Business Theme 2

Internal finance

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

Sources of Internal Finance

owners capital, retained profit, sale of assets

Owners Capital

money invested in the business from the owner's personal savings

Retained Profit

Profit which is kept back in the business and used to pay for investment in the business

Sales of Assets

Selling business assets which are no longer required (e.g. machinery, land, buildings) generates a source of finance

Advantages of Internal Finance

Internal finance is often free (e.g. it does not involve the payment of interest or charges)

It does not involve third parties who may want to influence business decisions

Internal finance can usually be organised very quickly and without significant paperwork

Businesses that may fail credit checks (necessary for a bank loan) can access internal finance sources more easily

Disadvantages of Internal Finance

There is a significant opportunity cost involved in the use of internal finance, e.g. once retained profit has been used, it is not available for other purposes

Internal finance may not be sufficient to meet the needs of the business

Using an internal finance method is rarely as tax-efficient as many external methods, e.g. loan repayments may be treated as a business cost and offset against tax

External Finance

Money raised from sources outside the business, e.g., a bank loan.

Sources of External Finance

Family and friends, banks, peer-to-peer lending,business angels, crowd funding and other businesses

Advantages of Family and Friends as a Source of Finance

Usually a very cheap source of funds

May have 'no strings attached (e.g. a share of the business) and can be provided to the business on very flexible terms

Disadvantages of Family and Friends as a Source of Finance

Relationships may be damaged if the finance is not repaid

Advantages of Bank Loans

May offer both short term finance (e.g. overdrafts) and long term finance (e.g. loans or mortgages) if a business qualifies

Banks are often keen to provide free advice and guidance to businesses that use their services

Small sums may be borrowed from unsecured

Disadvantages of Bank Loans

A business plan is usually required to access bank finance

Banks can be cautious about lending to new, untested businesses

Interest (and often an arrangement fee) is payable

Businesses must be customers of the bank (i.e. hold a banking account) to access some loans

For larger amounts, businesses may need to provide security to be granted a loan

Advantages of Peer-to-Peer Funding

Loans can usually be made available to businesses very quickly

Usually has 'no strings attached (e.g. a share of the business)

Disadvantages of Peer-to-Peer Funding

Borrowers are charged a small fee to access finance in this way and have to pay interest in the same way as a bank loan

The individuals who made the money available in the first place receive some of this interest as compensation

Advantages of Business Angels

Business angels tend to be more willing to take a risk than banks

Angels often offer advice and guidance to the businesses in which they invest

Investment is usually for a determined period of time so owners regain shares in the future

Disadvantages of Business Angels

Finding the 'right' business angel (e.g. with appropriate experience, expertise or interest) can be challenging

Networking is vital when entrepreneurs seek this kind of investment

As business angels own a stake in the business, they may be involved in decision-making and will receive a share of business profits

Advantages of Crowdfunding

Creates an organic customer base and the platform provides a form of free marketing

A good credit rating is not required so new businesses that lack a trading record can attract funding

Disadvantages of Crowdfunding

Businesses need to provide a persuasive business plan to convince individuals to invest in their product as they will be competing with many other projects online

The potential for negative publicity if the project is not successful in attracting enough crowdfunding capita

Advantages of Finance from Other Businesses

May provide access to business processes and market knowledge alongside finance

Can access large amounts of finance

Disadvantages of Finance from Other Businesses

Profits need to be shared between businesses

Decisions will usually need to be agreed by all businesses

Methods of Finance

- Loans

- Share Capital

- Venture Capital

- Overdrafts

- Leasing

- Trade Credit

- Grants

Benefits of Loans

Interest rates are fixed for the term of the loan

Repayments are made in equal instalments, helping budgeting

Businesses can purchase expensive equipment or property without the need for large amounts of capital

Control over decision-making is retained within the business

With debentures, interest is fixed, aiding budgeting

Drawbacks of Loans

Interest rates depend on the businesses credit rating

Non-current liabilities are increased in the balance sheet

With a mortgage, missed payments may lead to property being repossessed

Failure to repay debentures may deter investors in the future

Benefits of Overdrafts

A short-term source of finance that offers significant flexibility and aids cash flow

Drawbacks of Overdrafts

An overdraft may be 'called in' if the bank is concerned about a business's ability to repay what it owes

Benefits of Share Capital

Large amounts of capital can be raised, especially by public limited companies

Interest is not payable on finance raised in this way

Drawbacks of Share Capital

Shareholders usually have a vote at a company's Annual General Meeting (AGM) where they can have a say in the composition of the Board of Directors

