IB Business Management Finance

role of finance

role of finance

All businesses need money to finance their various activities: capital expenditure + revenue expenditure. Firms need to consider various factors when selecting sources of finance like Availability, Cost of finance (usually from interest charges) , Time period of repayment

Capital expenditure

finance spent on fixed assets like machines

pros of capital expenditure

can serve as collaterals for loans and adds extra production capacity and improves efficiency to replace worn out or obsolete equipment

cons of capital expenditure

high cost and limited source of finance

revenue expenditure

finance spent on daily running of business. costs in short term to pay off in the long term like advertisement, freight, office supplies

internal sources of finance

personal funds, retained profits and sale of assets

personal funds

used as source for sole traders and partnerships. uses capital and revenue expenditure

adv for personal funds

0 costs of finance unless borrowed from friends or w/interest

dis for personal funds

limits to amount of money available

retained profits

value of finance that business keeps after paying taxes to government and dividends to shareholders. uses capital and revenue expenditure

adv for retained profits

0 costs of finance and no interest

dis for retained profits

business makes a loss and source of finance won't be available

sale of asset

business can sell their unused assets to raise finance including subsidiaries

adv for sale of asset

0 costs of finance and no interest

dis for sale of asset

if assets are undesirable or no value, funds can't be raised and can sell for scrap value

external sources of finance

share capital, loan capital, overdrafts and trade credit

share capital as a source of finance

main source of finance for most LL companies. Privately held cannot sell but existing publicly held can increase $ by issuing shares and go public by IPO. Uses revenue expenditure

adv of share capital

can raise a huge amount of finance, especially for publicly held companies

dis of share capital

time consuming and expensive to prepare and launch and no guarantee that investors will want to buy your shares

loan capital

obtained from lending institutions or banks, interest is charged for loan and amount borrowed is repaid in installments over period of time like bank loans. uses capital expenditure

adv of loan capital

repaid in installments and gives business time to earn revenues so they can repay it

dis of loan capital

depending on interest rate, $ borrowed might be high. If collateral is provided(like property bought w/mortgage) and business fails, lender takes possession of asset

mortgages

loans for purchase of property(land, building) banks can repossess your property as collateral

business development loans

highly flexible loans catered to meet specific needs of borrowers and used to start or expand business, buy equipment, improve organisation's cash flow positions

debenture

long term loans issued by a business. Its holders(individual, gov etc) receive interest payments even if business works a loss and it is paid before shareholders are paid dividends, Interest can be fixed or variable

overdrafts

allows business to temporarily take out more money than it has in its bank accounts and uses revenue expenditure

adv of overdrafts

most flexible finance for unexpected large cash outflows

dis of overdrafts

cost of borrowing is high due to high interest rates compared to other loan bearing sources of finance and is repayable on demand from lender

when for overdrafts?

sudden need for large cash outflow and retailers during holidays and also when awaiting repayments of products traded on sole credit

trade credit

allows business to buy now and pay later. although a business has received goods it has purchased to pay. Uses revenue expenditure

adv of trade credit

allows time for business to process raw materials into goods/services and earn revenue so they can pay for raw materials

dis of trade credit

payments of voice are late and business can be charged overdue payment penalties

crowdfunding

raises finance from many individuals for a small amount of money to finance a new business venture and uses capital expenditure

adv of crowdfunding

potentially high reward in generating funding with low initial risk and feedback from potential investors could provide valuable market research

dis of crowdfunding

cost of finance in form of hosting fees to crowdfund platforms, low success rate in getting sufficient funding due to competition for funds and often highly regulated by government to prevent fraud

leasing

obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period. This avoids the need for businesses to raise long term capital to but the asset; ownership remains with the leasing company. This may cost more in the long term

adv for leasing

useful for business that don't have capital to purchase expensive assets outright, repairs and maintenance are the responsibility of the owner of asset and leasing is treated as an expense which helps to reduce profits tax on biz

dis for leasing

long-run cost of leasing can add up to be more than purchasing the asset outright

hire purchase

as asset sold to a company which agrees to make fixed repayments over an agreed time period; the asset belongs to the company

microfinance

finance service aimed at entrepreneur who comes from disadvantaged sector of society especially to lower socioeconomic status to access financial services in order to eradicate poverty and uses capital expenditure

adv of microfinance

accessibility to finance for those who are impoverished and job creation that benefits society by funding micro-businesses

dis of microfinance

unethical lending practices as many microfinance lenders operate as a for-profit entity and limited sums of finance available due to high risk of default

