Paper 2 Flashcards
What factors affect the type and amount of finance required?
- What the finance is required for (Long term assets or short term increases in stocks)
- The costs of the finance (interest, dividends - returns)
- Flexibility of the finance - what repayments and when.
- Business organisational structure (sole trader find it easier to raise finance than sole traders)
Business Plan
A document setting out a business idea, how it will be financed, marketed and put into practice.
Sections of a business plan
• Business overview - background, history, legal structure.
• Description of business idea - product/service and USP
• Market Research - Information about target market and marketing mix.
• Business strategy - Aims/objectives
• Financials - sales/profit forecast, break even
• Operations plan - facilities and equipment
• HR plan - management and personnel (skills and experience from key members of team).
• Evaluation - SWOT analysis
Which groups of people might be interested in seeing a business plan?
- Investors
- Shareholders
- Banks
Why is a business plan important?
1) To test the feasibility of your business idea.
2) To give your new business the best possible chance of success.
3) To secure funding such as bank loans.
4) To make business planning manageable and effective.
5) To attract investors.
Financial elements of a business plan?
1) Workforce plan - Identifies the number and type of skills needed to achieve output and sales targets.
2) Cash flow forecast - Predicts money coming into and out of the firm’s bank account.
3) Marketing plan - Identifies the target market, the promotional budget and how it is to be spent.
4) Financing proposals - Estimates the amount of capital required, how it is to be raised and how it is to be repaid.
5) Break-even analysis - Shows the sales volume (or value) needed to cover all costs.
6) Profit forecast - Estimates the revenue and costs anticipated over the lifetime of the proposal
SWOT analysis
Situational analysis - Strengths, weaknesses, opportunities, threads.
External and Internal.
PESTLE analysis
Political, Economic, Social, Technological, Legal, Environmental
What do bank managers want to see before agreeing to provide finance?
• Details of the owner/managers of the business, their background and experience, other activities, etc.
• Management commitment, with enthusiasm tempered by realism.
• Plan must be thought through and not be a skimpy piece of work
• The plan must be used to run the business and there must be a means for checking progress against the plan.
What 2 assurances are financial instituitions looking for?
1) That the business has the means of making regular payments of interest on the amount loaned.
2) That if everything goes wrong the bank can get its money back. Forward-looking financial statements, particularly the cash flow forecast, are therefore of critical importance.
What is a cash flow forecast?
A prediction of future inflow and outflows of cash into and out of a business.
Difference between a cash flow forecast and a cash flow statement?
A forecast is a prediction of future cash flow and a statement is a historical record of last cash flow.
Formula for net cash flow?
Inflows - Outflows
Opening balance
The money in the bank at the start of the month.
Take closing balance from previous month.
Closing balance
The money in the bank at the end of the month.
Opening balance + Net cash flow
Why is cash flow important?
• It is a dynamic and unpredictable part of life for most businesses.
• Cash flow problems are a main reason why a business fails.
• Regular and reliable cash flow forecasting can address many of the problems.
• If a business runs out of cash it will almost certainly fail.
• Few businesses have unlimited finance - cash is limited, so it needs to be managed carefully.
Cash flow problem
When a business does not have enough cash to be able to pay its liabilities.
What causes cash flow problems?
• Sales prove lower than expected.
• Customers do not pay up on time.
• Costs prove higher than expected.
• Rash cost assumptions - unexpected costs.
What impacts cash flow?
• A business gets an overdraft.
• The business allows customers longer to pay.
• The business is given a loan from the bank.
• Suppliers extend their period of trade credit offered to the business
• Petrol prices fall, reducing costs.
• A business sells and asset it no longer needs
Benefits of cash flow forecasts?
• It can identify potential cash flow problems in advance.
• It can help avoid the possibility of insolvency.
• It can provide ideas for how to improve liquidity e.g. leasing rather than buying assets.
• Can provide evidence for loan or investment requests.
• Can show the owners when an overdraft would be required.
Limitations of cash flow forecasts?
• Changes in the economy can affect sales predictions and cost forecasts.
• New competition can drastically change predicted sales figures.
• Can be based on inaccurate market research e.g. an unrepresentative sample.
• A change in consumer tastes would make sales forecasts unrealistic.
Sources of finance
The options available to a business when seeking to raise funds to support future business actions.
