3.6 Finance Flashcards
Finance
The capital needed to start up and run a business.
Why do businesses need finance?
• Rent or buy building
• Advertising
• Stock
Internal sources of finance
Definition
Capital found inside the business.
Internal sources of finance
Examples
• Retained profit
• Owners capital
• Share capital
• Selling assets and leaseback
• Redundancies
Retained profit
Advantage and disadvantage
+ No interest
- Opportunity cost
- Might not be available
Owners capital
Advantages and disadvantages
+ No interest
- Opportunity cost
- Risk own money if unlimited liability
Share capital
Advantages and disadvantages
+ Raise finance quickly and easily for PLCs
+ Limited liability
- Loose control
Sale and leaseback
Advantage and disadvantages
+ No interest
- Can undervalue asset
External sources of finance
Definition
Capital found outside the business.
External sources of finance
Examples
• Family and friends
• Loan
• Mortgage
• Overdrafts
• Trade credit
• Hire purchase
• Government grants
• New share issue
Loan
Advantages and disadvantages
+ Large amount of capital
- High interest
Mortgage
Advantages and disadvantages
+ Can purchase expensive property/land without having capital upfront
- High interest
Overdrafts
Advantages and disadvantages
+ Immediate emergency finance
- High interest
Trade credit
Advantages and disadvantages
+ Flexibility - time to sell products
- Requires good relationship with supplier
Hire purchase
Advantages and disadvantages
+ Spread the cost if don’t have immediate finance
- You won’t own it so can’t make decisions on it
- Cost more overall
Government grants
Advantages and disadvantages
+ Doesn’t have to be payed back
- Not a lot of money
New share issue
Advantages and disadvantages
+ Give a lot of money and advice
- Loose control
What factors influence the sources of finance chosen?
• The businesses profitability
• The amount of finance needed
• How risky the business is judged to be
• The amount of personal finance available
Cash flow
The amount of money moving in and out of a business on a day to day basis.
Importance of cash flow?
1) Cash to pay its bills on time to suppliers.
2) Enough money to pay workers
3) Enables the business not to borrow
Cash flow statement
A financial account that record the receipts and payments of a business (previous years).
Receipts
Money into the business.
Sales
Loan from a bank
Payments
Money out of the business.
Wages
Purchase of stocks
Net cash flow
The difference between the cash coming into the business and the cash flowing out.
Receipts - payments
Liquidity
If a business experiences problems where they do not have enough cash to cover their payments they cannot continue to trade.
What causes cash flow problems?
• Poor cash flow management/inexperienced managers
• Business is making a loss
• Relying on trade credit
• Giving customers too much trade credit
How can cash flow problems be resolved?
• Rescheldue payments (to suppliers, from customers)
• Cut costs (hold less stock, cheaper suppliers)
• Use an overdraft / other source of finance
• Sell assets / sale and leaseback
Profit
Total revenue - Total costs
Cash flow
Cash coming in and out of a business.
Creditor
Someone that you owe money too.
Suppliers
Debtor
Someone that owes you money.
Customers
Why are cash and profit different?
1) Profit exists in financial records.
2) Cash is the physical existence of cash.
Insolvency
Negative cash
Closing balance
Net cash flow + opening balance
Why does revenue not equal profit?
The business may have costs to pay with their revenue so it can’t all be kept as profit.
Break even
The level of production (output) at which a businesses total costs exactly equal total revenue.
Total revenue = Total costs
Why is break even important?
• Determines when you will start to make a profit
• Can allow the business to chose between different projects or products, which one breaks even first.
Fixed costs on a Breakeven chart
Fixed costs stay the same and are therefore a straight horizontal line.
Variable costs on a Breakeven chart
Variable costs change in relation to the number of items produced and therefore start at 0 and slope diagonally.
Total costs on a Breakeven chart
Total costs are fixed costs plus variable costs and therefore start at the point of fixed costs and then slope upwards at the same gradient as variable costs.
When does Breakeven output occur?
When total costs equal exactly total revenue.
Margin of safety
Definition
Measures the amount by which a businesses current level of production exceeds its Breakeven level of production.
Margin of safety
Equation
Current output - Breakeven output
Breakeven analysis
Breakeven analysis is a simple tool and makes assumptions.
• Fixed costs stay the same
• Variable costs per unit do not change as output change
• Output is all sold
• Selling price remains the same as output changes
Breakeven point
Equation
FC / SPPU - VCPU
Breakeven analysis advantages
• Easy to calculate
• Quick to produce
• Can be shown to a bank to support an application for a loan
• “What if” analysis can be used to see the effect of changes in selling price and costs.
