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MODULE 4 UNIT 1 LESSON

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Finance for operations
Explore financial statements and budgets from an operations point of view.

Introduction
There are three financial statements that explain where money for an operation came from,
where it went, and where it is now. Examine each statement and discover the most relevant
line items for operational decision-making.

Balance sheet
This is a snapshot of an organisation’s financial position at a specific period (Bamber & Parry,
2021; Berk & DeMarzo, 2020:60). Also called a statement of financial position, it is a summary
of an organisation’s assets and liabilities and is usually set up like the accounting equation:

Assets = Liabilities + Equity

Often, two years of data are provided for comparison purposes.

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 OM Production Company
Balance sheet
As on 31 March 2021
Rands '000
Assets 2021
Current assets
Cash and cash equivalents 86700
Accounts receivable 420750
Inventory 306000
Prepaid expenses 8500
Short-term investments 85000
Total current assets 906,950

Fixed (long-term) assets

Long-term investments
Property, plant, and equipment 3145850
Intangible assets 2592500
Total fixed assets 5,738,350

Other assets
Deferred income tax
Other 40800
Total other assets 40,800

Total assets 6,686,100

Liabilities and owner's equity 2021
Current liabilities
Accounts payable 198900
Short-term loans 42500
Income taxes payable 51850
Accrued salaries and wages 72250
Current portion of long-term debt 127500
Total current liabilities 493,000

Long-term liabilities
Long-term debt 2881500
Deferred income tax 212500
Other 76500
Total long-term liabilities 3,170,500

Other liabilities
Owner's investment 935000
Retained earnings 2040850
Other 46750
Total other liabilities 3,022,600

Total liabilities and owner's equity 6,686,100

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 • Assets: The assets side of the balance sheet summarises how an organisation uses
(i.e. invests) its capital. Assets represent resources that are owned or controlled by an
organisation.

• Current assets: These are the cash or items, such as stock inventory and cash
equivalents, that can be converted into cash within 12 months.

• Inventory: This relates to raw materials, works in progress, and finished goods.

• Fixed (long-term) assets: These are long-term assets that an organisation owns, such
as machinery and office furniture, which produce tangible benefits for longer than 12
months.

• Property, plant, and equipment: These are tangible, fixed assets that are not easily
converted to cash and are vital to an organisation’s production process. Purchasing
new plant and machinery is costly, and resources may only be available at lengthy
intervals. As such, plant replacement decisions are unlikely to be repeated in the short
term (Drury, 2018:171). This value is important because it informs the fixed costs of
production.

• Liabilities and owners equity: The liabilities side of the balance sheet summarises how
an organisation raises the capital it needs. Liabilities are what an organisation owes
to creditors, such as bills, loans, and outstanding salaries, while owner’s equity is what
an organisation must pay back to the owners (Berk & DeMarzo, 2020:61).

• Accrued salaries and wages: This amount is due in fewer than 12 months and is
therefore a current liability. It reflects amounts outstanding to staff for which cash
flow will be needed.

Income statement
This is a report showing how much an organisation earned over a specific period (usually 12
months). It also shows the costs and expenses associated with earning that income. When
costs and expenses are subtracted from revenue, it results in the literal “bottom line” of the
statement. This shows whether an organisation has made a profit or a loss over the period.

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 OM Production Company
Income statement
Year ended 31 March
Rands '000
2021
Sales revenue 13,770,000
Cost of goods sold (8,262,000)
Gross profit 5,508,000

Other revenue 0

Advertising (425,00)
Bad debt (17,000)
Commissions 0
Depreciation (7,140)
Employee benefits (255,000)
Insurance (34,000)
Interest expense (204,000)
Maintenance and repairs (466,290)
Office supplies (85,000)
Rent (408,000)
Salaries and wages (1,700,000)
Software 0
Travel (204,000)
Utilities (119,000)
Web hosting and domains (8,500)
Other 0

Earning before interest and taxes (EBIT) 1,957,570

Interest income/(expense) -
Income before tax 1,957,570

Income tax expense 0

Net income 1,957,570

• Sales revenue: This is the income received from selling the goods and services on
offer.

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 • Cost of goods sold: This amount is often shown as a summarised line item. However,
operations managers will want to know the breakdown of the expenses directly
associated with production: the cost of direct materials used in production, direct
labour (such as professional services), and direct overhead (relevant to the production
of the goods or services).

