unit 5 business

functions of financial department

• records transactions

• forecasts cash flow

• prepares accounting information

• prepares financial accounts

• makes financial decisions

start up capital definition

financial sources needed by an entrepreneur when first starting a business to buy fixed and current assets

assets definition

items of value which are owned by the business

Intangible assets definition

• assets that do not exist physically but can have value

• e.g brand name, patent, copyright

working capital definition

• finance needed by business to pay its day-to-day costs which do not involve the purchase of long-term, fixed assets

• e.g wages, bills, materials

capital expenditure definition

• spending by a business on fixed assets which will last for more than one year

• Used during start-up or during expansion

  • product development, R&D, takeovers

revenue expenditure definition

money spent by a business on day-to-day expenses which don’t involve purchase of long-term assets, such as wages or rent

short term finance definition

• loans or debts used to overcome cash-flow problems and the business expects to pay them back within one year

• short term bank loans, overdraft

long term finance definition

loans or debts to finance purchases of fixed assets or business expansion and the business expects to pay them back in 5 years or longer

internal sources of finance

• owners savings

• retained profit

• sale of unwanted fixed assets

• sale of inventories

• sale and leaseback

• use of working capital

owners savings internal sources of finance advantages + disadvantages

• advantages - no interest is paid, should be quickly available

• disadvantages - savings may be too low, increases risk taken by owners which have unlimited liability

retained profit definition

profit remaining after all expenses, tax and dividends have been paid out, and which is reinvested back into the business

retained profit internal sources of finance advantages + disadvantages

• advantages - does not have to be repaid, no interest

• disadvantages - new business has no retained profit, small firms → don’t have enough retained profit to finance expansion, lower dividends → investors invest into other businesses

sale of unwanted fixed assets internal sources of finance advantages + disadvantages

• advantages - makes better use of the capital tied up in the business, does not increase debts of a business, land + buildings often raise a lot of money

• disadvantages - may take time to sell assets, not available to new businesses as they dont have any unwanted fixed assets to sell

sale of inventories internal sources of finance advantages + disadvantages

• advantage - reduces opportunity cost + storage cost of high inventory levels

• disadvantage - must be done carefully - if too many inventories are sold → customers disappointed since not enough goods a kept in inventory

external sources of finance

• short term -

  • overdrafts

  • debt factoring

  • trade credit

• long term -

  • bank loans

  • mortgage

  • debenture

  • leasing

  • share issue

  • hire purchase

overdraft external source of finance

• Agreement with a bank that allows a business to spend more money than it has in its account up to an agreed limit. The loan must be repaid within 12 months

• able to take at short notice → flexible for business

• high interest rate → only used in case of short term cash flow problems

trade credit external source of finance

• agreement between a business and its supplier that the business can pay for the supplied materials at an agreed time in the future

• almost interest free

• Regular delayed payments → risk of demanding payment upfront

• no further deliveries until old ones are paid

• any discount will be lost

debt factoring external sources of finance

• selling trade receivables to improve business liquidity

• immediate cash for the business

• risk of collecting the debt becomes the factoring businesses problem

• business does not receive 100% of the value of the debts

trade receivables definition

Amount owed to a business by its customers who bought goods on credit.

mortgage external source of finance

• long term loan used to buy land or buildings

• interest is paid every year

• similar to bank loan

debenture external sources of finance

• bond issued by a company to raise long term finance usually at fixed rate of interest

• used to raise large sums of money

• owner of bond receives interest + full price upon maturity date

leasing external sources of finance

• using a fixed asset by paying a fixed amount per time period for a fixed period of time.

• ownership remains with leasing company

• used with machines

• no big one time payment needed

• high interest rates

hire purchase external source of finance

• purchase of an asset by paying a fixed repayment amount per time period over an agreed period of time.

• The asset is owned by the financing firm

  until the final repayment.

• purchasing firm responsible for maintenance + repairs

• higher interest rates

• no big one time payment needed

Bank loan external source of finance

finance provided by a bank which the business will repay with interest over an agreed period of time

share issue external source of finance

• source of permanent capital available to limited liability companies after they sell their shares

• capital does not have to be repaid however shareholders expect dividends

• no interest

• risk of takeover

authorised share capital definition

maximum amount of shares a business is allowed to sell

government grants source of finance

• often offered to startups/small/medium sized businesses

• do not have to be repaid

• often with strings attached e.g business has to relocate

crowd funding source of finance

• Financing a business idea by obtaining small amounts of capital from a large number of people, most often using internet and social medias

• include how investors benefit after enough money is raised

• if total amount is not raised finance has to be repaid

• can be a fast way to raise large sums

micro funding source of finance

• Small amounts of capital loaned to entrepreneurs in less developed countries where finance is often difficult to obtain.

