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Understanding The Language Of Finance

This article will take you through the maize of financial jargons and show you how income is calculated by finance experts to help you better understand your financial statements. This is a resource for non financial managers. I start of with very simple questions. What is income? How is it calculated? Very often, non financial managers and experts make the mistake of calculating income as the amount of cash received, totally oblivious to credit sales. This is not correct because strictly speaking income  is related to services or products that are delivered and accepted by customers without any dispute in return for a fee. As long as the services or products have been delivered in line with the requirements agreed between the two parties and the customer accepts the goods and services thereby accepting liability to make payment immediately or sometime in the near future, income has materialise.  So the key to determining what is income can be summed up as  delivery of goods and services by the supplying organisation and acceptance by the buying organisation. When these two activities have occurred, cash need not be paid by the buying organisation or individual to determine income. Cash may be paid immediately or not as the case may be where the supplying organisation  offers credit for 30 days (shorter or longer).  Another important point to note is when the activity takes place. This determines the period the income arise. In short, if the activity takes place in 2011 and buyer make payment the following year, the income is accounted for in 2011 not the date the cash was received in relation to the transaction. Use this as a generic approach to guide you and you will always get it right.

It is important to note that what constitutes income for an organisation is very much dependent on the nature of the business. For commercial profit making organisations, income will be the sale value of services or products in money's worth. For public sector or voluntary organisations (such as charities), income will mainly be the sum total of fees, grants and voluntary donations received during the year as well as the value of any services or products sold in money's worth. In the case of the governmental accounts, income will be mainly derived from revenue collected through tax assessments and other levies paid by individuals and businesses.

The size of an organisation's income is dependent on a number of factors:

Commercial profit making businesses

- The size of the market the business operates (i.e. the number of people and/or businesses who need the products or services of the organisation and have the means to pay for them).

- The size of the business clients or customer base in relation to the overall market size - as defined in the previous point. This represents the demand for the business' services or products.

- The price customers are charged for products or services. It is important to note that the price customers are charged will be influenced by the costs of producing the products, the business' profit margin policy (i.e. how much profit is required), the quality of the products relative to products from competitors and the intensity of competition in the market.

Profit margin is simply the difference between the selling price and the cost of producing the goods or services sold.

Non commercial not for profit businesses

- The range and level of services provided

- The importance of the organisation's services or products as perceived by governmental bodies and other funders.

- The financial resources of funders/ governmental bodies giving grants, relative to the demands on their funds.

- In the case of services or products being sold in return for money consideration, the amount customers are willing and able to pay, the number of customers and any regulatory restrictions placed on the organization.

The government

- The amount of revenue generated from taxation and other levies imposed on individuals and businesses.

The amount generated will depend on the tax rates, size of business profits and individual earnings/profits, government economic policies, as well as the number of taxes and efficacy of the tax system.

Having a good understanding of the relationships between the factors that determine the size of a business income goes a long way in helping users of financial statements to analyse the financial performance of the business.

Let us now look at a few examples to strengthen our understanding of income determination for the purpose of the financial statement.

Example 1- Illustrates how a private restaurant will determine its income

A restaurant provides a range of meals to customers. Customers can either buy their meals and eat in the restaurant or take their meals home. The restaurant charges a fixed price for eating in or take away meals. During the course of the year, the restaurant sells 200,000 meals at an average price of ?10 per meal. Assuming all meals were sold on a cash basis (i.e. no credit was given to any customer), the income of the restaurant is simply:

No of meals sold multiply by the average price per meal.

This is 10 x 200,000 = 2,000,000

Let us look at another example involving credit and cash sales

Example 2

Suppose the restaurant in example 1 sold 100,000 in cash and the remainder 100,000 on credit at an average price of 10 per meal. Suppose its accounting year is 1st January to 31st December. At the end of the financial year (i.e. 31st December), although the restaurant sold all 200,000 meals, only 100,000 meals were paid for fully. 100,000 meals valuing 100,000 still remains unpaid.

The total income of the restaurant is still the total meals sold (200,000) multiply by the average selling price of ?10 per meal.

Notice nothing has changed as far as the total income calculation is concerned

Looking at both examples, the total income is not restricted to services or products that customers actually paid for. The total income is the value of the services or products sold during the financial year for which the financial statement is prepared. This is an area that sometimes confuses non-financial experts, as they sometimes feel the income should be restricted to the cash received for services provided during the year.  This is not the case when preparing the profit and loss accounts or income and expenditure accounts.

In preparing financial statements, accountants are guided by a principle known as the accrual principle. There is no need to be confused or worried about this term.

It simply means that the value of all services or products provided to customers should be accounted for in the financial year they occur. Similarly, the value of all services or products received from suppliers must be accounted for in the financial year they occur regardless of whether the business has paid for them or not.

Let us now turn our attention to the non-commercial /not for profit businesses. We have already seen that the income of this type of business can vary considerably. Income sources can include grants, donations from the public, legacy from supporters, fundraising income, and sale of second hand products or gifts.

The nature of the main income source tends to be voluntary. As a result the amounts pledged cannot be demanded if not paid. For instance, if a supporter pledges 5,000 and fails to pay the pledge, the organisation cannot demand the payment as in the case of a commercial business that provides services in return for cash consideration. For that reason, income is normally limited to actual cash received during the course of the year except where there is a contractual agreement, with a governmental body or a reputable organisation, to provide services in return for grants. In such cases, the grant donors will put in place systems of accountability that will ensure that the voluntary organisation provides the level and quality of services it expects for the market concerned. Where such an arrangement exists, then income will be determined on an accrual basis. This implies, the value of the grants for the contracted services delivered during the year will be quantified and recorded as income irrespective of whether the grants have been paid or not.

I do hope this article has helped you understand how income is calculated and how to  interpret income in financial statements.Attending training courses such as Finance For Non Financial Managers delivered by organisations like ours can help you quickly learn the tools of the game and apply the skills correctly within your organisation. To find out more about how we can assist you, visit us at 

http://www.businessservicessupport.com/training-courses/finance-for-non-finance-managers.html



 

MD Business Services Support Limited

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