Theme 2 - Finance Flashcards
Name reasons why businesses need finance?
pay employees, marketing and advertising, day to day operations, innovation, start up costs
What is capital expenditure?
spending on businesses resources that can be used repeatedly over a period of time - machinery
What is revenue expenditure?
spending on business resources that will generate sales for a short/medium term - advertising, staff and raw materials
What is revenue?
Revenue is the income earned by a business over a period of time.
What does the amount of revenue earned depend on?
the number of items sold and their selling price.
revenue = price x quantity.
What is the revenue calculation?
revenue = price x quantity
What are costs?
Costs are the expenses involved in making a product.
what are variable costs and example?
costs that change with the amount produced. For example, the cost of raw materials rises as more output is made.
What are fixed costs and example?
costs that stay the same even if more is produced. Office rent is an example of a fixed cost which remains the same each month even if output rises.
what are direct and indirect costs?
Direct costs, such as raw materials, can be linked to a product whereas indirect costs, such as rent, cannot be linked directly to a product.
what is the total cost?
The total cost is the amount of money spent by a firm on producing a given level of output. Total costs are made up of fixed costs (FC) and variable costs (VC).
What is profit?
profit is the surplus left from revenue after paying all costs
How is profit found?
Profit is found by deducting total costs from revenue. In short: profit = total revenue - total costs.
Profit is the reward for risk taking
profit calculation
profit = total revenue - total costs
How can losses be prevented?
cutting costs - eg by letting staff go and asking those who remain to accept lower wages
increasing revenue - eg by cutting prices and selling more items - if demand is elastic
What is retained profit?
profit that has been made by the business in previous years
advantage and disadvantages of retained profit
+ - No interest or debt
- - money will be lost if business fails, start ups cant use this, conflict between investors, reduces profit.
what is owners capital?
Personal savings of the entrepreneur that they might want to invest into the business
advantage and disadvantages of owners capital
+ - no interest and no dilution of ownership
- -money will be lost if the business fails, limited amount of money
What is sale of assets?
Entrepreneurs may sell their personal things to get money
advantage and disadvantages of sale of assets
+ - dont have to invite anyone in meaning there is no dilution of ownership
- - can be difficult to sell things if they are obsolete
what is a bank loan?
provides a long term finance for a start up with the bank stating the fixed period the loan is provided , the rate of interest and amount of repayments, money that is borrows from the bank
advantages and disadvantages of bank loans
+lower rate of interest than a bank overdraft
+payment made over time- no debt
- expensive with interest
-may require security -personal things
What is a bank overdraft?
the bank lets the business go below zero, in return for charging a high rate of business
- allows a business to exceed their amount of money
advantages and disadvantages of bank overdrafts
+helps businesses handle seasonal fluctuations in cash flow
+helps when they run into short term cash flow problems
-interest charges are very high compared to loan
-only a short term solution
share capital
outside investors which for start up business will be family and friends
advantages and disadvantages of share capital
+may not want to get involved with the day to day operations
+no debt and no partner to help
-tensions may rise
-give control to someone else
what is venture capital?
made by funds managed by professional investors. They get involved in high risk opportunities and expect high reward
advantages and disadvantages of venture capital
+business network
+money and support
+distribution channels
-part loan
What is trade credit?
the credit extended to you by suppliers who let you buy now and pay later - dependant on the industries and relationships
advantages and disadvantages of trade credit
+minimal cash outlay, discounts for fast payments, good for cash flow
- fees and penalties if you pay late
- loss of trade crew if you unreliable and pay late
what is leasing?
businesses sign a contract to pay a rental fee to the owner of an asset in return for the use of the asset over a period of 2-4 years - machinery or vehicles
advantages and disadvantages of leasing
+manages and avoids big cash outflow when buying new assets, new technology
-expensive in the long run, early termination fees
what is financing through family and friends?
