Outcome 1 (chaps 1-4) Flashcards
Explain the purpose of accounting
The purpose of accounting then is to provide business owners with financial information that will assist them in making decisions about the activities of their firm
Define the term accounting
Accounting is the collection, recording, and reporting of financial information to assist business owners in decision-making
Identify the other users of accounting information and describe their interest in the accounting reports of a small business
- debtors and other customers, who may wish to know about the firms continuing ability to provide them with stock
- creditors and other suppliers , who may wish to know the firms ability to repay what it owes them
- bank and other financial institutions, want to know about the firms current levels of debt
- employees, want to know about the firms long term viability prospects
- prospective owners- whom may wish to know about the firms financial structure
- the Australian Tax Office- will require financial information for taxation purposes
Identify the other users of accounting information and describe their interest in the accounting reports of a small business
- Debtors and other customers, who may wish to know about the firm’s continuing ability to provide them with stock
- Creditors and other suppliers, who may wish to know about the firm’s ability to repay what it owes them
- Banks and other financial institutions, which will certainly want to know about the firm’s current levels of debt and their ability to repay before providing them with any additional finance
- Employees, who may wish to know about the firm’s long-term viability, and their own long-term employment prospects, or the firm’s ability to afford improvements in wages and conditions
- Prospective owners, who may wish to know about the firm’s financial structure and earning performance, and its assets and liabilities to determine the firm’s worth
- The Australian Tax Office (ATO), which will require financial information for taxation purposes.
Explain the relationship between financial data and financial information
Financial data is raw facts and figures upon which financial information is based
Financial information is financial data which has been sorted, classified and summarised into a more usable and understandable form
Explain the four stages of the accounting process?
- Collecting source documents
- Recording
- Reporting
- Advice
Explain the four stages of the accounting process?
- Collecting source documents
- Recording
- Reporting
- Advice
Collecting Source Documents
Is the pieces of paper that provide both the evidence that a transaction has occurred, and the details to the transaction itself Common source documents include - Reciepts - Cheque Butts - Invoices - Memos - Bank Statements
Recording
Sorting, classifying and summarising the information contained in the source documents so that it is more usable
Common accounting records include
- journals
- Stock Cards
Reporting
The preparation of financial statements that communicate financial information to the owner The three general purpose reports are - a statement of receipts and payments - an income statement - a balance sheet
Advice
The provision to the owner of a range of options appropriate to aims/objectives, and recommendations as to their stability
Transaction
An agreement between two parties to exchange goods or services for exchange
State and describe two types of accounting records
Journals- which record daily transactions of a common type (such as all cash paid etc)
Stick cards - which record all the movement of stock in and stock out of the business
State and describe three types of accounting reports
A statement of receipts and payments - to report on the cash the firm has received and paid, and change in it’s bank balance over a period
An income statement - report on the firms revenue and expenses over a period
A balance sheet- to report on the firms assets and liabilities at a particular point in time
Entity Principle
the business is assumed to be separate from the owner and other entities, and its records should be kept on this basis
List the 7 accounting principles
Entity principle Going concern principle Reporting period principle Historical cost principle Consistency principle Conservatism principle Monetary unit principle
Reporting Period Principle
the life of the business must be divided into ‘periods’ of time to allow reports to be prepared and the accounting records should reflect the reporting period in which a transaction occurs
Historical Cost Principle
transactions should be recorded at their original price, as this value is verifiable by source document evidence
Consistency Principle
The consistency principle states the business should use the same accounting methods to allow for the comparison of reports from one period to the next
Conservatism Principle
The conservatism principle states that losses should be recorded when probable, but gains only when certain so that liabilities and expenses are not understated and assets and revenues are not overstated
Monetary Unit Principle
The monetary unit principle states that all items must be recorded and reported in the currency of the country of location where the reports are being prepared.
Explain why a business is assumed to have a life separate to its owners?
In terms of accounting, we assume that the business and the owner are separate entities/beings. If we are to assess the performance of the business itself, we must only include information that is relevant to the business. The owner may have a home and a loan (mortgage), but if neither of these items is being used by the business, so it must not be included as a business asset or liability.
Define the length of a reporting period?
The length of a reporting period can be as short as the owner requires, but cannot be longer than a year to meet taxation requirements.
