illustrates
the central relationship between households and
firms in the operation of a market based
economy.

The circular flow of goods and incomes

Firms
Injections:
Government spending (G)
Exports (X)
Investment (I)

Factors of
production
Land
Labour
Capital

Rent
Wages
Interest/Profit

Consumer
expenditure (C)

Leakages:
Tax (T)
Imports (M)
Savings (S)

Aggregate Monetary Demand

AMD = C + I + G + X - M

Goods &
Services

Households

Free Market Economy

Advantages:
Efficiency in utilising scarce resources to meet consumers demands
for goods and services.
Efficiency in: Production, Distribution, Allocation, Product
development & technology.
Disadvantages:
Public and Merit goods may be underprovided
Inequalities
Competition may break down
Competition may lead to inefficiency
Power of advertising
Price mechanism may function slowly
Externalities
Unemployed resources

Mixed Economies Why do governments get involved?

Economists call it Market Failure
Unwillingness of the market to produce public goods:
Defence, Social Services, Infrastructure
Under provision of Merit goods Education, libraries
Externalities pollution, congestion
Monopoly OFCOM, OFSTED, OFGEM, OFWAT
Ability to pay is the key determinant not need or
equality
Under-utilisation of resources promotion of
technology, economic regeneration

Main Macro Objectives

Governments have five main macro objectives:

Controlling Inflation
Economic Growth
Reducing Unemployment
Favourable Balance of Payments
Controlled Public Borrowing

The Business Cycle

Output of
UK
Businesses

Time

What does PESTLE stand for:

Political
Economic
Social
Technological
--------------------------Legal
Ecological or Ethical?

DEMAND
The relationship between demand and price for normal good
The law of demand states:
As the price of a product increases, a lower quantity will be
demanded; likewise, as the price of a product decreases, a
higher quantity will be demanded.
the substitution effect: (Negative effect)
As the price of a good goes up alternatives to this good
seem more attractive and so people buy less of this good
the income effect: (Negative affect)
As the price of a good rises so the amount of income of a
purchaser will decrease and so they will buy less

DEMAND
Other determinants of demand
tastes
number and price of substitute goods
number and price of complementary goods
disposable income (concept of normal and
inferior goods).
expectations of future price changes

Demand
P

P2

P1

D
O

Q2

Q1

SUPPLY
The relationship between supply and price
The law of supply: all other factors being equal,
as the price of a good or service increases, the
quantity of goods or services offered by suppliers
increases and vice versa.
This is why why supply curves generally slope
upwards

Supply
S

P1

P2

Q2

Q1

Other determinants of supply

The costs of production
Main reasons include changes in:
-input prices, technology, organisation and
government policy.
Profitability of alternative products (substitutes in
supply)
Nature, random shocks & other unpredictable
events.
The aims of producers
Expectations of future price changes
The number of suppliers

Features of the four market structures

Understanding the industry-specific environment

Porters Five Forces

Competitive Rivalry
Threat of New Entrants
Supplier Power
Buyer Power
Threat of Substitutes

Four main forms of Business

Sole traders

Partnerships

Private limited company (Ltd)

Public limited company (plc)

Management and financial accounting compared

Management accounting
Nature of the
reports produced
Level of detail
Regulations
Reporting
interval

Time horizon

Range and quality

of information

Financial accounting

Tend to be specific purpose

Tend to be general purpose

Often very detailed

Usually broad overview

Unregulated

Subject to accounting
regulation

As short as required
by managers

Usually annual or bi-annual

Uses projected future

information as well as past
information

Almost always historical

Contains financial and nonfinancial information. Uses

information that cannot be
verified

Focus on financial
information. Emphasis on
objective, verifiable
evidence

Statement of Financial Position

(Balance Sheet)
A snapshot
Shows assets and liabilities
Assets

= what is owned

Liabilities = what is owed

Shows capital and reserves

Capital

= owners investment (equity)

Reserves = profit retained from previous period

Session 2 - Financial Statements

Statement of Financial Position

(Balance Sheet)

Net Assets = Total Equity

what is owned = how is it paid for

NB: Net assets = Fixed assets + current assets current liabilitie

Session 2 - Financial Statements

Statement of Financial Position

Assets
Non-Current (Fixed) Assets
Used in the conduct of the business
Tangible Non-Current (Fixed) Assets

Land, buildings, plant & machinery

Intangible Non-Current (Fixed) Assets

Invisible, difficult to value - intellectual property, brands, goodwill,

patents, licences

Can only go on the balance sheet if bought

Session 2 - Financial Statements

Statement of Financial Position

Assets
Current Assets
Used in the business for conversion into goods for sale

Cash and cash equivalents

Trade receivables (debtors)
Inventories (stock)
Raw materials, work in progress (WIP), finished goods

Session 2 - Financial Statements

Statement of Financial Position

Current Liabilities
Money due to be paid within 12 months
Trade payables (creditors)
payment owed to suppliers or government

Overdrafts
Tax

Session 2 - Financial Statements

Statement of Financial Position

Working Capital

= Current assets current liability

= The capital of a business that is used in its
day-to-day trading operations.

