Unit 2 Finance Review

Why do businesses need funding

Capital: Acquiring items that last longer than one year; e.g. fixed assets

Revenue Expenditures: Costs for the day-to-day running of a business; e.g. regular expenses

Internal sources of finance + examples explained

Finance generated from within the business

• Personal funds: Money invested into the business by the owner

• Retained profit: Profit kept by the business instead of being paid to the owners

• Sale of assets: Selling business assets to raise money; can include selling an asset and leasing it back

External sources of finance

Money raised from outside the business; Equity finance, Debt Finance, Other Sources

Equity finance

• Share capital: Money raised by selling shares in a business

• Business angels: Affluent individuals who provide financial capital to small start ups or entrepreneurs in return for ownership equity in the business Ex. Shark tank

• Venture capital: Investment from firms in businesses with high growth potential, usually in exchange for ownership

Debt finance:

• Loan Capital: Money borrowed from a lender that is repaid over a set period, usually with interest

• Overdrafts: A bank facility allowing a business to spend more money than it has in its account

• Trade credit: An agreement allowing a business to buy now and pay suppliers later

• Microfinance small loans, for low-income or unemployed individuals who lack access to traditional banking.

Other sources of External Finance

Crowdfunding: Raising small amounts of money from many people, usually through an online platform Ex. Kickstarter

Leasing: Paying to use an asset for a period of time instead of buying it;

Factors to consider when choosing a finance option

• Purpose: What the money will be used for;

• Cost: How expensive the finance is, including interest and opportunity cost;

• Opportunity cost: The value of the next best option given up;

• Length of financing: How long the business needs the money for;

• Size of business: The size of the business can affect which finance options are available;

• Amount required: The amount of money needed affects which finance options are suitable;

• Type of business: The type of business can affect which finance options are available;

• Flexibility: How easily the finance can be changed or adapted to the business's needs;

• State of external environment: Economic conditions can affect the availability and cost of finance;

“Please Come Over Later, Sarah And Take Five Eggs.”

Different length of financing

• Short-term finance: Finance needed for less than 1 year

• Medium-term finance: Finance needed for 1–5 years

• Long-term finance: Finance needed for 5–30 years

Opportunity cost

The value of the next best option that is given up when making a choice.
Example: If a business spends $10,000 on new equipment, it cannot use that $10,000 for advertising. The advertising is the opportunity cost.

Gearing:

The relationship between a business’s loan capital and share capital. A business with more loan capital than share capital is high geared, while one with more share capital than loan capital is low geared.

Types of Costs

• Fixed costs: Costs that stay the same even when production changes; example: salaries, equipment

• Variable costs: Costs that change depending on the level of production; example: ingredients, packaging

• Semi-variable costs: Costs that have both fixed and variable parts; example: phone bills, staff wages

• Direct costs: Costs that can be directly linked to producing a product or service; example: wages, materials

• Indirect costs: Costs that cannot be directly linked to producing a specific product or service; example: advertising

Total revenue

• The total money earned from selling goods or services

• Price × Quantity;

Types of Revenue

Money earned by a business from its activities or other sources;

• Rental revenue: Money earned from renting out property or equipment;

• Sale of fixed assets: Money earned from selling long-term assets, such as equipment or vehicles;

• Dividends: Money received from investments in shares of other businesses;

• Interest on deposits: Money earned from money kept in a bank account;

• Donations: Money given to a business or organization without expecting repayment;

• Grants and subsidies: Money provided by governments or other organizations to support a business or activity;

Stakeholders

• Internal: Shareholders, Managers, Employees

• External: Government, Competitors, Community, Suppliers, Customers, Media

What a Ratio Tells Us, Types of Ratios

• A ratio helps assess a business’s financial performance and position.

• It shows strengths, weaknesses, and areas for improvement.

• Ratios are most useful when:

  • compared with previous years (trend analysis)

  • compared with other businesses in the same industry

• Profitability Ratios: measure a business’s ability to generate profit.

