Chapter 3 Flashcards Key Concepts

Capital Expenditure

is the finance spent on fixed assets. These are items of monetary value that have a long-term function so can be used repeatedly, e.g. land, buildings, equipment, machinery and vehicles. Fixed assets determine the scale of a firm's operations. They are not intended for resale (in the short term) but for the purpose of generating money for the business. The sources of finance for capital expenditure tend to come from medium and long-term sources because of the high cost offinancing fixed assets. These assets can alsoprovide collateral (financial guarantee) for securing additional loan capital.

Revenue Expenditure

refers to payments for the daily running of a business, e.g. wages, raw materials, rent and electricity. It also includes the payment of indirect costs such as insurance and advertising. Costs must be controlled so that the business can generate enough revenue to earn a profit

Internal Sources of Finance

Ways of raising finance from within the business, such as retained profit or debt factoring.

Personal Funds

main source of finance for sole traders and for partnerships

Retained Profits

the value of profits that the business keeps (after paying taxes to the government and dividends to its shareholders) to use within the business. Retained profits are often used for purchasing and/or upgrading fixed assets.

Sale of Assets

Businesses can sell their dormant assets (unused assets), such as selling old machinery and computer equipment that have been replaced. If a business has chosen to relocate, it might be able to raise finance through the sale of land and buildings

External Sources of Finance

getting funds from outside the organization, e.g. through debt (overdrafts, loans and debentures), share capital, or the government.

Share Capital

the main source of finance for most limited liability companies, as shown in a firms balance sheet. Share capital is the money raised from selling shares in the company. The key advantage is that it can provide a huge amount of finance.

Private limited companies cannot sell their shares to the general public whereas public limited companies can issue their shares on a stock exchange

Initial Public Offering (IPO)

the first time a company issues stock that may be bought by the general public

Share issue (share placement)

Exists when an existing public limited company raises further finance by selling more of its shares. However, by issuing shares, ownership and control of the business becomes diluted.

Loan Capital

money sourced from financial institutions such as banks, with interest charged on the loan to be repaid

Mortgage

a long-term loan extended to someone who buys property

Business Development Loan

These loans are catered to meet the specific development needs of the borrower

Debentures

These are essentially long-term loans issued by a business. Debenture holders (individuals,

governments or other businesses) receive interest payments even if the business makes a loss and before shareholders are paid any dividend. The interest payment can be fixed or variable depending on the type of debenture. Unlike shareholders, debenture holders do not usually have ownership or voting rights.

What happens when shareholders sell their shares?

When shareholders sell their shares, the company does not receive any of this money as these shares are traded on the secondary market of the stock exchange; no new shares have been issued by the company.

Overdrafts

This allows a business to temporarily overdraw on its bank account, i.e. to take out more money than it has in its account. Overdrafts are commonly used when businesses have minor cash flow problems. Although overdrafts can demand a relatively high rate of interest, they are usually more cost-effective than bank loans. This is because, unlike bank loans, overdrafts are used as short-term sources of finance and interest is charged on a daily basis if, and only if, a business overdraws on its account

Trade Credit

This source of finance allows a business to 'buy now and pay later'. Although a sale is made at the time of purchase, the seller or credit provider does not receive any cash from the buyer until a later date.

Creditors

persons or institutions to whom money is owed

Debtors

Customers who have bought products on credit and will pay cash at an agreed date in the future

Credit Card

a small plastic card issued by a bank, business, etc., allowing the holder to purchase goods or services on credit.

Grants

This refers to government financial gifts (non-repayable funds) to support business activities. Grants are usually offered to eligible businesses as one-off payments and do not need to be repaid

Subsidies

The focus of subsidies is to provide extended benefits to society. It is a sum of money granted by the government or a public body to assist an industry or business so that the price of a commodity or service may remain low or competitive.

Debt Factoring

A financial service whereby a factor (such as a bank) collects debts on behalf of other businesses, in return for a fee.

Leasing

a form of hiring whereby a contract is agreed between a leasing company (the lessor) and the customer (the lessee). The lessee pays rental income to hire assets from the lessor, who is the legal owner of the assets. It can be cheaperto lease assets such as machinery, equipment, vehicles and buildings, especially in the short to medium term. Hence, leasing is suitable for business customers who do not have the initial capital to buy such assets.

