IUNITR 3FUCKL Flashcards
Define Finance
refers to the various available moneythat an organisation has to fund its business activities
Define Capital expenditure
refers to business spending on non-current assets or capital equipment of a business.These are items of monetary value that have a long-term function for businesses, so can be used repeatedly.
Reasons for capital expenditure in businesses
-to add extra production capacity as the business grows
- to improve efficiency by utilising their latest technologies, including IT systems and production technologies
- to replace worn-out, damaged and/or obsolete (outdated) capital equipment and machinery
- to comply with changing legislation and regulations, such as green technologies
Challenges of capital expenditure (3)
- High costs involved
- limited sources of finance available for such investments
- some investments are simply not feasible
What is revenue expenditure
Revenue expenditure refers to finance spent on the daily operations of a business
Characteristics of Revenue expenditure
-Short-term tenure
-Does not add to the value of a firm’s -non-current assets
-Recurring (regular) expenditure
-Provides short-term benefits
-Includes low-cost expenditures
-Expenditure reflected in profit and loss account
-Does not improve operational efficiency
Characteristics of Capital expenditure
-Long-term tenure
-Adds to the value of a firm’s non-current assets
-Non-recurring (one-off) expenditure
-Provides long-term benefits
-Represents significant investments in the firm
-Expenditure reflected in the balance sheet
-Improves the firm’s operational efficiency
Internal sources of finance
Refer to money or funds that come within the business
What are the three internal sources of finance
- Personal funds
- Retained profit
- The sale of assests
Definition of personal funds
refers to the use of an entrepreneur’s own savings
Advantages of personal funds
-Personal funds do not need to be repaid.
-There are no interest charges incurred either, unlike with external finance.
-By investing their personal funds, sole traders and partners have a better chance of being able to borrow money if they need to, as it shows greater commitment to the business venture.
-Whilst internal sources of finance are the cheaper of the two options, external sources of finance usually generate much more funds for a business.
Disadvantages of personal funds
-As sole traders represent relatively high risk, they are less likely to be able to secure external sources of finance, so need to rely on their personal funds.
-Personal funds are rarely sufficient for most small businesses.
-Many entrepreneurs risk their entire life savings in a business venture. In particular, sole traders and partners risk losing all their personal funds if the business venture fails.
Definition of retained profit
Retained profit comes from having a financial surplus. These funds are reinvested in the business, rather than being distributed to the owners (shareholders).
Advantages of retained profit (3)
-As an internal source of finance, retained profit does not incur any interest charges.
-As the money belongs to the business, it is considered as a permanent source of finance, because it doesn’t have to be repaid. If a business project fails, the use of retained profit does not necessarily pull the organization into debt.
-The business also has great flexibility in the use of retained profit - the business can use this for any purpose within the business. By contrast, bank loans are approved for specific uses only.
Disadvantages of retained profit (3)
-Start-up business don’t have any retained profit, so this is not a possible source of finance for creating a new business.
-Retained profit is rarely enough as a sole source of finance for most businesses in their pursuit of growth and evolution.
-Using the funds as retained profits for use to grow the business means there is less dividends paid out to shareholders and owners of the business.
Definition of profit
Profit is when a firm’s total revenue exceeds its total costs
Assest
asset is anything that a business owns and has a marketable value, such as buildings, vehicles, computers, equipment and intellectual property
Non-current assets
items a business owns and:
-uses for a period of more than 12 months
-can be used repeatedly
-generates income for the organization.
advantages of using the sale of assets as an internal source of finance include (3)
A large sum of money can be raised. For example, selling a fleet of old motor vehicles or a redundant (unused) office building can raise much needed finance for a business.
The sale of excess resources, redundant assets or obsolete (outdated) belongings is a sensible way for a business to raise finance. The alternative is that these resources would tie up much needed working capital for the organization.
Again, there are no costs of borrowing involved or interest repayments to make.
disadvantages of the sale of assets as an internal sources of finance too, (3)
The sale of certain non-current assets can hinder a firm’s productive capacity. For example, a struggling business that sells some of its computer equipment or machinery, which may actually be needed for production.
It can be very time consuming to find a suitable buyer for second-hand assets, especially if these are obsolete. Even if a buyer can be found, the purchase price is likely to be very low as the business is in a weaker bargaining position, especially if the business is desperate for cash.
The option of asset sales is only available to established businesses; new businesses are unlikely to be in such a position.
