Unit 3 Finance

IB Business Management HL -- DOES NOT CONTAIN ALL VOCAB! Check InThinking or BizMan

Define Finance

ability to access money to fund business activities

Capital expenditure

finance spent on fixed/non-current assets

fixed/non-current assets

long-term function items of monetary value

reasons for purchasing capital expenditure

* used as loan collateral
* repeatedly used
* additional production capacity
* improve efficiency with latest updates
* comply with changing regulations
* replace old/worn-out

challenge to capital expenditures

* high cost
* limited finance sources for such an investment
* if lacking finance, cannot adapt to external changes (competitors, trends)

examples: fixed assets

land, machinery, building, commercial vehicles

3 kinds of capital

1. start-up capital
2. working capital
3. business expansion

start-up capital

finance required to start a business (e.g. machinery, rent)

working capital

* finance to operate day-to-day
* current assets minus current liabilities = working capital
* easier to pay short-term liabilities if large

business expansion

* finance to move to new locations, open more branches, economies of scale, increased labor, equipment upgrades

Revenue expenditure

* finance used in day-to-day functioning
* spending happening to produce product/service

examples: revenue expenditure

hourly wages, inventory, utilities, advertising

what part of revenue expenditure must be controlled and why

costs so that the revenue is sufficient to cover production costs and still make profit

advantages to revenue expenditure

motivated workforce, employee loyalty, improved productivity

advantages of personal funds

* do not need to be repaid.
* no interest charges incurred
* sole traders and partners have a better chance of being able to borrow money if they need to, as it shows greater commitment to the business venture.
* Whilst cheaper, external sources of finance usually generate much more funds for a business.

disadvantages of personal funds

* As sole traders represent relatively high risk, they are less likely to be able to secure external sources of finance, so need to rely on their personal funds.
* rarely sufficient for most small businesses.
* risk their entire life savings in a business venture

profit

exists when a firm’s total revenue exceeds its total costs.

sources of finance

* the various ways that a business gets its money in order to run the business,
* **L**arry **T**osses **Ba**rry **S**caring the **L**iving **De**ad **Bo**dies of his ***C****lose*-**F**riends and **Mi**maw
* The sources of finance for a business can be classified as either internal sources or external sources.

internal sources of finance

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* come from within the organization, from its own resources and assets, without the help of a third party

retained profit advantages

* does not incur any interest charges.
* considered as a permanent source of finance, because it doesn’t have to be repaid. If a business project fails, the use of retained profit does not necessarily pull the organization into debt.
* great flexibility in the use of retained profit - the business can use this for any purpose within the business

retained profit disadvantages

* Start-up business don’t have any retained profit
* rarely enough as a sole source of finance
* less dividends paid out to shareholders and owners of the business.

fixed assets

* uses for a period of more than 12 months
* can be used repeatedly
* generates income for the organization

asset

anything that a business owns and has a marketable value, such as buildings, vehicles, computers, equipment and intellectual property. 

sale of assets advantages

* A large sum of money can be raised
* The sale of excess resources, redundant assets or obsolete (outdated) belongings is a sensible way for a business to raise finance.
* no costs of borrowing involved or interest repayments to make.

sale of assets disadvantages

* hinder a firm’s productive capacity if forced to sell
* time consuming to find a suitable buyer for second-hand assets, especially if obsolete.
* the purchase price is likely to be very low as the business is in a weaker bargaining position
* only available to established businesses

does a rise in exchange rate directly affect the interest paid

no

Initial public offering

Finance raised by a public limited company when it issues (sells) shares for the very first time on a stock exchange.

leasing

This financial service enables businesses to have access to fixed assets, by hiring these assets, but without the high costs of capital expenditure.

long term finance

Refers to sources of finance of more than five years, for the purchase of long-term fixed assets or to fund the growth of a business in overseas markets.

share capital

Also known as **equity capital**, this is finance raised through the issuing of shares via a stock exchange (or stock market).

stock exchange

A highly regulated marketplace where individuals and businesses can buy and sell shares in public limited companies

share capital advantages

* It is permanent capital as it does not need to be repaid
* no interest payments made to shareholders, thus this reduces the expenses
* does not involve debt or incur interest repayments.
* Any public limited liability company can raise further finance by selling additional shares (a process known as a **share issue**).

share capital disadvantages

* Shareholders need to (at some point) be paid dividends if the company earns a profit.
* the ownership and control of the organization may be diluted.
* Only public limited companies can trade their shares using the stock market

loan capital advantages

* It enables the borrower to repay in regular installments = more accessible and affordable
* not burdened by having to pay a large lump sum of money.
* Large businesses are often able to negotiate a lower rate of interest on their loans *(financial economies of scale).*
* suitable to raise finance but do not want to dilute their ownership or potentially lose control

loan capital disadvantages

* Interest is charged on the amount of borrowed funds. The interest rate can be a fixed or variable rate.
* offer collateral (security) before loans can be approved. Failure to repay the loan → lender being able to legally seize the firm’s assets to pay for the outstanding amount borrowed.
* Firms that borrow loan capital on variable interest rates may suffer from liquidity problems if the rate of interest increases, because their debt repayment burden will increase.

