U3 Finance Test part 2

U3.2, U3.3, U3.4, U5.5 (Break-even) and other terms

Assets

possessions of a business that have a monetory value. They are owned by a business and are categorised as current assets & non current assets which are reported on the balance sheet.

Non-current Assets

long term assets or possessions of an organization with a monetary value but are not intended for resale within the next 12 months of the balance sheet date. Instead, they are used over and over again as part of the organization’s operations. They are reported on the balance sheet.

Current Assets

They are possessions of an organization with a monetary value, but intended to be liquidated within twelve months.

It is reported on the balance sheet

What are internal sources finance?

Funds generated from within a business to meet financial needs without relying on external parties

Why do sole traders commonly use personal funds?

Because external funding may be hard to secure, and it demonstrates commitment and provides emergency funding. Personal funds in this context being the owner’s personal savings used to finance the business.

Why are internal sources of finance often the first choice for businessese?

They help maintain control and avoid debt.

Three disadvantages of using personal funds

• high personal financial risk, if the business fails the owner can lose life savings or money needed for future goals

• Limited availability, as personal savings are often small compared to the actual needs of a growing busienss

• No personal safety net or flexibility, as once the money is invested its gone, leaving less cash for emergencies, day-to day personal expenses or other opportunities, which can increase stress and pressure on owner

What is retained profit?

Retained profit is the profit generated by a business in a previous period that remains after deducting all expenses, taxes, and shareholder dividends.

It is reinvested back into the business as an internal source of long-term finance, supporting growth without incurring debt or interest costs.

What are three advantages of using retained profit as a source of finance?

Retained profit is an internal SOF, avoiding interest payments or fees associated with loans or external funding, which directly improves cash flow and profitability.

Business retain complete decision-making autonomy over how funds are allocated, without needing approval from lenders or investors, enabling quick and flexible reinvestment.

It builds a safety net for unexpected expenses or downturns, strengthens the balance sheet, and signals strong performance to stakeholders without diluting ownership.

What are three disadvantages of using retained profit as a source of finance?

Retained profit is limited to profitable businesses, relying on past profitability. So unprofitable or low-profit businesses lack sufficient funds for large-scale investments or growth if solely relying on retained profit.

Withholding profits reduces dividends, frustrating investors who expect returns and potentially lowering share price or causing conflicts.

Without external oversight, management may misuse funds on poor projects, leading to opportunity costs or overcapitalization.

State two advantages of using the sale of assets as a source of finance for a business.

It raises cash quickly from unused assets without incurring interest or debt costs.

No repayment obligations, as the funds come from owned capital rather than loans.

Explain what the sale of assets is (2)

Sale of assets involves a business disposing of surplus or underused fixed assets to generate immediate cash. The proceeds provide an internal, one-off source of short-term finance without interest costs or ownership dilution.

Explain internal sources of finance

An internal source of finance refers to money raised from the business's own resources, such as owner's capital, retained profits, or sale of assets, without external parties. These sources incur no interest costs or repayment obligations, maintaining full business control.

Explain external sources of finance

External sources of finance are funds obtained from individuals or organizations outside the business, such as bank loans, share capital, or overdrafts.

These typically involve costs like interest payments or equity dilution and repayment obligations, unlike internal sources.

Explain the term crowdfunding

Crowdfunding involves obtaining funds from a crowd of people, often through internet platforms, who contribute small sums in exchange for rewards, equity, or debt repayment.
It bypasses traditional lenders, providing startups with capital and market validation without upfront interest costs, though success depends on public appeal.

What are some advantages of a business using crowdfunding as an SOF?

No credit checks or collateral needed: Unlike bank loans, crowdfunding platforms do not require personal guarantees, credit history, or assets, enabling startups and small firms with poor credit to access capital quickly.

Market validation and free marketing: Campaigns test product demand directly with potential customers, generating buzz, feedback, and organic promotion that builds a customer base before launch.

Non-dilutive for rewards-based models: Businesses raise funds without giving up equity or paying interest (in reward/donation types), retaining full ownership while gaining community support

What are the disadvantages of Crowdfunding as an SOF

Low success rate and all-or-nothing risk: Most campaigns fail to meet funding targets (often under 30% succeed), and platforms return all funds if goals aren't hit, leaving businesses with no capital after heavy marketing efforts.

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High time and resource demands: Creating compelling campaigns requires extensive preparation, which diverts management from core operations and may cost thousands without guaranteed returns.

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Intellectual property and reputational exposure: Public campaigns reveal business ideas, risking idea theft by competitors, while failure damages credibility and complicates future funding attempts.

What are overdrafts?

An overdraft is a bank facility allowing a business to withdraw more money than its current account balance, up to an agreed limit.

Interest is charged only on the amount overdrawn, making it ideal for managing short-term cash flow fluctuations, though repayable on demand.

Advantages of using overdrafts as an SOF

Flexibility and on-demand access: Businesses draw funds only as needed up to a limit, paying interest solely on the overdrawn amount, ideal for irregular cash flows like seasonal dips.