External source of fiance
refers to money or founds that come from outside the business
What are the 8 sources of external finance
-Share capital
-Loan capital
-Overdrafts
-Trade credit
-Crowdfunding
-Leasing
-Microfinance providers
-Business angels
what is Share capital
is finance raised through the issuing of shares via a stock exchange/ stock market
long-term source of finance for limited liability companies, obtained by selling shares in the company.
what is an IPO ( initial public offering)
When a limited liability company sells its shares for the very first time on a public stock exchange
main functions of a stock exchange are to: (3)
-enable existing companies to raise share capital (through a share issue)
-oversees the initial public offering (IPO) of new publicly held companies
-to provide a market for trading of second-hand shares (and government bonds,).
Advantages of a share capital (4)
-It is permanent capital as it does not need to be repaid (shareholders sell their shareholdings to other buyers via the stock exchange).
-There are no interest payments made to shareholders, thus this reduces the expenses of the company.
-Unlike loan capital, share capital does not involve debt or incur interest repayments.
-Any publicly held company can raise further finance by selling additional shares (a process known as a share issue).
Disadvantages of share capital (3)
-Shareholders need to (at some point) be paid dividends if the company earns a profit.
-Although share capital can raise a lot of money for a company, the ownership and control of the organization may be diluted.
-Only publicly held companies can trade their shares using the stock market.
what is Loan capital
refers to borrowed funds from financial lenders, such as commercial banks.
Loan capital is typically used to purchase non-current assets, such as machinery and property.
what are the types of loan capital (4)
Bank loans
Mortgages
Debentures
Corporate boands
What is debenture
long-term loans issued by organizations that borrow money from investors and commit to repaying it with interest. Unlike secured loans, debentures are not backed by specific assets but depend on the borrower’s creditworthiness
what are corporate bonds
These are debt securities (guarantees) sold to investors
Advantages of loan capital (3)
-It enables the borrower to repay in regular instalments, making loan capital more accessible and affordable for many businesses as it is not burdened by having to pay a large lump sum of money.
-Large businesses are often able to negotiate a lower rate of interest on their loans (financial economies of scale).
-Loan capital is suitable if the owners need to raise finance but do not want to dilute their ownership or potentially lose control through issuing shares.
Disadvantages of loan capital (3)
-Interest is charged on the amount of borrowed funds. The interest rate can be a fixed or variable rate.
-In many cases, businesses have to offer collateral (security) before loans can be approved. Failure to repay the loan can lead to the lender being able to legally seize the firm’s assets to pay for the outstanding amount borrowed.
-Firms that borrow loan capital on variable interest rates may suffer from liquidity problems if the rate of interest increases, because their debt repayment burden will increase.
What is an overdraft
a financial service that allows a business to temporarily overdraw on its bank acccount,
i.e. to take out more money than it has in the account
Advantages of overdrafts (4)
- when there is a need for a large cash outflow
-Overdrafts are quite easy to obtain, (so are an important source of external finance for small businesses in particular).
-Overdrafts provide businesses with emergency funds to finance their operations, such as making payment to suppliers / wages to staff, during times when liquidity is a problem.
-It provides great flexibility for businesses as overdrafts are only used as and when needed.
Disadvantages of overdraft (4)
Interest is charged on the amount overdrawn, usually at rates higher than those charged for ordinary bank loans.
-Banks usually only lend a small amount of money, in order to keep a business operation; it is not a suitable source of finance for purchasing non-current assets, for example.
-Banks can ask for overdrafts to be repaid at very short notice.
-It is essentially a high cost, short-term loan for businesses.
what is trade credit
Trade credit enables a customer to purchase and obtain goods and services but to pay for these at a later date. (typically 30-60 days)
Advantage of trade credit (2)
-Buying goods and services on trade credit does not incur any interest charges if the amount owed is paid in full within the trade credit period.
-can help when firms are struggling with cashflow
what is crowdfunding
raising small amounts of money from a large number of people to fund a particular business project or venture
equity crowdfunding
involves the sale of a stake in a business to a number of investors in the crowd
donation-based crowdfunding
individuals donate small amounts of money to help fund a specific charitable project while receiving no financial stake or return for doing so.
Advantages of crowdfunding (5)
-As each individual lends a relatively small amount of money to the fundraiser, this limits the risks and impacts should the business project fail to succeed.
-It avoids the need for business owners or entrepreneurs to deal with commercial banks, which is often a time-consuming and bureaucratic process.
-Many people can invest in the business, so this can help to raise lots of much-needed finance for small to medium-sized enterprises.
-Unlike business angels, individuals of the crowd do not take any controlling interest in the organization.
-Crowdfunding is usually less costly than being listed on a public stock exchange.
Disadvantages of crowdfunding (3)
-There are legal challenges and considerations, such as transparent disclosure of legal documents, holding annual general meetings with investors, and publication of annual reports. This adds to the costs of the business.
-There needs to be due diligence Investors have the option to ask for additional information from the fundraiser, so this can delay decision making and incur additional costs for the business.
There are a lot of cases of crowdfunding scams. The loose regulatory requirements for crowdfunding in many parts of the world exposes investors to fraud.
