Unit 5. Financial Information

 Unit 5: Financial Information and Decisions

19. Business finance: needs and sources

Why businesses need finance:

• Start-up capital

• Working capital: capital needed for day-to-day expenses (e.g. wages)

• Fixed assets (non-current): assets owned by the business which is used >1 year

• Capital expenditure: latest technology 

• Market research

• Expansion 

Long-term finance: loans to finance non-current assets with maturity exceeding 5 years

Short-term finance: loans expected to be paid within a year

Internal sources of finance

• Owner’s saving

• Retained profit: remaining profit reinvested back into business 

• Sales/leasing of non-current assets: selling/renting out land owned by the business

*non-current assets may not have high commercial value

• Working capital 

Methods of using working capital

→ Reduce cash balances: cash used to pay for capital expenditure 

→ Reduce inventory levels

→ Reduce trade receivables: sell goods to customers on credit (customers receive goods and pay for them at an agreed date in the future)

Reduce trade receivables by:

+) Reduce length of waiting for payment/offer discounts for early payment

+) Reduce total accounts receivable

External sources of finance

Short-term sources

Overdraft: agreement with a bank that allows a business to spend more money than it has in its account. The loan has to be paid within 12 months

Trade credits: (business buying resources from suppliers on credit) supplier lending money for the cost of goods for the length of the agreed credit period

Debt factoring: selling trade receivables to customers 

Long-term sources

Bank loan: provision of finance by banks which businesses will repay with interest at an agreed period in time

Leasing: obtaining temporary use of a non-current asset by paying a fixed amount per time period (ownership remains with the leasing company)

Hire purchase: the purchase of an asset by paying the cost spread over a period of time (the asset is owned upon completion of payment)

Mortgage: long-term loans used for the purchase of lands/buildings (interest charged on the amount borrowed, must be paid each year) (full amount has to be paid within the mortgage term)

Debenture: the business lending money to another business for profit

Share issue: offer to sell shares (permanent capital) only available to limited companies

20. Cash-flow forecasting and working capital

Cash-flow forecast: an estimate of the total cash inflows and outflows of the business

(if business can predict a period of cash shortage → try to prevent)

Net cash flow: inflow - outflow

Methods to overcome short-term cash-flow problems

• Negotiate longer credit terms with suppliers

• Delay purchase of non-current assets (until cash-flow improves)

• Find other sources of finance to purchase non-current assets (e.g. hire purchase, overdraft)

Liquidity: the ability of a business to pay its short-term debts

Working capital: measures the liquidity of a business 

has poor cashflow (can’t repay debts) → weak working capital → illiquid

Working capital cycle:

→ cash

→ inventories purchased on credit

→ production of goods and services

→ goods sold to customers on credit

Length of working capital cycle depends on:

• Level of inventory held by the business

• Time taken to produce goods

• Time taken to find buyers/consumers

• Length of credit period

(improve by: reducing inventory levels, credit period, longer credit terms with suppliers)

21. Income statements

Types of profit

• Profit: the difference between revenue and total costs 

(revenue - total cost) 

(gross profit - expenses)

• Gross profit: the difference between the revenue earned from selling products and the costs of making those products (revenue - cost of sales)

• Retained profit

Revenue: the amount business earns from selling its product (selling price * quantity sold)

Cost of sales: the cost of purchasing the goods used to make the product sold

Expenses: day-to-day operating costs of a business

Importance of profit

• Measures success of business

• Finance purchase of non-current assets, expand business,...

• Decide if the product should be continued

• Measure performance of managers

• Attract investors 

22. Statement of financial position

Statement of financial position: an accounting statement that records assets, liabilities, and owner’s equity of a business at a particular date

Assets: resources owned by a business

• Non-current assets: resources with maturity exceeding 1 year

• Current assets: resources expected to be converted into cash before date of the next statement of financial position

Liabilities: debts of a business that is expected to be paid

• Current liabilities: debts expected to be paid before date of next statement of financial position

• Non-current liabilities: long-term debts with maturity exceeding 1 year

• Owner’s equity: amount owed by the business to its owners (investments/retained profit)

• Shareholder’s equity: owner’s equity (exclusive to limited liability companies)

23. Analysis of accounts

Methods of measuring profitability

• Gross profit margin: how much gross profit is earned per $1 (difference between revenue and cost of sales) 

Gross profit margin = (gross profit/revenue)*100

• Profit margin: how much profit is earned per $1 (performance of businesses converting revenue into profit) 

Profit margin = (profit/revenue)*100

⇒ measures how businesses add value and control costs

• Return on capital employed (ROCE): ratio between profit and capital employed (before tax) (how much profit is earned for every $1 invested into a business)