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Business - FINANCE-2
Business - FINANCE-2
Business - FINANCE-2
Finance is the money required in the business. Finance is needed to set up the business, expand it
and increase working capital (the day-to-day running expenses).
Start-up capital is the initial capital used in the business to buy fixed and current assets before it
can start trading.
Working Capital finance needed by a business to pay its day-to-day running expenses
Capital expenditure is the money spent on fixed assets (assets that will last for more than a year).
Eg: vehicles, machinery, buildings etc. These are long-term capital needs.
Revenue Expenditure, similar to working capital, is the money spent on day-to-day expenses which
does not involve the purchase of long-term assets. Eg: wages, rent. These are short-term capital
needs.
Sources of Finance
● Retained Profit: profit kept in the business after owners have been given their share of the
profit. Firms can invest this profit back in the businesses.
Advantages:
– Does not have to be repaid, unlike, a loan.
– No interest has to be paid
Disadvantages:
– A new business will not have retained profit
– Profits may be too low to finance
– Keeping more profits to be used as capital will reduce owner’s share of profit and they may
resist the decision.
● Sale of existing assets: assets that the business doesn’t need anymore, for example,
unused buildings or spare equipment can be sold to raise finance
Advantages:
– Makes better use of capital tied up in the business
– Does not become debt for the business, unlike a loan.
Disadvantages:
– Surplus assets will not be available with new businesses
– Takes time to sell the asset and the expected amount may not be gained for the asset
● Sale of inventories: sell of finished goods or unwanted components in inventory.
Advantage:
– Reduces costs of inventory holding
Disadvantage:
– If not enough inventory is kept, unexpected increase demand form customers cannot be
fulfilled
● Owner’s savings: For a sole trader and partnership, since they’re unincorporated (owners
and business is not separate), any finance the owner directly invests from hos own saving
will be internal finance.
Advantages:
– Will be available to the firm quickly
– No interest has to be paid.
Disadvantages:
– Increases the risk taken by the owners.
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Advantage:
Disadvantages:
Advantages:
Disadvantages:
Disadvantage:
Advantages:
Disadvantage:
○ The debt factor will get a percent of the debts collected as reward. Thus, the
business doesn’t get all of their debts
Grants and subsidies: government agencies and other external sources can give the
business a grant or subsidy
Advantage:
Disadvantage:
○ There are usually certain conditions to fulfil to get a grant. Example, to locate in
a particular under-developed area.
Micro-finance: special institutes are set up in poorly-developed countries where
financially-lacking people looking to start or expand small businesses can get small sums of
money. They provide all sorts of financial services
Crowdfunding: raises capital by asking small funds from a large pool of people, e.g. via
Kickstarter. These funds are voluntary ‘donations’ and don’t have to be return or paid a
dividend.
Short-term finance provides the working capital a business needs for its day-to-day operations.
● Overdrafts: similar to loans, the bank can arrange overdrafts by allowing businesses to
spend more than what is in their bank account. The overdraft will vary with each month,
based on how much extra money the business needs.
Advantages:
○ Flexible form of borrowing since overdrawn amounts can be varied each month
○ Interest has to be paid only on the amount overdrawn
○ Overdrafts are generally cheaper than loans in the long-term
Disadvantages:
○ Interest rates can vary periodically, unlike loans which have a fixed interest rate.
○ The bank can ask for the overdraft to be repaid at a short-notice.
Trade Credits: this is when a business delays paying suppliers for some time, improving
their cash position
Advantage:
Disadvantage:
○ If the payments are not made quickly, suppliers may refuse to give discounts in
the future or refuse to supply at all
Debt Factoring: (see above)
Long-term finance is the finance that is available for more than a year.
Advantage:
○ The firms doesn’t need a large sum of cash to acquire the asset
Disadvantage:
Advantages:
○ The firm doesn’t need a large sum of money to use the asset
○ The care and maintenance of the asset is done by the leasing company
Disadvantage:
○ The total costs of leasing the asset could finally end up being more than the
cost of purchasing the asset!
