Business management unit 3

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The role of finance

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97 Terms

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The role of finance

finance is needed for starting up a new business, for day to day operations, growth, and to expand the business

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Why do firms need capital

  • To start a business

  • Day-to-day operations

  • Growth and expansion

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Capital expenditure

  • Spending on items lasting more than a year

  • Fixed assests- machinery, land, equipment

  • Long-term investments

  • used collateral

  • Examples- Machinery, technology, vehicles

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Revenue expenditure

  • Revenue expenditure is spending on goods and services that a business uses in the short-term

  • Money on day to day activities

  • Examples- Rent, wages, raw materials, insurance, fuel

  • Otherwise, in the long run a business would be unable to grow and continue operating

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internal sources of finance

  • personal funds- personal savings of owners and risk for owners

  • Retained profits- Value of profit kept by the business after paying off the tax, interest, and dividends (to the shareholders) to use within the business

  • Often used for purchasing and/or upgrading fixed assets which will increase returns

  • advantages- cheap, permanent source, flexible, controlled by owners

  • Disadvantages- start ups are rarely profitable at first, might be insufficient for expansion, might be used up

  • Sale of assests- Businesses can sell their unused assets, such as selling old machinery and computer equipments that have been replaced

  • advantages- no interest or borrowing costs

  • disadvantage- available to established businesses only

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External sources of finance

  • share capital- money raised from selling shares in a company

  • Loan

  • Overdrafts

  • Grants

  • Debt factoring

  • Trade credit- payment made a later stage agreed upon between seller and buyer

  • Leasing- the lessee pays rental income to hire assets from the lessor, who is the legal owner of the assets.

  • venture capital- 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

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overdrafts

When a lending institution allows a firm to withdraw more money than it currently has in its account

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grants

Funds usually provided by a government, foundation, trust, or other agency to businesses which does not need to be repaid.

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subsidies

Financial Assistance granted by a government, NGO, or an individual to support businesses that are in the public interest

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loan

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

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debt factoring

a business sells its invoice to a third party

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short-term finance

  • Day to day running of business

  • one year or less

  • examples- overdrafts, trade crediting, debt factoring

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medium- term finance

  • 1-5 years

  • equipment, machinery, vehicles

  • examples - leasing, grants, loans

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long-term finance

  • expansion of business

  • 5-30 years

  • examples - loans, share capital

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fixed cost

  • costs of production which have to be paid regardless of output level

  • Examples- rent, interests, lease payments

  • independent of output level

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semi-variable cost

  • An element of both fixed and variable costs

  • Changes when production exceeds a certain level of output

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variable cost

  • cost of production which change in proportion to output level

  • Examples- raw materials, packaging

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direct cost

  • related to an individual product or to the output of a specific product

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Indirect costs

  • cannot be traced directly to the output of a product

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sales volume

  • the number of products sold

  • sales revenue = price * quantity

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revenue stream

Revenue streams are the sources of revenues or incomes for a company or a business

Firms utilising different sources/methods to generate income

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revenue streams examples

  • Advertising revenue: this is when an organisation is offering advertising space and charges other organisations for posting ads in this space

  • Royalties/franchisor: royalty payments are made to artists for the use of their artworks or to franchisors for the use of franchise

  • Sponsorship deals: the way it usually works is sponsor gives you financial support in exchange for an extra advertising space and publicity.

  • Subscriptions: use or access goods or services

  • Merchandise: in addition to the main trading activity, some organisations sell their souvenirs or clothes to get extra revenues

  • Dividends: companies that own stock/shares within another business can also get dividends

  • Donations: charities and non-profit

  • Interest earnings: on cash deposits in banks

  • Subversions: Government subsidies- aimed at benefiting society

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wholesale market

  • a market where a trader buys goods from a manufacturer in bulk and re-sells the goods to business houses or retailers to further sell the goods to end consumers

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Venture Capital

Financial capital proved by investors to high-risk, high potential start ups or small businesses.