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Quick arrangement: Overdrafts can be set up rapidly through existing bank relationships without lengthy applications or collateral, providing immediate liquidity for urgent expenses.

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Cost-effective for short-term use: No fixed repayments required; funds replenish the account as payments come in, avoiding long-term debt commitments unlike loans.

Disadvantages of Overdrafts as an SOF

• High interest rates and fees: Overdrafts typically charge higher interest than loans, plus arrangement fees and penalties for exceeding limits, making prolonged use expensive and eroding profitability.

• Repayable on demand: Banks can withdraw the facility or demand immediate repayment at any time, creating uncertainty and potential cash flow crises during unexpected reviews.

• Risk of debt dependency: Easy access encourages over-reliance instead of addressing underlying cash flow issues, potentially damaging credit ratings and limiting future finance options.

What are loans?

A business loan is a sum of money borrowed from a bank or financial institution, repaid over an agreed period with interest.

It is typically secured against assets with fixed monthly repayments, suitable for expansion or major investments.

Advantages of Loans as an SOF

Large funding amounts available: Loans offer significantly more capital than overdrafts or internal sources, enabling major investments like factory expansion or equipment purchases.

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Predictable repayments: Fixed monthly installments and interest rates allow precise cash flow planning, unlike variable overdraft costs.

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Retain business ownership: Unlike equity finance, loans maintain full management control without diluting shares or shareholder influence

Disadvantages of loans as an SOF

Interest costs and fixed repayments: Loans require regular interest payments regardless of business performance, plus mandatory monthly installments that strain cash flow during low-profit periods.

Collateral and security requirements: Banks typically demand assets as guarantee; default risks asset seizure, making loans unsuitable for businesses lacking collateral.

Lengthy approval process: Securing loans involves extensive applications, credit checks, and paperwork, delaying access to funds compared to overdrafts or internal sources.

Explain shares as an SOF

Shares are units of ownership sold by companies to investors, raising capital through initial issuance or rights issues.

No repayment obligation exists, but shareholders expect dividends and voting rights, diluting existing owners’ control.

Advantages of using shares as an SOF for a business

Large capital sums raised: Public limited companies can access significant funds through stock markets or rights issues, far exceeding internal sources for major expansions.

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No repayment obligation: Unlike loans, shares provide permanent capital without fixed repayments or interest, improving long-term cash flow stability.

Shared risk with investors: Shareholders bear losses alongside owners, reducing personal financial exposure while bringing expertise and networks to support growth.

Disadvantages of shares as an SOF

Dilution of ownership and control: Issuing shares reduces existing owners' percentage stake and voting power, as new shareholders gain influence over strategic decisions.

High issuance costs and complexity: Share capital requires expensive flotation processes, legal compliance, and stock exchange listing fees, making it time-consuming and unsuitable for small firms.

Dividend expectations and profit pressure: Shareholders demand regular dividends regardless of performance, diverting profits from reinvestment and creating ongoing financial commitments.

Whats leasing as an SOF?

Leasing involves a business (lessee) renting assets like machinery or vehicles from a finance company (lessor) through regular payments, without owning the asset outright. The lessor handles maintenance and repairs, while payments are tax-deductible, preserving cash flow for other uses though total costs exceed outright purchase over time.

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Advantages of leasing as an SOF

• Preserves working capital: No large upfront payment required, allowing businesses to conserve cash for operations, marketing, or other investments rather than tying it up in depreciating assets.

• Tax-deductible payments and maintenance included: Lease rentals count as business expenses (reducing taxable profits), while lessors typically cover repairs and servicing, lowering overall ownership costs.

• Flexibility against obsolescence: Easier to upgrade to newer technology at lease end without resale hassles, ideal for fast-changing sectors

disadvantages of leasing as an SOF

• Higher total cost over time: Cumulative lease payments often exceed the asset's purchase price due to built-in interest, making it more expensive long-term than outright buying.

• No ownership or residual value: Businesses never own the asset, missing potential resale value or equity buildup, and must return or re-lease it at term end.

• Restricted flexibility and control: Lease agreements impose usage limits, modification bans, and early termination penalties, reducing operational adaptability if business needs change.

Best SOF for smaller businesses / startups

• Personal funds

• Crowdfunding

• Overdrafts

• Microloans

Best / suitable SOF for larger businesses

• Retained profits

• Bank loans

• Share Capital

Income statement / statement of P&L

An income statement reports total revenue, costs, expenses, and net profit/loss for a trading period. It reveals operational profitability before calculating retained profit for reinvestment, essential for stakeholders assessing business viability

Balance sheet:

A balance sheet (or statement of financial position) shows what a business owns (assets), owes (liabilities), and the owners' stake (equity) on a specific date. It reveals financial stability and liquidity, helping stakeholders assess solvency and working capital needs alongside the income statement

Advantages of Balance sheet

• Assesses financial stability: Reveals the accounting equation (Assets = Liabilities + Equity), showing solvency and whether current assets exceed liabilities for short-term liquidity.

