Finance Flashcards
Overdraft
A facility in that the bank lets the business ‘owe it money’ when the bank balance goes below zero. (Short term)
Advantages of overdrafts
Relatively easy to arrange
Flexible - only use as cash flow requires
Interest - only paid on the amount borrowed under the facility
Not secured on assets of businesses
Disadvantages of overdrafts
Can be withdrawn at short notice
Interest rate varies with changes in interest rate
Higher interest rate than bank loan
Trade credit
Making use of an opportunity to defer payment to a supplier. (Short term)
Advantages of trade credit
Helps cash flow issues
The business can pay the supplier once they have received the payment for the good being sold
Disadvantage of trade credit
If you don’t pay in time, the suppliers may not supply you in credit again
Factoring
When a business raises finance by selling their debt to a third party, at a discount, for them to then follow up and collect to receive a profit. (Short term)
Advantages of factoring
Amounts owed by customers (receivables) are turned into cash quickly
Businesses can focus on selling rather than collecting debts
There is no security required - unlike a loan or overdraft
Hire purchase
Paying for an item in instalments over a period of months or years. The business owns the item after the instalments have been made. (Medium term)
Advantages of hire purchase
Quick and easy to raise finance
No security
Will eventually own the item and it will become an asset
Disadvantages of hire purchase
Not owned until the item is fully paid for
Interest charged
Bank loan
A fixed amount for a fixed term with regular fixed payments. The interest in a loan tends to be lower than an overdraft. (Medium/long term)
Advantages of bank loans
Greater certainty of funding, provided terms of loan complied with
Lower interest rate than a bank overdraft
Appropriate method of financing fixed assets
A large sum of money can be borrowed
Disadvantages of bank loans
Requires security (collateral)
Interest paid on full amount outstanding
Harder to arrange
Leasing
When a business ‘rents’ an item with regular payments but never owns it. (Medium term)
Advantages of leasing
Balanced cash flow
Gained access to quality assets
Allows for better budget planning
No risk of obsolescence
Disadvantages of leasing
No ownership
Debt
Maintenance of the asset
Retained profit
A portion of the business’ profits that is not paid out as dividends to shareholder but is instead retained by the business for future use. (Medium term) - often not considered as a source of finance in exams
Advantages of retained profit
Cheap
Very flexible
Do not dilute the ownership of the company
Disadvantages of retained profit
Shareholders would prefer to have a higher dividend
Shares
Selling a percentage of the business to individuals in return for money. (Long term)
Advantages of shares
Don’t take on new debt
No regular payments required, or interest paid
Can choose the price of shares and when they are issued
Disadvantage of shares
Loss of ownership
Loss of control
Venture capital / business angels
A form of private equity and a type of financing that investors provide to businesses that are believed to have long-term growth potential. (Long term)
Advantages of venture capital
Raise a substantial sum of money
Quick and scalable route to expand business
Brings expertise, resources, and technical assistance
Disadvantages of venture capital
Investors are likely to demand a significant return
May lose ownership and autonomy
Debenture
A loan given to a business by an individual. (Long term)
Advantage of debentures
Control of the business is not lost
Disadvantages of debentures
Interest must be paid even if the company makes a loss
Critical path analysis
A project management technique that requires mapping out every key ask that is necessary to complete a project
Float
The amount of time that a task in a project network can be delayed without causing a delay to project completion date
Total float
The amount of time that an activity can be delayed from its start date without delaying the finish time of the project
Free float
The amount of time an activity can be delayed without causing delay to the next task
Critical path
The sequence of project network activities that determine the shortest time possible to complete a project.
Any delays to activities on the critical path will result in delay to the overall completion time of the project.
Advantages of CPA
Helps reduce the risk and costs of complex projects
Encourages careful assessment of the requirements of each activity in a project
Helps spot which activities have some slack (‘float’) and could therefore transfer some resources (leading to better allocation of resources)
Provides managers with a useful overview of a complex project
Links well with other aspects of business planning including cash flow forecasting and budgeting
Disadvantages of CPA
Reliability of CPA - difficult to make accurate estimates and assumptions
CPA does not guarantee the success of a project - it still needs to be managed properly
Resources may not actually be as flexible as management hope when they come to address the network float
Too many activities could make the network diagram too complicated - activities might have to be broken down into mini-projects
Total float equation
LFT (this activity) - duration - EST (this activity)
Free float equation
EST (next activity) - duration - EST (this activity)
What are the two parts of capital structure?
