Section 5 Notes: Financial Information and Decisions

Why does a Business Need Finance?

• Finance: money that is needed to meet the expenses of a business. This is known as
capital.

• Capital is needed for:

o Starting up a business

o Expansion

o Increase working capital

o Capital Expenditure: money spent on non–current assets.

o Revenue Expenditure: money spent on day-to-day, recurring expenses.

The Responsibilities of the Finance Department

• Recording all financial transactions

• Prepare final accounts

• Cash flow forecast

• Make important decisions

• Provide info to managers

Sources of Finance

• The primary sources of capital include:

o Internal Sources: Obtained from within the business itself.

o External Sources: Obtained from outside and separate from the business.

Internal Sources of Finance

• Retained Profits: Profit businesses obtain after costs.

Advantages Disadvantages

It does not have to be repaid. The new business will not have any.

It doesn’t incur interest. Small firms’ retained profit may be low to finance the expansion.

Reduces payment to owners, e.g., dividends for shareholders.

• Sale of Existing Assets

 Advantages Disadvantages

Better use of unwanted capital It can take time to sell the assets, and the amount may not be the
same as when purchased.

Doesn’t increase the debts of a Source of finance not available for new businesses.
business

• Sale of Inventories

Advantages Disadvantages

Reduces opportunity cost. It may disappoint customers if a sudden change in demand is not met.

Reduces storage costs.

• Owner’s Savings

Advantages Disadvantages

Quick availability Savings may be low

No interest is paid Increases risks for owners, as they might have unlimited liability.

External Sources of Finance

• Issue of Shares: Sale of business shares (only for limited companies)

Advantages Disadvantages

A permanent source of capital Dividends are paid after tax.

It doesn’t need to be paid back Shareholders expect dividends.

No interest Ownership will change if many shares are sold.

• Bank Loans: A sum of money from a bank repaid with interest.

Advantages Disadvantages

Quick, easy to arrange Must be repaid with interest

Advantages Disadvantages

Available for varying lengths of time. Security or collateral security must be

given

Large companies receive low-interest rates if large sums are

taken.

• Selling Debentures

o Debentures are certificates issued to a debenture holder for the money they
lent, which must be repaid within 20 – 25 years.

Advantages Disadvantages

Long term finance Loans must be repaid, and interest must be paid.

• Debt Factoring

o Debt factors are specialist agencies that buy the claims of debtors of firms for
immediate cash.

Advantages Disadvantages

Availability of immediate cash The firm doesn’t receive 100%

amount

The risk of collecting the debtors becomes the factor, not the
business’s.

• Grants and Subsidies

Advantages Disadvantages

Don’t have to be repaid Given with strings attached

• Microfinance

o Providing financial services to poor people not secured by traditional banking.

Advantages Disadvantages

Small loans can be obtained by start-ups (especially if it’s by simple people) High-interest rates
 Advantages Disadvantages

Greater risk for the lender

• Crowdfunding

o Funding a project or venture by raising money from numerous people who each
contribute a relatively small amount.

Advantages Disadvantages

It's a fast way to raise a substantial sum. Crowdfunding platforms may reject the proposal
if it is not done well.

No initial fees are payable to the platform; only when If the total amount is not raised, money invented
the goal is reached a % will be taken. by others will have to be repaid.

It allows public opinion to be heard to see if the idea Media interest and publicity are needed for a
is good. chance of success.

It is often used by entrepreneurs when other Competitors could steal the idea.
traditional methods are not available.

Short vs. Long-term Sources

Short-term finance (shortage of cash in the short term can be overcome in 3 ways):

• Overdrafts

Advantages Disadvantages

‘Overdraw‘ (spend more money than is currently in the Interest rates are variable (vary from each
account) overdraw)

Flexible form of borrowing The bank can ask for the overdraft to be paid
quickly.

Interest will be paid only in the amount overdrawn.

Overdrafts are cheaper than short-term loans.

• Trade Credit

o It is when businesses delay payments to suppliers

 Advantages Disadvantages

Almost an interest-free loan May not provide discounts

Reduces cash outflows in the short run

• Factoring of Debt

Long-Term (Loans Available for More than a Year)

• Bank Loans

o They are payable over a fixed period

• Hire Purchase

o It allows a business to buy a fixed asset over a long period with monthly
payments, including interest.

Advantages Disadvantages

Doesn’t have to find a large cash sum to purchase the A cash deposit is paid at the start of the
asset month

High-interest rates

• Leasing

o It allows a firm to use an asset by paying regular instalments instead of

purchasing it outright. The firm pays an agreed amount over a period of time to
lease the property or asset.