banking overdrafts advantages

* quite easy to obtain, so are an important source of external finance for small businesses in particular.
* emergency funds to finance their operations: payment to suppliers or paying wages to staff, during times when liquidity is a problem.
* great flexibility: are only used as and when needed.

banking overdrafts disadvantages

* Interest is charged on the amount overdrawn → rates higher than ordinary bank loans.
* only lend a small amount of money --not suitable for purchasing fixed asseta
* Banks can ask for overdrafts to be repaid at very short notice.
* high cost, short-term loan for businesses.

trade credit advantages

* Interest free
* ‘buy now, pay later’ and still have access to the purchased items

trade credit disadavantges

* Only used for small items (eg purchase of raw materials)


* By not paying early, miss out on cash discounts, meaning the goods purchased may be more expensive
* Delay of payment may result in poor relations

crowdfunding advantages

* lends a relatively small amount of money → limits the risks and impacts if it fails


* It avoids the need to deal with commercial banks, which is often a time-consuming and bureaucratic process.
* Many people can invest in the business → help to raise for small to medium-sized enterprises.
* individuals of the crowd do not take any controlling interest in the organization.
* less costly than being listed on a public stock exchange.

crowdfunding disadvantages

* legal challenges and considerations: transparent disclosure of legal documents, holding annual general meetings with investors, and publication of annual reports → adds costs
* diligence (investigation and exercise of care prior to entering into a contractual agreement with another entity).
* option to ask for additional information from the fundraiser, which delays decision-making and incurs additional costs


* Theft of intellectual property is commonplace
* crowdfunding scams: loose regulatory requirements for crowdfunding

leasing advantages

* The lessor does not have to purchase expensive capital → money can be used for revenue expenditure purposes.
* The lessor takes responsibility for the maintenance of the capital equipment and other leased property → cut the operating costs of the lessee.
* advantageous if only needs to use the fixed capital for a short period of time, or does not want to deal with the cost of maintenance

leasing disadvantages

* lessee never owns the asset
* Over a long period of time, leasing can be more expensive than buying the asset outright due to the accumulated costs of leasing the asset over time.

sale and leaseback

sell it to someone else and then rent it from them → if it is rented, it lessens the profit and therefore lessens the amount of tax needed to pay

hire purchase

paying in little to eventually own

microfinance advantages

* help to provide poverty relief.


* help to empower entrepreneurs of small businesses, women, and the underprivileged in low-income countries.
* can create benefits for the wider community (improved healthcare, education, and employment opportunities)
* act in a socially responsible way by helping the poorest and most vulnerable adults in society.
* can help to build and foster a culture of entrepreneurship and economic independence.

microfinance disadvantages

* unethical: earn profits from low-income individuals and households.
* only provides finance on a small scale, so is unlikely to be sufficient to make a real difference
* incur interest charges, so can be expensive
* increases the debts of entrepreneurs who may subsequently struggle in their business ventures.
* low profitability: microfinance providers may struggle to attract and/or retain employees and managers

business angels advantages

* provide an essential source of finance for start-ups and small businesses that are unable to secure finance
* benefit from the expertise, experiences, and input in order to secure a significant return on their investment (ROI).

business angels disadvantages

* For business angels: extremely high risk
* no guarantees will earn a satisfactory ROI, despite the high potential returns.
* difficult to come by
* dilute the firm’s control and ownership as the angel investors will want a share and say in the organization.

cost

charges that an organization incurs from its operations

revenue

the money coming into a business from the sale of goods and services

revenue streams

various sources of revenue for a business.

total revenue

 sum of income received by a business from its trading activities. It is calculated by multiplying the unit price (P) of a good or service by the quantity sold (Q), i.e. TR = P × Q. 

average revenue

amount a business receives from its customers per unit of a good or service sold. Average revenue is mathematically the same value as the price per unit

final accounts

 published accounts of an organization, made available to and used by different **stakeholders**

managers’ interest in final accounts

* measure the performance of the business against organizational targets.
* benchmark key indicators (such as net profit figures) against those of rival businesses.
* review financial performance against planned or targeted performance.
* help with decision-making, e.g. to assess whether the business has sufficient funds for new investment projects.
* set budgets and targets for the future, e.g. target profit.
* monitor and control business expenditure across the various departments in the organization.
* assist strategic planning, e.g. growth and evolution of the organization.