Debt and equity
Debt
Finance provided to the business by external parties
Examples of debt
Bank loans
Other long term debt
Equity
Amounts of invested by the owners of the business
Examples of equity
Share capital
Retained profits
Reasons for higher debt
Low interest rates - cheaper to borrow
Don’t want to lose control of the business
Good cash flow - can easily pay it back
Reasons for higher equity
Where there is greater business risk (eg start up)
Where more flexibility is required (eg don’t have to pay dividends)
Creditors
Who you owe money to
Debtors
Who owe you money
What might determine a business’ choice of finance?
Whether it is needed for the short term or the long term
The legal structure of the business - some cannot issue shares
The state of the economy - eg interest rates
Having collateral (assets) to support a loan
Quantitative factors (measurable) - have several loans already when applied for
Qualitative factors (not measurable) - eg taking on a partner will increase capital and decrease control but by how much?
External factors (the economy - interest rates, disposable incomes)
Security - lack of security may mean that banks are unwilling to grant a loan
The current method used to finance the business - eg using an overdraft in the wrong way could make a bank loan more difficult to get
Fixed costs
Costs that do not change in relation to output
They do changes but not as a consequence of output changing
Examples of fixed costs
Rents and rates
Salaries
Advertising
Insurance, banking and legal fees
Software R+D
What are fixed costs also known as?
Overheads or indirect costs
Variable costs
Costs which change as output varies
Examples of variable costs
Raw materials
Piece rates
What are variable costs also known as?
Direct costs
Total costs
Fixed costs + variable costs
Revenue
Cash that flows into a business from the sale of goods and services
It is determined by the number sold and price that they are charged at
Other terms for revenue
Income
Sales turnover
Takings
Revenue equation
Volume sold x average selling price
Ways to increase revenue
Increase volume sold
Increase selling price
Profit equation
Total sales - total costs
Costing
An act of measuring the effects of any business activity in financial terms
Standard costing
The cost the business expects the production of a product or service to be
It is a forecast that gives the business a cost target
Cost centre
A specific part of the business where costs can be identified and allocated
How might costs be allocated?
The different products that a business produces
The individual department
Location of different business sites
Capital equipment
Physical size
Advantages of cost centres
Allows to monitor performance
Motivation of workforce
Look for new supplies or better production techniques
Disadvantages of cost centres
Issues collecting data (difficult to separate costs into different departments)
Allocation of costs can impact performance of different branches/departments
Some costs can’t be controlled (eg oil prices)
Some departments may see it as unfair causing internal conflict
Profit centre
A separately identifiable part of a business for which it is possible to identify revenue and costs (ie calculate profit)
Examples of profit centres
Individual shops in a retail chain
Local branches in a regional or nationwide distribution business
A geographical region (eg a country or region)
A team or individual (eg a sales team, a team of installers)
Advantages of profit centres
Provides useful insights into where profit is earned (comparisons can be made)
Supports budgetary control
Can improve motivation (target setting)
Finance can be allocated more effeciently - where it makes the best return
Disadvantages of using profit centres
Can be time consuming
May lead to conflict and competition within the business
Potentially de-motivating if profit centre targets are too tough, or if unfair cost allocations are made
Profit centres may pursue their own objectives rather than those of the broader business
Contribution
Revenue received from selling a product minus the direct costs of producing that good (variable cost)
Total contribution equation
Total revenue - total variable costs
Contribution per unit equation
Selling price (per unit) - variable cost (per unit)
Ways to increase contribution per unit
Increase the selling price per unit
Lower the variable cost per unit
Break even analysis
A method of determining the level of sales at which the company will break even (have no profit or loss)
Margin of safety
The difference between the actual (or forecasted) output and the break even output
Strengths of break even
Identifies how long it will take before a start-up reaches profitability (sales required)
Helps to understand the viability of a business proposition (helps to obtain finance)
Helps to determine the margin of safety (to determine how far sales can drop before losing money)
Illustrates the importance of controlling costs and setting the correct selling price
Limitations of break even
Unrealistic assumptions - price and costs can and do change
Most businesses sell more than one product, so break even for the business becomes harder to calculate
Break even analysis should be seen as a planning aid rather than a decision-making tool
Investment appraisal
The process of analysing whether investment projects are worthwhile
3 types of investment appraisal
Payback period
Average rate of return
Discounted cash flow (NPV)
Payback period
