Unit 3 Flashcards
Start-up capital
Capital needed by an entrepreneur to set up a
business
Working capital
The capital needed to pay for raw materials, day-
to-day running costs and credit offered to
customers.
Working capital (in
accounting terms)
Working capital = current assets - current liabilities
Internal finance
Money raised from the business’s own assets or
from profits left in the business (retained profits)
External finance
Money raised from sources outside the business
(e.g. share issue, leasing, bank loan)
Sources of
internal finance:
Retained profits
Sales of assets
Reduction in working capital
Sources of LONG
TERM external
finance:
Share issue
Debentures
Long-term loan
Grants
Sources of MEDIUM
TERM external
finance:
Leasing
Hire purchase
Medium-term loan
Sources of SHORT
TERM external
finance:
Bank overdraft
Bank loan
Creditors
Trade credit
Debt Factoring
Overdraft
An agreement with a bank for a business to
borrow up to an agreed limit as and when
required
Factoring (debt
factoring)
Selling of claims over debtors (individuals or
organisations who owe the business money) to a
debt factor in exchange for immediate liquidity
only a proportion of the value of the debts will be
received as cash
Leasing
Obtaining the use of equipment or vehicles and
paying a rental or leasing charge over a fixed
period. this avoids the need for the business to
raise long-term capital to buy the asset.
Ownership remains with the leasing company.
Long-term loans
Loans that do not have to repaid for at least one
year
Equity finance
Permanent finance raised by companies through
the sale of shares
Debentures
Bonds issued by companies to raise debt finance,
often with a fixed rate of interest (long-term
bonds)
Long-term bonds
Bonds issued by companies to raise debt finance,
often with a fixed rate of interest (debentures)
Rights issue
Existing shareholders are given the right to buy
additional shares at a discounted price
Venture capital
Risk capital invested in business start-ups or
expanding small businesses, that have good profit
potential, but do not find it easy to obtain finances
from other sources
Advantages of debt
finance:
- As no shares are sold, the ownership of the
company does not change and is not ‘diluted’ by
the issue of additional shares - Loans will be repaid eventually, so there is no
permanent increase in the liabilities of the
business - Lenders have no voting rights therefore there is
no loss of control of the company - Interest charges are an expense and are thus
tax deductible (reduce the total company tax
paid by the business)
Advantages of
equity finance:
- It never has to be repaid
- Dividends do not have to be paid every year. In
contrast, interest must be paid when demanded
by the lender - Much larger amounts of finance can possibly
be raised than through debt financing
Capital expenditure
Spending by businesses on fixed assets such as
the purchase of land, buildings and machinery
(investment expenditure).
Creditors
Individuals or organisations that the business
owes money to that needs to be settled within the
next twelve months
Revenue
expenditure
Spending on the day-to-day running of a business
(e.g. rent, wages and utility bills)
Examples of
revenue
expenditure
- Rent
- Wages
- Utility bills (e.g., water and electricity)
Examples of capital
expenditure
The purchase of any fixed asset:
- land
- buildings
- machinery
Fixed assets
Tangible assets as the have a physical existence
(so not a brand, for example) and are expected
to be retained and used by the business for more
than 12 months (e.g. land, buildings, vehicles and
machinery)
Investment
appraisal
Evaluating the profitability or desirability of an
investment project
Information
quantitative
investment
appraisal requires:
- Initial capital costs of the investment
- Estimated life expectancy
- The expected residual value (additional net
returns from the sale of the asset at the end of its
useful life) - Forecasted net returns or net cash flows from
the project (expected returns less running costs)
Methods of
quantitative
investment
appraisal
- Payback period
- Average rate of return
- Net present value using discounted cash flows
How external
factors (future
uncertainty) can
influence revenue
forecasts:
- Economic recession could reduce demand
- Increases in oil prices may increase costs of
production - Interest rates may decrease (both reducing
costs of finance and inflating future returns)
Payback period
The length of time it takes for net cash inflows to
pay back the original capital costs of the