● Purpose: if a fixed asset is to be bought, hire purchase or leasing will be appropriate, but if
finance is needed to pay off rents and wages, debt factoring, overdrafts will be used.
● Time-period: for long-term uses of finance, loans, debenture and share issues are used, but
for a short period, overdrafts are more suitable.
● Amount needed: for large amounts, loans and share issues can be used. For smaller
amounts, overdrafts, sale of assets, debt factoring will be used.
● Legal form and size: only a limited company can issue shares and debentures. Small firms
have limited sourced of finances available to choose from
● Control: if limited companies issue too many shares, the current owners may lose control of
the business. They need to decide whether they would risk losing control for business
expansion.
● Risk- gearing: if business has existing loans, borrowing more capital can increase gearing-
risk of the business- as high interests have to be paid even when there is no profit, loans and
debentures need to be repaid etc. Banks and shareholders will be reluctant to invest in risky
businesses.
Finance from banks and shareholders
● A cash flow forecast is presented detailing why finance is needed and how it will be used
● An income statement from the last trading year and the forecast income statement for the
next year, to see how much profit the business makes and will make.
● Details of existing loans and sources of finance being used
● Evidence that a security/collateral is available with the business to reduce the bank’s risk of
lending
● A business plan is presented to explain clearly what the business hopes to achieve in the
future and why finance is important to these plans
● the company’s share prices are increasing- this is a good indicator of improving
performance
● dividends and profits are high
● the company has a good reputations and future growth plans
If a firm doesn’t have any cash to pay its workers, suppliers, landlord and government, the business
could go into liquidation– selling everything it owns to pay its debts. The business needs to have an
adequate amount of cash to be able to pay for all its short-term payments.
Cash Flow
The cash flow of a businesses is its cash inflows and cash outflows over a period of time.
Cash inflows are the sums of money received by the business over a period of time. E.g.:
Cash outflows are the sums of money paid out by the business over a period of time. Eg:
● purchasing goods and materials for cash
● paying wages, salaries and other expenses in cash
● purchasing fixed assets
● repaying loans (cash is going out of the business)
● by paying creditors of the business- creditors are suppliers who supplied items to the
business but were not paid at the time of supply.
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Cash flow is not the same as profit! Profit is the surplus amount after total costs have been
deducted from sales. It includes all income and payments incurred in the year, whether already
received or paid or to not yet received or paid respectfully. In a cash flow, only those elements paid
by cash are considered.
A cash flow forecast is an estimate of future cash inflows and outflows of a business, usually on a
month-by-month basis. This then shows the expected cash balance at the end of each month. It can
help tell the manager:
● how much cash is available for paying bills, purchasing fixed assets or repaying loans
● how much cash the bank will need to lend to the business to avoid insolvency (running out
of liquid cash)
● whether the business has too much cash that can be put to a profitable use in the business
The opening cash/bank balance is the amount of cash held by the business at the start of the
month
The net cash flow is added to opening cash balance to find the closing cash/bank balance– the
amount of cash held by the business at the end of the month. Remember, the closing cash/bank
balance for one month is the opening cash/bank balance for the next month!
The figures in bracket denote a negative balance, i.e., a net cash outflow (outflows > inflows)
● when setting up the business the manager needs to know how much cash is required to
set up the business. The cash flow forecast helps calculate the cash outflows such as rent,
purchase of assets, advertising etc.
● A statement of cash flow forecast is required by bank managers when the business
applies for a loan. The bank manager will need to know how much to lend to the business
for its operations, when the loan is needed, for how long it is needed and when it can be
repaid.
● Managing cash flow– if the cash flow forecast gives a negative cash flow for a month(s),
then the business will need to plan ahead and apply for an overdraft so that the negative
balance is avoided (as cash come in and the inflow exceeds the outflow). If there is too much
cash, the business may decide to repay loans (so that interest payment in the future will be
low) or pay off creditors/suppliers (to maintain healthy relationship with suppliers).