The time it takes for a project to repay its initial investment
Benefits of payback period
Simple calculation
Emphasises speed of return
Straight forward to compare projects
Drawbacks of pay back period
Ignores cash flows after payback has been reached
Doesn’t take into account how the value of money changes over time
Encourages short term thinking
Simplistic -especially if it’s a complex investment
Average rate of return
Looks at the average return for a project to see if it meets the target return
Average rate of return equation
(Average annual return ÷ investment) x 100
Average annual return equation
Total net profit ÷ number of years
Advantages of ARR
Provides a percentage return which can be compared with a target return
Looks at the whole profitability of the project
Focuses on profitability - a key issue for shareholders
Disadvantages of ARR
Does not take into account cash flows - only profits (they may not be the same thing)
Takes no account of the value of money
Takes profits arising late in the project in the same way as those which might arise early
Net present value
Calculates the monetary value of a project’s future cash flows
Advantages of using NPV
Takes account of time value of money, placing emphasis on earlier cash flows
Looks at all the cash flows involved through the life of the project
Use of discounting reduces the impact of long-term, less likely cash flows
Has a decision-making mechanism - rejects projects with negative NPV
Disadvantages of using NPV
More complicated method - users may find it hard to understand
Difficult to select the most appropriate discount rate - may lead to good projects being rejected
The NPV calculation is very sensitive to the initial investment cost
Does not consider external factors (based on predictions)
Budget
A detailed plan for the future concerning the revenues and costs expected over a certain period of time
Budgetary control
The process by which financial control is exercised within an organisation
Managers use budgets to…
Control income and expenditure (the traditional use)
Establish priorities and set targets in numerical terms
Provide direction and co-ordination, so that business objectives can be turned into practical reality
Communicate targets from management to employees
Motivate staff
Improve efficiency
Monitor performance
Principles for good budgetary control
Managerial responsibilities are clearly defined
Performance is monitored against the budget
Corrective action is taken if results differ significantly from the budget
Variances are investigated
Variance analysis
Involves calculating and investigating the differences between actual results and the budget
Favourable (positive) variances
Actual figures are better than budgeted figure
Eg- costs lower than expected
Eg - revenue / profits higher than expected
Averse (unfavourable) variances
Actual figure is worse than the budget figure
Eg- costs higher than expected
Eg- revenue / profits lower than expected
Possible causes of favourable variances
Stronger demand than expected = higher actual revenue
Selling prices increased higher than budget
Cautious sales and cost assumptions (eg cost contingencies)
Better than expected productivity or efficiency
Possible causes of adverse variances
Unexpected events lead to unbudgeted costs
Over-spends by budget holders
Sales forecasts prove over-optimistic
Market conditions (eg competitor action) mean demand is lower than budget
Zero budgeting
An alternative to traditional budgeting
All budgets are set to zero and managers justify any requirements for funds
It helps to prevent a situation where the same money is given each year
Flexible budgets
These allow a business to make allowances for changes in the level of sales (adverse variances are avoided)
Cash flow
A dynamic and unpredictable part of life for most businesses (particularly start-ups and small businesses)
Cash flow problems are the main reason why a business fails
Regular and reliable cash flow forecasting can address many of the problems
Why produce a cash flow forecast?
Advanced warning of cash shortages
Make sure that the business can pay suppliers and employees
Important part of financial control
Provides reassurance to investors and lenders that the business is being managed properly
What are the two main kinds of cash flow?
Cash inflows and cash outflows
Examples of cash inflows
Cash sales
Receipts from trade debtors
Sale of fixed assets
Interest on bank balances
Grants
Loans from bank
Share capital invested
Examples of cash outflows
Payments to suppliers
Wages and salaries
Payments for fixed assets
Tax on profits
Interest on loans and overdrafts
Dividends paid to shareholders
Repayment of loans
Main causes of cash flow problems
Low profits or (worse) loses
Too much production capacity
Excess inventories held
Allowing customers too much credit and too long to pay
Over trading - growing the business too fast
Seasonal demand
How to manage cash flow problems
Use reliable cash flow forecasting
Keep costs under control
Manage working capital effectively
Choose the right sources of finance
Limitations of cash flow forecasting
Changes in interest rates
Changes in economic policy
Forecasts are estimates
Competitor behaviour
Changes in technology
Definition of the Principles of Accounting
Seven principles that ensure the figures produced are standardised so they can be analysed and viewed by stakeholders with a degree of confidence
What are the seven principles of accounting?