Leasing
involves the business or customer drawing up a contract with the leasing company to use particular non-current assets for an agreed fee. Examples: machinery, tools, equipment,
Advantages of leasing (3)
-The lessor does not have to purchase the expensive equipment, machinery, vehicles or other type of capital. Instead, its money can be used for revenue expenditure purposes.
-The lessor takes responsibility for the maintenance of the capital equipment and other leased property. This helps to cut the operating costs of the lessee.
-Leasing is particularly advantageous if the business only needs to use the fixed capital for a short period of time, or if it does not want to deal with the hassles and costs of repairs and maintenance.
Disadvantages of leasing (2)
With leasing, the lessee never owns the asset. Ownership remains with the lessor (the leasing company) before, during and after the leasing contract.
Over a long period of time, leasing can be more expensive than buying the asset outright due to the accumulated costs of leasing the asset over time.
Sale-and-leaseback
Involves a business selling a particular fixed assets and immediately leasing th property back.
i.e. the business transfers ownership although the asset does not physically leave the business
Microfinance providers
for-profit social enterprises that offer a financial service to those without a job or on very low incomes.
aim of microfinance
help entrepreneurs struggling to finance their business start-ups to gain access to loans of a small amount. Microfinance can give these people the opportunity to become self-sufficient and empower them to run their businesses. As with the majority of loans, interest is charged on the amount borrowed, although these are typically lower than what commercial banks would charge.
Advantages of microfinance providers (4)
-Microfinance can help many people to get out of poverty by making them become financially independent.
-can help to create new job opportunities
-Microfinance can create benefits for the wider community, such as improved healthcare, education and employment opportunities.
-Microfinance can help to build and foster a culture of entrepreneurialship and economic independence.
Disadvantages of microfinance providers (5)
Due to relatively low profitability, microfinance providers may struggle to attract and/or retain employees and managers, given that their remuneration packages are unlikely to be matched by larger for-profit financial companies such as commercial banks and insurance companies.
Microfinance only provides finance on a small scale, so is unlikely to be sufficient to make a real difference to society as a whole.
Microfinance loans incur interest charges, so can be rather expensive for small business owners who find it difficult to earn enough revenue to keep up with their loan repayments.
Microfinance increases the debts of entrepreneurs who may subsequently struggle in their business venture.
Some people regard the practice of microfinance providers as being unethical as they earn profits from low-income individuals and households.
Who are business angels
are wealthy and successful private individuals who risk their own money in a business venture that has high growth potential.
i.e. high-risk, high-return business ventures
what business angles consider before investing (4)
-Return on investment (positive)
-The business plan
-People (good team of people)
-Track record
Advantages of business angels (3)
-Business angels provide an essential source of finance for start-ups and small businesses that are unable to secure finance from conventional providers of finance, such as commercial banks and other financial institutions.
-The business can benefit from the expertise and experiences of the business angels, who are likely to provide their input in order to secure a significant return on their investment (ROI).
-It is particularly useful for small businesses and inexperienced entrepreneurs who are unable to raise sufficient finance on their own, such as those which are unable to secure loan capital or those that are not permitted to sell shares on a public stock exchange.
Disadvantages of business angels (4)
-For the business angels, such business ventures are extremely high risk, especially as they risk losing their personal money. Hence, the amount of finance available is often not easily available for start-ups and small businesses.
-This also means that there are no guarantees than angel investors will earn a satisfactory ROI, despite the high potential returns.
-Such finance is difficult to come by, not only due to the risks involved but also due to the large number of entrepreneurs competing for such funds.
-The use of business angels will dilute the firm’s control and ownership as the angel investors will want a share and say in the organization.
revenue expenditure
is the day-to-day or routine spending of a business, required for its ordinary operations.
Examples include the payment of rent, raw materials, wages, salaries, and utility bill
Short-term finance
refers to sources of finance needed for the day-to-day running of a business, i.e., its revenue expenditure.
examples of short-term finance (4)
Personal savings
Sale of assets
Overdrafts
Trade credit
Long-term finance
refers to sources of finance of more than one year from the balance sheet date.
The finance is used mainly to pay for fixed assets, i.e., capital expenditure such as the purchase of capital equipment, machinery, and motor vehicles.
