IB Business and Management Unit 3

Start-up capital

Capital needed by an entrepreneur to set up a business

Working capital

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.

Working capital (in accounting terms)

Working capital = current assets - current liabilities

Internal finance

Money raised from the business's own assets or from profits left in the business (retained profits)

External finance

Money raised from sources outside the business (e.g. share issue, leasing, bank loan)

Sources of internal finance:

Retained profits

Sales of assets

Reduction in working capital

Sources of LONG TERM external finance:

Share issue

Debentures

Long-term loan

Grants

Sources of MEDIUM TERM external finance:

Leasing

Hire purchase

Medium-term loan

Sources of SHORT TERM external finance:

Bank overdraft

Bank loan

Creditors

Trade credit

Debt Factoring

Overdraft

An agreement with a bank for a business to borrow up to an agreed limit as and when required

Factoring (debt factoring)

Selling of claims over debtors (individuals or organisations who owe the business money) to a debt factor in exchange for immediate liquidity - only a proportion of the value of the debts will be received as cash

Leasing

Obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period. this avoids the need for the business to raise long-term capital to buy the asset. Ownership remains with the leasing company.

Long-term loans

Loans that do not have to repaid for at least one year

Equity finance

Permanent finance raised by companies through the sale of shares

Debentures

Bonds issued by companies to raise debt finance, often with a fixed rate of interest (long-term bonds)

Long-term bonds

Bonds issued by companies to raise debt finance, often with a fixed rate of interest (debentures)

Rights issue

Existing shareholders are given the right to buy additional shares at a discounted price

Venture capital

Risk capital invested in business start-ups or expanding small businesses, that have good profit potential, but do not find it easy to obtain finances from other sources

Advantages of debt finance:

1. As no shares are sold, the ownership of the company does not change and is not 'diluted' by the issue of additional shares

2. Loans will be repaid eventually, so there is no permanent increase in the liabilities of the business

3. Lenders have no voting rights therefore there is no loss of control of the company

4. Interest charges are an expense and are thus tax deductible (reduce the total company tax paid by the business)

Advantages of equity finance:

1. It never has to be repaid

2. Dividends do not have to be paid every year. In contrast, interest must be paid when demanded by the lender

3. Much larger amounts of finance can possibly be raised than through debt financing

Capital expenditure

Spending by businesses on fixed assets such as the purchase of land, buildings and machinery (investment expenditure).

Creditors

Individuals or organisations that the business owes money to that needs to be settled within the next twelve months

Revenue expenditure

Spending on the day-to-day running of a business (e.g. rent, wages and utility bills)

Examples of revenue expenditure

- Rent

- Wages

- Utility bills (e.g., water and electricity)

Examples of capital expenditure

The purchase of any fixed asset:

- land

- buildings

- machinery

Fixed assets

Tangible assets as the have a physical existence (so not a brand, for example) and are expected to be retained and used by the business for more than 12 months (e.g. land, buildings, vehicles and machinery)

Investment appraisal

Evaluating the profitability or desirability of an investment project

Information quantitative investment appraisal requires:

1. Initial capital costs of the investment

2. Estimated life expectancy

3. The expected residual value (additional net returns from the sale of the asset at the end of its useful life)

4. Forecasted net returns or net cash flows from the project (expected returns less running costs)

Methods of quantitative investment appraisal

1. Payback period

2. Average rate of return

3. Net present value using discounted cash flows

How external factors (future uncertainty) can influence revenue forecasts:

1. Economic recession could reduce demand

2. Increases in oil prices may increase costs of production

3. Interest rates may decrease (both reducing costs of finance and inflating future returns)

Payback period

The length of time it takes for net cash inflows to pay back the original capital costs of the investment

Average rate of return ARR

Measures the annual profitability of an investment as a percentage of the initial investment

4 stages in calculating ARR

1. Add up all positive cash flows

2. Subtract cost of investment

3. Divide by lifespan

4. Calculate the % return to find the ARR

Criterion rate or level

The minimum level (maximum for payback period) set by management for investment appraisal results for a project to be accepted

Why future cashflows are discounted

1. Inflation: The same amount of money in the future will not purchase the same amount of goods and services as it can today

2. Interest foregone: Money can be invested for a return. If you invested the money safely now, it will be worth more in the future.