provide money either directly to the entrepreneur or into the business
advantages and disadvantages of family and friends helping to finance
+this can be quicker and cheaper to arrange -flexible
-can add stress if the business gets into difficulties
Business angles
External investors in a start up business. Professional investors who prefer to invest in businesses with high growth prospects
Advantages and disadvantages of business angels
+brings skills, experiences and contacts to a company
- some loss of control over business from entrepreneur
Crowdfunding
An alternative method of raising finance where the entrepreneur attracts a crowd of investors who all contribute to an online fundraising target
Advantages and disadvantages of crowdfunding
+ popularity has increased
+easy way to promote business
+early and initial way of testing the market
-risk of others copying idea -public display
Could take a long time to raise
Could potentially ruin reputation
Banks
If you get a loan the bank will insist on collateral. If the business is starting up without property assets, the collateral will be personal, such as the deeds to the owners home - they want to provide finance not to be a partner
Advantages and disadvantages of banks
+provides money for start up
- putting personal things at risk
Grants
Hand outs to small firms from governments. A grant may be given to encourage a start up or a relocation that is considered valuable - conditions- location,technology, environment, ethical
Advantages and disadvantages of grants
+encourage start ups to relocate to areas of unemployment
+done have to give it back
-a lot of competition to get grants
-lots of conditions
What factors depend on the source of finance to choose?
- how established the business is
- how quickly money is needed
- cost of borrowing (interest)
- willingness to surrender ownership
What is capital?
Any sum of money that can be used to fund operations
What is stock/inventory?
Products that you intent to sell Could be: -raw materials -work in progress -finished goods
What is a current asset?
Something a business owns that the business can sell and turn into cash within one year
Creditor
Anyone the business owes money to
Debtor
Individual or organisation who owes the business money
Current liability
Something that the business owes within one year
Working capital
Current assets - current liabilities
Day to day money in the business
Working capital equation
WC = current assets - current liabilities
How do you improve working capital?
Increase assets and decrease liabilities
How do you improve working capital?- increase assets
Collect debts quickly -give a short time to pay
Increase sales revenue - price rise
How do you improve working capital? - decrease liabilities
Pay debts quickly
Get a bank loan instead of an overdraft or negotiate better deals with suppliers
What is unlimited liability?
The business and the person have the same legal entity
If an individual invests in an organisation they can lose not only the investment but also personal possessions
-sole traders and partnerships
What is limited legal liability?
Two separate entities
If an individual invests in an organisation they would only lose what they have invested
LTD
Private limited company
PLC
Public limited company
What is a business plan?
A document setting out the strengths, aims and strategies of a business, it is therefore an important planning tool
What should be included in a business plan?
Financial situation- sources of finance,budgets, costs Contingency plan HR plan Marketing plan Production plan
Disruptive technology
Technology that makes the service that you sell useless
Benefits of having a business plan
Budget money Helps to secure finance Gives you direction/motivation Helps create objectives Reduces risk
Drawbacks of a plan
Uncertainty makes it hard to be accurate -more opportunities may come up
Takes time and money to produce
Doesn’t guarantee success
Constant change in market
Overestimate what you can achieve
Restrictive - lack of freedom
Particularly inaccurate in a dynamic market
What groups of people would be interested or need a business plan?
Shareholders Stakeholders Bank Suppliers Manager of business Employees for job security
Cash flow
The money flowing in and out of a business
Inflow- income - receipts - examples
Money going in
Revenue, loans, sales, sources of finance, investment
Outflow - expenses - payments
Money going out
Stock, wages , rent rates , utilities
Net cash equation
Net cash = inflow - outflow
Why is cash flow forecasting used?