Define Accounting Principles
The generally accepted rule which govern the way accounting information is recorded
Entity Principle
The entity principle states that from an accounting perspective, the business is separate from the owner and other entities, and its record should be kept on this basis
Going Concern Principle
The going concern principle assumes the life of the business is continuous, and its records are to be kept on this basis. This principles allow us to record transactions that affect the future of the business
Reporting Period Principle
The reporting period business states that the life of the business must be divided into periods of time to allow reports to be prepared, and the accounting records should reflect the period in which a transaction occurs. Since the life of the business is considered continuous, it is necessary to divide the life into periods so reports can be prepared
Historical Cost Principle
The Historical cost principle states that transactions should be recorded at their original purchase price, as this value is verifiable by source document evidence
Consistency Principle
The consistency principle states that the accounting methods used by the business should be kept the same from one period to the next. This is so the owner can be confident that changes in those reports reflect changes in business performance, not simply changes in accounting methods
Explain how the application of the Entity and Reporting Period principles ensure relevance in the accounting reports
When preparing a Balance Sheet it is not relevant to include the personal assets of the owner, as these are not being used by the business to earn revenue, and thus not useful for decision-making. Similarly, the Income Statement should include only revenues and expenses from the current reporting period and not from a previous or future reporting period, thus making decision-making more useful.
Conservatism Principle
The conservatism principle states that loses should be recorded when probable but gains only when actually certain so that liabilities and expenses are not understated and assets and revenues are not overstated
Monetary Unit Principle
The monetary unit principle states that all items must be recorded and reported in monetary terms; that is, in the currency of the country
Explain why a business is assumed to have a life separate to its owners?
If we assessing the performance of the business itself, we must only include information that is relevant to the business
Define the length of a reporting period?
The reporting period must be no longer than a year to meet tax requirements
Qualitative Characteristics
the qualities of the information in accounting reports
What are the four Qualitive Characteristics
- Relevance
- Reliability
- Comparability
- Understandability
Define Relevance
Relevance states that reports should include all information is useful for decision-making, and exclude information that is not. This information should be up to date, relate solely to the business and be appropriate to the decision at hand. Therefore financial reports should disclose all significant information that may affect the decision-making, and omit details that will not affect decision making
Define Reliability
Reliability states that reports should contain information that is free from bias, and thus can be relied upon for its accuracy.. This characteristics is telling us we should avoid the use of estimates.
Comparability
Comparability states that reports should be comparable over time, and between different companies, through the use of consistent accounting procedures
Understandability
Understandability states repots should be presented in manner that makes it easy for the user to understand their meaning
Explain how the application of the Entity and Reporting Period principles ensure relevance in the accounting reports
Relevance will be present if we follow the entity and reporting period principles. The entity principles ensures that information, like the owners personal assets are not included in reports as they are not useful for decision making. The reporting period principle is useful and as it makes sure that only revenues and expenses from this reporting period are in the report
What is the role of an accountant
The role of an accountant is to provide advice to small business owners so that they can make more informed decision
Assets
An asset is a resource controlled by the entity (as a result from past events) from which future economic benefits is expected
Liabilities
Liabilities are present obligation of the entity (arising from past events), the settlement of which is expected to result in an outflow of economic benefits
Owners Equity
Is the residual interest in the assets of the entity after deduction of its liabilities
List four assets and four liabilities, which would be common to most small businesses
Assets - Cash in Bank - Office Equipment - Debtors - Vehicles Liabilities - Creditors - Loans -Debt - Wages - Taxes
Referring to one Accounting Principle, explain why owners equity is said to be what the ‘business owes the owner’
Economic Entity Principle, the owners equity is the profit of the owner makes once liabilities have been taken away from assets
Equities
Claims on the assets of the firm, consisting of both liabilities and owners equity
Explain what liabilities and owners equity have in common
While liabilities are external claims on the assets of the firm, owner’s equity represents the internal claim on the assets of the firm (what the business owes the owner).
State the Accounting Equation
Assets = Liabilities + Owners Equity
Explain the difference between liabilities and owners equity?
Liabilities are present obligations of the entity while owners equity is the value of the business once liabilities have been taken away from assets
Referring to the definition of owners equity, explain why the accounting equation must always balance
It must always balance as the amount is always found once liabilities have been taken away from assets. It cant be higher as there would be insufficient assets and cant be lower as there would be extra money left over
Balance Sheet
The balance sheet is an accounting report that details a firms financial position at a particular point in time by listing its assets and liabilities and the owners equity.