investment
Average rate of
return ARR
Measures the annual profitability of an
investment as a percentage of the initial
investment
4 stages in
calculating ARR
- Add up all positive cash flows
- Subtract cost of investment
- Divide by lifespan
- Calculate the % return to find the ARR
Criterion rate or
level
The minimum level (maximum for payback period)
set by management for investment appraisal
results for a project to be accepted
Why future
cashflows are
discounted
- Inflation: The same amount of money in the
future will not purchase the same amount of
goods and services as it can today - Interest foregone: Money can be invested for a
return. If you invested the money safely now, it
will be worth more in the future. - Uncertainty: The cash today is certain, but the
future cash on offer is always associated with at
least a degree of risk and uncertainty
The present value
of a future sum of
money depends on
two factors:
- The higher the interest rate, the less value
future cash in today’s money - The longer into the future cash is received, the
less value it has today
Net present value
(NPV)
Today’s value of the estimated cash flows
resulting from an investment
Qualitative
investment
appraisal
Assessing non-numeric information in examining
an investment choice
Examples of
qualitative factors
in investment
appraisal
- Impact on the environment
- Planning permission (will local governments
allow the investment?) - Aims and obiectives of the business
- Risk
3 stages in
calculating NPV
- Multiply discount factors by the cash flows
(cashflows in year 0 are never discounted) - Add the discounted cashflows
- Subtract the capital cost to give the NPV
Factors in assessing
an ARR percentage
value
- The ARR on other projects (the opportunity
costs) - The minimum expected return set by the
business (the criterion rate) - The annual interest rate on loans (ARR needs to
be greater than the interest costs of borrowing;
even if the firm doesn’t need to borrow there’s
always an opportunity cost of interest foregone
by keeping the money in the bank)
Working capital
The capital needed to pay for raw materials, day-
to-day running costs and credit offered to
customers.
Working capital
(accounting terms)
Working capital = current assets - current
liabilities
Liquidity
The ability of a firm to pay its short-term debts
Liquidation
When a firm ceases trading and its assets are sold
for cash. Turning assets into cash may be insisted
on by courts if suppliers have not been paid.
Working capital
cycle
The period of time between spending cash on the
production process and receiving cash payments
from customers
Cash flow
The sum of cash payments to a business (inflows)
less the sum of cash payments made by it
(outflows)
Insolvent
When a firm cannot meet its short-term debts
Cash inflows
Payments in cash received by a business, such as
those from customers (debtors) or from the bank:
e.g. receiving a loan
Debtor
An individual or an organisation who has bought
on credit (or received a loan) from the business
and owes the business money
Creditor
An individual or organisation to whom money is
owed by the business
Cash outflows
Payments in cash made by a business, such as
those to suppliers or workers
Examples of cash
outflows include:
- Lease payments for premises
- Annual rent payment
- Electricity, gas and telephone/internet bills
- Labor cost payments
- Variable cost payments (e.g., raw materials)
Cash flow forecast
Estimate of the firm’s future cash inflows and
outflows
Net monthly cash
flow
Estimated difference between monthly cash
inflows and outflows
Opening cash
balance
Cash held by the business at the start of the
month
Closing cash
balance
Cash held at the end of the month becomes next
month’s opening balance
Benefits of cash
flow forecasts:
- By showing periods of negative cash flow, plans
can be put into place to provide additional
finance; e.g. arranging a bank overdraft or
preparing to inject owner’s capital - If negative cash flow appears to be too great,
then plans can be made for reducing these; e.g,
by cutting down on purchases of new materials or
reducing credit sales - A new business proposal will never progress
beyond the initial planning stage unless investors
and bankers have access to a cash flow forecast
(and the assumptions behind it)
Limitations of cash
flow forecasts:
- Mistakes can be made in preparing the revenue
and cost forecast (inexperience, seasonal
variations, etc) - Unexpected cost increases can lead to major
inaccuracies (e.g. fluctuations in oil prices