business angels

extremely wealthy individuals who choose to invest their own money in businesses that offer high growth potential. different from venture capitalists who operate as a pool of professionally managed funds. uses capital expenditure

adv of business angels

source of funding for firms that are unable to secure loans from banks and attract investments by venture capitalists

dis of business angels

some loss of control of business by angels who take a proactive role in business and may eventually have to buy out stakes owned by angels

what to consider for sources of finance

ROI: most startups fall so they need to be confident in positive returns and growth potential. Business plan, people(good team w/diversity) and track record(credit payment history)

repayment methods of finance

financial managers must be aware of repayment periods for all sources of finance. Firms cash flow position has more cash coming in than going out

short term

within next 12 months

long term

5+ years

short-term finance

within 1 year before due for repayment and typically used to pay for daily routine operations like trade credit

long term finance

1+ year before due for repayments and typically used to purchase fixed assets or finance expansions

timeline affecting business

business that heavily develop and involve with research see long term 10+ years. fast paced industries might see 5+ years too far ahead to plan for effectively

SPACED concept

size of firm, purpose, amount required, cost of finance, external influences and duration required

cost

expenditure incurred by business and not amount paid by customers

price

sum paid by customer

business expenditure

all business must spend money in order to earn it. business need to pay for set-up and running costs

set-up costs

items of expenditure needed to start business

running costs

ongoing costs of running the business

fixed costs

cost of production that a business pays regardless of how much it produces even no outputs like rent

variable costs

cost of production that change in proportion to level of output. if output=0 then variable=0

direct costs

specifically related to individual products of the output of a particular product. Typically are variable but not always

indirect/overhead costs

cannot be clearly traced to the production or sale of any products and are fixed. Unlike fixed, overheads are difficult to identify with particular business activity

revenue

money generated from normal business operations calculated as the average selling price x number sold/quantity

total cost formula

total variable cost + total fixed cost

total fixed cost formula

average fixed cost x quantity

average fixed cost formula

total fixed cost/quantity

average variable cost formula

total variable cost/quantity

total variable cost formula

average variable cost x quantity

average cost formula

(total cost)/quantity or AFC + AVC

revenue stream

money comes into firm from means other than sales revenue like advertising, transactions fees etc

subscription fees

customers who use or access a good or services based on a formal agreement

interest earnings

earn in less on cash deposits at a commercial bank when a business has a positive cash balance

dividends

share of net profits distributes to shareholder at the end of the tax year

donations

financial gifts from individuals or other organizations to a business

subventions

subsidies offered from government to certain businesses to help reduce their cost of operations

final accounts

comprise of profit loss/income statement and balance sheet and all businesses need to keep records of their financial statements to allow proper accounting allows for better. obliged to produce this to ensure transparency

shareholders + interest in final account

sees where their money was spent and how well their investments perform

employees + interest in final account

to assess likelihood of pay increments and job security

managers + interest in final account

to judge the operational efficiency of their organization and used for target setting and strategic planning

competitors + interest in final account

to compare financial performance with their rivals

financiers + interest in final account

to assess credibility of debt repayment

suppliers + interest in final account

to decide whether trade credit should be approved

potential investments + interest in final account

to use accounts to aid potential investment decisions

3 sections of P + L

trading account, profit and loss account and appropriation account

trading account

first section of P + L, shows difference between firm's sales revenue and the cost of goods sold. the difference = gross profit

gross profit formula

sales revenue - cost of goods sold

COGS formula

opening stock + purchases - closing stock

profit and loss account

shows net profit or loss of a business at the end of a trading period

net profit

financial surplus from sales revenue after cost and expenses are accounted for

net profit formula

gross profit - expenses

cost of sales

costs that a business can easily connect to the good or service it has produced and known as direct costs

expenses

costs that affect the business not just good or services and known as indirect cost

appropriation account

shows how net profit is distributed w/ dividends and retained profits

dividends in appropriation account

amount distributed to owners/shareholders and decided by BOD and approved at AGM typically paid bi-annually(interim and final)

interim dividends

paid midway through the year

final dividend

paid end of fiscal year

retained profits in appropriation account

profit kept for business as an internal source of finance(retained surplus) and transferred to firm's equity amount of their balance sheet and recorded as retained earnings

profit

profit-making business earns after all expenses have been paid for from the firm's gross profit. Profit-making entities distribute profits by reward shareholders in form of dividend and reinvest profits back into business to use in retained profits

surplus

what non-profit business earns after all expenses have been paid for from the gross surplus. non-profit entities reinvest all profits back into the business for its own use in form of retained surplus

benefits of P+L statements

shows variable profits after cost, allows historical completion and supports financial analysis