- For a start up business this might be raising sufficient capital to establish the business.
- For an established business this might be to fund growth or implement a new strategy e.g. relocation.
Internal sources of finance
Found within the business.
Capital generated by the business or the current owners.
External sources of finance
Funded from outside of the business.
Capital raised from outside of the business.
Internal sources of finance examples
Retained profit
Selling assets
Owners capital
Internal sources of finance: Retained profit - definition
Money left after all costs to the business have been paid, which is re-invested into business growth.
Internal sources of finance: Retained profit - positives
+ Don’t have to pay it back
+ No interest charged
+ No loss of ownership.
Internal sources of finance: Retained profit - negatives
- May not have any or enough.
- May reduce the profit used as a reward for the business owner.
Internal sources of finance: Owners capital - definition
Money invested by the business owner such as personal savings.
Internal sources of finance: Owners capital - positives
+ No interest to pay, or repayments to make.
+ Will generate a high level of commitment from the owner to protect their investment.
Internal sources of finance: Owners capital - negatives
- Amount available likely to be limited.
- Can cause friction when multiple owners do not invest same amount.
Internal sources of finance: Sale of assets - definition
Money gained from selling something that the business owns, but which is no longer needed, such as old machinery or property.
Internal sources of finance: Sale of Assets - Positives
+ No interest charged.
+ Can allow a business to dispose of an asset no longer required.
+ Reduce costs of maintenance or upkeep of the asset.
Internal sources of finance: Sales Of Assets - Negatives
- Unlikely that the amount received will be a true reflection of the asset value.
- Can increase costs in long run if asset needs to be leased back.
- May not have assets to sell.
3 reasons why a business might need finance?
- To start up
- To expand
- Day-to-day trading
How much, when, challenges.
Capital expenditure
Spending on business resources that can be used repeatedly over a period of time e.g. vehicles, machinery.
Revenue expenditure
Spending on business resources that have already been consumed or will be very shortly e.g. raw materials, wages.
Working capital
Current assets - Current liabilities
Money that you have left after you have paid your short-term debts.
Money gained from reducing current liabilities or increasing current assets which can be used to fund day to day running of the business.
Current assets
Things a business owns which can be turned into cash quickly.
Cash from sales, debtors and stock/inventory.
Current liabilities
Things a business owes which it needs to pay in the next 12 months.
Overdraft.
Advantage of working capital
- Can improve efficiency by reducing waste.
Disadvantage of working capital
- Reducing current liabilities may affect customer satisfaction because customers will have to pay sooner and won’t get much trade credit.
Factors that affect the type and amount of finance required?
- What the finance is required for (Long-term assets/short-term increase in stock)
- The cost of the finance (Interest/dividends-returns)
- Flexibility of the finance - Repayments and when.
- Business organisational structure (limited companies find it easier to raise finance than sole traders.)
External finance: Source of finance with examples
Where the finance is coming from. The provider.
- Family and friends
- Banks
- Peer to peer funding
- Business angels
- Crowd funding
- Other businesses
External finance: Method of finance with examples
How the finance is provided.
- Loans
- Share capital
- Venture capital
- Overdrafts
- Leasing
- Trade credit
- Grants
External source of finance: Family and friends - definition
When loans of gifts are given by people known to the owners.
Suitable for small businesses who don’t require a lot of finance.
External source of finance: Family and friends - advantages
+ Don’t have to be repaid which reduces the costs of the business.
+ Can be flexible, with low/no interest.
External source of finance: Family and friends - disadvantages
- Can cause friction with family members if something goes wrong with the business, or if they want to get involved in decisions.
External source of finance: Banks (loans and overdrafts) - definition
Loans are when someone borrows a set amount from the bank with a fixed repayment term and interest. Can be secured against an asset.
Overdrafts are when a business pre-arranges with the bank that it can spend more than it has in its current account.
Any business can get a loan and overdraft. High risk projects including new innovations are rarely successful in getting a loan.
External source of finance: Banks (loans and overdrafts) - advantages
+ Loans: Large amounts can be borrowed. Repayments are predictable.
+ Overdrafts are flexible and only used when needed.
External source of finance: Banks (loans and overdrafts) - disadvantages
- Interest must be paid wether the business is profitable or not.
- Interest payments are usually very high making this a very expensive source of finance.