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Business Angels

Highly affluent individuals who provide financial capital to small startups in return for ownership in their business.

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High Geared

Large proportion of loan capital to share capital

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Low Geared

Small proportion of loan capital to share capital

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Cost

The total expenditure incurred by a business in order to run its operations

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Revenue

Measure of the money generated from the sale of goods/services

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Contribution

sum of money that remains after all direct and variable costs have been taken away from sales revenue

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Contribution Per Unit

Refers to the difference between the selling price per unit and the variable costs

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Margin of Safety

The difference between the firm’s sales and the break-even quantity

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Target Profit Output (TPO)

The level of output that is needed to earn a specified amount of profit

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Trading Account

Shows the difference between the sales revenue and the cost of goods sold

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Profit and Loss Account

Second part of the income statement that shows the net profit before interest and tax, net profit before tax, and net profit after interest

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Appropriation Account

final part of the profit/loss account that shows how the company's net profit after interest and tax is distributed

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Gross Profit

profit made by a company (sales revenue - cost of goods sold)

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how to improve gross profit

  • lower costs

  • increase sales

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net profit

  • the profit after all expenses are subtracted from the total revenue

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Dividends

A sum of the money paid to shareholders which is decided by the board of directors

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Stock

unsold goods, raw materials or work-in-progress that the company has in hand at the end of the trading period

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Opening Stock

the quantity of goods produced/owned by the business that are unsold in the previous accounting period

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Closing Stock

the quantity of goods produced/owned by the business after sales at the close of the accounting period such as a year

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Balance Sheet

a statement of the financial position of a business in terms of assets, liabilities and owner's equity at a particular point in time

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Assets

all items of value that are owned by the firm, such as cash or buildings

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Fixed Assets

Long-term assets that last in a business for more than 12 months (Ex. vehicles, buildings, and machinery)

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Current Assets

Short-term assets that last in a business for up to 12 months (Ex. Cash, debtors, stock)

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Liabilities

all funds owed by the company to financial and other institutions, such as banks and suppliers

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Long-term liabilities

Long-term debts payable after 12 months by the business (Ex. Mortgages)

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Current Liabilities

Short-term debts that are payable within 12 months (Ex. creditors, tax, overdraft)

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Working Capital

(Net current assets) Helps establish whether a firm can pay its day-to-day running costs

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Equity

shows the value of the business attributable to its owners

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intangible assets

Non-physical fixed assets that have the ability to earn revenue for a business

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Debtors

people who owe money

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Creditors

People who lend money

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Patents

exclusive rights to make or sell inventions

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Goodwill

the value of all favorable attributes that relate to a company

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Copyright Laws

laws that provide creators with the exclusive right to protect the production and sale of their artistic or literary work

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Trademarks

Recognizable symbol, word, phrase, or design that is officially registered and identifies a product or business

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Depreciation

the decline in the value of fixed assets over time mainly due to usage and newer models or better technologies being available

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Obsolescence

state of being no longer useful or in fashion

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Straight-line method

Spreads out the cost of an asset equally over its lifetime by deducting a given constant amount of depreciation

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Reducing Balance Method

the value of the asset depreciates by a predetermined percentage for the duration of its life

more realistic

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Residual Value

the estimated value of a fixed asset at the end of its useful life

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Ratio Analysis

Financial management tool for analysing and judging the performance of a business

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Profitability Ratios

show a company's overall efficiency, performance and financial position

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liquidity ratio

ability of firm to pay its short-term liabilities

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current ratio

looks at whether a company can pay/cover its short-term debts

current assets/current liabilities

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acid test (quick) ratio

similar to current ratio but ignores stocks

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cash

cash-

  • held by hand

  • deposited in bank account

role of cash-

  • business need cash to sustain itself

  • inability to pay suppliers, employees or creditors would a successful business into bankruptcy

