section 5 Flashcards
finance
Finance is the money required in the business.
Finance is needed to set up the business, expand it and increase working capital
start-up capital
the capital needed by an entrepreneur when first starting a business
why businesses need finance
- to set up a business (start-up capital)
- to pay day-to-day expenses (working capital)
- purchase non-current (fixed) assets (capital expenditure
- market research
- expansion
working capital
the capital needed to finance the day-to-day running expenses and pay the short-term debts of a business
non-current (fixed) assets
resources owned by a business which will be used for a period longer than one year, for example buildings and machinery
capital expenditure
spending by a business on non-current assets such as machinery and buildings
long-term finance
debt or equity used to finance the purchase of non-current assets or finance expansion plans. long-term debt is borrowing a business does not expect to repay in less than five years
short-term finance
loans or debt that a business expects to pay back within one year
retained profit
profit remaining after all expenses, tax and dividends have been paid and which is ploughed back into the business
internal sources of finance
- owner’s savings
- retained profits
- some of the business’s working capital
- sale of non-current assets such as equipment and machinery
retained profits +- (internal finance)
+ no interest paid
+ no need to repay
- Takes time to raise this
- Might not raise enough
- can only be used as a source of finance if the business is profitable
owner’s savings +- (internal finance)
+ no interest paid
+ no need to repay
- Risk losing own money
- Might not raise enough
sale of non-current assets +- (internal finance)
+ no interest paid
+ no need to repay
- must find a buyer first, may be a slow process
- Might not raise enough
- Limited number of assets can be sold
use of working capital +- (internal finance)
+ no interest paid
+ no need to repay
- Can upset customers, if asked to pay earlier
- Can lead to insufficient inventory levels
use of working capital examples
- cash balances (the amount of money currently available to the business)
- reducing inventory levels (selling inventory to free up cash)
- reduce trade receivables
external sources of finance
short-term sources and long-term sources
short-term sources of finance
- overdraft
- trade credit
- debt factoring
overdraft
an agreement with the bank which allows a business to spend more money that it has in its account up to an agreed limit. the loan has to be repaid within 12 months.
overdraft +-
+ quick to arrange
+ flexible source of finance (can change the amount of borrowing)
- Interest needs to be paid
- Recalled at short notice
trade credits
when a business delays paying suppliers for some time, improving their cash position.
trade credits +-
+ No interest paid
+ Easy to arrange
- Suppliers can refuse future deliveries
- Can damage relations
trade receivables
amount owed to a business by its customers who bought goods on credit
debt factoring
selling trade receivables to improve business liquidity
debt factoring +-
+ Immediate cash
+ No responsibility to collect
debts
- Never receive full amount owed
long-term sources
- bank loan
- hire purchase
- leasing
- mortgage
- debenture
- share issue
bank loan
provision of finance by a bank which the business will repay with interest over an agreed period of time
bank loan +-
+ Large amounts of money can be borrowed
+ No risk to ownership
+ Business has a set time period to repay
- Needs to be repaid with interest
- Collateral will be requested
leasing
obtaining the use of a non-current asset by paying a fixed amount per time period for a fixed period of time. Ownership remains with the leasing company
leasing +-
+ No large initial payment needed
+ Leasing company covers the repair cost
+ Replace asset if technology improves
- The business never owns the asset
- Overall cost can be high due to monthly
payments
hire purchase
the purchase of an asset by paying a fixed repayment amount per time period over an agreed period of time. the asset is owned by the purchasing company on completion of the final repayment
hire purchase +-
+ No large initial payment needed
+ The business owns the item at the end
- Responsible for maintenance
- Overall cost can be high due to monthly
payments
mortgage
a long-term loan used for the purchase of land or buildings
debenture
a bond issued by a company to raise long-term finance usually at a fixed rate of interest
share issue
a source of permanent capital available to limited liability companies
share issue +-
+ No need to repay
+ No interest paid
- Risk for takeover, if too many shares are issued
- Only for limited/incorporated businesses
- Less control for existing shareholders
debt or equity financing
advantages and limitations
equity finance
permanent finance provided by the owners of a limited company
micro-finance