Anticipates timings and amounts of any cash shortages
Arrange financial cover for any shortages
Causes of cash flow problems
Have to pay suppliers before you sell products
May have more outflows than inflows
Starting balance may be low
Balance of payment -paying for stock upfront and giving customers too long to pay - trade credit
Unforeseen circumstances
Stock piling
Trends
Failure to negotiate good terms - discounts with suppliers
Solutions to cash flow problems - increase inflow
Generate alternative revenue streams Increase price of products Diversify product range Promote product range Promote products Offer less trade credit Increase production
Solutions to cash flow problems - decrease outflow
Use cheaper suppliers Spread out payments Build relationship with suppliers Change suppliers Just in time - only get stock that you need Improve efficiency - no waste Pay staff less - cut backs Change location - lower rent
Extrapolation
Making the assumption that what happened before will happen again - the trend will continue
Positives of extrapolation
Not much data required
Simple method
Using existing data
Quick and cheap
Negatives of extrapolation
Unreliable if in the past there was significant fluctuation
Retrospective
Assumption -unlikely in competitive business environments
Ignores qualitative data
Correlation
Looks at the strength of the relationship between two variables plotted with a scatter graph
Independant variable
the factor that causes the dependant variable to change
Dependant variable
The variable that is influenced by the independent variable
Positive correlation
A positive relationships exists where as the independent variable increases in value, so does the dependant variable falls in value
Negative correlation
A negative correlation exists whereas the independent variable increases in value, the dependant variable falls in value
No correlation
There is no discernible relationship between the independent and dependant variable
Positives of correlation
Data from market
Aids planning
Negatives of correlation
Can only use 2 variables
What is moving averages?
A technique for identifying an underlying trend by smoothing out fluctuations in data
- it smooths out the trend in the raw data
- It makes it easier to analyse erratic data
What is sales forecasting?
A business process, assessing the probable outcome using assumptions about the future
What is a sales forecast?
Projection of future sales revenue, often based on previous sales and market data
How do they do a sales forecast?
- previous sales data
- Trends -market trends, consumers, social/ethical
- seasonal factors
- experience of managers
- economic climate
What are the challenges of predicting accurately?
Unforeseen circumstances Changes in economic climate climate change Bad PR Change in legislation Trends - may fluctuate - dynamic market disruptive market
Economic factors that effect sales forecasting
business cycle exchange rates interest rates trade political unemployment change in legislation
3 Period moving average
add up 3 periods and divide by 3
Positives of 3 period MA
Removes the extreme values
Negatives of 3 period MA
Assumptions - using previous data
Dependant on the scale
Disregards some data that could be used to show where the business needs to be improved - erratic values are for planning
4 period MA
1/2 of 1st , add with 2nd, 3rd, 4th and 1/2 of 5th and divide by 4
Positives of 4 period ma
Good for erratic data
easier to analyse smoother trends
Accounts for variation in data
More statistically reliable - 4 period ma
Negatives of 4 period ma
Trends can change due to time period used
Don’t take into account any changes that you can’t expect - new competitors
uses past info
most useful in stable periods
reduced accuracy and original data distorted as averaged out
Sales volume
the number of products/ services sold over a period of time
Sales revenue
The revenue from selling products/services over a period of time
Fixed costs
A cost which does not change with output
Variable costs
A cost that varies directly with output
Total costs
Fixed costs + Variable. costs
Profit
The difference between total revenue and total costs
Direct costs
is the price that can be directly tied to the production of specific goods or services
Indirect costs
They are not directly accountable to a cost object
margin of safety
units sold - breakeven
break even formula
Fixed costs / contribution per unit
Contribution per unit
Sales price per unit - variable cost per unit
Benefit of break even
gives objectives to business on how much they need to sell - setting targets
Provides a focus/guidance
Good for identifying for potential changes of cost and price
Planning tool
Drawbacks of break even
Assumes that everything is sold
assumes that the business sells everything at the same price during the year
Variable costs aren’t constant - can only be as accurate as the predictions of sppu -vppu
total contribution formula
total contribution = cpu x units sold
What is a budget?
A forward financial plan concerning the revenue that a firm or department must aim to reach over a given amount of time
Different types of budget
Revenue budget
Expenditure budget
Profit budget
What is a revenue budget?
sets out expected sales revenues from selling its products
Includes level of sales and selling price
Start up business may have low revenue budget
What is expenditure budget?