3. Uncertainty: The cash today is certain, but the future cash on offer is always associated with at least a degree of risk and uncertainty

The present value of a future sum of money depends on two factors:

1. The higher the interest rate, the less value future cash in today's money

2. The longer into the future cash is received, the less value it has today

Net present value (NPV)

Today's value of the estimated cash flows resulting from an investment

Qualitative investment appraisal

Assessing non-numeric information in examining an investment choice

Examples of qualitative factors in investment appraisal

1. Impact on the environment

2. Planning permission (will local governments allow the investment?)

3. Aims and objectives of the business

4. Risk

3 stages in calculating NPV

1. Multiply discount factors by the cash flows (cashflows in year 0 are never discounted)

2. Add the discounted cashflows

3. Subtract the capital cost to give the NPV

Factors in assessing an ARR percentage value

1. The ARR on other projects (the opportunity costs)

2. The minimum expected return set by the business (the criterion rate)

3. The annual interest rate on loans (ARR needs to be greater than the interest costs of borrowing; even if the firm doesn't need to borrow there's always an opportunity cost of interest foregone by keeping the money in the bank)

Working capital

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.

Working capital (accounting terms)

Working capital = current assets - current liabilities

Liquidity

The ability of a firm to pay its short-term debts

Liquidation

When a firm ceases trading and its assets are sold for cash. Turning assets into cash may be insisted on by courts if suppliers have not been paid.

Working capital cycle

The period of time between spending cash on the production process and receiving cash payments from customers

Cash flow

The sum of cash payments to a business (inflows) less the sum of cash payments made by it (outflows)

Insolvent

When a firm cannot meet its short-term debts

Cash inflows

Payments in cash received by a business, such as those from customers (debtors) or from the bank; e.g. receiving a loan

Debtor

An individual or an organisation who has bought on credit (or received a loan) from the business and owes the business money

Creditor

An individual or organisation to whom money is owed by the business

Cash outflows

Payments in cash made by a business, such as those to suppliers or workers

Examples of cash outflows include:

- Lease payments for premises

- Annual rent payment

- Electricity, gas and telephone/internet bills

- Labour cost payments

- Variable cost payments (e.g., raw materials)

Cash flow forecast

Estimate of the firm's future cash inflows and outflows

Net monthly cash flow

Estimated difference between monthly cash inflows and outflows

Opening cash balance

Cash held by the business at the start of the month

Closing cash balance

Cash held at the end of the month becomes next month's opening balance

Benefits of cash flow forecasts:

- By showing periods of negative cash flow, plans can be put into place to provide additional finance; e.g. arranging a bank overdraft or preparing to inject owner's capital

- If negative cash flow appears to be too great, then plans can be made for reducing these; e.g., by cutting down on purchases of new materials or reducing credit sales

- A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to a cash flow forecast (and the assumptions behind it)

Limitations of cash flow forecasts:

- Mistakes can be made in preparing the revenue and cost forecast (inexperience, seasonal variations, etc)

- Unexpected cost increases can lead to major inaccuracies (e.g. fluctuations in oil prices affecting cash flows of airline companies)

- Wrong assumptions can be made in estimating the sales of a business (e.g., poor market research)

Causes of cash flow problems:

1. Lack of planning

2. Poor credit control

3. Allowing too much credit

4. Expanding too rapidly

5. Unexpected events

Credit control

Monitoring of debts to ensure that credit periods are not exceeded

Bad debt

Unpaid customers' bills that are now very unlikely to ever be paid

Ways to improve cash flow:

1. Increase cash inflows

2. Reduce cash outflows

(careful! its the cash position of a business, NOT sales revenues or profits)

Methods to increase cash flow:

1. Overdraft

2. Short-term loan

3. Sale of assets

4. Sale and leaseback

5. Reduce credit terms to customers

6. Debt factoring

Debt factoring

Short term liquidity problem, sell debt to a factoring agency, instant inflow of cash but the cost is a fee payable to the agency that lowers the profit on the original business

Overdraft

A negative balance in a business's bank account

Overdraft facility

An ability to have a negative balance up to an agreed limit in a business's bank account

Sale and leaseback

Assets can be sold (e.g. to a finance company), but the asset can be leased back from the new owner