List three pieces of information that must be present in the title of each Balance Sheet
- Who the report is prepared for (eg- Handsome Hair)
- What type of report it is (eg Balance Sheet)
- When it is accurate (eg as at 31 December 2016)
State one reason why a Balance Sheet is titled ‘as at’
A Balance Sheet is titled ‘as at’ as it is only ever accurate on the day it is prepared. The following day, the assets and liabilities it reports will probably change, meaning a new Balance Sheet is required.
Explain the relationship between the Balance Sheet and the Accounting Equation
The Balance Sheet is a reflection of the firm’s accounting equation as it provides the headings within the Balance Sheet, and it shows the firm’s assets on the left side, with the equities (liabilities and owner’s equity) listed on the right side.
Classifying/ Classification
Grouping together items that have some common characteristic
Current Asset
A resource controlled by the entity (as a result of a past event), from which a future economic benefit is expected in 12 months or less
Non - Current Asset
A resource controlled by the entity ( as a result of a past event) from which future economic benefit is expected after the next 12 months
List 3 examples of Current Assets
- cash in bank, debtors, stock of supplies
List 3 Non-Current Assets
- vehicles, shop fittings, equipment, premises, office furniture
Current Liability
A present obligation of the business ( as a result of a past event), the settlement of which is expected to result in an outflow of economic benefits in the next 12 months
Non - Current Liability
A present obligation of the entity (arising from past events), the settlement of which is expected to result in an outflow of economic benefits sometime after the next 12 months
List three Current Liabilities
- bank overdraft, creditors, GST payable, loan/mortgage (amount owed in next 12 months)
List three Non-Current Assets
- loan, mortgage, a loan from a different lending institution
State two rules of double entry accounting
1) Every transaction will affect at least two items in the accounting equation
2) After recording these changes, the accounting equation must still balance
Indicator
A measure that expresses profitability, liquidity or stability in terms of the relationship between two different elements of performance
Liquidity
Liquidity refers to the ability of a business to meet its debts as they fall due, which is essential to its survival
Working Capital Ratio
A liquidity indicator that measures the ratio of current assets to current liabilities to assess the firms ability to meet its short term debts
What is the Working Capital Ratio Equation?
Working Capital Ratio = Current Assets/Current Liabilities
Explain one benefit of classifying the items in a Balance Sheet as current or non-current.
One benefit of classifying the items is that it enhances the usefulness of the Balance Sheet because it allows for the calculation of performance indicators. These performance indicators compare items within the Balance Sheet in order to assist management in determining the financial health of their business by assessing the firm’s liquidity and stability.
Define the term ‘liquidity’.
Liquidity is the ability of the business to meet its short-term debts as they fall due.
State what is measured by the Working Capital Ratio. Show how it is calculated.
The Working Capital Ratio is a liquidity indicator that measures the ratio of current assets to current liabilities to assess the firm’s ability to meet its short-term debts.
Working Capital Ratio (WCR) = Current assets/Current liabilities
Explain how the Working Capital Ratio can be used to assess whether liquidity is satisfactory or not.
The Working Capital Ratio should be at least 1:1, as this indicates that there is at least $1 of current assets available to meet every $1 of current liabilities. As a result, the firm would be able to meet all its short-term debts as they fall due. If the Working Capital Ratio is less than 1:1, then the firm will have difficulty meeting all its short-term debts.
Define the term ‘stability’.
Stability is the ability of a firm to meet its debts and continue its operations in the long term
State what is measured by the Debt Ratio. Show how it is calculated.
The Debt Ratio is a stability indicator that measures the proportion of the firm’s assets that are funded by external liabilities.
Debt Ratio = Total liabilities/Total assets x 100
Explain how a high Debt Ratio can have negative consequences for liquidity
A high Debt Ratio means than a high proportion of the firm’s assets are funded by external sources. This places pressure on the firm’s cash flow to meet principal and interest repayments, and therefore a greater risk of the business facing financial collapse.
Define the term ‘small business’
Small business is a business in which the owner and the manager is the same person (or people), and which employs fewer than 15 people.
State three characteristics that distinguish a business as small.