External source of finance: Peer to peer funding - definition
When other business owners or individuals lend money in return for interest.
For established businesses not start-ups.
External source of finance: Peer to peer funding - advantages
+ Can raise between 5,000 and 50,000 with repayment terms from 6 months to 5 years.
+ Quick access to finance.
External source of finance: Peer to peer funding - disadvantages
- Not suitable for very large amounts.
- Pay back terms are usually fairly short.
External source of finance: Business angels - definition
Wealthy individuals who will give businesses finance in return for equity.
Any small to medium sized Ltd.
External source of finance: Business angels - advantages
+ Can raise between 10,000 and 250,000.
+ Business angels can help with decision making and give good advice and contacts - they want to business to succeed as they own part of it.
External source of finance: Business angels - disadvantages
- Not suitable for very large amounts.
- You loose equity, including less share of the profits and less control over decision making.
External source of finance: Crowd funding - definition
When lots of individuals give small amounts (pool their money) to businesses who are worth while some way.
Start-up businesses usually with a social benefit such as social enterprises.
External source of finance: Crowd funding - advantages
+ Flexible about how the funders are rewarded e.g. discounts, previews, free goods or equity.
+ Risky projects can attract funding.
External source of finance: Crowd funding - disadvantages
- You may not raise as much as you need.
External source of finance: Other businesses - definition
Businesses with a healthy cash balance may invest in other businesses.
For established businesses.
External source of finance: Other businesses - advantages
+ May be a good source of cash if on good terms.
External source of finance: Other businesses - disadvantages
- May require repayment with interest.
- May have specific terms.
Share capital
- Share capital is finance raised from the sale of shares in a limited company.
- Shareholders are the owners of shares and they are entitled to a share of the company’s profit when dividends are declared
Venture capital
- Funds provided by specialist investors (venture capitalists) working on behalf of a venture capital firm in small to medium-sized businesses that have significant potential for growth e.g. in the technology sector
- Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business
- Businesses that may have been refused finance from other sources may seek the investment of less risk-averse venture capitalists
Leasing
- An asset such as a piece of machinery or a vehicle by the business in return for regular payments. The business does not own the asset during the period of the lease and so is not responsible for maintenance or repair costs.
- Leasing is usually more expensive in the long run than buying an asset.
Trade credit
- An agreement is made with suppliers to buy raw materials, components and stock which are paid for at a later date, typically 30 to 90 days later.
- Trade credit is usually interest-free
Grant
- Governments and industry trusts may offer grants to businesses that meet specific criteria.
- Grants do not need to be repaid.
- The business must use the finance for its intended purpose
Limited liability
An investors liability/financial commitment is limited to the total amount invested or promised in share capital.
An investors personal belongings beyond this venture are protected.
Unlimited liability
The owners of a business are responsible for the total amount of debt of the business.
The owner may loose their personal belongings, e.g. home and cars, if the value of these is needed to cover the debts of the business.
Limited companies
• LTD = Private limited company - shares only sold to friends and family with permission.
• PLC = Public limited company - shares sold on the stock exchange to anybody.
What finance is appropriate for limited companies?
• Share capital
• Retained profit
• Venture capital
• Business angels
• Bank loans
• Leasing
• Trade credit
Unlimited liability businesses
Sole trader = When there is a single business owner with unlimited liability.
Partnership = When there are 2 or more business owners and at least one has unlimited liability?
What source of finance is appropriate for unlimited liability businesses?
• Owners capital
• Retained profit
• Unsecured bank loans
• Peer to peer lending
• Crowd funding
• Grants
• Bank overdraft
• Leasing
• Overdrafts
How does a business generate revenue?
A business generates revenue by satisfying customer demand.
Demand
The amount of a product that customers are prepared to buy.
Sales volume
The number of units sold by a business.
Revenue
The amount (value) of a product that customers actually buy from a firm.
The value of sales in a given time period.
Revenue arises through income from the trading activities of a business.
Total revenue (calculation)
Volume sold X Average selling price (SPPU)
What factors influence demand and therefore revenue?
• Prices and incomes (availability of finance)
• Tastes and fashions
• Competitors actions
• Quality
• Government decisions
How can business increase revenue?
- Increase quantity (amount) sold.
- Perhaps by cutting the price or offering volume-related incentives (e.g. 2 for the price of 1).
