IB Business Unit 3

Start-up capital

Capital needed by an entrepreneur to set up a business

Working capital

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.

Working capital (in *accounting terms*)

Working capital \= current assets - current liabilities

Internal finance

Money raised from the business's own assets or from profits left in the business (retained profits)

External finance

Money raised from sources outside the business (e.g. share issue, leasing, bank loan)

Sources of *internal* finance:

Retained profits
Sales of assets
Reduction in working capital

Sources of LONG TERM *external* finance:

Share issue
Debentures
Long-term loan
Grants

Sources of MEDIUM TERM *external* finance:

Leasing
Hire purchase
Medium-term loan

Sources of SHORT TERM *external* finance:

Bank overdraft
Bank loan
Creditors
Trade credit
Debt Factoring

Overdraft

An agreement with a bank for a business to borrow up to an agreed limit as and when required

Factoring (debt factoring)

Selling of claims over debtors (individuals or organisations who owe the business money) to a *debt factor* in exchange for immediate liquidity - only a proportion of the value of the debts will be received as cash

Leasing

Obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period. this avoids the need for the business to raise long-term capital to buy the asset. Ownership remains with the leasing company.

Long-term loans

Loans that do not have to repaid for at least one year

Equity finance

Permanent finance raised by companies through the sale of shares

Debentures

Bonds issued by companies to raise debt finance, often with a fixed rate of interest (*long-term bonds*)

Long-term bonds

Bonds issued by companies to raise debt finance, often with a fixed rate of interest (*debentures*)

Rights issue

Existing shareholders are given the right to buy additional shares at a discounted price

Venture capital

Risk capital invested in business start-ups or expanding small businesses, that have good profit potential, but do not find it easy to obtain finances from other sources

Advantages of *debt finance*:

1. As no shares are sold, the ownership of the company does not change and is not 'diluted' by the issue of additional shares
2. Loans will be repaid eventually, so there is no * permanent* increase in the liabilities of the business
3. Lenders have no voting rights therefore there is no loss of control of the company
4. Interest charges are an expense and are thus tax deductible (reduce the total company tax paid by the business)

Advantages of *equity finance*:

1. It never has to be repaid
2. Dividends do not have to be paid every year. In contrast, interest must be paid when demanded by the lender
3. Much larger amounts of finance can possibly be raised than through debt financing

Capital expenditure

Spending by businesses on *fixed assets* such as the purchase of land, buildings and machinery (*investment expenditure*).

Creditors

Individuals or organisations that the business owes money to that needs to be settled within the next twelve months

Revenue expenditure

Spending on the day-to-day running of a business (e.g. rent, wages and utility bills)

Examples of *revenue expenditure*

- Rent
- Wages
- Utility bills (e.g., water and electricity)

Examples of *capital expenditure*

The purchase of any *fixed asset*:
- land
- buildings
- machinery

Fixed assets

Tangible assets as the have a physical existence (so *not* a *brand*, for example) and are expected to be retained and used by the business for *more than 12 months* (e.g. land, buildings, vehicles and machinery)

Investment appraisal

Evaluating the profitability or desirability of an investment project

Information * quantitative* investment appraisal requires:

1. Initial capital costs of the investment
2. Estimated life expectancy
3. The expected residual value (additional net returns from the sale of the asset at the end of its useful life)
4. Forecasted *net* returns or *net* cash flows from the project (*expected returns less running costs*)

Methods of *quantitative* investment appraisal

1. Payback period
2. Average rate of return
3. Net present value using discounted cash flows

How external factors (*future uncertainty*) can influence revenue forecasts:

1. Economic recession could reduce demand
2. Increases in oil prices may increase costs of production
3. Interest rates may decrease (both reducing costs of finance and inflating future returns)

Payback period

The length of time it takes for *net cash inflows* to pay back the original capital costs of the investment

Average rate of return *ARR*

Measures the *annual profitability* of an investment as a percentage of the initial investment

4 stages in calculating ARR

1. Add up all positive cash flows
2. Subtract cost of investment
3. Divide by lifespan
4. Calculate the % return to find the ARR

Why future cashflows are discounted

1. *Inflation*: The same amount of money in the future will not purchase the same amount of goods and services as it can today
2. *Interest* foregone: Money can be invested for a return. If you invested the money safely now, it will be worth more in the future.
3. Uncertainty: The cash today is certain, but the future cash on offer is always associated with at least a degree of risk and uncertainty

The *present value* of a *future* sum of money depends on two factors:

1. The higher the *interest rate*, the less value future cash in today's money
2. The *longer into the future cash is received*, the less value it has today

Net present value (*NPV*)