- They are independently owned and operated.
- They are closely controlled by the owner/manager who also contributes most, if not all, of the operating capital.
- The principal decision-making is made by the owners/managers.
Explain two reasons why small businesses are important to the Australian economy.
Small businesses play a vital role in the Australian economy as they employ almost 5 million people, which is almost half of all private sector employment. They also contribute strongly to Australia’s level of economic activity and production, and exports, which (most importantly from the government’s perspective) are a major source of tax revenue.
List four reasons why an individual might want to own their own small business.
- Profit motive
- A desire for greater independence – to be your own boss
- Identifying a market opportunity
- Unemployment
List three costs involved with leaving salaried employment to become a small business owner
- Many hours of hard work and periods of stress
- Loss of secure income and other benefits (e.g. Paid holidays, sick pay and employer-funded superannuation)
- Risk of losing their investment of funds into the business.
Explain the main difference between a bank account and a term deposit.
A bank account pays a low return with interest on deposits earned at only half a per cent to one-and-a-half per cent, while a term deposit provides a higher rate of interest in return for agreeing to invest for a set term.
List the main returns to be gained from investing in property.
- Can provide a capital gain
- Can provide an income stream in the form of rent
- Provides the tax benefit of negative gearing
Explain the main benefit of negative gearing.
Negative gearing is a strategy used by investors to reduce their taxable income by purchasing property that generates rental income that is less than the costs it incurs (including the interest payments on the loan).
Explain the factors that can make property a risky investment.
The property market is subject to fluctuations, and growth rates can vary dramatically according to the location of the property. Interest rate rises will reduce any capital gains, rental income is not guaranteed, and any profit made on the sale of the property is subject to capital gains tax.
List the benefits of becoming a shareholder.
- Greater returns
- Tax benefits
- Diversification
- Flexibility
Explain the benefits of investing in shares rather than other investment options.
Shares have the ability to achieve a higher return than other investments, and they can be liquidated at short notice. While investing in cash is safe, there are no large returns. Investing in property means money is locked in the property until it is sold, which takes time
Explain the risks associated with owning shares.
The dividend return is dependent on the profitability of the company, and the capital gain/loss is dependent on the share market (can suffer a capital loss if the market value of the shares falls below their purchase price)
Explain why an individual should explore alternative investments when considering starting their own small business.
An individual should consider whether investing their funds into a small business will provide a return that is comparable, if not better, than alternative investments. If the individual does their homework, they can compare possible returns on investments prior to commencing a small business in order to be completely satisfied that their decision to start a small business is the best choice.
What are the Three Alternative Investments to Small Business Ownership
- Cash
- Property
- Shares
What are the two forms when of Cash Investment?
Bank Accounts - Most common form of cash investment, put money into bank or a similar institution such as a building society or credit union. Cash readily accessible and no risk involved but with a low return
Term Deposits - An Investment option that requires the investor to agree to invest for a specified length of time
Explain the personal qualities shared by successful small business owners.
- Expertise – a detailed knowledge of their product or service and the market into which it is being sold, as well as a range of other management issues, including marketing, management, human resources, finance, the law and accounting
- Entrepreneurship – the ability to recognise a business idea, accept the risk and transform it into a functioning and successful business
- Determination – a willingness to persevere in the face of hardships and setbacks
- Confidence – the self-belief to make decisions and then accept the consequences
- Cordiality and patience – an ability to develop good relationships with customers and employees and resolve disputes in a pleasant manner
- Humility – a willingness to recognise their own limitations and seek expert assistance in areas in which their knowledge is lacking
List five areas in which a small business owner must have expertise
- Their product or service
- The market into which it is being sold
- Marketing
- Management
- Human resources
- Finance
- The law
- Accounting
Explain the importance of seeking additional advice to ensure the successful running of a small business.
One of the main reasons for small business failure is a lack of managerial experience and an unwillingness to seek assistance. It is those owners who can identify their shortfalls or lack of expertise and seek professional assistance that will ensure their small business survives.
