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• Module overview
• 1. Introduction to budgets
  • 1.1 Introduction to the Budget Process
  • 1.2 Budget types
    • 1.2.1 The Budget Guidelines
    • 1.2.2 The Sales Budget
    • 1.2.3 Budget for Operating Expenses
    • 1.2.4 Profit Budget
    • 1.2.5 Cash-Flow Budget
    • 1.2.6 The Financial Position Budget
    • 1.2.7 Additional Types of Budgets
    • 1.2.8 Additional Budgeting Techniques
  • 1.3 The budget process and its objectives
  • 1.4 Budgets for performance management
    • 1.4.1 Master budget

• 2. Planning the budget

  • 2.1 Planning the Budget
    • 2.1.1 Business income
    • 2.1.2 Visual representation of sales and budgets
    • 2.1.3 The break-even point
    • 2.1.4 Contribution margin

• 3. Controlling the budget

  • 3.1 Controlling budgets
    • 3.1.1 Variance analysis
    • 3.1.2 Taking action to achieve the objectives of the budget
    • 3.1.3 Resource acquisition and usage

• 4. Introduction to Financial Management

  • 4.1 Business Objectives
    • 4.1.1 Maximising profit
    • 4.1.2 Maximising wealth
  • 4.2 Ethics and conflicts in business
    • 4.2.1 The dilemma of ethics in finance, investment and accounting
  • 4.3 Financial Managers
    • 4.3.1 Financial information and objectives
    • 4.3.2 Accounting, the financial information system
  • 4.4 The finance function
    • 4.4.1 Business and financial calculations

• 5. Elements of Business and Financial Management

  • 5.1 Business Structures
    • 5.1.1 Sole proprietors
    • 5.1.2 Partnerships
    • 5.1.3 Corporations and companies
  • 5.2 Reporting financial data and information
  • 5.3 Financial reports
    • 5.3.1 Statement of financial performance (profit and loss statement)
  • 5.4 Capital Markets
    • 5.4.1 Capital Markets
  • 5.5 Regulation and financial institutions
    • 5.5.1 Interest rates, supply and demand and market efficiency
  • 5.6 An overview of taxation implications

• 6. Obtaining Funds: Sources of Long Term and Short Term Finance

  • 6.1 Finance from external sources
    • 6.1.1 Equity finance
  • 6.2 Debt
  • 6.3 Long-term debt
    • 6.3.1 Debentures and unsecured notes (bonds)
    • 6.3.2 Mortgage loans
  • 6.4 Hybrids of debt and equity
  • 6.5 Leasing
    • 6.5.1 Operating Lease
    • 6.5.2 Financial Lease
    • 6.5.3 Distinguishing between an operating lease and a financial lease
    • 6.5.4 Sale and Leaseback
    • 6.5.5 The issue of gearing
  • 6.6 Short-term debt
    • 6.6.1 Bank Overdrafts
    • 6.6.2 Fully drawn advance
  • 6.7 Retained Earnings, internal funds and depreciation

• 7. Managing Working Capital

  • 7.1 Managing current assets and current liabilities
    • 7.1.1 Appropriate level of working capital
  • 7.2 Managing inventories
    • 7.2.1 Reasons for holding inventories
    • 7.2.2 The economic order quantity (EOQ)
    • 7.2.3 Re-order point (ROP)
    • 7.3.4 Safety stock (SS)
    • 7.2.5 Quantity discounts
  • 7.3 Managing trade debtors (accounts receivable)
    • 7.3.1 Credit policies
    • 7.3.2 Collection period
    • 7.3.3 Managing cash and near-cash assets
    • 7.3.4 Managing trade creditors (accounts payable)

• 8. Job Costing

  • 8.1 Accounting information about product, service and project costs
    • 8.1.1 Full costing
    • 8.1.2 Single product/service line
    • 8.1.3 Multi product/service
    • 8.1.4 Direct and indirect costs
  • 8.2 How costs behave
    • 8.2.1 Allocating Overheads
  • 8.4 Cost drivers
    • 8.4.1 ABC and the service industry
  • 8.5 Conclusion

6.7 Retained Earnings, internal funds and depreciation

There are ways that companies can increase their financial resources or manage working capital items more efficiently without transacting with external parties, in both cases making cash and other assets available for particular activities. These processes are referred to as raising finance from internal sources . Figure 13.3 in Atrill, p451, summarises the internal sources available to financial managers:

This chapter explains retained profits as a source and chapter 7 deals with the management of the three working capital items.

As you know from Chapter 3, retained profits represent the portion of profits of the current and previous years that the directors have decided not to pay out in dividends (so the amount of retained profits is influenced directly by a company's dividend policy). In this sense shareholders are making extra involuntary investments . This is because:

• Profit is an increase in shareholders equity
• Profit is a concept and cannot be paid out, spent or invested
• Profit is represented by an increase in company assets (refer to the definition for revenue), but not necessarily cash
• Assets are the investments made by the providers of finance (in this case existing shareholders).

(If you understand the logic of these dot points and you will understand the next paragraph!).

It is sometimes rather loosely stated in management texts and business journals that 'retained profits are reinvested in the assets of the company' or that 'profits are ploughed back', thus giving management a reasonably cheap and easily accessible source of funds to finance growth. These 'internally generated funds' are easily accessible provided a company makes good profits, because directors can, within limits, choose dividend levels. They can choose to retain and use (reinvest) the resulting increase in company assets. The funds are also cheap because there are no costs involved in issuing more shares and no borrowing costs. What this really means is that the managers of profitable businesses have more assets to use in productive activities.

Most companies, especially large ones, expand their activities in this way to some degree.

Sometimes companies will convert part of retained profits into permanent share capital by issuing bonus shares to existing shareholders, free of any cash contribution (because the increase in assets from profit making has already been received). From a company viewpoint bonus shares have no effect on financing or investing activities (see textbook, pages 457-459).

Sometimes depreciation is also loosely spoken of as a 'source of internal funds'. You now know that depreciation expense is a 'book entry' that reduces the amount of non-current assets (in the position statement) and reduces profit (in the performance statement). There is no cash transaction or any other external transaction so depreciation is not a form or source of finance.

However, recording depreciation expense does have two important financial effects:

• It reduces the profit available for dividends and may reduce the cash outflow for dividend payments
• It reduces taxable income and the amount payable for income tax, which may also reduce cash outflows.

In this sense it is possible to argue that recording depreciation has a savings effect by reducing possible cash outflows, and that managers can use the cash 'saved' for other purposes. For large construction or mining companies the cash savings may be significant.

Text reading

Atrill, Mclaney, Harvey & Jenner, pages 451-452

Do Activity 13.8

To finish off this chapter read the Summary in Atrill, p460, and see whether you can answer the discussion questions 13.1, 13.2, 13.3, 13.11, 13.14, 13.15 and 13.19 on pp460-461. If not, it means that you should re-read the relevant parts of the chapter.

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