affecting cash flows of airline companies)
Wrong assumptions can be made in estimating
the sales of a business (e.g., poor market
research)
Causes of cash flow
problems:
- Lack of planning
- Poor credit control
- Allowing too much credit
- Expanding too rapidly
- Unexpected events
Credit control
Monitoring of debts to ensure that credit periods
are not exceeded
Bad debt
Unpaid customers’ bills that are now very unlikely
to ever be paid
Ways to improve
cash flow:
- Increase cash inflows
- Reduce cash outflows
(careful! its the cash position of a business, NOT
sales revenues or profits)
Methods to
increase cash flow:
- Overdraft
- Short-term loan
- Sale of assets
- Sale and leaseback
- Reduce credit terms to customers
- Debt factoring
Debt factoring
Short term liquidity problem, sell debt to a
factoring agency, instant inflow of cash but the
cost is a fee payable to the agency that lowers
the profit on the original business
Overdraft
A negative balance in a business’s bank account
Overdraft facilitv
An ability to have a negative balance up to an
agreed limit in a business’s bank account
Sale and leaseback
Assets can be sold (e.g. to a finance company),
but the asset can be leased back from the new
owner
Evaluation of
overdraft as a way
to increase
cashflow
- Interest rates can be high
- Overdrafts can be withdrawn by the bank and
this often causes insolvency
Evaluation of short-
term loan as a way
to increase
cashflow
- The interest costs have to be paid
- The loan must be repaid at the due date
Evaluation of sale
of assets
- Selling assets quickly can result in a low price
- The assets may be required at a later date for
expansion - The assets could have been used as collateral
for future loans
Collateral
An asset that is the subiect of a secured loan, and
can be sold by the lender to recover the amount
owed
Secured loan
A loan backed by an asset of value, such as
property or vehicles
Evaluation of sale
and leaseback as a
way to increase
cashflow
- The leasing costs add to the annual overheads
- There could be loss of potential profit if the
asset rises in price - The assets could have been used as collateral
for future loans
Evaluation of
reduce credit terms
to customers as a
way to increase
cashflow
- Customers may purchase products from firms
that offer extended credit terms
Evaluation of debt
factoring as a way
to increase
cashflow
- Only about 90-95% of the debt will n ow be
paid by the debt factoring company - this reduces
profit - The customer has the debt collected by the
finance company - this could suggest (give the
perception) that the business is in trouble
Methods to reduce
cashflow
- Delay payment to suppliers
- Delay spending on capital equipment
- Use leasing, not outright purchase of capital
equipment - Cut overhead spending that does not directly
affect output; e.g. promotion costs
Evaluation of delay
payments to
suppliers
(creditors) as a way
to reduce cashflow
- Suppliers may reduce any discount offered witht
he purchase - Suppliers can either demand cash on delivery
or refuse to supply at all if they believe the risk of
not getting paid is too great
Evaluation of delay
spending on capital
equipment as a way
to reduce cashflow
- The business may become less efficient if
outdated and inefficient equipment is not
replaced - Expansion becomes very difficult
Evaluation of use
leasing, not
outright purchase
of capital
equipment as a way
to reduce cashflow
- The asset is not owned by the business
- Leasing charges include an interest cost and
add to annual overheads
Evaluation of cut
overhead spending
that does not
directly affect
output as a way to
reduce cashflow
- Future demand may be reduced by failing to
support products effectively
Budget
A detailed financial plan of the future
Budget holder
Individual responsible for the initial setting and
achieving of the budget.
Delegated budgets
Control over budgets is given to less senior
management
Incremental
budgeting
Incremental budgeting uses last year’s budget as
a basis and an adjustment is made for the
following year
Zero budgeting
Setting budgets to zero each year and budget
holders have to arque their case to receive any
finance
Variance Analysis
The process of investigating any differences
between budgeted figures and actual figures
Adverse variance
Exists when the difference between the budgeted
and actual figure leads to a lower than expected
profit
Favourable
variance
Exists when the difference between the budgeted
and actual figure leads to a higher than expected
profit.
Limitations of
budgets
- Lack of flexibility.