Consistency
Going concern
Matching
Materiality
Objectivity
Prudence
Realisation
Consistency (principles of accounting)
Accounts produced in the same way
Going concern (principles of accounting)
Operating as normal (not in danger of closing)
Matching (principles of accounting)
Dates used to record financial transactions are when transaction takes place not when the payment is made
Materiality (principles of accounting)
Value of business needs to be realistic figure, not calculating every asset. (Eg not counting the amount of office stationery)
Objectivity (principles of accounting)
Accounts must be realistic and based on facts and not opinions and guesses (eg valuing a piece of machinery highly because it is estimated that inflation would increase)
Prudence (principles of accounting)
Similar to objectivity and is concerned with not overstating the organisations financial situation (principle suggest it is appropriate to take a pessimistic approach regarding possible future profits)
Realisation (principles of accounting)
Similar to matching, in that realisation takes place when the legal ownership changes hands and not when the payment is made.
Generally accepted accountancy practice (GAAP)
Framework for accountancy rules (stakeholders can make comparisons knowing businesses all use the same principles)
Working capital
The capital of a business which is used in its day to day trading operations
Working capital equation
Current assets - current liabilities
Current assets
Assets that you can turn into cash within a year
Examples of current assets
Stock
Cash
Debtors
Current liabilities
Short term money that you owe
Examples of current liabilities
Overdraft
Creditors
Net current assets equation
Current assets (cash + stock + debtors) - current liabilities (creditors + overdraft)
(Same as working capital equation)
What are the two main categories of accounting?
Financial accounting
Managerial accounting
Financial accoutning
Concentrates with assets, profits and levels of cash within the business.
This information is issued in the annual report to satisfy external stakeholders
Managerial accounting
Concentrates on internal records allowing the business to monitor and evaluate performance to set targets
Factors affecting the level of working capital
Businesses with a lot of cash sales and few credit sales should have minimal trade debtors (eg supermarkets)
Some finished goods, notably food stuffs, have to be sold within a limited period because of their perishable nature
Larger businesses may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers
Some business will receive their monies at certain times of the year (seasonal)
Depreciation
An accounting estimate of the fall in value of a fixed asset over time
What are the two main methods of calculating depreciation?
Straight line
Reducing balance
Straight line equation
(Cost - residual value) ÷ estimated useful life
(Residual value = the value of an asset at the end of its useful life)
Reducing balance equation
Net book value x depreciation rate
(Net book value = the value of the asset)
The amount of working capital held by a business depends on a variety of factors:
Need to hold inventories
Production lead time
Lean production
Expected credit period by customers
Effectiveness of the credit control function
Credit period offered by suppliers
Main causes of working capital problems
Poor control of inventories (stocks)
Poor control of receivables (trade debtors)
Ineffective use of payables (trade creditors)
Poor cashlow forecasting
Unexpected events
Income statements (profit and loss account)
Measures the business performance (income and costs) over a given period of time, usually a year
It shows the profit or loss made by the business - which is the difference between the firm’s total income and its total costs
Revenue
The amount of money generated by sales
Cost of sales
The cost of making the goods or buying them (direct cost)
Eg - stock, labour involved in production (piece rates)
Gross profit
Sales - direct cost of sales
Overheads and expenses
Costs not directly involved in the production process (indirect costs)
Eg - cost of premises (eg rent, insurance, repairs), office costs (eg stationery, postage, computer maintenance, staff salaries and wages)
The usefulness of income statements
Progress can be monitored by management and the business can set targets (objectives) and make decisions
Figures can be used to carry out ratio analysis
Provides other stakeholders with valuable information (banks, investors, HMRC, employees, suppliers)
Operating profit
Gross profit - overheads
Balance sheet
A snapshot of the business’ assets (what it owns or is owed) and its liabilities (what it owes) on a particular day - usually the last day of a financial period.