List and describe four external support sources that small business owners may turn to for advice
- Accountants – provide advice and direction on ownership structures, pricing policies, tax minimisation, superannuation obligations, tax obligations regarding PAYG and GST, and strategies for improving business performance
- Lawyers – provide assistance in any form of legal matters, such as establishing an ownership structure, representation in civil cases, or assistance with the lodging of a registered trademark
- Bank managers – provide specific advice regarding business finance and suggest alternatives in terms of financing options
- Sponsored Assistance Programs - there are many private and government sponsored programs to assist small businesses to survive and thrive
What are the three types of resources required to commence a small business
Personal Resources - the qualities and traits the individual can bring to the business
Financial Resources - how the business is to be financed
External Support Resources - how professionals such as accountants and solicitors, the government and professional organizations provide advice to assist small business owners to succeed
List the issues that must be addressed in a comprehensive business plan.
- A description of the business and the most appropriate business structure
- A description of the product of service
- A market analysis that would include marketing strategies
- An analysis of the personal strengths and weaknesses of the owner
- A detailed list of establishment costs and the expected sources of finance
- Projected sales figures and estimated running costs
Explain how a trading firm earns profit. State two examples of trading firms in your area.
A trading firm purchases finished goods for the sole purpose of resale. Stock is purchased from wholesalers/manufacturers at a cost price, and then sold to consumers through a retail outlet at a marked-up selling price. Examples include clothing, hardware, CDs and hi-fi equipment, groceries and books
Explain how a service firm earns profit
A service firm performs a service for the customer, so in fact what is being sold is the time, labour and expertise of the business.
Suggest two reasons why manufacturing firms sell predominantly to trading firms rather than to the general public.
• To make a greater profit
• To guarantee sales
Suggest one reason why manufacturing firms may open a factory outlet to sell direct to the public.
Suggest one reason why manufacturing firms may open a factory outlet to sell direct to the public.
What are four nature of business operations
Retail/ Trading - purchases finished goods for the purpose of resale. Stock is purchased from manufacturers at a cost price, and then sold to consumers through a retail outlet at a marked up price
Service - Provides a service for the customer so in fact what is being sold is the time, labour and expertise of the business
Manufacturing - Produces the goods it sells, using the production process to transform raw materials into a finished product
Mixed Businesses - businesses that combine one or more types of operation
Define Cost Price
The original purchase price of stock
Define the following types of ownership structure:
• sole proprietorship
• partnership
• proprietary company
- sole proprietorship – a business owned by a single individual, operating their business in their own right under their own name or a registered business name
- partnership – a business owned by two or more persons in business together with a view to making a profit
- proprietary company – a business that exists as a separate legal entity that is entitled to do business in its own right.
List the advantages and disadvantages of Sole Proprietorship
Advantages
• Easy and cheap to set up
• Owner has full control over decision-making
• Owner receives all the profits and has full access to the capital
• Simple to sell or wind up
Disadvantages
• Owner has unlimited liability
• Business has a limited life
• Limited access to capital
• Skills may be limited
• Owner may have to endure personal hardship
List the advantages and disadvantages of Partnership
Advantages • Cheap to set up • Simple to wind up and reclaim an individual’s investment in the business • Greater access to capital and skills • Tax advantages where partners are married Disadvantages • Control over decision-making is shared • Owners have unlimited liability • Partnership has a limited life • Profits are shared among partners
List the advantages and disadvantages of Proprietary Company
Advantages
• Limited liability
• Greater ability to attract capital
• Life of business is ongoing due to it being a separate legal entity
• Firm can conduct business Australia-wide using company name
Disadvantages
• Establishments costs are high
• Difficulty attracting additional capital because cannot advertise for funds
• Higher compliance costs
• Separate tax return is required by ASIC and ATO – degree of regulation is higher than other forms of ownership
Distinguish between a private company and a public company.
A private company (Pty Ltd) tends to be of a small nature and their ownership is more difficult to transfer and they do not have to make their financial reports available to the public. A public company (Ltd) is a large business structure that can publicly raise funds by advertising and selling shares though the Australian Stock Exchange. A public company is also open to scrutiny by the public and has to make its financial reports public.
Distinguish between limited and unlimited liability.
Limited liability is the legal status of a company, which exists as a separate legal entity, so the owners have no further responsibility for liabilities incurred by the business. Whereas unlimited liability is the legal status of sole proprietorships and partnerships in that they are not recognised as separate legal entities, so the owner(s) is personally liable for the debts of the business.
Referring to one Accounting Principle, explain the effect of unlimited liability on the recording of transactions for a sole proprietor or partnership.