employees’ interest in final accounts

* Employees can use final accounts to gauge the extent to which their jobs are secure; a profitable business with a healthy balance sheet will create improve job security and promotional opportunities.
* Workers can use final accounts as part of the negotiation process with labour unions to discuss pay rises and conditions of employment; again, a profitable and healthy business helps workers to strengthen their case for job security and pay rises.

shareholders’ interest in final accounts

* Measure whether the business is more or less profitable, and how this has changed over time.
* Measure the value of the business and judge whether this has increased over time.
* Calculate the return on their investment (refer to profitability ratios).
* Determine how much dividends (share of the organization’s profits) they receive.
* Decide whether the organization has prospects for growth and expansion.
* Compare the financial performance of different businesses in order to make rational investment decisions (whether to buy or sell any shares in the company).

financiers’ interest in final accounts

* Decide whether to lend money to the business, and how much to lend, by judging the degree of risk involved.
* Check on the creditworthiness of the organization before overdrafts or loans are given.
* Assess the extent to which the business is able to pay back its borrowing (with interest).

suppliers’ interest in final accounts

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* Assess whether the business has sufficient liquidity to pay its debts (trade credit).
* Determine the creditworthiness of the business in order to gauge the level of risk involved.
* Negotiate improved credit terms, such as deciding whether to extend the trade credit period or to demand immediate cash payment.

customers’ interest in final accounts

* Gauge whether a business is finically secure, especially if there is a long **working capital cycle** (a lengthy delay between the customers paying and receiving the products).
* Determine whether the business offers security and reliability in its services; otherwise, customers will go elsewhere and purchase by rival suppliers.
* Determine whether there will be future supplies of the product they are purchasing – this is particular important for customers that rely on a particular supplier or business.

government’s interest in final accounts

* to calculate and check (verify) the amount of tax that is due to be paid by the business.
* To measure the extent to which the business is able to expand and create jobs in the economy.
* To assess the liquidity position of the business, in case there is a threat of business closure, which could cause serious economic problems (depending on the size of the business and the market in which it operates).
* To ensure the business operates within the law, by adhering to the country’s accounting rules and laws.

competitors’ interest in final accounts

* Being able to compare their own financial accounts with the business in question, in order to judge their own financial performances.
* Benchmark best practise by examining what the business does well, and determine how they themselves can improve.

expenses

 firm’s indirect costs of production, e.g. rent, management salaries, marketing campaigns, accountancy fees, bank interest charges, travel expenses, utilities, repairs and maintenance, and general insurance. Note that both interest and tax are not included in this section of the P&L account

profit and loss account

firm’s profit (or loss) after all production costs have been subtracted from the organization’s revenues, each year. It is also known as the **statement of profit or loss** or **income statement**

tax

 compulsory deductions paid to the government as a proportion of a firm’s profits

balance sheet

(also known as the **statement of financial position**) is an essential set of final accounts that shows the value of an organization’s assets, liabilities, and the owners’ investment (or equity) in the business at a particular point in time. Hence, the balance sheet is often referred to as a “snapshot” of a firm’s financial position, indicating its financial health. The reporting date of the balance sheet for an organization is the same each year.

assets

 possessions of a business that have a monetary value. 

liabilities

debts of a business, i.e. the money owed to others. 

cost of goods sold formula

Opening stock + Purchases – Closing stock

cost of goods sold

direct cost associated with the production or purchase of goods to be sold to customers

accumulated depression

 sum of the fall in a non-current asset's value because of wear and tear over time.

equity

the value of the owners' stake in the business, i.e. what the business is worth at the time of reporting the balance sheet.

copyrights

give the registered owner the legal rights to creative works of authors, musicians, conductors, playwrights (scriptwriters) and directors.

goodwill

reputation and established networks (know-how) of an organization, which adds significance above the market value of the firm’s physical assets

intangible assets

type of fixed asset except they are non-physical assets with a monetary value to the business. These assets are protected by intellectual property rights (IPRs).

patents

official rights given to a business to exploit an invention or process for commercial purposes

trademarks

official rights given to a business to exploit an invention or process for commercial purposes

depreciation

* the **fall in value** of a **non-current (fixed) asset** over **time**
* spreads **historic cost** (purchase cost) of a non-current asset **over its useful life/value**

straight line method

reduces the value of a non-current asset as the same value each year throughout its useful life

* \[Purchase Cost - Residual Value aka resale price\] /lifespan of asset

straight line method advantages

* ease since same amount
* suitable for assets known to have useful shelf-life and can be estimated accurately.
* suitable for assets that have a consistent usage rate over the lifetime of the asset, e.g. furniture or automated machinery.
* easier to depreciate the value of assets until their scrap value is zero.
* easier to make historical comparisons of the data.

straight line method disadvantages

* Many fixed assets (motor vehicles and computers) depreciate most during the initial stages. A uniform depreciation value can be misleading and inaccurate.