What might be included under goodwill and intangible assets on a balance sheet?
The know-how and experience of staff and management
The value of brands and customer loyalty
Reputation for quality in the market
Main elements of current liabilities
Trade credit and other payables - trade creditors
Short-term borrowings - overdraft
Current tax liabilities - taxes that still need to be paid to the government
Provisions (eg dividends due to be paid to shareholders, estimates of potential costs which the business might incur in relation to known disputes or other issues)
How can financial accounts be used to assess business performance?
Comparing performance over time
Comparing performance against competitors or the industry as a whole
Benchmarking against best-in-class businesses
Ratio analysis
Involves the comparison of financial data to gain insights into business performance
Ratio analysis helps to understand…
Why one business is more profitable than another
What returns are being earned in investment in a business
If a business is able to stay solvent
How effectively a business is using its assets
Gross profit margin
(Gross profit ÷ sales revenue) x 100
Gross profit
Sales revenue - direct costs
What might a fall in gross profit margin suggest?
Higher costs from suppliers or a decision to sell at lower prices
What might an increase in gross profit margin suggest?
Better buying from suppliers or selling price rises
Net profit margin
(Net profit (before tax) ÷ sales revenue) x 100
Net profit
Sales revenue - costs (direct and indirect)
Where can the figures be found for gross and net profit margins?
Income statement
Return on capital employed (ROCE) is a useful ratio to…
Evaluate the overall performance of the business
Provide a target return for individual projects
Benchmark performance with competitors
ROCE equation
(Operating profit (or net profit) ÷ total equity + non current liabilities) x 100
Capital employed equation
Total equity + non current liabilities
Return on equity
Measures the ability of a business to generate profits from its shareholders investments into the business
Return on equity equation
(Operating profit ÷ total equity) x 100
Liquidity
Measures the ability to convert assets into cash
(Cash being the most liquid asset)
Current ratio
Estimates whether the business can pay debts due within 1 years out of the current assets
Current ratio equation
(Current assets ÷ current liabilities)
Evaluating current ratio
Ratio of 1.5-2.0 suggests efficient management of working capital
Low ratio (<1) indicates cash flow problems
High ratio may indicate too much working capital
Acid test ratio
Ability to pay off short term debts without your stock (you may not sell it)
It is a more reliable test of liquidity
Acid test ratio equation
((Current assets - stock) ÷ current liabilities)
Interpreting liquidity results
A better indicator of liquidity problems for businesses that usually hold inventories
Significantly less than 1 is often bad news
Economies of scale
When unit costs fall as output rises
Disconomies of scale
When unit costs rise as output rises
Why do businesses grow?
Greater profits
Increased market share
More chance of survival
Cost reduction
Internal economies of scale
Arise from the increased output of the business itself
Purchasing EOS
Achieved via buying in bulk
Financial EOS
As a firm gets larger it is able to access business loans more easily at lower rates of interest
Managerial EOS
As a firm expands, it is able to afford more specialist managers in different areas of the business
Technical EOS
As a firm expands, it is able to afford better technology and capital equipment to help with the running of its operations
Marketing EOS
As a firm increases its product range it is able to market all its products under its brand/logo
Risk bearing EOS
As a firm becomes larger, it is able to grow their product range - allowing them to diversify their risk as they are not relying on only one product or service
External economies of scale
Occur within an industry
(ie all competitors benefit)
Concentration EOS
When firms within the same industry cluster together, they can take advantage of the existing infrastructure and supply networks.