Due to the Entity principle, the owner and the business are considered separate accounting entities not legal entities (for sole proprietorships and partnerships). Therefore, although the owner’s personal assets are not listed in the firm’s Balance Sheet, they can be used to pay off business debts if the business winds up.
List the advantages and disadvantages of starting a business from scratch.
Advantages:
• Almost total freedom in determining how the business operates
• Freedom to set customer expectations
• No need to pay for goodwill
• Rewarding for the owner knowing they have created the entire business
Disadvantages:
• No track record, so greater risk of failure
• No customer base – could mean low cash inflows in first months of operation
• Large start-up capital required that will essentially have to be provided by the owner
• More difficult to obtain finance
Define the term ‘goodwill’.
Goodwill is an intangible asset representing the value of the firm’s reputation, clientele, viability and future growth prospects.
Explain how goodwill can bring both benefits and costs for the purchaser of an existing small business.
Purchasing an existing business (and thus its goodwill) means the reputation and clientele already exist, enabling the new owner to have an immediate income stream, and all practices are already established. However, purchasing an existing business means you have to pay for the goodwill, which is difficult to value accurately.
List the advantages and disadvantages of buying an established business.
Advantages:
• A proven track record can increase the chances of success
• All assets, practices, suppliers and customers are already established
• An immediate income stream is available
• Previous owner(s) and current employees can assist in the change of ownership as they can provide helpful advice
Disadvantages:
• Previous success may have been dependent on the skills of the previous owner(s) and their relationship with customers
• Difficult to change existing procedures, staff and customer expectations
• Must pay for goodwill (which is difficult to value accurately)
• Existing assets may require major renovation, repair or even replacement
Define the term ‘franchise’.
A franchise is an arrangement under which one party (the franchisor) grants to another party (the franchisee) certain rights, including the use of the franchise name and business practices.
Suggest two reasons for the growth in the popularity of franchising.
- Proven track record of success
* It offers the support and advice of a large financial corporation
List the advantages and disadvantages of buying a franchise
Advantages:
• Recognised brand name/national advertising
• Established (and proven) reputation and business practices
• All equipment necessary to commence operations is provided
• Bulk buying power through the franchise group.
Disadvantages:
• High purchase price, ranging from $15 000 for a lawn-mowing business to upwards of a million dollars for a fast-food restaurant
• Ongoing franchise fees (frequently based on sales) to cover expenses, such as advertising and administration)
• Rigid guidelines for operations
• Competition from fellow franchisees
• Dependence on the operations of the franchisor.
What are the three business options
- Starting a new business
- buying an existing business
- Buying a Franchise
Franchise
An arrangement under which one party (the franchisor) grants to another party (the franchisee) certain rights, including the use of the franchise name and business practices
Franchisee
the entity that purchases the right to operate under the franchise agreement
Franchisor
the entity that holds ( and sells to the franchisee) the rights to operate under the franchise agreement
List the common characteristics of successful small businesses.
• High demand for their product or service
• A location that is visible and easily accessible for customers
• A thorough business plan that details all aspects of the firm’s operations
• Sufficient starting capital that can support the business and the owner until the business is functioning in a profitable manner
• An owner who exhibits the following qualities:
– a strong knowledge of the good or service that they are selling
– business acumen – insight or good judgement when it comes to business dealings and decisions
– humility – not being afraid to seek assistance for any areas that they feel they don’t have the required level of expertise; for example, legal or financial matters
– friendly and fair – when dealing with the public, whether employees or customers
– resilience – the ability to withstand failures, learn from mistakes and resolve issues and move on.
List the reasons why 80% of small businesses fail in the first five years of operation.
- Competition from other small and large businesses
- A poor location
- Insufficient start-up capital
- Poor marketing, targeting either the wrong people or no one at all
- Poor management skills and a lack of willingness to seek professional advice
- Poor customer relations
Distinguish between internal and external sources of finance
Internal sources of finance refers to funds generated from within the business itself; that is, from owner’s equity. External sources of finance refers to funds generated from outside the business; that is, from liabilities.
List two forms of internal finance
- Capital contribution
* Retained earnings
List two forms of internal finance
- Capital contribution
* Retained earnings
State the main advantages and disadvantages of using internal finance.