Advantages Disadvantages

Doesn’t have to find a large cash sum to The total cost of leasing changes will be higher than
purchase the asset purchasing the asset.

Maintenance is taken care of by the leasing

company.

• Issue of Shares

o Only available to limited companies

• Debentures

• Long-term Loans or Debt Finance - this is different from share capital:

o Loan interest is paid before tax and is an expense.

 o Loan interest must be paid every year.

o The loan must be repaid.

o Often ‘secured‘ against particular assets.

Factors When Choosing the Source of Finance

• The main factors considered in making the financial choice:

o Size of business & Legal Form (type of business): Public limited companies
have a larger choice of sources of finance because they pay less interest (less
risk).

o Amount of Capital Required: if you need just a little money, you won’t issue
new shares.

o Purpose of Capital & Time Period: The general rule is that the finance source
should match the financial need:

▪ If the use of capital is long-term, the source should be long-term (same

with short-term).

o Existing Loans (risk and gearing ratio): If a business has already taken out
many loans, banks will think it is too risky to finance.

▪ Gearing: measures the proportion of total capital raised from long-term

loans.

Common Reasons The Banks Refuse to Loan to Small Businesses

• Weak cash flow

• Lack of security or collateral.

• Poor preparation by the business owner when applying for the loan.

Banks Need These to Lend

• Cashflow forecast

• Business plan

• Collateral/security

• Forecast income statement available

Cash-Flow Forecasting and Working Capital

• Cash is a Liquid Asset: it can be immediately available to spend on goods & services.

• Cash Flow: the cash inflows (money received by business) & outflows (money paid)
over some time.

• Cash Inflow: money coming into the business.

o Sale of goods

o Sale of assets
 o Payments to debtors

o Borrowing money

o Investors

• Cash Outflow: money going out of the business.

o Purchase of goods

o Purchase of non-current assets

o Payments of salaries

o Repaying loans

o Trade payables

Cash Flow Cycle

• It shows the stages between paying out cash and receiving cash.

1. Cash outflow to pay for materials, rent, etc.

2. Goods produced

3. Goods sold

4. Cash payment received for goods sold (cash inflow)

• The longer it takes for the cash flow cycle to be completed, the greater the working
capital.

• Cash flow is not the same as profit.

• Profit consists of goods sold on credit, whereas cash flow is a business's cash sales in a
month.

• When profitable businesses run out of cash, it is known as insolvency

• Due to:

o Over-trading

o Long credit time

o Less credit time received

o Many fixed assets purchased

Cash Flow Forecast

• Cash-Flow Forecast: an estimate of a business's future cash inflows and outflows on a

month-by-month basis. Shows the expected cash balance at the end.

• Closing Cash Balance: the amount the business holds at the end of each month.

• Opening Cash Balance: the amount the business holds at the start of each month.

• Net Cash Flow: The difference between the cash inflow and outflow (inflow – outflow)
 • January February March

Opening bank balance (A) 10,000 15,000 (5,000)

Cash inflow (B) 35,000 45,000 50,000

Cash outflows (C) 30,000 65,000 40,000

Net cash flow (D=B-C) 5,000 (20,000) 10,000

Closing bank balance (=A+D) 15,000 (5,000) 5,000

Uses of Cash Flow Forecast

• Starting up a business

o The first few months are crucial to every business, as owners don’t realise the
amount of cash needed, which is why they fail.

o Businesses need to spend on labour, land, and capital. They even have to
advertise and promote extensively.

o Many owners don’t understand the importance of cash flow in a business, so

they fail.

• Keeping the bank manager informed

o A cash flow forecast will help a business receive a loan.

o The bank manager needs to know when the amount is needed, for how long, and
when it will be repaid.

• Managing an existing business

• Managing cash flow

o Businesses with high bank balances can use their cash effectively in other
areas.

How do you Overcome Cash Flow Problems?

Short Term Solutions

• Increasing bank loans will inject more cash into the business, but interest and loan
must be paid.

• Delaying payments to suppliers will decrease cash outflows in the short run, but
suppliers may refuse to provide discounts or supply.

• Reducing credit periods may help a business increase short-term cash inflows, but
customers may switch to competitors.
 • Delaying the purchase of fixed assets will reduce cash outflows, but in the long run, a
company may lack efficiency as they don’t have up–to–date technology.

Long Term Solutions

• Attracting new investors

• Cutting costs and increasing efficiency using lean production.

• Develop new products

Working Capital

• In the short run, it is the capital available to a business to pay for day–to–day expenses.