Examples of long-term finance (6)
-Share capital
-Loan capital, such as mortgages
-Leasing
-Business angels
-Microfinance providers
-Crowdfunding
Appropriateness of sources of finance for a given situation (SPACED)
- Size and status of the firm
-purpose of finance - amount required
- cost of finance
-external factors
-duration
what are costs
Costs are the charges that an organization incurs from its operations
Set-up costs
items of expenditure needed to start a business
Running costs
ongoing costs of operating the business
what are Fixed costs
Fixed costs are costs of production that a business has to pay regardless of how much it produces or sells.
e.x: rent, loans, salaries, etc
Total cost equation
TC= TVC + TFC
Total cost = total variable cost + total fixed costs
what are variable costs
Variable costs are the costs of production that change in proportion with the level of output or sales.
i.e As output increases total variable cost increases
Direct cost
items of expenditure that can be evidently and explicitly associated with the output or sale of a certain good, service, or business operation.
example: direct costs for a hair salon include the money spent on hair products such as shampoos, conditioners, hair sprays, and hair dyes.
Direct costs may comprise of
Variable costs, such as direct raw materials and direct labour costs, or
Fixed costs, such as third party motor insurance and depreciation costs for taxi operators. Rent is another example of a direct cost if this fixed cost is for a production facility.
definition of revenue
Revenue refers to the money coming into a business from the sale of goods and services.
Indirect costs
those that cannot be clearly traced to the production or sale of any single product
examples:
-Rent on premises.
-Salaries for administrative staff.
-Fees paid for legal and accounting services.
-Utility bills (gas, electricity, and water).
-General insurance for third parties, fire, and theft.
-Costs involved with maintaining and running the organization.
what are revenue streams
refers to the various sources of revenue for a business.
Total reveunue
sum of income received by a business from its trading activities
Formula of Total revenue
TR = P × Q
Total revenue = P) of a good or service X the quantity sold (Q)
Formula of Average revenue
AR = TR ÷ Q
Average revenue = Total revenue divided ÷ Quanitity
Examples of revenue streams
-Advertising revenue
-Transaction fees
-Franchise costs and royalties
-Sponsor ship revenue
-Subscription fees
-Merchandise
-Interest earnings
-Dividends
-Donations
-Subventions
what is a final account
published accounts of an organisation, made available to and used by different stakeholders
what are the two final accounts
- Profit and loss account (income statement)
2.. Balance sheet
Why would managers be interested in a final account (6)
-measure the performance of the business against organizational targets.
-benchmark key indicators (such as net profit figures) against those of rival businesses.
-help with decision-making, e.g., to assess whether the business has sufficient funds for new investment projects.
-set budgets and targets for the future, e.g., target profit.
-monitor and control business expenditure across the various departments in the organization.
Why would suppliers be interested in a final account (3)
-Assess whether the business has sufficient liquidity to pay its debts (trade credit).
-Determine the creditworthiness of the business in order to gauge the level of risk involved.
-Negotiate improved credit terms, such as deciding whether to extend the trade credit period or to demand immediate cash payment.
Why would employees be interested in a final account
Employees can use final accounts to gauge the extent to which their jobs are secure; a profitable business with a healthy balance sheet will create improve job security and promotional opportunities.
Workers can use final accounts as part of the negotiation process with labour unions to discuss pay rises and conditions of employment; again, a profitable and healthy business helps workers to strengthen their case for job security and pay rises.
Why would shareholders be interested in a final account (6)
-Measure whether the business is more or less profitable, and how this has changed over time.
-Measure the value of the business and judge whether this has increased over time.
-Calculate the return on their investment (refer to profitability ratios).
-Determine how much dividends (share of the organization’s profits) they receive.
-Decide whether the organization has prospects for growth and expansion.
-Compare the financial performance of different businesses in order to make rational investment decisions (whether to buy or sell any shares in the company).
Why would financiers be interested in a final account (3)
-Decide whether to lend money to the business, and how much to lend, by judging the degree of risk involved.
-Check on the creditworthiness of the organization before overdrafts or loans are given.
-Assess the extent to which the business is able to pay back its borrowing (with interest).
Why would customers be interested in a final account (2)
-Determine whether the business offers security and reliability in its services; otherwise, customers will go elsewhere and purchase by rival suppliers.
-Determine whether there will be future supplies of the product they are purchasing – this is particular important for customers that rely on a particular supplier or business.
Why would competitors be interested in a final account
-Being able to compare their own financial accounts with the business in question, in order to judge their own financial performances.
-Benchmark best practise by examining what the business does well, and determine how they themselves can improve.
Why would the government be interested in a final account (4)
-To calculate and check (verify) the amount of tax that is due to be paid by the business.
-To measure the extent to which the business is able to expand and create jobs in the economy.
-To assess the liquidity position of the business, in case there is a threat of business closure, which could cause serious economic problems (depending on the size of the business and the market in which it operates).
-Yo ensure the business operates within the law, by adhering to the country’s accounting rules and laws.
Intangible assets
are non-physical assets that have the ability to earn revenue for a business
what are the five types of intangible assets
goodwill, patents, copyrights and trademarks, branding
definition of good will
Goodwill is the reputation and established networks of an organisation, which adds significance above the market value of the firm’s physical assets.