How can cash flow problems be overcome?
When a negative cash flow is forecast (lack of cash) the following methods can be used to correct it:
● Increase bank loans: bank loans will inject more cash into the business, but the firm will
have to pay regular interest payments on the loans and it will eventually have to be repaid,
causing future cash outflows
● Delay payment to suppliers: asking for more time to pay suppliers will help decrease cash
outflows in the short-run. However, suppliers could refuse to supply on credit and may
reduce discounts for late payment
● Ask debtors to pay more quickly: if debtors are asked to pay all the debts they have to the
firm quicker, the firm’s cash inflows would increase in the short-run. These debtors will
include credit customers, who can be asked to make cash sales as opposed to credit sales
for purchases (cash will have to be paid on the spot, credit will mean they can pay in the
future, thus becoming debtors). However, customers may move to other businesses that still
offers them time to pay
● Delay or cancel purchases of capital equipment: this will greatly help reduce cash
outflows in the short-run, but at the cost of the efficiency the firm loses out on not buying
new technology and still using old equipment.
In the long-term, to improve cash flow, the business will need to attract more investors, cut costs
by increasing efficiency, develop more products to attract customers and increase inflows.
Working Capital
Working capital the capital required by the business to pay its short-term day-to-day expenses.
Working capital is all of the liquid assets of the business– the assets that can be quickly
converted to cash to pay off the business’ debts. Working capital can be in the form of:
Profit
For social enterprises, profit is not one of their primary objectives, but welfare of the society is.
However, they will also strive to make some profit to reinvest it back into the business and help it
grow.
Profit is not the same as cash flow! Profit is the surplus amount after total costs have been
deducted from sales. It includes all income and payments incurred in the year, whether already
received or paid or to not yet received or paid respectfully. In a cash flow, only those elements paid
in cash immediately are considered.
Income Statement
An income statement is a financial document of the business that records all income generated by
the business as well as the costs incurred by the business and thus the profit or loss made over the
financial year. Also known as profit and loss account.
Cost of Sales = total variable cost of production + (opening inventory of finished goods – closing
inventory of finished goods)
Retained Profit for the year = Profit after Tax – Dividends. This retained earnings is then kept aside
for use in the business.
5.4 – Statement of
Financial Position
The balance sheet, along with the income statement is prepared at the end of the financial year. It
shows the value of a business’ assets and liabilities at a particular time. It is also known as a
‘statement of financial position’.
● Fixed/non-current assets (buildings, vehicles, equipment etc.) are assets that remain in the
business for more than a year – their values fall over time in a process called depreciation
every year.
● Short-term/current assets (inventory, trade receivables (debts from customers), cash etc) are
owned only for a very short time.
● There can also intangible (cannot be touched or felt) non-current assets like copyrights and
patents that add value to the business.
Liabilities are the debts owed by the business to its creditors.
Shareholder’s Equity is the total amount of money invested in the company by shareholders. This
will include both the share capital (invested directly by shareholders) and reserves (retained
earnings reserve, general reserve etc.).
Shareholders can see if their stake in the business has risen or fallen by looking at the total equity
figure on the balance sheet.
● When the current assets subtotal is compared to the current liabilities subtotal, investors
can estimate whether a firm has access to sufficient funds in the short term to pay off its
short-term obligations i.e., whether it is liquid
● One can also compare the total amount of debt (liabilities) to the total amount of equity
listed on the balance sheet, to see if the resulting debt-equity ratio indicates a dangerously
high level of borrowing. This information is especially useful for lenders and creditors,
(especially banks) who want to know if the firm will be able to pay back its debt
● Investors like to examine the amount of cash on the balance sheet to see if there is enough
available to pay them a dividend
● Managers can examine its balance sheet to see if there are any assets that could
potentially be sold off without harming the underlying business. For example, they can
compare the reported inventory assets to the sales to derive an inventory turnover level,
which can indicate the presence of excess inventory, so they will sell off the excess inventory
to raise finance
5.5 – Analysis of Accounts
The data contained in the financial statements are used to make some useful observations about
the performance and financial strength of the business. This is the analysis of accounts of a
business. To do so, ratio analysis is employed.