Working Capital = Current Assets – Current Liabilities

• Working capital can be in the form of:

o Cash

o Value of debtors

o Value of inventory

• Working capital should be handled properly because it shows investors & banks how
efficient a business is and its financial strength.

Income Statements

• Accounts: the financial records of a firm’s transactions.

• Accountants: professionally qualified people who are responsible for keeping accurate
accounts and producing final accounts.

• Final Accounts: These are produced at the end of the financial year and give details
about the profit/ loss made over the year and the worth of the business.

• The simple equation for profit:

Profit = Sales revenue – total costs

• Profit can be increased through:

o Increasing the sales revenue so that it is higher than the production costs.

o Reducing the production costs.

o A combination of the two.

Importance of Profits

• Importance for Private Sectors:

o Reward for enterprise

▪ Entrepreneurs have special qualities, and they must earn rewards for
that.

o Reward for risk-taking

 ▪ Shareholders/investors/owners take risks when they provide capital;
profits reward those risks.

▪ Payments act as incentives to invest more and make the business

profitable

o Source of Finance

▪ Profits after payments can be used to fund expansion

o Indicator of Success

▪ Profits show that investing can be profitable, but losses show that
investment must not be made.

▪ However, Profit ≠ Cash as profit is derived from revenue, but cash can be
derived from many places (e.g. selling assets like cars).

• Importance of profit to the public sector:

o Used as a source of finance to develop the state-owned business or be more

efficient.

• Importance of profit to social enterprise:

o Balance profit-making with their aims, as profit is used for the firm's survival.

Understanding Income Statements

• Income Statement: a financial statement that records the income of a business and all
costs incurred to earn that income over some time.

• Managers, banks and other investors will use it to see if a business is making a profit:

o To compare with previous years - if it is greater than the year before

o To compare to competitors

• The main features of an income statement include:

o Revenue: the income to a business from the sales of goods and services.

▪ Equation: Units sold x Price per unit

o Costs of Sales: the cost of production or buying the goods the business sells
during a period.

▪ Equation: Opening inventories + Purchases – Closing inventories

o Gross Profit: the profit made in revenue is greater than the cost of sales.

▪ Equation: Revenue – Cost of sales

o Trading Account: shows how gross profit is calculated.

o Net Profit: the profit the business makes after deducting all costs.

▪ Equation: Gross profit – Overhead costs (Fixed costs)

 ▪ Depreciation: the fall in the value of a fixed asset over time.

o Retained Profit: the net profit, after taking away taxes and payments to owners –
which is reinvested into the business.

• Limited companies will have in their income statements:

o Corporation tax is paid from net profit.

o Dividends paid to shareholders.

o Retain profit after these two deductions.

o Results from the previous year will allow for easy comparisons.

Example of Income Statement

2018 2017

Revenue $1250 $1300

Cost of sales – $900 – $900

Gross profit $350 $400

Expenses, including interest paid – $155 – $160

Net profit $195 $240

Corporation tax – $35 – $40

Profit after tax $160 $200

Dividends – $120 – $130

Retained profit for the year $40 $70

• Uses of income statement:

o Know the profit/loss made.

o Compare their performance.

o Profitability of individual products.

o Products to launch.

Statement of Financial Position

 • Statement of Financial Position – a document that shows the value of the business’s
assets and liabilities at a time.

• Assets: Items of value owned by a business.

o Current Assets: (Short-term Assets) Items owned by the business for less than 1
year, i.e. Raw material, cash.

o Non-Current Assets: (Long-term Assets) Items owned by a business

for more than 1 year, i.e. Buildings, land, company cars.

• Liabilities: debts owed by the business.

o Current Liabilities: (Short Term Liabilities) Debts owed by business for less than
1 year, i.e. bank overdrafts and wages.

o Non-current liabilities: (Long-term Liabilities) debts owed by a business for

more than 1 year, i.e., long-term bank loans and creditors (money the business
owes to suppliers).

o The Total Equity (AKA Shareholders’ funds) is how much a business is worth.
(only for limited companies).

▪ Shareholders’ Funds = Total Assets – Total Liabilities

o The shareholders’ funds are the total money invested in a business by the
shareholders/owners.

o This money can be invested by either share capital or reserves (Retained profit
and loss).

o If the total equity of a business has increased/fallen, the shareholder’s stake in

the company will be worth more/less, respectively.