Part of the company’s whole budget that deals with the costs required to operate the business
Labour, materials
What is profit budget?
Shows the expected income
How much profit is likely from your expected level of trading
Start up may not make any for the first few years
What are the 2 methods of creating a budget?
Historical budget
Zero-based budgets
Historical budget
Uses lasts year data as basis
Realistic - based on actual results
However, circumstances may have changed
- doesn’t encourage efficiency
Zero based budget
Budgeted costs and revenues are set to zero
Budget is based on new proposals for sales and costs
Makes budgeting more complicated and time consuming but potentially more realistic
Variance analysis
Calculating and investigating the differences between actual results and the budget
Positive/favourable variance
better than expected
Negative/adverse
Worse than expected
Why are budgets set?
- To enable spending power to be delegated to managers who know the needs to be spent which speeds ups decision making
- Establish priorities and set targets
- Assign responsibilities and allocate resources
- Control finance
- monitor performance
Drawbacks of setting budgets
- Time and money consuming
- Strategic rigidity - hard to stick to targets if market shifts
- Budgeting is based on predictions - relies on market research accuracy and changes in trends
- external factors - changing competitors and economy
- Decisions made by government and other public bodies - inflation
Inflation
The general rise in price
Income statements
A financial document that summarises a businesses historic trading activity- sales revenue- and expenses to show whether it has made a profit or loss over a period of time
Profit equation
Profit = total revenue - Total costs
Why are there different types of profit?
If a business is not doing well, then it uses different kinds of profit to work out where the issue is
Why does a business need profit?
To re-invest
As a reward for the business owners
As a measure of performance
Structure of an income statement
Revenue Cost of sales Gross profit Fixed overheads Operating profit Net financing costs - positive or negative Profit before tax Corporation tax Net Profit
Gross profit formula
Revenue - cost of sales
Cost of sales
How much it costs to make the product
Operating costs formula
Gross profit - fixed overheads
Fixed overheads
Fixed costs, a cost that doesn’t change with output
Rent and utilities
Net Profit formula
Profit before tax - corporation tax
Net financing costs
The amount of interest paid
Current rate of corporation tax
19%
Profit Utilisation
The way in which profit is used
The split between how much is distributed to shareholders (dividends) and how much is re-invested back into the business (retained profit).
Profit Quality
A measure of whether profit is sustainable in the long run high quality profit is profit that will continue; Low quality profit will arise from exceptional or extraordinary circumstances that are unlikely to continue
Which part of the income statement do employees want?
Net profit and fixed overheads
- If making a good net profit, employees will have job security and negotiate pay
Which part of the income statement do government want?
Profit before tax and corporation tax
-to see if businesses are paying the amount of corporation tax
Which part of the income statement do shareholders want?
Net profit, cost of sales, fixed overheads
- look at profit utilisation
- To know how well the business is doing, and how much dividends they are going to be paid, to see if the business is being run well and where to cut back costs
Which part of the income statement do managers want?
Revenue, gross profit, cost of sales, fixed overheads, operating profit
- To know if they are meeting their targets
- To know how much they need for budgets
- To know where to cut costs
- Tells them how good their decisions are
Which part of the income statement do suppliers want?
Net profit, financing costs
- how much debt the business is in
- see how much money they are making to see if it is reliable
Which part of the income statement do potential shareholders want?
Net profit and revenue
Want to see if they have a steady stream of money
Which part of the income statement do bank want?
Net profit and financing costs
-How reliable the business is
Profitability ratios
A technique for analysing a businesses financial performance by comparing one piece of accounting information to another
Gross profit margin
Gross proft/sales revenue x100
Operating profit margin
Operating profit/ revenue x100
Net profit margin
Net profit / revenue x100
- a ratio that expresses a businesses profit after the deduction of all costs as a percentage of sales
How do you make sure the gpm is as high as possible?
Reduce cost of sales - use cheaper suppliers and negotiate price
Increase revenue
How do you make sure the opm is as high as possible?