- Key issues (is demand sensitive to price). - Achieve a higher selling price.
- Best to add value rather than simply increase price.
- Does market research suggest that prices are high enough or too low.
Costs
Amounts that a business incurs in order to make goods and/or produce services.
Variable costs
Costs which change as output varies.
- Lower risk for a start-up: no sales = no costs
Raw materials, packaging, wages, postage/shipping.
Total Variable costs formula
VCPU X Volume sold (output)
Fixed costs
Costs which do not change as output varies.
- Fixed costs increase the risk of a start-up.
Rent, marketing, insurance, salaries, interest payments.
Total costs formula
Fixed costs (FC) + Total variable costs (TVC)
Profit
The reward or return for taking risks and making investments.
Profit formula
Total revenue - Total costs
Contribution
The difference between sales revenue and total variable cost.
• It is used to pay the firms fixed costs.
• Once fixed costs are paid, additional contribution generates profit.
• Most important to those firms that produce a variety of products.
Contribution per unit formula
Selling price per unit - Variable cost per unit
Contribution per unit can be increased by either increasing selling price or reducing variable costs.
Total contribution
Contribution per unit X Quantity sold
Profit formula: contribution
Total contribution - fixed costs
Advantages of using contribution to help make financial decisions?
• Helps allocation of fixed costs to see which products contribute more.
• Costing and pricing this way is simple to operate.
• Looks at the whole business.
• Can be adjusted when changes occur e.g. to vcpu
Disadvantages of using contribution to help make financial decisions?
• Hard to classify costs into fixed and variable.
• Can easily be confused with profit.
• Can only be used in the short term when fixed costs do not change and output is fixed for a certain period of time.
Breakeven
A level of output at which total sales revenu is equal to the total costs of production.
The business doesn’t make a loss but also doesn’t make a profit.
Break even output
Fixed costs / contribution per unit
Margin of safety
The difference between the actual level of output of a business and its breakeven level of output.
Margin of safety
Actual output - Breakeven output
Breakeven advantages
• Helps entrepreneur understand the level of risk involved in a start-up.
• Calculations are quick and easy - great for giving estimates.
• Focuses entrepreneur on how long it will take before a start-up reaches profitability.
• Helps to hypothesise the impact of changing variables on Breakeven and profit.
• Margin of safety calculations shows how much a sales forecast can prove over-optimistic before losses are incurred.
• Helps entrepreneur understand the viability of a business; also those who will lend money to, or invest in the business.
• Illustrates the importance of a start-up keeping fixed costs to a minimum.
• Breakeven analysis should be seen as a planning aid rather than a decision-making tool.
Breakeven disadvantages
• Sales are unlikely to be the same as output - there may be some build up of stocks or wasted output too.
• Unrealistic assumptions – products are not sold at the same price at different levels of output; fixed costs do vary when output changes.
• Variable costs do not always stay the same. E.g. as output rises, the business may benefit from being able to buy inputs at lower prices which would reduce vcpu.
• Most businesses sell more than one product, so break-even for the business becomes harder to calculate
Forecasting
A business process, assessing the probable outcome using assumptions about the future.
Sales forecast
Projection of future sales revenue often based on previous sales and market data.
The purpose of sales forecasts
• Used in cash flow forecasts in order to estimate inflows each month.
• Used in Human Resources planning to estimate how many staff to employ or make redundant.
• Used in production planning to estimate how much stock/raw materials to buy.
• Used in Human Resources and finance to estimate what sales targets to give to the sales force and what bonuses/commissions to pay.
• Forms the basis of the businesses overall aims and objectives which are viewed by investors and other market commentators to judge the success of the company.
How are sales forecasts derived?
- Using correlation:
- Sometimes there is a link (correlation) between internal/external influences and future sales. If we can understand this relationship, we can predict how the external influence will affect sales in the future.
E.g. if you are a house building company, then your sales are going to be correlated to the interest rate.
- If you know the magnitude of that relationship, then this can be used for forecasting. - Using past sales data:
- Using past sales data to predict future sales data is called extrapolation.
Factors affecting sales forecast:
Rise in sales
• Higher conumser income for a normal good.
• A successful promotion campaign.
• Training for staff in a service industry.
Factors affecting sales forecast:
Fall in sales
• Launch of a close substitute by a competitor.
