Accounting and finance

Main objective of financing policy

Raise finance so the wealth of the business and its owners are maximised by choosing sources that combine cost and risk so the overall cost of capital is minimised

Internal vs external sources of finance

Internal comes from inside the business (needs only directors/managers agreement) and external comes from outside (often needs shareholders/lenders)

Internal sources of finance long term

Retained earnings, dividend policy

Internal sources of finance short term

Tighter credit control, delaying payment to creditors, reducing inventory levels

Ordinary equity (shares)

Risk capital, no fixed dividend, paid last but firm can skip dividends

Preference shares

Lower risk, fixed dividend paid before ordinary, priority in wind up, usually no vote

Hire purchase

Own it at the end, fixed payments, on a balance sheet, maintenance is your responsibility

Leasing

Never own it, regular rental payments, operating lease is off balance sheet, finance lease is on it, maintenance is lessors responsibility

Finance lease

The bank (lesor) buys an asset and leases it to the business (lessee). Legal ownership stays with the lessor but virtually all risks and rewards pass to the lessee. Form of lending

Debt factoring

A factor (often a bank subsidiary) takes over collecting a firm’s trade receivables. The firm sells its invoices to the factor at a discount, the factor may also run credit checks

Financial gearing

Financing partly by borrowing. Some is good (borrowing rates < shareholders required return, lowering cost of capital) but only to a point

Trade-off theory

Optimal capital structure balances debt and equity to maximise firm value / minimise cost of capital

Why is stock riskier than bonds

Stockholders rank BELOW bondholders if the firm fails, dividends can be cut at any time, and price increases are not guaranteed

Common stock

Voting rights, variable dividends

Preferred stocks

Acts partly like a bond. Fixed dividend, stable price, usually no vote, claim on assets ahead of common but behind bondholders

Organised exchange

NYSE, LSE. Auction markets using specialists (floor traders)

Over the counter

NASDAQ. No physical floor, traded over networks using market makers who quote bid/ask price

High P/E ratio

Either means the market expects earnings to rise, earnings are seen as low risk so a premium is paid, or the stock is overvalued

Key feature of a corporate bond

UK face value normally £100, pays interest semi annually, cannot be redeemed early unless a call option exists

Secured bond

Mortgage bond, backed by collateral

Unsecured bond

Debentures, backed only by issuer creditworthiness

Junk bond

Rated below BBB, sub investment grade

Eurobond

A bond issued in a currency that is NOT the domestic currency of the country where it is issued

Reasons money loses value over time

Interest loss, risk, and inflation

Simple interest

Interest on the principal only

Compound interest

Interest on principal AND on previously earned interest. This always wins over time

Why NPV is best appraisal method

It accounts for the timings of cash flows (time value of money), all relevant cash flows, and it links directly to owner wealth

Internal rate of return

The discount rate that makes NPV exactly zero, found by trial and error. Accept if IRR > the required return/hurdle rate. Weakness is that it doesn’t directly address wealth generation

Appreciation

Currency rises in value, stronger purchasing power

Depreciation

Currency falls in value, weaker purchasing power

Spot transactions

Immediate (two day) exchange of bank deposits at the spot rate

Forward transactions

Exchange at a specified future date at the forward rate

How does depreciation affect exports and imports

Depreciation makes exports cheaper abroad (good for exporters) but imports more expensive (bad for importers). Appreciation does the inverse

Purchasing power parity

A theory which states that in the long run, exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services in different countries.

Long run factors affecting exchange rates

Relative price levels, tariffs and quotas, preferences for domestic vs foreign goods, and productivity. Rule → anything raising relative demand for domestic goods → currency appreciates

Financial accounting

Serves external users (investors, banks) with standard format statements

Management accounting

Serves internal managers for decision making

Current assets

Expected to turn to cash within one year (cash, inventory, receivables), listed in order of liquidity

Non current assets

Useful life over a year (land, buildings, plant)

The three statements as snapshot vs video

• Balance sheet = a snapshot on the last day of the period

• Income statement = a video of revenue/expenses over the period

• Cash flow statement = a video of cash in and out over a period

Profit vs cash

Profit is an accruals based estimate (recorded when earned/incurred); cash is reality (recorded when it happens). They diverge from credit sales/purchases, accruals/prepayments, and depreciation of capex

Ways to compare financial ratios

Over previous years (chronological), against competitors (externally), and against the industry average

Budget

A carefully prepared short term plan of what should happen, used to plan and control what’s done/spent and when. Includes planned sales revenue, cost and expenses

Favourable variance

Over recovery, costs lower than expected or revenue/profit is higher

Adverse/unfavourable variance

Under recovery, costs higher or revenue/profit is lower

Benefits of budgeting

Control (benchmark), coordination (aligns departments), authorisation (spending within limits), problem solving (identifies variances), motivation (clear targets)

Two ways to classify costs

1. Fixed / variable / semi variable: how cost changes with activity

2. Direct / indirect: is the cost directly traceable to the product

Variable costs

Total cost varies, unit cost constant

Fixed cost

Total cost stays the same, unit cost falls as output rises

Semi variable cost

Both total cost and unit cost vary

Key assumptions of CVP analysis

• Volume is the only thing that changes

• One product or constant sales mix

• Total cost and revenue are linear

• Profits use variable costing

• Costs can be accurately split into fixed and variable