• Gross profit: This is determined by subtracting the direct costs of production from
sales revenues. This amount is of particular importance to operations managers
because, in a way, it is a financial representation of the operations function’s efforts.

• Other: These are all other financial outlays that are necessary to the overall
functioning of the business, but are not directly related to production.

• Net income: This is the bottom line of the income statement after all expenses and
taxes have been subtracted from revenues. If net income is positive, an organisation
has made a profit and can be considered viable. If it is negative, there are concerns
that managers will have to address if the organisation is to continue operating over
the long term. When net income is zero, the organisation is said to break even.

Cash flow statement

This reports the movement of cash in and out of an organisation. While the income statement
indicates whether an organisation made a profit, a cash flow statement indicates whether the
organisation generated cash. This is important because an organisation must have enough
cash to pay expenses and purchase assets.

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 OM Production Company
Cash flow statement
Year ended 31 March
Rands '000
2021
Operating activities
Net income 1,957,570
Depreciation and amortisation 7,140
Other non-cash items 17,000
Cash effect of changes in:
Accounts receivable (173,400)
Accounts payable (1,648,150)
Inventory (85,000)
Other net operating assets
Cash from operating activities 75,160

Investing activities
Capital expenditures 85,000
Acquisitions and other investing activity
Cash from investing activities 85,000

Financing activities
Dividends paid 0
Sale/(purchase) of stock 4,250
Increase in borrowing 0
Cash from financing activities 4,250

Change in cash and cash equivalents 164,410

• Cash from operating activities: The operating activities section is an analysis of cash
flow from net income or losses. It also reconciles the net income from the income
statement with the actual cash an organisation received from its operating activities.
To do this, net income is adjusted for any non-cash items (like adding back
depreciation) and for any cash that was used or provided by other operating assets.
Cash from operating activities represents operating liquidity for an organisation after
paying necessary expenses for financing and tax.

• Investing activities: This includes purchasing property, plant, and equipment, which
is shown as a cash outflow. If a company sells off some investments, then that will
appear as a cash inflow.

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 • Financing activities: Any short-term financing raised through the bank, or by selling
stocks or bonds, will appear here as a cash inflow. However, paying back a loan will
appear as a cash outflow. Operations frequently use short-term financing activities to
keep processes going.

Budget
The budget is formatted similarly to the income statement. Managers formulate the budget
using the information from the income statement along with a cost analysis of anticipated
steps to meet long-term goals (Drury, 2018:374). This is a master budget: a composite of many
smaller budgets compiled by each department in an organisation.

Budgets are documents for internal use, unlike the financial statements, which are publicly
available to external stakeholders.

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 OM Production Company
2021 Budget
Rands '000
Income Budget
Operating income
Quarter 1 884860.2
Quarter 2 1474767
Quarter 3 1651739.04
Quarter 4 1887701.76
Other 0

Non-operating income
Interest income 0
Rental income 0
Other 0

Total income 5,899,068.00

Expenses
Operating expenses
Accounting fees (23576)
Legal fees (4182)
Advertising (45518)
Bad debt (18207)
Commissions 0
Depreciation (7647)
Employee benefits (273105)
Insurance (36414)
Interest expense (218484)
Maintenance and repairs (499397)
Office supplies (91035)
Rent (436968)
Salaries and wages (1820700)
Software 0
Travel (218484)
Utilities (127449)
Web hosting and domains (9104)
Other 0

Non-operating expenses
Other 0

Total expenses (3,830,269)

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Conclusion
Understanding the financial statements and how they align with the budget is the foundation
of financial analysis. Operations managers can use financial analysis to:

• Gain an overview of the financial well-being of an operation;

• Assess whether there is cash on hand to carry out processes; and

• Use the income statement as a starting point for budgeting.

References
Bamber, M. & Parry, S. 2021. Accounting and finance for managers: a business decision-
making approach. 3rd ed. London: Kogan Page. Available: Perlego.

Berk, J. & DeMarzo, P. 2020. Corporate finance. 5th ed. United Kingdom: Pearson Education
Limited.

Drury, C. 2018. Management and cost accounting. 10th ed. United Kingdom: Cengage Learning
EMEA.

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