• Poor weather forecast for a barbecue manufacturer.
• Higher consumer income for an inferior good.
Factors affecting sales forecasts
- Consumer trends
- Economic variables
- Actions of competitors.
Consumer trends
• Seasonal variations in demand for certain goods.
• Fashion - Celebrities influences can have a short-term impact on sales.
• Consumer behaviour, attitudes and spending habits change over time.
Economic variables
An economic variable is any measurement that helps us to determine how an economy functions.
1. Interest rates.
2. Consumer incomes rising (slowly)
3. Exchange rate for pound declining.
4. Tax on sugary drinks increasing.
Interest rates
The cost of borrowing money or reward for saving money.
When interest rates are high, consumer spending calls as people are more likely to save so sales revenue falls.
Consumer incomes rising (slowly)
The money a consumer earns from work or investment.
Income elasticity = measures the sensitivity of demand to changes in consumer income.
A normal good is one with a positive relationship between income and demand e.g. bottled water. When income rises, demand for bottled water rises.
An inferior good is one with a negative relationship between income and demand e.g. supermarket own brand products. When income rises, demand for these products falls, as they can afford a more luxurious product.
Exchange rate for pound declining
Rate at which one currency will be exchanged for another.
If the pound is worth less the cost of buying goods from overseas goes up which means business costs go up so price goes up and therefore sales revenue falls.
Tax on sugary drinks increasing
Will lead to a fall in sales of sugary drinks.
Actions of competitors
• Short term actions of competitors - sales promotions.
• Long-term strategies - changes to product ranges and expansion plans.
• Competitor actions are difficult to predict so the use of past sales data to predict future sales may be limited as a result.
Challenges with sales forecasting
• If the business is new - a new startup (difficult to forecast sales).
• If the market is subject to significant disruption from technological change (dynamic market)
• If demand is highly sensitive to changes in price and income (elasticity)
• If the product is a fashion item.
• If there are significant changes in market share (e.g. new market entrants)
• If management have demonstrated poor sales forecasting ability in the past.
How is correlation measured?
Correlation is usually measured using a scatter diagram, on which data points are plotted.
The independent variable (one causing other to change) is on the x-axis), dependent (being influenced) on the y-axis.
Correlation
A statistical technique used to establish the strength of relationship between 2 variables.
- Line of best fit (regression line) is added and used to forecast sales and identify factors influencing demand.
- If the data suggests strong correlation, then the relationship might be used to make marketing predictions.
Positive correlation
- As one variable increases so does the other.
- Direct relationship.
- E.g. sales and advertising or income and sales.
- Close to the line = strong.
- Far from the line = weak.
- On the line = perfect.
Negative correlation
- As one variable increases the other decreases.
- Inverse relationship.
- E.g. price and demand.
- E.g. Interest rate rises, fall in demand for new houses.
No correlation
- When there is no apparent link between the variables.
- E.g. price of beef and cinema ticket sales.
Correlation coefficient
Correlation is expressed as a number between +1 and -1 with 0 = no correlation.
Closer to +1 (+ve positive correlation) and -1 (-ve negative correlation) the stronger the correlation.
Positives of scatter graphs?
- Useful to predict sales and demand factors.
- Can see if there is a link that can be influenced for the benefit of the business.
- Simple technique and useful for tactical thinking.
- If appears regularly, the more chance there is that correlation exists.
Negatives of scatter graphs?
- Coincidental links - does not always show casual links e.g. does coffee make you smoke.
- Shows a link but hard to distinguish between cause and effect e.g. price rises and wage rises are strongly correlated which is dependant and independent.
- Need to find a casual link by looking at other factors - treat with caution as almost impossible to isolate factors.
Extrapolation
A method used by businesses to predict future levels such as sales, through analysing trends in past data.
How do you implement extrapolation?
- To predict sales.
- Carried out visually by reading off a correlated graph.
- Extend the line forward by eye.
- Go to the forecasted time period and predict sales levels.
Advantages of extrapolation
+ Can help firms look ahead and plan in the future (staff, production and distribution levels)
+ The past can be useful in the immediate future of some markets.
+ Can prepare for times of the year when busy and adapt marketing strategies.
+ Can identify particular segments of growth/decline.
