Topic 3; Finance

Capital Expenditure

Capital Expenditure

funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment

Revenue Expenditure

the ongoing operating expenses which are used to run day to day operations for a business

Internal sources of finance

• Personal funds

• Retained profit

• Sale of assets

Personal funds

the borrowing, receiving, or possessing of funds by an individual in their name but not under their business

Retained profits

the amount of profit a company has left over after paying all its direct costs, indirect costs, income taxes and its dividends to shareholders

Sale of assets

when a company sells one or more of its financial assets

External sources of finance

• Share capital

• Loan capital

• Overdrafts

• Crowdfunding

• Leasing

• Microfinance providers

• Business Angels

Share capital

the money a company raises by issuing common or preferred stock

Loan capital

money required to run a business which is raised from loans rather than shares

Overdrafts

when an account lacks the funds to cover a withdrawal, but the bank allows the transaction to go through anyway

Trade credit

in which a customer is allowed to purchase goods or services and pay the supplier at a later scheduled date

Crowdfunding

the use of small amounts of capital from a large number of individuals to finance a new business venture

Leasing

a financial arrangement in which a person, company, etc. pays to use land, a vehicle, etc. for a particular period of time

Microfinance providers

that is provided to low-income individuals who have no other means of gaining financial services

Business Angels

a private individual, often with a high net-worth, and usually with business experience, who directly invests part of their assets in new and growing private businessesnet worth

Types of costs

• Fixed

• Variable

• Direct

• Indirect

Fixed costs

Fixed costs are costs that have to be paid regardless of how much the business produces (rent, utilities, property tax) 

Variable costs

Variable costs are costs that change depending on how much the business produces (raw materials, commissions)

Direct costs

expenses that are directly linked to the goods or services a business sells

Indirect costs

expenses a business incurs that are not directly related to making a product or service.

Revenue

Total amount of money brought in by a business over a period of time

The purpose of accounts to different stakeholders

provide a wealth of information about a company's financial performance and position, enabling stakeholders to make informed decisions

Profit and Loss statement

financial statements of a company and shows the company's revenues and expenses during a particular period

Balance sheet

a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period.

Different types of intangible assets

• computer software

• licenses

• trademarks

• patents

• films

• copyrights

• import quotas

Depreciation

The monetary value of an asset decreases over time due to use, wear and tear or obsolescence

Straight line method

A method of accounting for depreciation that assumes assets lose value at a constant rate. With the straight-line depreciation method, the value of an asset is reduced uniformly over each period until it reaches its salvage value.

Straight line method formula

(cost of the asset – estimated salvage value) ÷ estimated useful life of an asset

Units of production method

The units of production method depreciates an asset based on its usage or production output during an accounting period (usually a year)

Units of production method formula

divide the original cost of the equipment, minus its salvage value, by the expected number of units the asset should produce given its useful life. Then, multiply that quotient by the number of units used during the current year. This calculates depreciation expense for a given year.

When to use the straight line method

• The asset's value is unlikely to change due to obsolescence

• A small business is valuing assets

• Assess are of relatively low value

• Assets have a predictable lifespan

When to use the depreciation method

• The asset's value is linked to its amount of use

• Assets are valuable and need to be valued with precision

• A manufacturing business is valuing assets

Gross profit margin

reflects how successful a company's executive management team is in generating revenue, considering the costs involved in producing its products and services

Gross profit margin formula

Revenue - cost of goods sold / revenue

Profit margin

profit before interest and tax / sales revenue * 100

Return on capital employed

used to measure a company’s profitability and efficiency

Return on capital employed formula

EBIT/Capital Employed

Ways to increase GPM

• Raise revenue

• Reduce cost of sales

Ways to increase PM

• Reduce operating costs

• Raise prices

Current ratio

Current assets / current liabilities

Acid test ratio

Current assets - inventory / current liabilities * 100

Stock turnover

Stock turnover measures the number of times a firm sells its stock within a time period, usually one year

Stock turnover formula

• Stock turnover (number of times) = Cost of sales/Average stock 

• Stock turnover (number of days = Average stock/cost of sales * 365

Debtor days

Measures the average number of days it takes a business to collect money from its debtors 