Breakeven analysis disadvantages
• If a firm sells products at different prices it’s difficult to use
• If the data is not accurate the break-even point will be incorrect
• Predicted sales levels might not be met
Investment project
When a business invests in an asset in the hope of making a profit from its use.
Investment project examples
1) New machinery
2) New building/land
3) New vehicles
4) New products
Average rate of return
Definition
An investment appraisal technique (assessing wether an investment is worthwhile).
Average rate of return
Calculation
Average annual profit / Initial investment cost X 100
Average annual profit
Total profit - initial investment / number of years
Why is ARR a useful investment tool?
• Business investment projects need to earn a satisfactory rate of return which can be seen with ARR.
• ARR provides a percentage return which can be compared with a target return.
• ARR looks at the whole profitability of the project.
• Focuses on profitability - a key issue for shareholders
Why is ARR not a useful investment tool?
• Does not take into account cash flow - only profits (may not be the same thing).
• Takes no account of the time value of money (inflation).
• Hard to gauge your profits that far in advance.
Income statements
A record of the costs and revenues of a business over a period of time (1 year).
Gross profit
Sales turnover - cost of sales
Net profit
Gross profits - overheads
How does an income statement help a business?
1) If a business is making a loss it shows the directors what is causing it.
2) Assess business performance in terms of profitability
3) identify which costs need to be reduced
Sales turnover
SPPU x Output
Retained profit
Net profit - (tax + dividends)
Depreciation
The fall in value of an asset over time.
Which is depreciation important for an income statement?
1) It is an expense as the asset that you bought is not worth the same so it has lost you money.
2) To recognise that a business must ‘write off’ things that change in value.
How do Businesses use financial information to analyse performance?
• Compare with previous years
• Conparison with competition
• Comparison to targets
Statement of financial position
Part of business accounts that records assets and liabilities.
Assets
Resources a business owns.
Non current assets
Resources used often that are difficult to turn into cash. Usually owned for a long period of time (+1yr)
Building, furniture, equipment, shareholders funds, investments, vehicles, brand name.
Current assets
Short term assets that can be turned into cash within 12 months.
Cash at the bank, stock, raw materials, petty cash.
Liabilities
Resources/items it owes.
Non current liabilities
Debts due to be repaid after more than 12 months.
Long term loans, mortgage.
Current liabilities
Debts due to be repaid within one year.
Bank overdraft, dividends.
Capital/financed by
The money to fund the assets must have come from somewhere (capital employed = the investments)
Capital is funds provided by the owners/shareholders.
Capital is also provided from previous sales in the form of retained profit/reserves.
Net current assets
Current assets - current liabilities
Net Assets
Non current assets + Net current assets - Non current liabilities
Should equal total equity.
How can a statement of financial position be used to assess performance?
• To see if assets are more than liabilities.
• To see wether you have enough current assets to keep you going in the short term.
• If you have a good amount of net assets.
Why does the statement of financial position balance?
If a business purchased some new vehicles, they would have to raise the finance somehow.
What is the purpose of the statement of financial position?
Measures the worth or value of a business.
1. Judge if it is safe to lend money to the business.
2. Judge if it is safe to invest in that business.
Why is net current assets an important calculation?
Net current assets (working capital)
Working capital = Current assets - Current liabilities
• Pay for day to day running day to day.
• Useful if no trade credit.
• Can tell if firm has liquidity problem.
Profitability
Analysing how profitable a business is.
Profitability ratios
These ratios are ways of measuring how profitable a business is so that it’s performance can be assessed. All the information is found in the income statement.
Gross profit margin
Gross profit/Sales X 100
• Expressed as %
• The higher the better
• The purpose of this ratio is to show what percentage of turnover is represented by gross profit (or how many pence out of every £1 of sales is gross profit)
- Ignores overheads
+ Useful to assess control direct costs and ability to max sales.
Net profit margin
Net profit/Sales X 100
• Expressed as %
• The higher the better
• The purpose of this ratio is to show what percentage of turnover is represented by net profit (or how many pence out of £1 of sales is net profit).
+ Best measure of quality of profit.
+ Sales turnover measures scale.
Interpreting ratios
• Compare to the businesses target for that margin.
• Compare to previous years.
• Compare to the margin for other similar businesses.