It includes the willingness of employees to go above and beyond the call of duty, as they are devoted to the organisation
Definition of patents
provide legal protection for investors, preventing others from copying their creation for a fixed number of years
what do patents incentivise
patents acts as an incentive for firms to innovate, invest in research and etc
they allow the inventor to have exclusive rights to commercial production for a specified time period.
definition of copy rights
give the registered owner the legal rights to creative pieces of work
definition of trade marks
form of intellectual property, the value of which may be reported on the balance sheet. They give the listed owner the legal and exclusive commercial use of the registered brands, logos, and/or slogans (catchphrases).
Limitations of final accounts (4)
- human resources are ignored when examine final accounts
- final accounts do not reveal anything about the firm’s non-financial matter/priorities such as its organisational culture.
- there also needs to be access to the final accounts of other business in order to benchmark the financial performance with competitors in the industry
-final accounts are historical accounts of the financial position of a business at one point in time.
Definition of depreciation
Depreciation is the fall in the value of nuncurrent assets over time
what are the two reasons for depreciation
1.wear and tear
2. Obsolescence
residual value
This is the value of the non-current asset at the end of its useful life, before it is replaced
what are the two methods of measuring depreciation
1.the straight line method, and
2.the units of production method.
straight line method
calculates depreciation by reducing the value of a non-current asset by the same value each year though-out it’s useful life.
formula of Net book value
Net book value (NBV) = Original cost of asset – Accumulated depreciation
Formula of straight line method (annual depreciation)
Annual depreciation = Purchase cost – Residual value / Estimated useful lifespan
Advantages of straight line method (5)
-The ease of calculating depreciation, as the same amount is deducted each year. This means depreciation is treated as a fixed cost and does not change with the level of output or production.
-It is suitable for depreciating assets that have a known useful shelf-life and can be estimated accurately.
-It is also suitable for assets that have a consistent usage rate over the lifetime of the asset, e.g., furniture or automated machinery.
-It is also easier to depreciate the value of assets until their scrap value is zero.
-As the same amount is charged to the profit and loss account each year, it is easier to make historical comparisons of the data.
Disadvantages of straight line method (4)
-Many non-current assets, such as motor vehicles and computers, depreciate in value the most during the initial stages of their useful shelf life. Hence, using a uniform depreciation value can be misleading and inaccurate.
-In addition, many assets do not depreciate consistently as they become less efficient over time. For example, machinery, computers and vehicles tend to have higher repair costs over time. The depreciation expense does account for (higher) maintenance costs over time.
-it is not suitable or useful if the functional life span of the asset cannot be estimated accurately.
-Scrap values are only estimates of the future value of an asset. This makes the provisions for depreciation less accurate.
formula of units of production rate
Units of production rate = (Cost of asset – Salvage value) / Estimated units of production
formula of depreciation expense
Depreciation expense = Units of production rate × Actual units produced
Advantages of units of production depreciation (3)
-For many businesses, it is more realistic or accurate to use this method to depreciate the value of an asset due to its usage than just the passing of time. In particular, it works well for businesses that use machinery or capital equipment to manufacture a product.
-Similarly, this method is more accurate for non-current assets that depreciate directly due to wear and tear, rather than the passage of time which eventually makes the product obsolete.
-It is useful for manufacturers that experience fluctuations in production, based on changes in consumer demand over time. Hence, depreciation is treated as a variable or direct cost that changes with the level of output or production.
Disadvantages of units of production depreciation (3)
-It is more complicated to calculate than the straight line method of depreciation.
-There is a degree of subjectivity as the salvage value is subject to change and the estimated units of production is exactly that - an estimate only. Over- or under-estimating the figures will make the depreciation expense less accurate.
-Many tax authorities (such as the IRS in the US) do not allow the units of production depreciation method to be used for tax purposes. Hence, this method is primarily used for internal bookkeeping (accounting records)
Definition of the profit and loss account (income statement)
Financial statement of a firm’s trading activities over a period of time
Definition of sales revenue
is the money an organisation earns from selling goods and services.
Definition Cost of goods sold
are the direct costs of production, such as the cost of raw materials, component parts, and direct labour
formula for cost of goods sold (COGS)
COGS= opening stock + purchases - closing stock
Definition of gross profit
refers to the profit from a firm’s everyday trading activities
Definition of net profit
financial surplus from sales revenue after all costs and expenses are accounted for
Formula for net profit
Net profit= Gross profit - expenses
Expenses
are a firm’s indirect costs of production
Retained profit definition
shows how much of the net profit after interest and tax is kept by the business for its own use as an internal source of finance.
Retained profit equation
Retained Profit = Profit after interest and tax – Dividends.