*Today's value* of the estimated cash flows resulting from an investment

Qualitative investment appraisal

Assessing *non-numeric* information in examining an investment choice

Examples of *qualitative* factors in investment appraisal

1. Impact on the environment
2. Planning permission (will local governments allow the investment?)
3. Aims and objectives of the business
4. Risk

3 stages in *calculating NPV*

1. Multiply discount factors by the cash flows (cashflows in year 0 are never discounted)
2. Add the discounted cashflows
3. Subtract the capital cost to give the NPV

Factors in assessing an ARR percentage value

1. The ARR on other projects (the opportunity costs)
2. The minimum expected return set by the business (the * criterion rate*)
3. The annual interest rate on loans (ARR needs to be greater than the interest costs of borrowing; even if the firm doesn't need to borrow there's always an opportunity cost of interest foregone by keeping the money in the bank)

Working capital

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.

Working capital (accounting terms)

Working capital \= *current assets - current liabilities*

Liquidity

The ability of a firm to pay its short-term debts

Liquidation

When a firm ceases trading and its assets are sold for cash. Turning assets into cash may be insisted on by courts if suppliers have not been paid.

Working capital cycle

The period of time between spending cash on the production process and receiving cash payments from customers

Cash flow

The sum of cash payments to a business (*inflows*) less the sum of cash payments made by it (*outflows*)

Insolvent

When a firm cannot meet its short-term debts

Cash inflows

Payments in cash received by a business, such as those from customers (*debtors*) or from the bank; e.g. receiving a loan

Debtor

An individual or an organisation who has bought on credit (or received a loan) from the business and *owes the business money*

Creditor

An individual or organisation to whom money *is owed by* the business

Cash outflows

Payments in cash made by a business, such as those to suppliers or workers

Examples of *cash outflows* include:

- Lease payments for premises
- Annual rent payment
- Electricity, gas and telephone/internet bills
- Labour cost payments
- Variable cost payments (e.g., raw materials)

Cash flow forecast

Estimate of the firm's future cash inflows and outflows

Net monthly cash flow

Estimated difference between monthly cash inflows and outflows

Opening cash balance

Cash held by the business at the start of the month

Closing cash balance

Cash held at the end of the month becomes next month's opening balance

Benefits of cash flow forecasts:

- By showing periods of *negative cash flow*, plans can be put into place to provide additional finance; e.g. arranging a bank overdraft or preparing to inject owner's capital
- If negative cash flow appears to be too great, then plans can be made for reducing these; e.g., by cutting down on purchases of new materials or reducing credit sales
- A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to a cash flow forecast (and the assumptions behind it)

Limitations of cash flow forecasts:

- Mistakes can be made in preparing the revenue and cost forecast (inexperience, seasonal variations, etc)
- Unexpected cost increases can lead to major inaccuracies (e.g. fluctuations in oil prices affecting cash flows of airline companies)
- Wrong assumptions can be made in estimating the sales of a business (e.g., poor market research)

Causes of cash flow problems:

1. Lack of planning
2. Poor credit control
3. Allowing too much credit
4. Expanding too rapidly
5. Unexpected events

Credit control

Monitoring of debts to ensure that credit periods are not exceeded

Bad debt

Unpaid customers' bills that are now very unlikely to ever be paid

Ways to improve cash flow:

1. Increase *cash inflows*
2. Reduce *cash outflows*
*(careful! its the cash position of a business, NOT sales revenues or profits)*

Methods to increase cash flow:

1. Overdraft
2. Short-term loan
3. Sale of assets
4. Sale and leaseback
5. Reduce credit terms to customers
6. Debt factoring

Debt factoring

Short term liquidity problem, sell debt to a factoring agency, instant inflow of cash but the cost is a fee payable to the agency that lowers the profit on the original business

Overdraft

A negative balance in a business's bank account

Overdraft facility

An ability to have a negative balance up to an agreed limit in a business's bank account

Sale and leaseback

Assets can be sold (e.g. to a finance company), but the asset can be leased back from the new owner

*Evaluation* of *overdraft* as a way to *increase cashflow*

1. Interest rates can be high
2. Overdrafts can be withdrawn by the bank and this often causes insolvency

*Evaluation* of *short-term loan* as a way to *increase cashflow*

1. The interest costs have to be paid
2. The loan must be repaid at the due date

Evaluation of *sale of assets*

1. Selling assets quickly can result in a low price
2. The assets may be required at a later date for expansion
3. The assets could have been used as *collateral* for future loans

Secured loan

A loan backed by an asset of value, such as property or vehicles

*Evaluation* of *sale and leaseback* as a way to *increase cashflow*

1. The leasing costs add to the annual overheads
2. There could be loss of potential profit if the asset rises in price
3. The assets could have been used as *collateral* for future loans