* do not depreciate consistently as they become less efficient over time -- machinery, computers, and vehicles have higher repair costs over time.
* not suitable or useful if the functional life span of the asset cannot be estimated accurately.
* Scrap values are only estimates of the future value of an asset. This makes the provisions for depreciation less accurate.

units of production

apportions an equivalent value of depreciation to a non-current asset based on each physical unit of output

* **Depreciation per unit** = \[purchase cost - scrap value\] / expected number of units over lifetime


* **Depreciation expense** = depreciation per unit X number of units produced

  Advantages of units of production depreciation

* more realistic or accurate due to its users than just the passing of time
* works well for machinery or capital equipment to manufacture a product.
* more accurate for non-current assets that depreciate directly due to wear and tear, rather than the passage of time which eventually makes the product obsolete.
* It is useful for changes in consumer demand over time.

 Disadvantages of units of production depreciation

* more complicated than the straight line method of depreciation.
* degree of subjectivity as the salvage value is subject to change and the estimated units of production an estimate only.
* Over- or under-estimating the figures will make the depreciation expense less accurate.
* Many tax authorities (such as the IRS in the US) do not allow the units of production depreciation method to be used for tax purposes. Hence, this method is primarily used for internal bookkeeping (accounting records).

gross profit margin

profitability ratio that measures the amount of trading profit as a percentage of the sales revenue

* the higher the GPM ratio, the more profitable the firm has been & the lower the cost of sales (COS) in relation to the sales revenue.

how to improve gross profit margin

* decrease costs or increase revenue
* how to lower direct costs: cheaper material, cheaper packaging
* labor costs (it’ll be more direct if its hourly paid employees)
* increase price
* promotional strategies
* go to different revenue streams

net profit margin

* profitability ratio that measures the amount of profit (gross profit minus expenses) as a percentage of the sales revenue,
*  indicator of how well a business can manage its indirect costs (overhead expenses).


* high *turn* over of sales means low-profit margins
* The higher the ratio, the more cash the company has available to distribute to shareholders or invest in new opportunities. (20% very good, 10% average, 5% low)

how to improve net profit margin

* fire salaried employees
* lowering expenses
* making the government pay for rent
* Insurance
* Lease payments for capital equipment and other fixed (non-current) assets
* Mortgage payments
* Phone and Internet services
* Rent on commercial buildings/land
* Salaries for management and administrative personnel
* Utility bills.

why does net profit ratio use “profit before interest and tax”

* historic benchmarking -- tax and interest vary over years
* inter-firm benchmarking -- tax and interest vary across companies

return on capital employed

a firm’s efficiency and profitability in relation to its size (as measured by the value of the organization’s capital employed)

net profit margin vs gross profit margin

* NPM: managing indirect costs
* GPM: managing direct costs
* BOTH: overall profit as a percentage of its sales revenue

improving ROCE

* **Increasing sales revenues:** reduced prices to attract, new sales promotions, offering a wider and more efficient distribution network, and/or launching new and improved products.
* **Reduce costs of production:** alternative suppliers, having improved stock control systems, seeking additional economies of scale, and improved quality management systems to reduce the cost of wastage
* **Selling unproductive, unused, underused, and obsolete assets** in order to improve operational efficiency and liquidity

capital employed

**value of all sources of finance of a business at a point in time, including internal and external finance**. It is calculated using the formula: Non-current liabilities + Equity.

liquidity ratios

financial ratios that examine an organization’s ability to pay its short-term liabilities and debts

liquidity

the ease with which a business can convert its assets into cash without affecting its market value, i.e. it measures a firm’s ability to repay short-term liabilities without having to use external sources of finance.

current ratio

short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts

* generally 1.0 but can *kind of* go up to 2.0

improving current ratio

* Attract more customers
* Encourage customers to pay by cash → improving cash inflows.
* Use cash to pay off short-term debts → reducing the interest (debt) burden
* Negotiate with suppliers for an extended trade credit period → improving its own liquidity position
* liquidate unused non-current assets to improve current assets because you’ll have more cash even with the same current liabilities
* use surplus cash to generate trade
* too much stock → increase storage & insurance costs

acid test ratio

short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts (within the next twelve months of the balance sheet date), without the need to sell any stock (inventories)

* some inventories are not highly liquid, such as work-in-progress or very expensive finished goods sold in niche markets, long working capital cycle
* best: 1:1

improving acid test ratio

* raise cash inflows for the business and/or reduce its cash outflows
* Improve its stock control management system to reduce the cash outflows associated with poor stock control management. This is because the value of a firm’s acid test ratio improves as its level of stocks (inventories) falls.