Limitations of profit and loss account (3)
- P&L account shows the historical financial performance of a business. So there is no guarantee that future performance will be successful
-As there is no international standardised format for the P&L account, it might be difficult to compare the account in different countries
-Window dressing can occur, where this is the legal act of creative accounting by manipulating final accounts to make them appear more attractive.
What is a balance sheet
Balance sheet is one of the annual financial statements that all limited liability companies are legally required to produce for auditing purposes
what are assets
the possessions of a business that have a monetary value. Assets are owned by a business.
what are liabilities
are the debts of a business
i.e., the money owed to others
what are the two things that a balance sheet needs to show
-the organisation’s sources of finance, including borrowed funds (part of its liabilities) and equity (internal finance invested by shareholders, and any accumulated retained earnings).
-the organization’s uses of finance, i.e. how the business has used its sources of finance, such as the purchase of non-current assets (also referred to as non-current assets) and current assets for trading.
Non-current assets (fixed assests
Is any asset used for business operations (rather than for selling) and is likely to last for more than 12 months from the balance sheet date.
What are current assets
refers to cash or any other liquid asset that is likely to be turned into cash within twelve months of the balance sheet date.
what are the three main types of current assets
Cash, Debtors, Stocks
Cash
This is the money that is held in the business or at the bank.
Cash is the most liquid of current assets and is easily accessible to the business
Debtors
Refers to people or other organisations that owe money to the business as they have purchased goods on credit.
The usual trade credit period is between 30 and 60 days.
Stocks
goods that a business has available for sale, per time period. Stocks are intended to be sold as quickly as possible, thereby generating cash for the business.
What are the three types of stocks
-Raw materials
- work in progress
- Finished goods
Non-current liabilities (long-term liabilities)
are the long-term debts of a business, falling due after 12 months of the balance sheet date
Total liabilities
the sum of current liabilities and non-current liabilities
i.e the sum of all the monies owed by the business
Net assets
refers to the overall value of an organisations assets after all its liabilities are deducted
What are the two equations of net assets
Net assest = Total assets – Total liabilities
Net assets = (Non-current assets + Current assets) – (Current liabilities + Non-current liabilities)
Definition of equity
refers to the value of the owners’ stake in the business, i.e. what the business is worth at the time of reporting the balance sheet.
what is equity comprised of
- share capital
- Retained earnings
what is the equation of Retained earnings
Retained earnings= Opening retained earnings + profit after interest and tax for current period - Dividends for current period
Limitations of balance sheet (3)
-Balance sheets are static documents, the financial position of a business might be very different in subsequent positions
-The figures are only estimates of the value of assets and liabilities. The market value of an assest is not necessarily the same as its book value
-No universal format of a balance sheet, different business will produce different formats (different assets and liabilities) - makes it difficult to compare the financial position of different firms
-Not all assets of a business included in a balance sheet, esp intangible assets and the value of human capital
Definition of ratio analysis
is a quantitative management planning and decision-making tool, used to analyse and evaluate the financial performance of a business.
i.e. the firm’s financial statements, consisting of the balance sheet and income statement.
what are the purpose of ratio analysis (4)
- to examine a firm’s financial position, such as its profitability as well as short-and long-term liquidity position
-To assess a firm’s finanical performance
-To compare actual figures with projected or budgeted figures in order to improve financial management
-To aid decision-making, such as wether investors should risk their money by investing in tge business
what are the three ratios of ratio analysis
-Gross profit margin
-Profit margin
-Return on capital employed (ROCE)
how can a firm improve its Gross profit margin (2)
Raising sales revenue
Reducing direct costs
Definition of gross profit margin
profitability ratio that measures an organization’s gross profit expressed as a percentage of its sales revenue. It is also an indicator of how well a business can manage its direct costs of production.
Definition of profit margin
profitability ratio that measures a firm’s overall profit (after all costs of production have been deducted) as a percentage of its sales revenue.
It is also an indicator of how well a business can manage its indirect costs (overhead expenses
How to improve profit margin (3)
- Discuss preferential payment terms with trade creditors and suppliers
- Negotiate cheaper rent
- Reduce indirect costs
Definition of ROCE
a profitability ratio that measures a firm’s efficiency and profitability in relation to its size (as measured by the value of the organization’s capital employed).
Definition of capital employed
the value of the funds used to operate the business and to generate a financial return for the organisation.
Formula for capital employed
Capital employed = Non-current liabilities + Share capital + Retained earnings
Capital employed = Non‐current liabilities + Equity
Formula for ROCE
Return on capital employed (ROCE) = (Profit before interest and tax / Capital employed) × 100
How to improve ROCE (3)
Increasing the firm’s sales revenues by using strategies such as reduced prices to attract more customers,
Reduce costs of production through methods such as using alternative suppliers, having improved stock control systems
Selling unproductive, unused, underused, and obsolete assets in order to improve operational efficiency and liquidity.