Sale-and-leaseback

A transaction in which the owner sells improved property and, as part of the same transaction, signs a long term lease to remain in possession of the premises.

Hire Purchase

an asset is sold to a company that agrees to pay fixed repayments over an agreed time period - the asset belongs to the company

Venture Capital

Money provided by large investors to finance new products and new businesses that have a good chance to be very profitable. This is a form of high-risk capital, usually in the form of loans or shares, invested by venture capital firms, usually at the start of a business idea.

Return on Investment (ROI)

the direct financial impact of a firm's expenditure of a resource, such as time or money

The Business Plan

A written description of the business idea and how it will be carried out, including all major business activities. This should outline the long-term aim and purpose of the business venture. The purpose creates direction and an identity for the business, which is central to securing finance from investors.

Business Angels

wealthy entrepreneurs who risk their own money by investing in small to medium-sized businesses that have high growth potential

Short Term Finance

Sources of money for businesses that may have to be repaid with immediately or fairly quickly, such as an overdraft, usually within a year.

Medium Term Finance

acquiring finance medium-term (1-5 years typically) from an outside source. This is not cheap but it is good for short-term cash. Medium term sources of finance include commercial loans or hire purchase agreements in excess of a year.

Long Term Finance

refers to any period of five years or longer. The longer the time period in question, the harder it becomes to plan effectively. Examples of long-term sources of finance include long-term loans such as mortgages and debentures.

STAGE PC

Size and status of firm

Timeframe

Amount Required

Gearing

External Factors

Purpose of Finance

Cost of Finance

Types of Cost

fixed, variable, total

Fixed Costs

Costs that do not vary with production or sales level. . Examples include rent on leased premises, interest payments on bank loans, advertising expenditure, market research, management salaries, etc...

Variable Costs

Costs that vary with the quantity of output produced. This means that if the level of output or sales doubles, then variable costs would also double. For example, raw material costs will increase if a textiles firm makes more curtains. Other examples include the commission earned by sales staff and the packaging costs directly associated with output.

Semi-Variable Costs

Costs that vary somewhat based on the number of units you sell. For example, mobile telephone and internet service providers often allow a user to have a predetermined number of 'free minutes' or a limit on data usage. However, there is also a 'standing charge' which means no matter how much (or little) the person uses the phone or internet, there is a fixed minimum monthly charge. If the user exceeds the quota, then the telephone and internet bills become variable.

Direct Costs

Costs that can be specifically identified with a particular project or activity. This can include variable costs such as raw materials. However, unlike variable costs, direct costs are not necessarily related to the level of output, i.e. they can be fixed costs. For example, the direct costs of purchasing a commercial building include: consultancy costs, solicitors fees, telephone bills, postage, photocopying costs, mortgage fees and bank charges.

Indirect costs (overheads)

Costs that are the result of a firm's general operations and are not directly tied to any specific cost object. For example, rent and lighting costs can be associated with all areas of a business rather than being directly linked to the output of a particular product.

Revenue

An increase in owner's equity resulting from the operation of a business

Revenue Equation

Sales revenue = Price x Quantity sold

Revenue Streams

Represents the cash a company generates from each customer segment.

Advertising Revenue

Money made by the network or station from the sale of commercial air time

Transaction Fees

A charge for making a transaction. Transaction fees may be a percentage of the total amount or a flat rate regardless of size.

Franchise Costs and Royalties

Franchisees pay a fee to the franchisor to purchase the right to use its brand name, logos and trademarks.

Sponsorship Revenue

Any revenue that comes from corporate sponsors is considered sponsorship revenue. Selling advertising space in and around a stadium is the primary way to generate sponsorship dollars.

Subscription Fees

The price of an individual channel, or, when bundled with other channels, makes up an entire cable package fee.

Merchandise

goods that a business purchases to sell

Dividends

Company's share profits to the shareholders based on the corporation's performance.

Donations

monetary or other gifts to organizations or people who are in need.