*Evaluation* of *reduce credit terms to customers* as a way to *increase cashflow*

1. Customers may purchase products from firms that offer extended credit terms

*Evaluation* of *debt factoring* as a way to *increase cashflow*

1. Only about 90-95% of the debt will n ow be paid by the debt factoring company - this reduces profit
2. The customer has the debt collected by the finance company - this could suggest (give the perception) that the business is in trouble

Methods to reduce cashflow

1. Delay payment to suppliers
2. Delay spending on capital equipment
3. Use leasing, not outright purchase of capital equipment
4. Cut overhead spending that does not directly affect output; e.g. promotion costs

*Evaluation* of *delay payments to suppliers (creditors)* as a way to *reduce cashflow*

1. Suppliers may reduce any discount offered witht he purchase
2. Suppliers can either demand cash on delivery or refuse to supply at all if they believe the risk of not getting paid is too great

*Evaluation* of *delay spending on capital equipment* as a way to *reduce cashflow*

1. The business may become less efficient if outdated and inefficient equipment is not replaced
2. Expansion becomes very difficult

*Evaluation* of *use leasing, not outright purchase of capital equipment* as a way to *reduce cashflow*

1. The asset is not owned by the business
2. Leasing charges include an interest cost and add to annual overheads

*Evaluation* of *cut overhead spending that does not directly affect output* as a way to *reduce cashflow*

1. Future demand may be reduced by failing to support products effectively

The *three* main business accounts:

1. Income statement
2. Balance sheet
3. Cash-flow statement

Income statement

Records the revenue, costs and profit (or loss) of a business over a given period of time

Three *sections* of an *income statement*:

1. *Trading account*
2. *Profit and loss account*
3. *Appropriation account*

Gross profit

*Gross profit* \= *sales revenue less cost of sales*

Sales revenue

The total value of sales made during the trading period \= *selling price x quantity sold* (sales turnover)

Sales turnover

The total value of sales made during the trading period \= *selling price x quantity sold* (sales revenue) Sales revenue

Cost of sales

This is the *direct cost* of purchasing the goods that were sold during the financial year (cost of goods sold)

Cost of goods sold

This is the *direct cost* of purchasing the goods that were sold during the financial year (cost of sales)

Operating profit

Operating profit \= *gross profit - overhead expenses* (net profit)

Net profit

Net profit \= *gross profit - overhead expenses* (net profit)

Dividends

The share of profits paid to shareholders as a return for investing in a company

Retained profit

The profit left after all deductions, including dividends, have been made. This is 'ploughed back' into the company as a source of finance

Low-quality profit

One-off profit that cannot easily be repeated or sustained

High-quality profit

Profit that can be repeated and sustained

How *stakeholders* use business accounts: *Business managers*

1. Measure the performance of a business against targets, previous time periods and competitors
2. Help them with decisions; e.g., new investments, branch closures, launching new products
3. Control and monitor the operation of each department, branch and division
4. Set targets for the future and review against actual performance

How *stakeholders* use business accounts: *Banks*

1. Decide whether to lend money to a business
2. Assess whether to allow for an increased overdraft facility
3. Decide whether to renew sources of finance; e.g., overdraft, loans, etc

How *stakeholders* use business accounts: *Creditors, such as suppliers*

1. Assess whether the business is secure and liquid enough to pay off its debts
2. Assess whether the business is a good credit risk
3. Decide whether to press for early repayment of outstanding debts

How *stakeholders* use business accounts: *Customers*

1. Assess whether a business is secure
2. Determine whether they will be assured of future supplies of the good they are purchasing
3. Establish whether there will be security of spare parts and service facilities

How *stakeholders* use business accounts: *Government and tax authorities*

1. Calculate how much tax is due form the business
2. Determine whether the business is likely to expand and create more jobs
3. Assess whether the business is in danger of closing down, creating economic problems
4. Determine whether the business is staying within the law in terms of accounting regulations.

How *stakeholders* use business accounts: *Investors, such as shareholders in the company*

1. Assess the value of the business and their investment in it
2. Establish whether the business is becoming more or less profitable
3. Determine the share of the profits investors are receiving
4. Decide whether the business has potential for growth
5. To compare businesses before making an investment and/or purchasing shares in a company
6. To consider whether they should sell all or part of their holding

Uses of *income statements*:

1. Measure and compare the performance of a business over time or with other firms
2. The actual profit data can be compared with the expected profit levels
3. Bankers and creditors will need the information to help decide whether to lend money to the firm
4. Potential investors may assess the value of the business from the profits being made