• These loans are usually repaid after a relatively short period of time

factors influencing source of finance

• amount of finance required

• length of time when finance is needed

• size + legal form of business

• existing borrowing

• profitability of business

• desire to keep ownership of business

will banks lend ?

• is cashflow forecast available?

• is business plan available?

• is a forecasted income statement available?

• will the loan be secured?

• why is the loan needed?

will shareholders invest ?

• are the future prospects for a company good?

• how do company dividends differ from other companies

• how has the companies share price level varied?

cash inflow

• sums of money received by a business during a period of time

• e.g sales revenues, payment by debtors, borrowing, sales of assets, investments

cash outflow

• sums of money paid out by a business during a period of time

• e.g Expenditures to buy materials, paying wages & bills, paying off debts, buying fixed assets

cash flow

cash inflows and cash outflows over a period of time

net cash flow, positive cash flow, negative cash flow

• net cash flow - cash inflow - cash outflows

• positive cash flow - cash inflows > cash outflows

• negative cash flow - cash inflows < cash outflows

cash flow management

Ensures that the business has enough cash whenever they need to pay their employees, suppliers, etc.

why are cashflow forecasts important

• prevent negative cash flow

• convince banks to provide loans

• to help managers plan ahead

how to solve short term cash flow problems

• hire purchase, leasing

• bank loan

• overdraft

• all more expensive than delaying purchase by one month

• ask customers to pay trade receivables quicker

• negotiate longer trade credit with supplier

what is meant by liquidity of a business

ability of a business to pay its short term debts

how to measure business liquidity

• working capital

• Enough working capital to pay debts → business is liquid

working capital cycle definition

Time it takes from buying raw materials, making these into goods for sale, finding buyers for them and receiving payments from customers

factors that affect amount of working capital

• level of inventories - less inventories → less working capital needed

• trade credit terms - longer trade credit → less working capital needed

• length of production process - short production process → less working capital

• how quickly the business finds customers - quickly → less working capital

• trade receivables terms - shorter credit sales → less working capital

overhead costs

• day-to-day operating expenses of a business, but not directly related to creating a product

• e.g rent, insurance, marketing, wages of sales people

cost of goods sold

• direct costs of producing the goods sold by a company: costs of material & production labor

• e.g costs of flour, sugar to make a cake, baker’s wages

profit vs gross profit vs retained profit

• profit - difference between total revenue and total costs

• gross profit - difference between revenues and direct production costs.

• retained profit - profit remaining after all expenses, tax and dividends have been paid, which is then reinvested back into the business”

dividends

payment, out of profit, to shareholders as reward for their investment

why is profit important

• As a reward for business owners for the risk of investing into business

• To attract investors who provide additional funs for business expansion

• As a measure of success of a business & performance of managers

• Source of finance: retained profit as an internal source of finance

• To decide whether to continue making & selling a product or not

• To decide if to expand the business / buy fixed assets

cash flow vs profit

• cash flow - pays day to day expenses → important to business short term + long term

• profit - measure of success of business → important long term

• How do the following directly affect cash flow and profit?

  1. Business takes a bank loan:

  2. Business buys a new machine:

  3. Business sold goods, but will receive money for it next month

• 1 - Cash increases, profit unchanged

• 2 - Cash decrease profit unchanged

• 3 - Cash unchanged, profit increased

how can a profitable business run out of cash

• buy too many fixed assets at once

• offer too long trade credit period

• expanding too quickly

• too many inventories

income statement

• financial statement which records the revenue, costs and profits of a business for a given period of time (usually once a year)

• necessary for strategic decision making

how is the income statement important for shareholders + lenders

shareholders - high profit → high dividends + increase in market price of shares

lenders - higher profit → safe to pay loans on time

how is the income statement important for managers + employees

managers - high profit → business done well + source of finance for expansion

employees - high profit + chance of bonuses

how is the income statement important for government + suppliers

government - higher profit → higher tax revenue

suppliers - higher profit → promise of future purchases of their supplies

balance sheet / statement of financial position definition

• an accounting statement that records assets, liabilities and owner’s equity of a business at a particular date