Debtor days formula

Debtor days = Debtors/Total sales revenue * 365 

Credit days

This ratio is used to measure the number of days it takes, on average, for a business to pay its trade creditors 

Credit days formula

Creditors/cost of sales * 365

Strategies to improve credit days

• A firm needs to improve its debtor days in order to collect enough cash to pay its creditors in a timely manner 

• Therefore using strategies to improve debtor days may help improve its creditor days 

• A firm can also negotiate for longer trade credit terms if its struggles are due to a long working capital cycle

Gearing ratio

The gearing ratio is used to assess a firm's long-term liquidity position

Gearing ratio formula

noncurrent liabilities/capital employed * 100 

higher than 50% = highly geared —> difficult to seek external sources finance as lenders are hesitant to lend to a highly geared business

Strategies to improve gearing ratio

• Develop closer relationships with customers to reduce the debt collection time 

• Develop closer relationships with creditors and suppliers to extend credit periods 

• Introduce a system of just-in-time production to eliminate the need to hold large amounts of stock 

• Improve credit control  

Insolvency

• Occurs when firms are unable to settle their debts when due because of lack of funds or cash in their bank accounts 

• A firm can recover from insolvency if it takes the measures necessary to tackle insolvency

Bankruptcy

• This is the formal and legal declaration of a firm’s inability to settle its debt 

• The business owes so much that selling all its assets is not enough to settle its debts 

• The business has failed and is unable to continue trading 

Difference between profit and cash flow

Cash flow shows how much money moves in and out of your business, while profit illustrates how much money is left over after you've paid all your expenses.

Working capital

Difference between a company’s current assets and current liabilities

Liquidity position

a company's ability to use its current assets to meet its current or short-term liabilities

Cash flow forecasts

shows where your cash balances will be at certain points in the future. This helps highlight when and where funding needs arise and allows you to take advantage of times when excess liquidity is available.

The relationship between investment, profit and cash flow

• Business investment involves the purchase of assets that are expected to create value over time

  • E.g the purchase of new machinery will improve productivity or quality which may allow the business to sell more items at a higher price and this increases sales revenue 

• Financial investment may include the purchase of shares, bonds or property with the expectation that they will gain value over time

Strategies for dealing with cash flow problems

• Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action

• Budget effectively and consider adopting zero budgeting to carefully control spending

• Set clear financial objectives and look for ways to reduce outflows and increase inflows wherever possible

• Reduce the credit period offered to customers

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

• Sell off excess stock

• Sell assets and lease fixed assets instead

Investment appraisal

Investment appraisal involves comparing the expected future cash flows of an investment with the initial expenditure on that investment 

Simple payback period

• The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself 

• initial outlay / net cash flow per period = years/months

Average rate of return

• The Average Rate of Return compares the average  profit per year generated by an investment with the value of the initial capital cost 

• ((total returns - capital cost) /years of use) /capital costs  

Net present value

• The Net Present Value (NPV) takes into account the effects of interest rates and time

• It recognises

  • The fact that that money received in the future is often worth less than money received today (inflation)

  • The opportunity cost of not having the money available for other uses

  • the value of all future net cash flows in today’s terms need to be calculated first and then discounted using a table

  • The cost of the initial investment is deducted from the total of the discounted net cash flows

    • If future net cash flows minus the initial investment are positive, then the investment is likely to be worthwhile

    • If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile

The difference between cost and profit centres

Profit Center: is a unit of a business to which costs and profits can be allocated for accounting purposes

Cost Center: A unit of a business to which the costs can be allocated for accounting purposes

Purpose is to see how efficiently costs are minimised and profits are maximised in different business parts

Pros of cost and profit centres

• efficiency monitoring

• decision making and planning

• motivator

• new perspective

Cons of cost and profit centres

• Stress

• qualitative factors are ignored

• interdependence and coordination are at risk

• not always feasible

Budget

Financial plan of estimated revenues and expenditures for a future time period

Budget holder

person or group of people who formulate budgets and are in charge of their achievement

Variance

discrepancy between actual and budgeted outcomes

expressed as % or $

favourable or adverse