small amounts of capital loaned to entrepreneurs in countries where business finance is often difficult to obtain. these loans are usually repaid after a relatively short period of time
crowd- funding
financing a business idea by obtaining small amounts of capital from a large number of people, most often using the internet and social media networks
factors influencing the choice of finance
- size and legal form of business
- amount required
- length of time
- existing borrowing
why is cash important to a business
- pay employees wages
- pay suppliers
pay rent, heating, and lighting etc
cash-flow forecast
an estimate of the future cash inflows and outflows of a business
net cash flow
cash inflow minus cash outflow
constructing a cash flow forecast
- net cash flow= inflow - outflow
- closing balance of one month is opening balance of next
- net cash flow + opening balance= closing balance
liquidity
the ability of a business to pay its short-term debts
the working capital cycle
- inventories purchased on credit
- production of goods for sale
- goods sold to customers on credit
- cash
the length of the working capital cycle depends on
- the length of the credit period customers are given (credit sales)
- how long it takes to produce the goods for sale
- how quickly they find buyers
credit sales
goods sold to customers who will pay for these at an agreed date in the future
gross profit
the difference between revenue and cost of sales
gross profit formula
revenue - cost of sales
profit (net profit)
the difference between revenue and total costs
(net) profit formula
revenue - cost of sales - expenses
or
gross profit - expenses
total cost
costs of sales plus expenses
revenue
the amount earned from the sale of products
revenue formula
selling price x quantity
cost of sales
the cost of purchasing the goods used to make the products sold
expenses
day-to-day operating expenses of a business
importance of profit to private sector businesses
- measure the success of a business
- measure the performance of managers
- finance the purchase of non-current assets + expansion
- attracts investors
difference between profit and cash
- money invested in a business or borrowed by a business increases cash but not profit
- capital expenditure such as buying a new machine decreases cash but not profit
- sales of goods on credit increases profit but does not increase cash until buyer pays for the goods
income statement
a financial statement which records the revenue, costs and profits of a business for a given period of time
uses of income statements
statement of financial position
an accounting statement that records the assets, liabilities and owners’ equity of a business at a particular date
assets
resources that are owned by a business
liabilities
debts of the business that will have to be paid sometime in the future
constructing a statement of financial position
net assets=non-current assets + current assets - current liabilities
capital employed= owner’s capital + retained profit + non-current liabilities
non-current (fixed) assets
resources that a business owns and expects to use for more than one year
current assets
resources that the business owns and expects to convert into cash before the date of the next statement of financial position
trade receivables
the amount of money owed to the business by customers who have been sold goods on credit
current liabilities
debts of the business which it expects to pay before the date of the next statement of financial position
trade payables
the amount a business owes to its suppliers for goods bought on credit
non-current liabilities
debts of the business which will be payable after more than one year
owner’s equity
the amount owed by the business to its owners, includes capital and retained profits
shareholders’ equity (funds)
alternative term for owner’s equity, but can only be used by limited liability companies
liabilities
- current liabilities
- non-current liabilities
- owner’s equity
- shareholders’ equity
assets
- current assets
- non-current assets
interpreting a statement of financial position
analysing a business’s profitability (ratios)
- gross profit margin
- profit margin
- return on capital employed
gross profit margin
ratio between gross profit and revenue
gross profit margin formula
gross profit/revenue x100
profit margin
ration between profit (before tax) and revenue
profit margin formula
profit /revenue x 100
adding value
selling a product for more than it cost to produce it
return on capital employed (ROCE)
ratio between profit before tax and capital employed
ROCE formula
profit/capital employed x100
liquidity
the ability of a business to pay its short-term debts
how to measure liquidity
- current ratio
- acid test ratio
current ratio
ratio between current assets and current liabilities
current ratio formula
current assets/current liabilities
acid test ratio
ratio between liquid assets and current liabilities
acid test ratio formula
(current assets - inventories)/current liabilities
profitability vs liquidity
why and how accounts are used