Subventions

These are subsidies offered from the government to certain businesses to help reduce their costs of production. They are usually given to organizations that generate benefits to society, such as private schools and hospitals.

Interest Earnings

Premium dollars are invested in various investments-stocks, mutual funds, real estate, etc., and the returns on these investments, including earned interest, help to keep the overall cost of life insurance premiums down.

Contribution

refers to the sum of money that remains after all direct and variable costs have been taken away from the sales revenue, i.e. the amount available to contribute towards paying fixed costs of production.

Unit Contribution Equation

Contribution per unit =P- AVC

where P is the price and AVC represents the average variable costs

Total Contribution Equation

Total contribution = (P - AVC) x Q

Profit Equation

Profit = Total contribution - TFC

total fixed costs (TFC)

How can profit be increased?

• Increasing sales of the product, which raises the total contribution (gross profit).

• Reducing variable costs, perhaps through negotiating better deals with current suppliers or seeking new suppliers that are more competitive.

• Reducing fixed costs and overheads, perhaps through better financial control or the use of cost and profit centers

Contribution Analysis

is a management tool that helps managers to identify areas of their business that are relatively profitable and areas that might need more attention.

Pricing Strategy

Contribution analysis helps a business to set prices for each of its products to ensure there is contribution being made towards payment of fixed and indirect costs.

Product Portfolio Management

The analysis can help managers to decide which products should be given investment priority. In general, products with a higher total contribution tend to be given precedence. Products that earn a low unit contribution rely on high sales volumes to avoid being withdrawn or replaced by other products.

Allocation of Overheads to cost and profit centers

The use of contribution analysis can ensure that cost allocation is done in a fair manner.

Make-Or-Buy decisions

Contribution analysis can help a business decide whether it should produce (make) the products or purchase them (buy) from suppliers. The relative difference between the unit contribution of making or buying the product is likely to determine the decision.

Special Order Decisions

These occur when a customer places an order at a price that differs from the normal price charged by the business. The price could be higher (although the customer will request added benefits for this, such as shorter delivery times) or lower (probably because the customer is buying a significant amount of the product). Whether the business takes on this special order will largely depend on the total contribution made from such a deal.

Break-Even Analysis

A business breaks even when neither a profit nor a loss is made. This occurs at the level of output where total costs equal total revenue, i.e. TC = TR. Break-even is a key objective of new and unestablished firms.

How does performing a Break Even Analysis help managers?

Whether it is financially worthwhile to produce or launch a particular good or service

The expected level of profits that the business will earn if all goes according to plan.

Margin of Safety

difference between your actual or expected profitability and the break even point

Margin of safety = Level of demand minus Break-even quantity

The MOS is calculated and shown on the x-axis of a break even chart, i.e. the unit of measurement is the volume of output rather than the value of that output.

*NOT A MONETARY VALUE

Benefits of BEA model

• Produce and/or sell a single, standardized product.

• Operate in a single market.

• Make products to order, i.e. all output is sold.

Downsides of BEA Model

BEA assumes that all cost functions are linear. In reality, cost curves are unlikely to be linear because economies of scale (and hence lower average costs of production) can be gained by operating on a larger scale. Fixed costs might also change, perhaps due to an increase in rent,

BEA assumes the sales revenue function is linear. In reality, customers would demand discounts for larger orders, thereby distorting the sales revenue line

It assumes that the business will sell all of its output. However, in reality most businesses will have some unsold stock, which do not generate cash but cost the firm money

As a static model, BEA might not be very useful in a dynamic business environment. For example, it ignores the possibility that production costs can and do change at short notice, such as fluctuating exchange rates which affect the costs and revenues of exporting firms.

BEA is really only suitable for single-product firms that sell all of their output. For firms with a broad product portfolio, overheads have to be split between the various products in a rather subjective way.

Final Accounts

Produced at the end of the financial year and give details of the profit or loss made over the year and the worth of the business

Final account statements consist of

The profit and loss account shows the trading position of a business at the end of a specified accounting period.

The balance sheet shows the assets and liabilities of a business at a particular point in time.

Which stakeholders are concerned with Final Accounts?