Ratio Analysis
● Gross Profit Margin: this calculates the gross profit (sales – cost of production) in terms
of the sales, or in other words, the % of gross profit made on each unit of sales revenue.
The higher the GPM, the better. The formula is:
● Net profit Margin: this calculates the net profit (gross profit-expenses) in terms of the sales,
i.e. the % of net profit generated on each unit of sales revenue. The higher the NPM, the
better. The formula is:
● Liquidity Ratios: liquidity is the ability of the company to pay back its short-term debts. It
if it doesn’t have the necessary working capital to do so, it will go illiquid (forced to pay off its
debts by selling assets). In the previous topic, we said that working capital = current assets –
current liabilities. So a business needs current assets to be able to pay off its current
liabilities. The two liquidity ratios shown below, use this concept.
○ Current Ratio: this is the basic liquidity ratio that calculates how many current
assets are there in proportion to every current liability, so the higher the current
ratio the better (a value above 1 is favourable). the formula is:
○ Liquid Ratio/ Acid Test Ratio: this is very similar to current ratio but this ratio
doesn’t consider inventory to be a liquid asset, since it will take time for it to be sold
and made into cash. A high level of inventory in a business can thus cause a big
difference between its current and liquidity ratios. So there is a slight difference in
the formula:
● Managers: they will use the accounts to help them keep control over the performance of
each product or each division since they can see which products are profitably performing
and which are not.
● This will allow them to take better decisions. If for example, product A has a
good gross profit margin of 35% but its net profit margin is only 5%, this means
that the business has very high expenses that is causing the huge difference
between the two ratios. They will try to reduce expenses in the coming year. In
the case of liquidity, if both ratios are very low, they will try to pay off current
liabilities to improve the ratios.
● Ratios can be compared with other firms in the industry/competitors and also
with previous years to see how they’re doing. Businesses will definitely want to
perform better than their rivals to attract shareholders to invest in their business
and to stay competitive in the market. Businesses will also try to improve their
profitability and liquidity positions each year.
● Shareholders: since they are the owners of a limited company, it is a legal requirement that
they be presented with the financial accounts of the company. From the income
statements and the profitability ratios, especially the ROCE, existing shareholders and
potential investors can see whether they should invest in the business by buying shares. A
higher profitability, the higher the chance of getting dividends. They will also compare the
ratios with other companies and with previous years to take the most profitable decision.
The balance sheet will tell shareholders whether the business was worth more at the end of
the year than at the beginning of the year, and the liquidity ratios will be used to ascertain
how risky it will be to invest in the company- they won’t want to invest in businesses with
serious liquidity problems.
● Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash
position and debts of the business. They will only be ready to supply to the business if they
will be able to pay them. If there are liquidity problems, they won’t supply the business as
it is risky for them.
● Banks: Similar to how suppliers use accounts, they will look at how risky it is to lend to the
business. They will only lend to profitable and liquid firms.
● Government: the government and tax officials will look at the profits of the company to fix a
tax rate and to see if the business is profitable and liquid enough to continue operations and
thus if the worker’s jobs will be protected.
● Workers and trade unions: they will want to see if the business’ future is secure or not. If
the business is continuously running a loss and is in risk of insolvency (not being liquid), it
may shut down operations and workers will lose their jobs!
● Other businesses: managers of competing companies may want to compare their
performance too or may want to take over the business and wants to see if the takeover will
be beneficial.
● Ratios are based on past accounting data and will not indicate how the business will
perform in the future
● Managers will have all accounts, but the external users will only have those published
accounts that contain only the data required by law- they may not get the ‘full-picture’
about the business’ performance.
● Comparing accounting data over the years can lead to misleading assumptions since the
data will be affected by inflation (rising prices)
● Different companies may use different accounting methods and so will have different
ratio results, making comparisons between companies unreliable.