• needs to be done by incorporated businesses at the end of each financial year

owners equity

• amount owed by business to its owners, including capital and retained profit

• money invested by owners

net assets formula

• total assets - total liabilities

• = working capital

capital employed formula

non current liabilities + shareholders equity

a balance sheet shows

• Assets that the business owns and their value

• What the business is owed and its value

• What the business owes and its value

• How the business finances its activities

• Amount of working capital

disadvantages of balance sheets

• shows the financial position of a business for only one particular day

• value of assets/liabilities can be changed quickly

• does not show trends / flows

• value of non current assets might not reflect the market value of them

• not a good indicator of how much a business is worth

how do banks + share holders benefit from balance sheets

• banks - know if it is risky to lend money

• shareholders - see how much business is worth + if it is managed well

capital employed definition

shareholders equity + non current liabilities → the total long term and permanent capital invested in a business

profitability definition

the measurement of the profit made relative to either the value of sales achieved or the capital invested in the business

who is profitability important for

• investors when deciding which business to invest into

• directors + managers to assess if the business is becoming more/less successful overtime → might lead to changes in operations to improve profitability

how to measure profitability ?

• gross profit margin

• profit margin

• return on capital employed

Gross profit margin, profit margin, return on capital employed formula

• gross profit - (gross profit/revenue) x 100

• profit - (profit/revenue) x 100

• return on capital employed - (net profit/capital employed) x 100

higher gross profit margin means…

• higher revenues without similar increase in cost of sales

• keeping revenues and lowering costs of goods sold

• good has more added value (added value = selling price - direct costs)

profit margin description

• profit earned per 1$ revenue

• affected by cost of goods sold + revenue + expenses

higher profit margin means …

• higher revenues without similar increase in costs of sales, keeping revenues and lowering cost of goods sold

• lower expenses (overheads)

what does the difference between profit and gross profit mean

• difference = expenses

• small difference → low expenses → costs controlled well

• big difference → high expenses → costs controlled poorly

Analysis of return on capital employed

• ROCE increases over time → business is getting more profitable

• if ROCE of business A > ROCE business B → Business A = more profitable

• ROCE high → business is using resources efficiently

how to measure liquidity - ratio

• current ratio

• acid test ratio

current ratio - formula + optimum value + limitation

• current assets/current liabilities

• optimum value → between 1.5 and 2

• limitation → inventories are the least liquid form of current assets → including them can skew the current ratio significantly

analysis of current ratio

• below 1.5 → risk of not having enough cash to pay short term debts → cash flow problems

• more than 2 → business has too much cash in unprofitable assets → missing on potential gains

why are inventories less liquid

• it takes time to sell finished goods

• when goods are sold on credit → business needs to wait for customer to pay

Acid test ratio optimum value + formula

• (current assets-inventories)/current liabilities

• optimum value - 1

analysis of acid test ratio

• if less than 1 - risk of not having enough cash to pay short term debts → cash flow problems

• if more than 1 - business has too much cash in unprofitable assets → missing on potential gains

profitability vs liquidity

• a lot of cash → increases liquidity but limits profitability as is not used to buy profit making assets

• a lot of non current assets → limits liquidity in short run but increases profitability in long run

Benefits of ratio analysis

• Stakeholders can compare ratios over time → can identify trends

• No need to investigate all financial statements to get the information → information received quickly

• Stakeholders can compare results with other businesses to see how well the business is doing

Limitations of ratio analysis

• Ratios compare past data → does not predict the future

• Ratios do not include all strengths & weaknesses that affect profitability (e.g. quality of human capital)

• Financial statements prepared in different ways from company to company → harder to compare

• Effect of external factors, (e.g. laws, exchange rates, economic factors, not considered)

Who cares about ratio analysis pt 1 - owners+shareholders, potential investors, lenders, managers

• owners + shareholders - more profit → higher investment, business market value increases → wealth

• Potential investors - comparing dividends between businesses

• Lenders - high profit + liquidity → safe (lenders get back money + interest)

• Managers - are financial objectives achieved? , more retained profit → can buy more technologies,

Who cares about ratio analysis pt 2 trade payables, government, employees, customers

• trade payables - does business have enough working capital to pay goods on credit?,higher profits → chance of expansion → more need for raw materials → chance to increase supplier revenue

• government - higher profit → more tax revenue, higher revenue + profit → higher employment → government spends less on unemployment

• employees - more profit + revenues → job security + chance to negotiate higher wages

• customers - higher profits + revenues → business will continue to producing goods + profit reinvested to increase the quality