Session 2 - Financial Statements

Statement of Financial Position

Non-Current Liabilities
Money due to be paid beyond 12 months
Long-term loans, overdrafts and other borrowings > 1 year

Session 2 - Financial Statements

Statement of Financial Position

Total Shareholders Equity
Equal to the Net Assets
Share capital - shares sold to raise money
Share premium gain in value of shares over the sold price
Reserves retained earnings from yearly profits

Session 2 - Financial Statements

Depreciation
Straight line
Pat has bought a van for 25,000 which he expects to use
in his business for the next four years after which he
expects to sell it for 5000.

Session 2 - Financial Statements

Income Statement
(Profit & Loss Account)

A snap shot

Relates to performance over a defined period usually 1 year

Shows sales (or revenue or turnover)

Shows gross profit (or trading profit)

Sales minus the cost of sales (raw materials and labour)

Shows net profit (or operating profit)

Gross profit minus the cost of running the company (wages, salaries, rent and
utilities, etc.)

Shows profit after financing costs, interest and tax

Shows how much is paid to shareholders (dividends) and how much is kept in
the business for future investment (retained profit/reserves)

Session 2 - Financial Statements

The layout of the Income Statement

Sales revenue
less

Cost of sales
equals

Gross profit
less

Operating expenses
equals

Operating profit
less

Interest payable
plus

Interest receivable
equals

Profit for the period

Session 2 - Financial Statements

Terminology

Current UK term
Balance sheet:
Bank and cash:
Interest payable:
Interest receivable:
Profit and Loss Account:
Debtors:
Creditors
Fixed assets
Long-term liabilities
Stock

International term
Statement of Financial Position
Cash and cash equivalents
Finance costs
Investment revenues
Income statement
Trade Receivables
Trade Payables
Non-current assets
Non-current liabilities
Inventory

Ratios benchmarks

Ratios may be compared with:

Past periods

Similar businesses

Planned performance

Profitability ratios
Return on capital employed
Operating or Net profit
Equity + Non-current liabilities

Operating profit margin

Operating or Net profit
Sales revenue 100

Gross profit margin

Gross profit
100
Sales revenue

100

Efficiency ratios
Formula
Inventories turnover
period

Inventories
Cost of sales

Settlement period for

receivables (days)

Trade receivables

Settlement period for

payables (days)

x 365
x 365

Sales revenue
Trade payables
x 365
Credit purchases

Liquidity ratios

Formula

Current ratio

Current assets
Current liabilities

Acid test ratio

Current assets (excluding inventories)

Current liabilities

Gearing ratio

Formula

Gearing
ratio

Non-Current (Long-term) liabilities

Capital Employed ie
(Total Equity+ Non-Current (Long-term) liabilities)

100

Investment ratios
Formula

Dividend yield ratio

Earnings per share

Price/earnings ratio
(P/E)

Dividend per share

Market value per share

Earnings available to ordinary shareholders

Number of ordinary shares in issue

Market value per share

Earnings per share

Limitations of ratio analysis

Quality of financial statements

Inflation

Over reliance on ratios

The basis for comparison

Statement of financial position
ratios

KEY RATIOS
ROCE
GROSS Profit Margin
NET Profit Margin
Acid Test
Gearing
Receivable days
Dividend Yield

Investment appraisal methods

Four methods of
evaluation

Payback period (PP)

Accounting/Average rate
of return (ARR)
Net present value
(NPV)
Internal rate of return
(IRR)

Payback period (PP)

Payback period
(PP)

The payback period is the

length of time it takes for
the initial investment to be
repaid out of the net cash
inflows from the project.

Peter Atrill & Eddie McLaney, Accounting and Finance for Non-Specialists, 5th Edition Pearson Education Limited 2006

43

Accounting/ROI/Average rate of return

(ARR)

ARR =

Average annual profit

x100%

Average investment to earn that profit

44

ARR - attributes
Advantages
Considers levels of profit
Offers easy comparison
If a project exceeds the firms required ARR the
project can go ahead
Disadvantages
Ignores the timing of receipts

45
Session 5 Investment Decisions

45

Which discount factor?

Cost of capital (borrowing) to the
firm
Firms investment criteria:
maybe15% profit
Reflects inflation
Reflects risk
46
Lecture 5 Investment Decisions

The main investment appraisal methods

Investment appraisal methods

Discounted
cash flow methods

Net
present
value

Internal
rate
of return

Non-discounted
cash flow methods

Accounting
rate
of return

Payback
period

Why NPV is superior to ARR and

PP

NPV fully addresses each of the following:

The timing of the cash flows

The whole of the relevant cash flows

The objectives of the business

Peter Atrill & Eddie McLaney, Accounting and Finance for Non-Specialists, 5th Edition Pearson Education Limited 2006

48