Reduce/manage fixed overheads
Reduce operating costs
How do you make sure the npm is as high as possible?
Manage and reduce all costs
Drawbacks to income statement and profitability
Need previous data
Need competitors data
ROCE
Return on capital employed - how much money you get back on the money that you invested into the organisation
- compares profit earned with the amount of capital employed in the business
- the higher the better (20-30%)
- measures the efficiency with which the firm generates profits from funds invested in the business
- investors will look at this to see what return they will get and whether it is better than the bank
ROCE eqaution
Operating profit/capital employed
Capital employed = total equity+non-current assets
How do you improve ROCE?
Increase operating profit
Reduce capital employed
External factors that affects profit margins
- Environmental factors - natural disasters
- Economy - spending patterns and recessions
- Legislation - change in
- Negative PR
Cash
the money circulating around the business at any given time - money available could be in the form of a loan
Profit
Total revenue - total costs
Generate profit by selling goods and services and deducing costs that are associated plus tax
Balance sheet
A financial statement that summarises the net worth of a business
-Tells you the way that the business has raised its capital and the uses to which capital has been put out
Liability
Something the business owes
Assets
Something the business owns
Structure of balance sheet
-Non current assets- buildings, vehicles, machinery , brand
-Current assets - Cash, stock/inventory, money in bank, debtors
-Current liabilities - trade credit/suppliers, overdraft
-net current assets= current assets-current liabilities
-non-current liabilities- bank loan, mortgage
- Net assets = non current assets+net current assets - non current liabilities
-financed by - retained profit, shareholder investment
= total equity
Non current assets
assets owned for more than a year
- vehicles
- buildings
- machinery
- brand
Current assets
something you own for less than a year
- cash
- stock/inventory
- debtors
- money in bank
current liabilities
Something the business owes within a year
- Bank overdraft
- Trade credit/suppliers
Net current assets
Current assets - current liabilities
Non- current liabilities
Something you owe over a year
- bank loan
- mortgage
Net assets
Non-current assets + net current assets - non current liabilities
Financed by
Where does the money come from
- retained profit
- shareholder investment, reserves
=total equity
Liquidity
Shows whether a firm is able to meet its short term liabilities and meet its debts - measures the cash position
Business could be making profit but not be able to pay their bills
Current Ratio
Shows a businesses ability to meet debts over the next year
Current assets / current liabilities (CL always 1)
Ideal current ratio
- 5:1
- too high- not taking advantage of investment opportunities
- too low - can’t pay bills
Acid test ratio
Measures short term liquidity - more accurate indicator as it takes out inventories which is to be considered less liquid than cash
(Current assets - stock) / current liabilities
How to improve liquidity?
Decrease liabilities
-sell assets
-increase non current liabilities- bank loan
-Negotiate with creditors to get better prices
Increase current assets
-Reduce trade credit
-Sell stock - increase sales revenue
Working capital
Net current assets
Money circulating in the business day to day
Why is working capital important to a business?
Buy materials, stock and pay wages, day to day bills - electricity and phone bills
- ensuring that the cash available is sufficient to meet the cash requirements at any one time
- Gives you continuity
- Shortage of cash means that no funds are available for development
Ways to improve working capital
- Earn additional profit
- Sell stock
- Borrow money on long term basis
- Replace short-term debt with long term debt
- Sell long term assets for cash
- negotiate terms and prices with suppliers
Causes for working capital problems
When a business is expanding too quickly
Holding too much stock
Trade credit too long
Too many short term debts
Reasons for business failure
- Lack of demand
- Bad cash flow
- Not adapting
- New technology
- trends, debts, lack of innovation
- competitors
- online shopping
Internal reasons for business failure
Marketing failure
lack of innovation
skills set of staff not good
poor leadership
external reasons for business failure
competitors legislation new technology interest rate increase negative PR economic change new trends
Financial reasons for business failure
below break even point for a long time bad budgeting poor financial planning poor cash flow overtrading debt