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profit

profit-

  • difference between total sales revenue and costs

  • any sales beyond- lead to a profit

purchases made can be through a cheque, cash, on credit (Buy now pay later)

credit option-

  • enables customers to buy right away

  • might result in cashflow problems for the business

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short-term liquidity problems

occur due to-

  • poor credit control

  • expanding too quickly

  • hence cashflow management is key

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working capital cycle

the delay between cash receipts from customers and cash payments to supplier

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working capital cycle cont’d

  • working capital- The cash or liquid assets available for the daily running of a business

  • used to pay suppliers, employees, creditors

  • liquidity- how easily an asset available could be turned into cash

  • insolvency- working capital insufficient to meet current liabilities

  • liquidation- selling off of a business

  • creditors take legal action against the business to recover their money

  • working capital=current asset-current liabilities

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current asset

  • the liquid resources, which could be converted into cash within a year

  • cash

  • Debtors

  • stock

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current liabilities

  • money owed which needs to be repaid within a year

  • overdrafts

  • creditors

  • tax

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cash flow

  • Financial document that shows expected movement of cash inside and outside of a business per time period

  • Cash inflows – usually from sales revenues when cash payment is received

  • Cash outflows – payment of bills, usually itemised expenses

  • Net cash flow – the differences between cash inflow and outflow

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reasons for cashflow

  • business planning

  • is the business financially healthy

  • plan for and alleviate liquidity crisis

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causes of cashflow problems

  • overtrading

  • over borrowing

  • overstocking

  • poor credit control

  • unforeseen changes

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strategies to deal with cash flow problems

  • reducing cash outflows

  • improving cash inflows

  • seeking alternative sources of finance

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Return on Capital Employed (ROCE)

  • Measures the financial performance of a firm compared with the amount of capital invested

<ul><li><p>Measures the financial performance of a firm compared with the amount of capital invested</p></li></ul>
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Stock Turnover Ratio

Measures how quickly a firm's stock is sold and replaced over a given period

<p>Measures how quickly a firm's stock is sold and replaced over a given period</p>
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Debtor Days

Measures the number of days it takes on average for a firm to collect its debts from customers if it has sold goods to on credit.

<p>Measures the number of days it takes on average for a firm to collect its debts from customers if it has sold goods to on credit.</p>
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Creditor Days

measures the average number of days a firm takes to pay its creditors

<p>measures the average number of days a firm takes to pay its creditors</p>
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Gearing Ratio

Measures the extent to which capital employed by a firm is financed from loan capital

<p>Measures the extent to which capital employed by a firm is financed from loan capital</p>
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Opening Balance

The amount of money in a business at the start of the month

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Closing Balance

The amount of money in a business at the end of the month

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Investment

Purchase of asset with potential to yield a financial benefit in the future

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Investment Appraisal

Quantitative techniques used to calculate the financial costs and benefits of an investment

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Payback Period

Estimates the length of time required for an investment project to pay back its initial cost outlay

<p>Estimates the length of time required for an investment project to pay back its initial cost outlay</p>
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Average Rate of Return

Measures the annual net return on an investment as a percentage of its capital cost

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Net Present Value

considers time value of money

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Budget

A financial plan for expected revenue and expenditure for an organisation for a given time period

reasons-

  • planning and guidance

  • coordination

  • control

  • motivation

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Cost Center

  • Department or unit of business that incurs costs

  • Doesn’t contribute to profit directly.

    • e.g. Marketing and HR departments

  • Departments must be made aware of their costs to help managers operate within the allocated budget

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Profit Center

  • Branch of a company that is accounted for on a standalone basis for the purposes of profit calculation

  • Used to know which aspects of a business are the most and least profitable

  • Managers have to be responsible for costs and earnings of their profit center, and they should know how to best use resources to maximise profitability

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variance analysis

variance- difference between budgets and actuals

favorable variance-

adverse variance- overspending and/or underselling

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Benchmarking

a process by which a company compares its performance with that of high-performing organizations

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