• Liquidity Ratios: measure a business’s ability to pay short-term liabilities.

• Efficiency Ratios: measure how effectively a business uses its assets, liabilities, and performs as a business

Gross Profit Margin (GPM)

• Shows the % of sales revenue that remains after covering the cost of goods sold.

• A higher percentage is better, as it leaves more money to cover operating expenses and profit.

• Increase selling prices

  • Source cheaper supplies

  • Reduce direct labour costs

  • Promotions to increase sales

Profit Margin (PM) what is it? high vs low percentage? how to improve 4?

• Shows the % of sales that becomes profit (For every $100 of sales, it shows how much profit the business earns.)

• A higher percentage is better.

• A low profit margin may make it difficult to cover expenses.

• How to improve:

• Increase prices

• Reduce production costs

• Lower operating expenses

• Improve efficiency

Current Ratio. What is it? High, Low,? (3 reasons)

• Indicates whether the business can meet its short-term obligations.

• An acceptable range is generally 1.5:1 to 2:1.

• Below 1:1 is a warning sign.

• A very high ratio may suggest inefficient use of assets.

• Possible reasons for a very high ratio:

  • Too much cash sitting idle

  • High AR

  • Excess inventory

Acid-Test (Quick) Ratio

• Similar to the current ratio, but excludes stock/inventory.

• Measures the ability to pay current liabilities without relying on stock sales.

• A higher ratio generally indicates stronger liquidity.

Debtor Days, how long should it be (how to imporve 4)

• Measures the average number of days customers take to pay. A shorter period is better, as cash is collected more quickly.

• How to improve: Offer early-payment discounts, Charge penalties for late payment, Use debt factoring, Strengthen credit control procedures

Creditor Days. What is it? long vs short? imporve (3)

• Measures the average number of days the business takes to pay suppliers.

• A longer period can improve cash flow.

• However, taking too long may damage supplier relationships.

• How to improve management: Maintain strong supplier relationships, Review whether early payment discounts are worthwhile, Use effective credit control

Gearing Ratio, What is it? High? Low? How to Improve?

• Shows the % of capital financed through loans (liabilities).

• High gearing: More financing comes from debt. High gearing increases financial risk.

• Low gearing: More financing comes from owner’s equity. Low gearing usually means greater financial stability.

• How to improve: Use alternative sources of finance (such as equity), Retain profits instead of paying large dividends Reduce reliance on borrowing

Return on Capital Employed (ROCE)

• % evaluating the return generated from the capital employed in the business.

• The higher the ROCE, the higher the return for the business.

• To improve it, minimize loan capital, which reduces capital employed.

• Compare it with the bank interest rate: if ROCE is higher, the capital earns more inside the business than it would in a bank.

Stock Turnover Ratio, What is it? Whats better high or low? how to improve (3

Shows how many times inventory/stock is sold and replaced during a period. Higher turnover (or fewer days) is usually better. Ideal turnover varies by industry. Formula for Average Stock: Average Stock = Opening Stock + Closing Stock/2 How to improve: Dispose of obsolete inventory, Narrow the product range, Use Just-in-Time (JIT) stock control

Fixed Vs. Intangible Assets

Fixed assets are physical assets used by a business long-term (e.g., buildings, machinery, vehicles)

Intangible assets have no physical form but still have value (e.g., patents, goodwill, copyright laws, trademarks).

Patent

A patent gives an inventor exclusive legal rights to an idea or invention, allowing them to use, sell, or control it and prevent others from copying it. It can last up to 20 years.

What is goodwill?

Goodwill is the extra value of a business beyond its book value, based on things like its reputation, customer base, brand name, employees, and location. It is determined when the business is sold.

What are copyright laws?

Copyright laws protect original creative works from being used without permission. Examples include music, novels, and computer software.

What is a trademark?

A trademark is a symbol, word, or phrase that identifies a product or business. It can be renewed every 15 years for a fee.

What is working capital? What does it do?

Working Capital = Current Assets − Current Liabilities. It measures the amount of money available for a business’s day-to-day operations.