Evaluation of overdraft as a way to increase cashflow

1. Interest rates can be high

2. Overdrafts can be withdrawn by the bank and this often causes insolvency

Evaluation of short-term loan as a way to increase cashflow

1. The interest costs have to be paid

2. The loan must be repaid at the due date

Evaluation of sale of assets

1. Selling assets quickly can result in a low price

2. The assets may be required at a later date for expansion

3. The assets could have been used as collateral for future loans

Collateral

An asset that is the subject of a secured loan, and can be sold by the lender to recover the amount owed

Secured loan

A loan backed by an asset of value, such as property or vehicles

Evaluation of sale and leaseback as a way to increase cashflow

1. The leasing costs add to the annual overheads

2. There could be loss of potential profit if the asset rises in price

3. The assets could have been used as collateral for future loans

Evaluation of reduce credit terms to customers as a way to increase cashflow

1. Customers may purchase products from firms that offer extended credit terms

Evaluation of debt factoring as a way to increase cashflow

1. Only about 90-95% of the debt will n ow be paid by the debt factoring company - this reduces profit

2. The customer has the debt collected by the finance company - this could suggest (give the perception) that the business is in trouble

Methods to reduce cashflow

1. Delay payment to suppliers

2. Delay spending on capital equipment

3. Use leasing, not outright purchase of capital equipment

4. Cut overhead spending that does not directly affect output; e.g. promotion costs

Evaluation of delay payments to suppliers (creditors) as a way to reduce cashflow

1. Suppliers may reduce any discount offered witht he purchase

2. Suppliers can either demand cash on delivery or refuse to supply at all if they believe the risk of not getting paid is too great

Evaluation of delay spending on capital equipment as a way to reduce cashflow

1. The business may become less efficient if outdated and inefficient equipment is not replaced

2. Expansion becomes very difficult

Evaluation of use leasing, not outright purchase of capital equipment as a way to reduce cashflow

1. The asset is not owned by the business

2. Leasing charges include an interest cost and add to annual overheads

Evaluation of cut overhead spending that does not directly affect output as a way to reduce cashflow

1. Future demand may be reduced by failing to support products effectively

Budget

A detailed financial plan of the future

Budget holder

Individual responsible for the initial setting and achieving of the budget.

Delegated budgets

Control over budgets is given to less senior management

Incremental budgeting

Incremental budgeting uses last year's budget as a basis and an adjustment is made for the following year

Zero budgeting

Setting budgets to zero each year and budget holders have to argue their case to receive any finance

Variance Analysis

The process of investigating any differences between budgeted figures and actual figures

Adverse variance

Exists when the difference between the budgeted and actual figure leads to a lower than expected profit

Favourable variance

Exists when the difference between the budgeted and actual figure leads to a higher than expected profit.

Limitations of budgets

1. Lack of flexibility.

2. Focused on the short-term.

3. Result in unnecessary spending.

4. Training needs must be met

5. Setting budgets for new projects.

Purposes of setting budgets and establishing financial plans for the future:

1. Planning

2. Effective allocation of resources

3. Setting targets to be achieved

4. Coordination

5. Monitoring and controlling

6. Modifying

7. Assessing performance

Master budget

The overall or consolidated budget, comprised of all the separate budgets within an organisation. The Chief Financial Officer (CFO) will have general control and management of the master budget.

Importance of Variance Analysis:

1. It measures differences from the the planned performance of each department.

2. It assists in analysing the causes of deviations from budget.

3. An understanding of the the reasons for variations form the original planned levels can be used to change future budgets in order to make them more accurate.

4. The performance of each individual budget-holding section may be appraised in an accurate and objective way.

The three main business accounts:

1. Income statement

2. Balance sheet

3. Cash-flow statement

Income statement

Records the revenue, costs and profit (or loss) of a business over a given period of time

Three sections of an income statement:

1. Trading account

2. Profit and loss account

3. Appropriation account

Gross profit

Gross profit = sales revenue less cost of sales

Sales revenue

The total value of sales made during the trading period = selling price x quantity sold (sales turnover)

Sales turnover

The total value of sales made during the trading period = selling price x quantity sold (sales revenue) Sales revenue

Cost of sales

This is the direct cost of purchasing the goods that were sold during the financial year (cost of goods sold)