Skilled workers tend to shift close to such clusters, giving firms easy availability to labour
Examples of diseconomies of scale
Poor communication
Lack of motivation
Loss of direction and co-ordination
Benefits of economies of scale
Lower production costs
Increase profitability
Offer lower prices
Provide a competitive advantage
Drawbacks of economies of scale
Decrease flexibility
Increase bureaucracy
Risk of diseconomies of scale
Trade receivables (debtors)
Amounts owed to a business by customers
Trade payables (creditors)
Amounts owed by a business to suppliers and others
Receivables days
The average length of time taken by customers to pay amounts owed
Payables days
The average length of time taken by a business to pay amounts it owes
Receivables days equation
(Trade receivables ÷ revenue) x 365
Payables days equation
(Trade payables ÷ cost of sales) x 365
Asset turnover
This ratio measures how efficiently a business is able to use its net assets to generate sales revenue
Asset turnover equation
Sales revenue ÷ net assets (assets-liabilities)
Evaluating asset turnover
In general a higher number is better
Low numbers compared to previous years or competitors may suggest a problem with generating sales revenue with the assets you have
Stock turnover
This ratio measures how quickly the stock is turned over (sold)
Stock turnover equation (number of times)
Cost of sales ÷ stock
Interpreting stock turnover
In general, a higher number is better
Low number (compared with previous period or competitors) suggests problem with stock control
Issues to consider with stock turnover
Stock turnover varies from industry to industry
Holding more stock may improve customer service and allow the business to meet demand
Seasonal fluctuations in demand during the year may not be reflected in the calculations
Stock turnover is irrelevant for many service sector businesses (but not retailers, distributors etc)
Gearing ratio
All about how a business is financed and the relationship between the amount of finance provided by equity and debt
Gearing equation
(Non current liabilities ÷ total equity + non current liabilities ) x100
Benefits of high gearing
Less capital required to be invested by the shareholders
Debt can be a relatively cheap source of finance compared with dividends
Easy to pay interest if cash flows and profits are strong
Benefits of low gearing
Less risk of defaulting on debts
Shareholders rather than debt providers ‘call the shots’
Business has the capacity to add debt if required
What percentage reflects a highly geared business
Above 50% (more debt than equity)
What percentage reflects a lowly geared business
Below 50% (more equity than debt)
Ways to reduce gearing
Focus on profit improvement (eg cost minimisation)
Repay long term loans
Retain profits rather than pay dividends
Issue more shares
Convert loans into equity
Ways to increase gearing
Focus on growth - invest in revenue growth rather than profit
Convert short term debt into long term loans
Buy back ordinary shares
Pay increased dividends out of retained earnings
Issue preference shares or debentures
Interest cover
This ratio measures the number of times in which a business can pay its interest charges with the operating profit it makes
The higher the number the better (indicates that the business can easily afford the interest payments)
Interest cover equation
Operating profit ÷ interest payable
What do shareholder ratios do?
Measure the return that shareholders gain from their investment
Rewards for shareholder = capital gain (share price increasing), shareholder dividends (percentage of profit)
Dividend per share equation
Total dividends paid ÷ number of shares in issue
Interpreting dividend per share
A basic calculation of the return per share
Problems = we don’t know how much the shareholder paid for the shares, we don’t know how much profit per share was earned which might have been distributed as a dividend
Dividend yield equation
(Dividend per share ÷ share price) x 100
Evaluating dividend yield
Yield can be compared with industry standard, rates of return on alternative investment
Shareholders consider dividend yield in deciding whether to invest in the first place
Unusually high yield might suggest an under-valued share price or a possible dividend fault
Dividend yield will change constantly as the share price changes
Total net assets equation
Total assets - total liabilities
Solvency
The ability of a company to pay its debts and other financial obligations
What does it mean when a business is solvent?
When its assets are more than liabilities (able to pay its debts) —> link to current and acid test ratios.
What does it mean when a company is insolvent?
When it can’t pay its debts
Dividend cover
A measure of how many times dividends can be paid from the net profits
Dividend cover equation
Profit after tax ÷ dividends
Interpreting dividend cover
If the DCR > 1 it indicates that the profit is enough to pay shareholders with their dividends
A DCR > 2 is considered good
A consistently low or a deteriorating dividend cover may signal poor company profitability in the future, which may mean the company will be unable to sustain its current levels of dividend pay-outs
Earnings per share
Shows how much profit each share generates
Earnings per share equation
Profit after tax ÷ number of shares issued
Price earning ratio
This ratio is a measure of confidence about what the shares will earn
The ratio compares the current market price with the earning for that share
Price earning ratio equation
Share price ÷ earnings per share
Stepped fixed costs
A cost that changes when maximum capacity has been breached.
When the threshold of maximum capacity has been breached the fixed cost must change to accommodate this.
(Eg if a machine can only produce up to 10,000 units, but the business scales up production to 12,000 units it is necessary to purchase an additional machine. This increased production level increases the cost of machinery, making it a step cost)
Stock turnover equation (number of days)
(Stock (inventories) ÷ cost of sales) x 365