What are net assets?

Net Assets = Total Assets − Total Liabilities.

What is equity?

Equity is the owner’s/shareholders’ claim on the business after all liabilities are paid.

• Share Capital: Money invested in the business by shareholders when they buy shares.

• Retained Earnings: Profits kept in the business instead of being paid to shareholders.

• Formula: Equity = Share Capital + Retained Earnings

What is depreciation? What are the main methods of calculating depreciation?

What are the benefits and disadvantages of the Units of Production and Straight-Line depreciation methods?

Depreciation is the decrease in the value of a fixed asset over time due to use, wear and tear, or age.

Units of Production Method

Depreciation per unit = cost - salvage value / total estimated units

Depreciation expense = depreciation per unit x units produced

Straight-line method

Original cost − Residual value ÷ Expected useful life

• Units of Production: ✅ More accurate when an asset’s use varies each year. ❌ Requires tracking how much the asset is used/produces.

• Straight-Line: ✅ Simple and easy to calculate. ❌ Less accurate if the asset is used more in some years than others.

What are the elements of a decision tree?

□ Square (Decision Node):

○ Circle (Probability Node):

✕ Crossed-out line: Indicates that the option is rejected.

What is an income statement (profit and loss account)?

An income statement shows a business’s revenue, costs, expenses, and net income (profit).

Gross Profit

Revenue − Cost of Goods Sold

Net Income

Gross Profit − Expenses

Cost of Goods Sold (COGS)

• The cost of purchasing or producing the goods sold during the period.

• COGS = Opening Stock + Purchases − Closing Stock

For these main stakeholders, why would they want to see financial statements?

• Owners & Shareholders

• Managers

• Employees

• Investors

• Bankers & Lenders

• Government

• Suppliers

• Customers

• Owners & Shareholders: To see if the business is profitable and if their investment is doing well.

• Managers: To make business decisions and plan for the future.

• Employees: To see if the business is financially stable and can pay their wages.

• Investors: To decide whether to invest in the business.

• Bankers & Lenders: To determine if the business can repay loans.

• Government: To calculate taxes and ensure laws are being followed.

• Suppliers: To see if the business can pay its bills.

• Customers: To see if the business is stable enough to continue operating.

Net cash flow

The difference between cash inflow and cash outflow. If inflows are bigger the number is positive, if outflows are bigger it is negative.

Insolvency

• When a business could be profitable but has little or no cash.

• Can occur when: Debtor days too long, Loss on sales, Increased cost, Creditor days too short

• Legal action: If business in insolvent - try to resolve, can declare bankrupt or liquidate

Liquidation

Selling assets to pay off debts.

Working capital, also called..

Current assets minus current liabilities. Also called net current assets.

Cash flow forecast

A prediction of future cash inflows and outflows. Used to anticipate future operations and avoid cash flow problems.

Explain the benefits of a cash flow forecast

It helps a business anticipate future operations and avoid cash flow problems, for example by spotting a future cash shortfall early so finance can be arranged in time.

Strategies to reduce cash outflow and improve cash inflow

Reduce outflow: delay payment to creditors, delay purchase of fixed assets, lease rather than purchase, use cheaper suppliers, decrease expenses.
Improve inflow: insist customers pay cash, offer discounts or incentives for early payment, diversify the product offering, sell fixed assets.

Payback period

The time it takes for an investment to pay for itself.

1. When cash flow is the same each year:

Payback period= Initial investment cost/Annual net cash flow

• Shorter payback period = better, because the business gets its money back faster.

• Payback measures how quickly the money is recovered, not how profitable the investment is overall.

2. When annual cash flow is different each year

• Calculate the cumulative cash flow year by year.

• Subtract each year's net cash flow from the remaining investment cost until the amount left to recover reaches $0 or less.

• If the investment is paid back partway through a year, calculate the partial year.

• (Amount left to pay/Net cash flow in that year) x12

Average rate of return, What is it? What’s Criterion rate, whats capital cost and total returns, what is better

• ARR tells you the average annual return an investment makes compared with its original cost.