Shareholders

Employees

Managers

Competitors

Government

Financiers

Suppliers

Potential Investors

profit and loss account (income statement)

A financial record of a firm's trading activity over the past 12 months, consisting of three parts: the trading account, the P&L account and the appropriation account.

Trading Account

Appears at the top section of the profit and loss account and shows the difference between a firms sales revenue and its direct costs of trading.

Gross Profit

net sales - cost of goods sold

Gross profit = Sales revenue - Cost of goods sold

Cost of Goods Sold (COGS)

manufacturing costs, wages of blue-collar workers, transport costs etc.

COGS = Opening stock + Purchases - Closing stock

How can a business improve its gross profit

• Using cheaper suppliers - This reduces the COGS, although finding cheaper suppliers without hindering quality can be problematic.

• Increase selling price - This raises the value of each item sold, but is likely to cause a fall in the volume of sales.

• Enhanced marketing strategies - Methods such as promotions and repackaging can be used to make the product more appealing. However, this will raise the firm's expenses.

Net profit

The amount left after operating expenses are subtracted from the gross profit

Net profit = Gross profit - Expenses

*Expenses are the indirect or fixed costs of production, e.g. administration charges, management salaries, insurance premiums (for buildings, vehicles and stock) rent of land and property, and stationery costs.

How to reduce expenses

• Rent charges could be negotiated or the firm could move to cheaper premises; although relocation might not prove feasible due to industrial inertia

• Fuel consumption such as heating and lighting could be targeted, e.g. businesses could turn down the heating temperature during the winter, use less air conditioning in the summer and turn off lights when not required. Such actions help to reduce electricity bills and can give firms a better image with environmentalists.

• Administration costs could be examined by reviewing the work of clerical staff to reduce costs. This might be achieved by combining jobs or employing fewer people to carry out such tasks.

Retained Profit

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

The balance sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date.

Assets

money and other valuables belonging to an individual or business

Fixed Asset

the buildings, land and/or equipment that a business owns (not rents) used to conduct business

Current Asset

an asset that is expected to be converted to cash, sold, or consumed during the next 12 months, or within the business's normal operating cycle if longer than a year

Liabilities

a legal obligation of a business to repay its lenders or suppliers at a later date, i.e. the amount of money owed by the business

long-term liabilities

obligations that a company expects to pay after one year

Current Liabilities

Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.

Net Assets

Net assets = Fixed assets + Working capital - Long-term liabilities

Or

Net assets =Total assets-Total liabilities

shareholders' equity

the difference between total assets and total liabilities

Owner's Equity

the amount remaining after the value of all liabilities is subtracted from the value of all assets

Total assets -Total liabilities = Net assets = Owners' Equity

Limitations of the Balance Sheet

Some of the major limitations of the balance sheet are:

1. Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value.

2. Companies use judgments and estimates to determine many of the items reported in the balance sheet.

3. The balance sheet necessarily omits many items that are of financial value but that a company cannot record objectively.

Intangible Assets

Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance.

intellectual property rights

A product of the intellect, such as an expressed idea or concept, that has commercial value.

Brand

a name, term, symbol, design, or combination thereof that identifies a seller's products and differentiates them from competitors' products

Patents

licenses that give an inventor the exclusive right to make, use, or sell an invention for a set period of time

Copyright

a document granting exclusive right to publish and sell literary or musical or artistic work

Goodwill

the audience's perception of whether the speaker has the best interests of the audience in mind

Registered Trademarks

Distinctive signs that uniquely identify a brand, a product or a business. Trademarks can be expressed by names, symbols, phrases or an image. Like Copyrights and patents, trademarks provide legal protection against those who may try to copy their creations and inventions. Registered trademarks can be sold and ownership of trademarks can be transferred for appropriate fees.

Ratio Analysis

the assessment of a firm's financial condition using calculations and interpretations of financial ratios developed from the firm's financial statements

Purpose of Ratio Analysis

• Examine a firms financial position, e.g. its short- and long-term liquidity position

• Assess a firms financial performance, e.g. its ability to control expenses

• Compare actual figures with projected or budgeted figures (known as variance analysis)

• Aid decision-making, e.g. whether investors should risk their money by investing in the business.