Example of Statement of Financial Position

Assets 2018 ($00) 2017 ($00)

Non-current (fixed assets):

Land and buildings 450 440

Machinery 700 $600

1150 1040

Current assets:

Inventories 80 50
 Assets 2018 ($00) 2017 ($00)

Account receivables (debtors) 50 60

Cash 10 15

140 125

Total Assets 1290 1165

Liabilities:-

Current liabilities:

Account payables (Creditors) 65 40

Bank Overdraft 65 60

130 100

Non-Current liabilities:

long-term bank loans 300 245

Total Liabilities 430 345

Total Assets - Total Liabilities 860 820

Share capital 520 500

Profit and loss reserves 340 320

Total Shareholders’ funds/equity 860 820

Interpreting Balance Sheets

• Shareholders can see the value of their stake

• Shareholders can also analyse how expansion has been paid for by long-term loans,
retained profit, or increased share capital (sales of shares).
 • You can calculate the Working Capital.

o Working Capital = Current Assets - Current Liabilities

• You can also calculate the Capital Employed – the long-term and permanent capital
invested in a business.

o Capital Employed = Non-Current Liabilities + Total Equity

• Alternative Formula

o Return on capital employed (ROCE) = 100 X Profit before tax/ capital employed
Where Capital employed = Non-current liabilities + Shareholders fund = Total
assets – Current liabilities

Analysis of Accounts

• Analysis of Accounts: using data in the accounts to make useful observations about a
business's performance and financial strength.

• Used to compare results from other years and other businesses.

• Liquidity: the ability of a business to pay back its short-term loans (debt).

• Illiquid: assets are not readily convertible into cash.

• Profitability: the measurement of the profit made relative to either sales achieved or the
capital invested in the business. Also, a measure of efficiency.

• There are 2 types of ratios:

o Profitability Ratios – how profitable a business is

o Liquidity Ratios – how able a business is to pay its short-term debts (current
liabilities)

• Profitability Ratios:

o Gross Profit Margin (%): how well a company converts sales into gross profit.

▪ GPM(%)=100×ProfitSales RevenueGPM(%)=100×Sales RevenueProfit

▪ The percentage of how much profit you have to earn from the capital
employed. The higher the %, the more efficient the business is with its
capital employed.

o Net Profit Margin (%): how well a company converts sales into net profit.

▪ NPM(%)=100×Net ProfitSales RevenueNPM(%)=100×Sales RevenueNet

Profit

▪ Shows the percentage of gross profit per $1 worth of goods. If the

following year's profit increases, either the price increases or the cost of
sales is reduced.

o Return on capital employed: how profitable a company is compared to the

money used.
 ▪ RoCE(%)=100×Net ProfitCapital EmployedRoCE(%)=100×Capital Emplo
yedNet Profit

▪ Shows the net profit made on each $1 Worth of sales. The higher the
results, the more net profit is gained from the sales.

• One profitability ratio isn’t helpful by itself. You need to use all the profitability ratios and
compare them with previous years of the business.

• Liquidity Ratios:

o Current Ratio: how good a company is to pay off its current liabilities with its
current assets.

▪ Current Ratio=Current-AssetsCurrent-LiabilitiesCurrent Ratio=Current-

LiabilitiesCurrent-Assets

▪ Shows whether the business has enough current-term assets to pay off
short-term debts; if less than 1 means the business does not have
money, 1 is when a business can exactly pay debts, and when more than
2 means it has excessive assets that could be put to use.

o Acid Test Ratio: measures the ability of a company to pay off its liabilities
without depending on the inventory sales.

▪ Acid Test Ratio=Current assets-inventoriesCurrent-

liabilitiesAcid Test Ratio=Current-liabilitiesCurrent assets-inventories

▪ The acid ratio considers only the liquid assets of the business, not the
inventories. The uses as the current ratio.

Users of Accounting Information

• Managers

o They will help them keep control over the performance of each product.

o Help decision-making

o Ratios are a quick way for managers to compare their ratios with other
businesses and previous accounts.

• Shareholders

o Shareholders and potential investors want to know how big a profit/ loss the
company has made.

o They will want to check the profitability and liquidity ratios and decide whether
shareholders have to buy more shares.

• Creditors/Trade Payable

o Liquidity ratios indicate the ability of the company to pay back its debts.

• Banks

o Risk of illiquid, no lending.

 • Government

o To check the tax revenue, whether the firms are paying the right taxes.

• Workers and trade unions

o They just want to assess whether the company's future is secure.

o Access the profits to help unions improve wages and working conditions of
employees.

• Other businesses – competitors

o The managers will compare their profitability and liquidity with other businesses.

Limitations of Accounting Records and Ratio Analysis

• Managers have access to all account data; external users only have what the business
requires to show by the law.

• Ratios are based on past accounting data and can not be used to forecast future
business performance.

• Accounting data over time will be affected by inflation, and comparisons can be
misleading.

• Different companies may use different ways of accounting. Therefore, comparisons may
be difficult.