• A higher ARR means the business earns a greater return for the money it invested. Investment A: ARR = 5% Investment B: ARR = 12% Investment B is better because it earns a higher average return relative to its cost.

• Capital cost is the initial amount of money a business spends to buy or start an investment.

• Total returns = total money received from the investment over its lifetime.

• Criterion rate = the minimum ARR (%) a business is willing to accept for an investment. Example: If a business sets a criterion rate of 10%: ARR of 15% → meets the requirement ✅ ARR of 7% → below the requirement, so the business may reject it ❌ Remember: Criterion rate = the minimum acceptable return.

Net present value

• Measures whether an investment's future returns, adjusted for the time value of money, are worth more or less than its original cost.

• Positive NPV: Investment is expected to create value.

• Negative NPV: Investment is expected to lose value.

• Higher NPV is generally better when comparing investments.

Advantages and disadvantages of each investemnt appraisal method 

Payback:

• it is simple and quick and shows how fast the cash is recovered.

• it ignores cash flows after payback and ignores the time value of money.
  
  

ARR:

• it uses all profits and is easy to compare against other options or a criterion rate.

• it ignores the time value of money and is based on profit not cash.

NPV:

• it accounts for the time value of money through discounting.

• it is more complex and depends on picking the right discount rate

Budget

A financial plan setting targets for income and spending. Important for planning (set targets), motivation (to reach the goal), resource allocation (limits on how much to spend and where), and control (checking how money is being spent).

Cost centres

Parts of the business that look after costs. Can be a department, a product, or a location. Examples: wages, advertising, insurance.

Profit centres

Parts of the business that look after revenue and costs. Can be a department, a product, or a location.

Variance

The difference between the budgeted and actual numbers. Favourable variance means the figures are better for the business. Adverse variance means they are worse, more costly.

Explain the advantages and disadvantages of using budgets and variances

Advantages:

• budgets set targets for planning

• motivate staff to reach goals

• allocate resources by limiting spending

• and allow control by checking how money is spent

• Variances highlight where actual figures differ from the budget so corrective action can be taken.

Disadvantages:

• budgets take time to prepare

• unrealistic targets can demotivate

• and they rest on forecasts that may be wrong.

• Investigating variances costs time and money, and a variance may reflect a bad budget rather than bad performance.

Profit

sales revenue - cost of goods sold

Working capital cycle

The time between paying for goods supplied and receiving cash from the sale.

Why can a business have positive profit margins but negative cash flow?

Because profit is recorded when sales are made, but cash only arrives when customers actually pay. If customers do not pay on time, the business shows a profit but has no cash.

Additional finance sources for cash flow problems

Bank overdraft, borrowing short term from the bank to cover a cash shortfall. Sale and leaseback, selling a fixed asset and then leasing it back to raise cash while keeping its use.

Limitations of cash flow forecasting

Forecasts rely on assumptions that may not hold. They can be thrown off by changes in the economy, poor market research, difficulty predicting customer behaviour, equipment failure, or demotivated employees.

Cash flow at different business stages

Startup: high investment, no profit, negative cash flow because outflows are larger than inflows. Growing: investment could still be high, small profit, positive but probably low cash flow. Established or thriving: low investment, high profit, positive cash flow.

Limitations of financial statements

Profit and loss account gives an accurate description of annual profits but may be of limited predictive value. Balance sheet is only a snapshot of one point in time and can change rapidly if the business sells assets or takes on debt. Cash flow forecast includes assumptions about the future that may not hold true.

Collateral

An asset pledged as security for a loan. If the borrower cannot repay, the lender can take and sell the collateral.

Investment appraisal

• evaluating an investment to decide whether it is worth the money.

• businesses use methods such as: Payback period, Average Rate of Return, Net Present Value

Microcredit

small loans to underprivileged clients

Bankruptcy

• Unable to pay debt - and file for bankruptcy

• once bankrupt chance to restructure