• Supports loan applications and investment: Provides clear proof of net worth and asset backing to banks or shareholders, essential for securing external finance.

• Identifies working capital needs: Highlights current ratios and cash positions, helping managers optimize inventory, receivables, and payables for operational efficiency.

Disadvantages of balance sheet

• Historical cost basis: Assets appear at original purchase price minus depreciation, not current market value, understating worth of appreciated items like land or equipment.

• Excludes intangibles: Internally generated assets like brand value, expertise, or customer loyalty receive no recognition, hiding true business value.

• Point-in-time snapshot: Shows position only on a single date, ignoring cash flow trends or performance between periods that the income statement captures better.

Advantages of P&L statement

• Measures operational performance: Shows net profit after all costs, revealing how efficiently revenue converts to earnings for strategic decisions.

• Supports budgeting and forecasting: Enables trend analysis across periods to identify growth areas, cost efficiencies, or declining margins.

  • Essential for stakeholders: Investors and lenders use it to assess viability and dividend potential, while tax authorities rely on it for compliance.

Disadvantages of P&L statement

• Ignores cash flow timing: Uses accrual accounting where revenue/expenses are recorded when earned/incurred, not when cash changes hands, creating profit without liquidity.

• Historical data only: Shows past performance without predicting future results or accounting for market changes, seasonal trends, or economic shifts.

• Easy manipulation risk: Accounting choices like revenue recognition or expense categorization can artificially inflate profits through creative accounting practices.

How to calculate profitability ratios

(check online)

Define fixed costs

Fixed costs are business expenses that do not change with output levels. These must be paid regardless of activity, creating high risk during low sales periods but enabling profit leverage when volume increases.

Define variable costs

Variable costs are expenses that fluctuate in proportion to the quantity produced or sold. Unlike fixed costs, they are zero when production stops, making them lower risk during downturns but scalable during growth.

Define total costs

Total costs are the sum of all fixed costs and variable costs incurred in production, calculated as Total Costs = Fixed Costs + Variable Costs. They determine break-even points and profit margins, rising with output volume due to variable components while fixed costs remain constant.

define contribution per unit

Contribution per unit is the selling price per unit minus the variable cost per unit, representing revenue available after direct production costs. It is used to calculate the break even point by dividing total fixed costs by this figure.

define total contribution

Total contribution is the contribution per unit multiplied by total units sold, or total sales revenue minus total variable costs. It shows how much revenue remains to pay fixed costs after production costs; once fixed costs are covered, all additional total contribution becomes profit.

define assets

Assets are items of value owned or controlled by a business expected to provide future economic benefits. Classified as current (convertible to cash within 1 year) or non-current (long-term use); total assets = liabilities + equity in the accounting equation.

define current assets

Current assets include cash, accounts receivable, inventory, and prepaid expenses that can be liquidated or consumed within 12 months or one operating cycle. They measure short-term liquidity; businesses aim for current assets to exceed current liabilities to maintain solvency and working capital.

calculate break-even quantitiy

Break-even quantity = Fixed Costs ÷ Contribution per Unit, where contribution per unit = Selling price - Variable cost per unit.

calculate margin of safety

you know this already just practice

evaluate strengths of break-even analysis

Simple, quantitative tool using contribution data; ideal for startups setting targets or managers stress-testing scenarios. Enhances decision-making with margin of safety insights.

evaluate limitations of using break-even analysis

Assumes constant costs/prices (ignores inflation, discounts); static single-product focus neglects multi-line complexity; doesn't guarantee demand at break-even volume.

What are liabilities?

Liabilities are present financial obligations of a business, such as loans, accounts payable, taxes owed, or accrued wages, requiring future payment of cash, goods, or services. Divided into current (due within 1 year) and non-current (longer-term); total liabilities + equity = total assets in the accounting equation.

Whats equity?

Equity refers to the value of the owner’s stake in the business. It represents the the worth of the business at the time of reporting the balance sheet. It is comprised of both share capital and retained earnings.

Accumulated Depreciation

the falling value of non-current assets due to wear & tear

Liabilities

They are the debts or financial obligations of a business to external parties that must be repaid in the future and are recorded on the balance sheet.

Share capital

By selling shares, the business receives money from shareholders

Retained Earnings

money earned by the business and carried forward to the next year

Net assets

refers to the overall value of an organization’s assets after all its liabilities are deducted.

Net assets = Total assets - Total liabilities

What is balance sheet also known for?

Statement of Financial position

Define Intangible Asset

are non-physical fixed assets with monetary value, protected by intellectual property rights.

Goodwill

represents a business’s reputation, networks, employee loyalty and value beyond its physical assets, often arising from acquisitions and recorded on the balance sheet to attract investors.

Licenses

• type of intangible asset

• right to use (legally)

Patents

• official rightsgiven to a business to use innovations

• for a finite / limited time period

Copyrights

• give registered owner the legal rights to creative pieces of work

• they protect creative works, preventing unauthorised replication

  • extend post creator’s life

Brand value

measures a brand’s expected future sales revenue and earning potential