Definition of liquidity
Liquidity refers to the ease with which a business can convert its assets into cash without affecting its market value,
i.e. it measures a firm’s ability to repay short-term liabilities without having to use external sources of finance.
what are the two liquidity ratios
Current ratio
Acid test ratio
Current ratio
The current ratio is a short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date)
what is the generally accepted current ratio and why
1.5 to 2.0
it allows for a safety net because in reality it might not be possible to sell current assets quickly without losing some value.
what does a current ratio of less than 1.0 mean
it means that the short-term debts of the business are greater than its liquid assets,
this could jeopardise its survival if creditors demand payment
what if the current ratio is too high (3)
- too much cash in the business
- too many debtors
- too much stock
how to improve current ratio and acid test ratio (4)
-Attract more customers, perhaps by changing the pricing strategy and/or improving its promotional strategies.
-Encourage customers to pay by cash, thereby improving the firm’s cash inflows.
-Use any available cash to pay off short-term debts, thereby reducing the interest (debt) burden on the business in the long run.
-Negotiate with suppliers for an extended trade credit period (e.g. from 30 days to 40 days), thereby improving its own liquidity position.
Acid test ratio (quick test)
is a short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts , without the need to sell any stock (inventories).
why are stocks ignored from acid test ratio
because some inventories are not highly liquid such as work-in-progress or very expensive finished goods sold in niche markets.
whats the ideal acid test ratio
1:1
what happens if the acid test ratio is not 1:1
firm might experience working capital difficulties or even a liquidity crisis
what does a high acid test ratio suggest
firm is holding onto too much cash
Efficiency ratios
efficiency ratios examine the use of an organisation’s resources in terms of its assets and liabilities.
i.e. used by managers and other decision makers to measure how well the resources of a business are used in order to generate income from the firm’s capital.
what are the four Efficiency ratios
-Stock turnover ratio (or inventory turnover ratio)
-Debtor days ratio
-Creditor days ratio
-Gearing ratio
Stock turnover ratio
an efficiency ratio that measures the number of days it takes a business to sell its stock (inventory),
i.e. how quickly the stock is sold and needs to be replenished.
why is a high rate of stock turnover ratio important for perishable goods such as milk or fresh flowers
This is because any unsold stocks cannot be stored so need to be disposed as when their sell-by date has expired.
How can a firm improve stock turnover ratio (3)
-Holding lower stock levels requires inventories to be replenished more regularly
-Disposal of stocks which are slow to sell e.x: obsolete stock
- Reduce the range of products being stocked by only keeping the best-selling products
Debtor days
The debtor days ratio is an efficiency ratio that measures the average number of days an organization takes to collect debts from its customers (as they have bought goods and services on trade credit but have yet to pay for these).
Why is a low ratio of debtor days good for a firm
This is because a low debtors day ratio shows that the firm is efficient in getting debtors to pay on time. This helps to improve the firm’s working capital cycle.
how can a firm improve their debtors day ratio (3)
-Creating incentives for customers to pay by cash rather than credit, such as giving customers a discount if they pay by cash and/or charging customers interest if they pay using credit terms.
-Shortening the credit period given to customers. For example, by reducing the credit period from 60 days to 30.
-Improved credit control by using stricter criteria for those wanting to purchase products using trade credit. For example, the business might choose to offer credit only to customers with a proven track record of having paid their invoices in a timely manner.
creditor days ratio
is an efficiency ratio that measures the average number of days an organisation takes to repay its creditors
what does a high creditors day ratio suggest (2)
-repayments are prolonged, help to free up cash in the business
-suggest a firm is taking too long to pay its trade creditors
How does a firm improve their creditors days ratio (3)
-Negotiating an extended credit period with the firm’s suppliers
-Looking for different suppliers who offer preferential trade credit agreements
-Using cash to pay for inventories (cost of sales), instead of over-relying on trade credit.
gearing ratio
is an efficiency ratio that measures the extent to which an organization is financed by external sources of finance.
i.e. it is loan capital expressed as a percentage of the firm’s total capital employed
business to improve its gearing ratio (3)
-Paying off some of the firm’s long-term liabilities (loan capital), such as making additional mortgage payments.
-Enhancing the firm’s working capital (liquidity position) by improving its stock control, giving incentives for customers to pay earlier / on time, and/or reducing the credit period given to customers. An improved working capital position (or working capital cycle) enables the business to use additional funds to pay off debts, thereby reducing its level of gearing.
-Trying to use or rely more on internal sources of finance, such as retained profits or share capital, instead of external finance (which incurs interest charges).