Advantages:
• No set repayment date
• No interest charge
Disadvantages:
• Limited to resources of the owner and previous profits
What are the four forms of External Finance
- trade credit
- bank overdraft
- term loan
- leasing
Define Trade Credit
a form of finance offered by suppliers that allows customers to purchase goods/services and pay at a later date
Define Bank Overdraft
A source of finance provided by a bank that allows the account holder to withdraw more than their current account balance
Define Term Loan
A form of finance provided by banks and other lenders for a specific purpose and repaid over time
Define Leasing
A written agreement that grants to the lessee the right to use a particular asset for a specified period of time in return for periodic payments to the lessor.
Advantages and Disadvantages of Trade Credit
Advanatages
• Allows immediate access to goods/services
• Allows businesses time to generate sales before payment is required
• No interest charge if credit terms are met
• Discounts are available from some suppliers for early repayment
Disadvantages
• Trade credit can only be used for purchases with that supplier
• Interest charges and late fees may be incurred for late payment (if stated in credit contract)
Advantages and Disadvantages of Bank Overdraft
Advantages • Readily accessible • Flexible – can be used for a variety of purposes Disadvantages • High interest charge • Can be recalled at short notice
Advantages and Disadvantages of a Term Loan
Advantages
• Makes possible the purchase of expensive assets
• Flexible – can be used for a variety of purposes
• Secured loans attract a lower interest rate
Disadvantages
• Interest charges
• Requires commitment by business to make repayments for the term of the loan
• Principal and interest payments can put pressure on cash flows
Advantages and Disadvantages of Leasing
Advantages
• Reduces initial outlay to acquire assets
• Makes it possible to obtain technologically advanced assets
• Allows assets to be updated when they become out-dated or technologically obsolete; for example, computers
• Reduces maintenance and repair costs
Disadvantages
• No ownership of asset
• Requires commitment by business for the term of the lease
Distinguish between a secured loan and an unsecured loan.
A secured loan requires the borrower to put an identified asset up as security (collateral) so that if the borrower defaults on the loan, the lender is entitled to claim that asset to settle the debt. An unsecured loan does not require an asset as security; however, this type of loan usually attracts a higher interest rate to compensate for the higher risk accepted by the lender.
Capital Contribution
An internal Source of Finance consisting of cash (or other assets) contributed to the business from the personal assets of the owner
Retained Earnings
An internal source of finance consisting of funds generated from business profits that are not taken as drawings by the owner
Explain why the finance term should match the life of the asset.
Short-term assets should be purchased using short-term finance, and long-term assets should be purchased using long-term finance. This is because long-term finance allows the business enough time to generate revenue to repay the larger amount of finance.
Explain the difference between an interest-only loan and a principal and interest loan.
Interest-only loans only require the borrower to make regular interest repayments, with the entire principal repaid at the end of the term of the loan. Principal and interest loans require larger repayments over the borrowing period, but reduce the need for a large cash outlay at the end.
Explain how a firm’s Debt Ratio can affect a firm’s ability to access external finance.
Businesses that already have a high Debt Ratio, and therefore have a large proportion of their assets funded by debt, could be forced to accept a higher rate of interest (as the risk to the lender is higher) or could be denied further finance altogether.
What are the guideline for seeking external finance
- The term of the finance should match the life off the asset
- The cost of interest must be considered
- The terms of the loan should be tailored to suit the borrower
- Consider the impact on the debt ratio and the firms ability to borrow further
Interest Only Loan
A loan which requires the borrower to make regular interest payments before repaying the entire principal in one lump sum on the last day of the loan period
Principal and Interest Loan
a loan which requires the borrower to make regular repayments of both the principal and interest over the life of the loan
Debt Ratio
measures the proportion of the firms assets that are funded by external sources
List the various types of information which must be provided when applying for a loan
- Amount and purpose of the loan
- Business details - nature, ownership structure, future goals
- Financial statements -statement of receipts and payments, cash budget, income statement, balance sheet
- Credit rating
- Deposit - amount contributed by the business
- Security - collateral (assets) the business will provide as security
Explain the role of the following financial statements in the process of applying for a loan:
- Statement of Receipts and Payments – to determine if the business generates sufficient cash flows to be able to meet the debt servicing requirements of the loan
- Income Statement – to determine whether the firm is likely to continue trading into the future
- Balance Sheet – to determine the firm’s current Debt Ratio, and the impact that the loan will have on its stability.