Disadvantages of extrapolation
- Only effective if trends continue into the future - unlikely in a competitive environment.
- Unanticipated external and seasonal factors change forecasts or render useless.
- Some new random factors cannot be predicted.
- Treat figures with caution: depends on what extent the past repeats itself.
- Ignores quantitative factors (e.g. changes in tastes and fashions.)
- Not statistically valid.
- Unreliable if there are significant fluctuations in historical data.
Moving averages
Statistical calculation of underlying trends in data.
- Useful when dealing with erratic/seasonal data.
- Average of multiple time periods.
- Minimises effect of extreme values as an average taken.
- Used to emphasise the direction of trend and reduce ‘noise’ that can confuse interpretation.
Moving averages - Analysing markets
This looks at several periods at a time and averages out the data. By doing so, this helps to iron out all peaks and troughs in demand and gives a more accurate figure of whether sales have risen or fallen in a market over a period of time.
Variation
Sales in a specific time period - The moving average sales
Time series analysis
Recording data at regular intervals in order to identify trends and make forecasts.
Advantages of moving averages
+ Easier to analyse smoother trends.
+ Accounts for variation in data.
+ More statistically reliable.
Disadvantages of moving averages
- Reduced accuracy and original data distorted as ironed out.
- Erratic values may be useful to know.
- Most useful only in stable periods.
- Still based on past information.
Budgeting
A business tool to enable a business to run efficiently and effectively through setting financial targets.
A financial plan/target for the future of costs and incomes for a particular aspect of a business that must be reached over a given period of time.
There are individual and master budgets.
The main types of budgets
- Revenue (or income) budget:
- Expected revenues and sales volume. Start ups?
- Broken down into more detail (products, locations etc) - Cost (or expenditure) budget:
- Expected costs based on sales budget.
- Overheads and other fixed costs - plan for. - Profit budget:
- Based on the combined sales and cost budgets - calculate expected profit or loss.
- Of great interest to stakeholders - investors/bank managers.
- May form basis of performance bonuses.
How is a profit budget constructed?
- Analyse market
- Market size and growth.
- Market share.
- Market prospects. - Draw up sales budget
- Sales forecast
- New products
- Pricing changes - Draw up cost budget.
- Based on sales budget
- Allow for known changes in supplier prices.
- Include contingencies - a potential negative event that may occur in the future.
What is the purpose of a budget?
- To motivate staff.
- A means of controlling income and expenditure.
- To monitor performance - acts as a review and allows time for corrective actions to take place.
- Provides direction and helps in the coordination of a business and improves communication between different sections of the business.
- Provides clear targets to be met and helps employees to focus on costs.
- Forecast outcome.
- Turn objectives into practical reality.
- They allow delegation without loss of control - delegate responsibility for revenue and cost targets to departments of geographical locations in order to improve control and accountability.
Historical budgeting
- Use last year’s figures as the basis for the budget.
- Realistic in that it is based on actual results.
- However circumstances may have changed (e.g. new products, lost customers, credit crunch).
- Does not encourage efficiency.
Strengths and weaknesses of historical budgeting.
+ Quick and simple.
+ Can be accurate as based on actual figures from previous time periods.
- Departments can feel an expectation to spend a certain amount of money, regardless of what they really need.
- Managers can become complacent with their companies budgets.
- No incentives for developing new ideas or reducing costs.
- Fails to take into account changing circumstances.
- Encourages spending up to the budget so that the budget is maintained next year.
Zero budgeting
- Budgeted costs and revenue are set to zero.
- Budget is based on new proposals for sales and costs i.e. built from the bottom up.
- Makes budgeting more complicated and time-consuming, but potentially more realistic.
Strengths and weaknesses of zero-budgeting.
+ Eliminates unnecessary costs as all spending has to be justified.
+ Can take into account current and likely future conditions which may be more accurate.
+ Helps the business to identify those departments which require large amounts of essential capital and day-to-day expenditure as well as those which require minimal expenditure.
- Time consuming.
- These budgets can be very tight, especially if managers are interested only in profit.
Budget
Forecast of cost or revenue
Actual
The amount of cost spent/revenue that is accounted for during the time period.
Variance
Difference between Budgeted - Actual figures.
Every variance must be listed as either neutral or adverse (unfavourable/worse than expected) or favourable (positive/better than expected).