Benefits of Venture Capital

Businesses that may have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists

Drawbacks of Venture Capital

Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business

Benefits of Leasing

The business does not own the asset during the period of the lease and so is not responsible for maintenance or repair costs

Drawbacks of Leasing

Leasing is usually more expensive in the long run than buying an asset

Benefits of Trade Credit

Trade credit is usually interest-free

Drawbacks of Trade Credit

Discounts for early payment will not be available

Benefits of Grants

Grants do not need to be repaid

Drawbacks of Grants

The business must use the finance for its intended purpose

Types of Liability

• Limited liability

• Unlimited liability

Limited Liability

Companies are incorporated and owners are considered a separate legal entity to the business

This means that if a company fails, the owners would lose their investment (shares) but would not have to use their assets to meet additional debts or legal fees

Unlimited Liability

There is no legal distinction between owners with unlimited liability and the business

As a result, these business owners may have to use their own personal assets to pay debts or legal fees

Sources of finance for limited liability businesses

Retained Profit, Debentures, Share Capital, Venture Capitalists, Business Angels

Sources of finance for unlimited liability businesses

Personal Savings, Retained Profits, Overdraft, Mortgages, Grants, Crowd Funding, Leasing, Trade Credit

Business Plan

A business plan is a document produced by the owner at start-up, which provides forecasts of items such as sales, costs and cash flow

Cash flow forecast

A cash flow forecast is a prediction of the anticipated cash inflows and cash outflows, typically for a six to twelve month period

Cash Flow Forecast key terms

The net cash flow is calculated by subtracting total outflows from total inflows

The opening balance is the previous month's closing balance carried forward

The closing balance is calculated by adding the net cash flow to the opening balance

Uses of Cash Flow Forecasts

Cash flow forecasts can support an application for a loan and are an integral part of the business plan

They can help identify where the business may experience cash shortfalls or cash surpluses so that plans can be made to manage these periods (e.g. arranging an overdraft)

Cash flow forecasts aid planning and help a business avoid costly mistakes

Limitations of Cash Flow Forecasts

Forecasts are usually based on estimates and in reality, inflows and outflows may differ significantly from the estimates

Cash flow forecasts require appropriate skills, insight, research and time to prepare and update adequately

External factors that can impact inflows and outflows may not be reflected in the cash flow forecas

Sales Forecast

Sales forecasts predict future revenues based on past sales figures

They commonly focus on what will happen in the future to:

The volume and value of sales

The size of the market

Sales as a result of promotional activity

Sales as a result of cyclical factors

Factors affecting Sales forecast

Consumer trends

- Seasonal variations

- Fashion

- Long term trends

Economic variables

- Economic Growth

- Inflation

- Unemployment

- Interest Rates

- Exchange Rates

Actions of competitors

Types of Costs

fixed costs, variable costs, total costs

Fixed costs

costs that do not change as the level of output changes

Variable costs

are costs that vary directly with the output

Total costs

the sum of the fixed + total variable costs

Calculation of Fixed, Variable & Total Costs

TC = TFC + TVC

TVC = VC x Q

ATC = TC/Q

AVC = TVC/Q

Contribution

A product's selling price minus the variable costs directly involved in producing that unit

Contribution calculation

Selling price per unit - variable cost per unit

Break-even point

Is where a total revenue earned for a product is exactly equal to its total costs and where the business is making neither a profit nor a loss

Break-even point calculation

Fixed costs / Contribution

Uses of Break-even point

The break even point is expressed as several units (e.g. the number of scented candles)

Identifying the break even point allows a business to understand how many items it needs to produce and sell to cover all costs before it starts to make a profit

Margin of Safety

The margin of safety is the difference between the actual level of output of a business and its break even level of output

Margin of Safety calculation

Actual level of output - Breakeven level of output

Limitations of Break Even Analysis

1. The assumption that all costs and revenues are represented by straight lines in unrealistic.

2. Not all costs can be conveniently classified into fixed and variable costs. The introduction of semi-variable costs will make the technique more complicated.

3. There is no allowance made for stock levels on the break-even chart. It is assumed that all units produced are sold. This is unlikely to always be the case in practice.