Insolvency
Insolvency refers to the situation where a person or a business is unable to meet their bill and other debt obligations
Situations that can cause Insolvency (5)
-A cash flow crisis caused by overspending (cash outflows) or debtors (trade customers) who are late paying.
-Loss of customers who have switched to a competitor’s good or service due to changing needs and market trends.
-Loss of an important supplier that accounts for significant cost savings.
-Financial mismanagement.
-Global and local supply chain issues that prevent the business from being able to trade.
Bankruptcy
means a situation when a person or business declares that they can no longer pay back their debts, so the entity collapses
Cash flow
refers to the movement of an organisation’s cash inflow and cash outflows
Sales revenue
is the value of goods and/or services sold to customers.
Formula of sales revenue
Sales revenue = Price × Quantity
Profit
is the value of sales revenue after all costs have been accounted for. This is the money that the business earns.
Hence, profit is the positive difference between a firm’s sales revenue and its total costs of production.
Formula of profit
Profit = Sales revenue – Total costs
Working capital
refers to cash or other liquid assets available to an organisation for its daily operations.
Formula of working capital
Working capital = Current assets – Current liabilities
Working capital cycle diagram
Cash in - payments to suppliers/employees - goods produced - goods sold
Define the term working capital cycle
refers to the duration between the organization paying for the production costs of a good or service and it receiving the cash from customers purchasing the product.
Definition of liquidity position
indicates the extent to which a business has sufficient liquidity to continue its business activities. Being in a good liquidity position means the business can avoid bankruptcy (business closure) as the organization has sufficient liquidity to continue operating
Cash flow forecast
financial tool used to show the expected movement of cash into and out of a business, for a given period of time.
Cash inflows
the money going into the business from earnings and other sources of finance
Cash outflows
money going out of a business to pay for its spending
Net cash flow
is the numerical difference between an organization’s total cash inflows and its total cash outflows, per time period.
Net cash flow formula
Net Cash Flow = Cash inflows – Cash outflows
What is a liquidity problem
when there is a lack of cash in the organisation because its cash inflow is less than its cash outflow,
i.e., it experiences negative net cash flow.
Reasons for cash flow forecast (3)
-banks and other lenders require a cash flow forecast to help them assess the financial health of the business seeking external sources of finance
-Help managers to anticipate and indentify periods of potential liquidity problems
- facilitate business planning
Closing balance formula
Closing balance = Opening balance + Net cash flow
Opening balance formula
Opening balance = Closing balance in previous month
what are cash flow problems
arise when an organization has insufficient funds to run its business, i.e. when net cash flow is negative
examples of cash flow problems (7)
-A lack of financial planning resulting in sales revenue being lower than expected
-Poor credit control, which can lead to bad debts (debtors who are unable to pay for their purchases that have been bought on trade credit)
-Poor cost control, resulting in costs of production being higher than budgeted
-Poor inventory control, resulting in overstocking of products (which have cost money to purchase but have yet to be sold to customers)
-Overtrading, i.e. the firm expanding too fast, which increases cash outflows, but not necessarily with the cash inflows
-Seasonal fluctuations in demand for the firm’s goods and/or services
-Unexpected events, such as a crisis or unforeseen costs that arise rapidly.
Strategies to reduce cash outflows (4)
-Negotiate with creditors and suppliers to improve trade credit terms. Securing a longer credit period helps to delay cash outflows.
-Pay for purchases of goods and services on trade credit, rather than using cash.
-Opt for leasing capital equipment instead of purchasing such assets. Although this reduces the organization’s net assets on its balance sheet, it can provide much needed liquidity for the firm.
-Reducing stock levels (inventories), as this can reduce cash outflows needed to pay for purchasing stocks. This is particularly important for organizations with a long working capital cycle.
Strategies to increase cash inflows (5)
-Raising prices of the products the business sells that have few substitutes or a high degree of brand loyalty.
-Reduce prices of the products the business sells that have a high degree of competition. This can help to attract customers from rival firms.
-Reducing the credit period helps to improve the cash flow cycle, because customers buying on credit pay within a shorten time period.
-Encourage debtors to pay their invoices early by offering discounts. This shortens the working capital cycle.
-improved marketing strategies to attract customers, raise brand awareness, boost sales and develop customer loyalty.
Strategies to seek additional sources of finance(4)
-Businesses will often rely on bank overdrafts or bank loans as additional finance when faced with a liquidity problem.
-Secure finance from sponsorships, donations or financial gifts. This can help to boost cash inflows, thereby improving the cash flow position.
-Selling shares in a limited liability company in order to raise additional sources of finance. Whilst this could bring in additional cash, it can be an expensive operation, and such option is not available to sole traders and partnerships.
-In the worst-case scenario, an organization could sell its fixed assets to raise additional finance.