Explain the difference between a simple interest loan and a reducing balance loan
A simple interest loan calculates the interest charge on the original amount borrowed, regardless of how much of the principal has been repaid; while a reducing balance loan calculates the interest charge on the actual balance owing at that particular date.
State one benefit and one cost of taking out a loan over a longer period.
A benefit of taking out a loan over a longer period is that the amount of each instalment will decrease; a cost is that over the length of the loan the interest charge will increase.
Explain how a reducing balance loan can be modified to reduce the amount of interest paid.
A reducing balance loan can be modified in terms of the number of times it reduces. The more often interest is calculated on a lower principal, the less the overall interest charge will be
Explain why the interest charge on a simple interest loan is likely to be higher than the interest charge on a reducing balance loan.
The interest charge on a simple loan calculates interest on the amount borrowed rather than the amount owing; thus, overall, the amount of interest charged will be higher than that charged on a reducing balance loan.
Define the term ‘Debt Ratio’.
The Debt Ratio is a stability indicator that measures the percentage of a firm’s assets that are financed by liabilities.
Show the formula to calculate the Debt Ratio.
Debt Ratio = Total Liabilities/Total Assets x 100
Explain how the choice of internal or external finance can affect the Debt Ratio.
Using external finance to purchase assets will increase the Debt Ratio as it will increase liabilities proportionately more than assets; using internal finance will decrease the Debt Ratio as it increases assets but there is no change in liabilities.
Explain the dangers of a high Debt Ratio.
A high Debt Ratio would indicate a high reliance on liabilities, and consequently a high risk of financial collapse, as the business must be able to meet not only the loan repayments, but also the interest charges. Also, a high Debt Ratio may prevent a business from being able to access more borrowed funds as lenders perceive that the risk is too high.
State two benefits of a high Debt Ratio.
Borrowing gives the business access to funds to purchase assets that it may not have been able to afford trying to raise funds internally. These assets should allow the business to expand its revenue earning capability and increase its profits. Further, a high Debt Ratio will mean a higher return for the owner, as they have less capital invested, but still earn all the profits. That is, high risk will mean high return for the owner.
State two benefits of a high Debt Ratio.
Borrowing gives the business access to funds to purchase assets that it may not have been able to afford trying to raise funds internally. These assets should allow the business to expand its revenue earning capability and increase its profits. Further, a high Debt Ratio will mean a higher return for the owner, as they have less capital invested, but still earn all the profits. That is, high risk will mean high return for the owner.
Show the formula to calculate Return on Owner’s Investment.
Return on Owner’s Investment (ROI) = Net Profit/Average Owners Equity x 100
Explain why high risk (a high Debt Ratio) leads to a high return (Return on Owner’s Investment).
A high Debt Ratio means high risk, but it should also mean a high Return on Owner’s Investment because the business is earning profit, but using outside funds to do so. That is, the owner still receives all the profit earned by the business, but has had to contribute very little in the way of capital to earn that profit.
Explain how the application of the Historical Cost principle ensures reliability in the accounting reports.
Accountants apply the Historical Cost principle because using the original purchase price of a transaction is the best way to ensure that the information in the Balance Sheet is free from bias and error. This price is verifiable by reference to a source document and ensures reliability in the accounting reports.
Term Deposit
An investment option that requires the investor to agree to invest for a specified length of time
Negative Gearing
A strategy used by investors to reduce their taxable income by purchasing property which generates rental income which is less than the cost it incurs
Share
A document that verifies part- ownership in a public company
Dividend
A share of the profit earned by the company that is distributed to shareholders
Franking Credit
Dividend income received by the investor on which the company has already paid tax
Creditor
A supplier who is owed a debt by the business for goods or services purchased from them on credit
Security
Also known as the collateral; an identified asset that can be claimed by a lender from a borrower who defaults on a loan
Mortgage
A loan that is secured against property
Lease
A written agreement which grants to lessee the right to use a particular asset for a specified period of time in return for periodic payments to the lessor
Lessee
The entity that is leasing the non- current asset
Lessor
The entity that provides The non current asset for lease
Return on Owners Investment (ROI)
A profitability indicator that measures how effectively a business has used to owners capital to earn profit