4. It is also unlikely that fixed costs will remain unchanged at different output levels up to a maximum capacity.

Budgets

A budget is a financial plan that a business (or department in the business) sets about costs and revenue

The budget is usually closely aligned with the business objective

Types of Budgets

Historical figure budgets

Zero based budgeting

Historical figure budgets

Budgets are usually based on historical data (e.g. sales and costs data from previous years) and allow for factors such as Inflation and other relevant economic indicators (e.g. exchange rate variations)

Zero based budgeting

Requires all spending to be justified, which means that many unnecessary costs can be eliminated

Variance Analysis

Seeks to determine the reasons for the differences in the actual figures and budgeted figures

Difficulties of Budgeting

Take time and skill to set, monitor and review

Setters have significant influence

Can lead to competition and confict between different business fucntions

Encourgaes managers to focus on the short-term and not the long-term

Types of Profits

Gross profit, operating profit, net profit

Gross Profit (GP)

The difference between revenue and the costs directly related to production

GP = Revenue - cost of sales

Operating Profit (OP)

The difference between the gross profit and the indirect expenses involved in operating the business

OP = Gross Profit - Operating Expenses

Net Profit (NP)

The difference between the operating profit and any Interest paid and received, as well as any One-off costs

NP = Operating Profit - (Net Interest + Exceptional Costs)

Statement of Comprehensive Income (Profit & Loss Account)

The Statement of Comprehensive Income is an end of year financial statement that shows all of a businesses income and expenses over the previous twelve months

Gross Profit Margin

Gross profit/sales revenue x 100

Operating Profit Margin

Operating profit / sales revenue x 100

Net Profit Margin

Net profit/sales revenue x 100

Ways to Improve Profitability

Raising prices

Reducing variable costs

Reducing other expenses (e.g. reduce staff levels)

Reducing one-off costs and interest charges

Statement of Financial Position (Balance Sheet)

The Statement of Financial Position contains the financial information required to draw conclusions about the liquidity of the business

Liquidity

the ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets

Current Ratio

current assets/current liabilities

Acid Test Ratio (liquid capital ratio)

Current Assets - Stock / Current Liabilities

Ways to Improve Liquidity

- Reduce the credit period offered to customers

- Ask suppliers for an extended repayment period, e.g. an - - - - extension from 60 to 90 days

- Make use of overdraft facilities or short-term loans

- Sell off excess stock

- Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash)

- Storage and security costs may also be reduced

- Stock may need to be sold at a low price to attract sales

- Sell assets and lease fixed assets instead (e.g. Sale and Leaseback)

- Introduce new capital and reduce drawings from the business

Managing Working Capital

Working capital is the money that a business has to fund its day to day activities

It is often described as net current assets on the Statement of Financial Position

Working Capital

current assets - current liabilities

Internal Causes of Business Failure

-Lack of planning

-Cash flow problems

-Lack of funds

-Marketing problems

-Failure to innovate

-Poor leadership

External Causes of Business Failure

- competition

- changes in legislation

- changes in consumer tastes

- economic conditions

- changes in market prices

Methods of Production

Job, batch, flow, cell

Batch Production

Groups of the same product are produced, before moving on to a group of different products

Adv and Dis of Batch production

Advantages

- Workers can specialise

- Production can take place as the previous 'batch' starts running out

Disadvantages

- Requires careful coordination to avoid shortages

- Money is tied up in stock as completed products need to be stored

Job production

Producing one item at a time, as ordered by the customer

Adv and Dis of Job production

Advantages

- High quality product

- Motivated and highly skilled workers

- Customised products can be produced

Disadvantages

- Production is slow

- Labour costs are high

Flow Production

Continuous manufacturing of standardised products, usually on a production line

Adv and Dis of Flow production

Advantages

- Low unit costs due to economies of scale

- Rapid production

- Usually highly automated (capital intensive)

Disadvantages

- Customisation is difficult

- Capital equipment can be expensive to purchase

Cell Production

This involves workers being organised into multi-skilled teams, with each team responsible for a particular part of the production process

Adv and Dis of Cell production

Advantages

- Cell production is often more efficient than other methods as workers share their skills and expertise

- Motivation is usually high as employees work as a team

Disadvantages

- Requires extensive reorganisation of production processes

- Teams efficiency may be reduced by weaker workers

Labour productivity

Output / number of employees

Capital productivity

Output / number of machines

Factors that Influence Productivity

- Employee motivation

- Skills, education & training staff

- Business organisation & working practices

- Investment in capital equipment

Efficiency

Total costs / Number of units

Factors that Influence Efficiency

- Standardisation of the production process

- Relocation or downsizing

- Investment in capital equipment

- Organisational restructuring

- Outsourcing

- Adoption of lean production techniques

Labour-intensive production

Predominantly uses physical labour in the production of goods/services