- Focused on the short-term.
- Result in unnecessary spending.
- Training needs must be met
- Setting budgets for new projects.
Purposes of setting
budgets and
establishing
financial plans for
the future:
- Planning
- Effective allocation of resources
- Setting targets to be achieved
- Coordination
- Monitoring and controlling
- Modifying
- Assessing performance
Master budget
The overall or consolidated budget, comprised of
all the separate budgets within an organisation.
The Chief Financial Officer (CFO) will have
general control and management of the master
budget.
Importance of
Variance Analvsis:
- It measures differences from the the planned
performance of each department. - It assists in analysing the causes of deviations
from budget. - An understanding of the the reasons for
variations form the original planned levels can be
used to change future budgets in order to make
them more accurate. - The performance of each individual budget-
holding section may be appraised in an accurate
and objective way.
The three main
business accounts:
- Income statement
- Balance sheet
- Cash-flow statement
Income statement
Records the revenue, costs and profit (or loss) of
a business over a given period of time
Three sections of
an income
statement:
- Trading account
- Profit and loss account
- Appropriation account
Gross profit
Gross profit = sales revenue less cost of sales
Sales revenue
The total value of sales made during the trading
period = selling price x quantity sold (sales
turnover)
Sales turnover
The total value of sales made during the trading
period = selling price x quantity sold (sales
revenue) Sales revenue
Cost of sales
This is the direct cost of purchasing the goods
that were sold during the financial year (cost of
goods sold)
Cost of goods sold
This is the direct cost of purchasing the goods
that were sold during the financial year (cost of
sales)
Operating profit
Operating profit = gross profit - overhead
expenses (net profit)
Net profit
Net profit = gross profit - overhead expenses
(net profit)
Dividends
The share of profits paid to shareholders as a
return for investing in a company
Retained profit
The profit left after all deductions, including
dividends, have been made. This is ‘ploughed
back’ into the company as a source of finance
Low-quality profit
One-off profit that cannot easily be repeated or
sustained
High-quality profit
Profit that can be repeated and sustained
How stakeholders
use business
accounts: Business
managers
- Measure the performance of a business against
targets, previous time periods and competitors - Help them with decisions; e.g., new investments,
branch closures, launching new products - Control and monitor the operation of each
department, branch and division - Set targets for the future and review against
actual performance
How stakeholders
use business
accounts: Banks
- Decide whether to lend money to a business
- Assess whether to allow for an increased
overdraft facility - Decide whether to renew sources of finance;
e.g., overdraft, loans, etc
How stakeholders
use business
accounts: Creditors,
such as suppliers
- Assess whether the business is secure and liquid
enough to pay off its debts - Assess whether the business is a good credit
risk - Decide whether to press for early repayment of
outstanding debts
How stakeholders
use business
accounts:
Customers,
- Assess whether a business is secure
- Determine whether they will be assured of
future supplies of the good they are purchasing - Establish whether there will be security of spare
parts and service facilities
How stakeholders
use business
accounts:
Government and
tax authorities
- Calculate how much tax is due form the
business - Determine whether the business is likely to
expand and create more jobs - Assess whether the business is in danger of
closing down, creating economic problems - Determine whether the business is staying within
the law in terms of accounting regulations
How stakeholders
use business
accounts: Investors.
such as
shareholders in the
company
- Assess the value of the business and their
investment in it - Establish whether the business is becoming
more or less profitable - Determine the share of the profits investors are
receiving - Decide whether the business has potential for
growth - To compare businesses before making an
investment and/or purchasing shares in a
company - To consider whether they should sell all or part
of their holding
Uses of income
statements:
- Measure and compare the performance of a
business over time or with other firms - The actual profit data can be compared with
the expected profit levels - Bankers and creditors will need the information
to help decide whether to lend money to the firm - Potential investors may assess the value of the
business from the profits being made
Balance sheets
An accounting statement that records the values
of a business’s assets, liabilities and shareholders’
equity at one point in time
Assets
Items of monetary value that are owned by the
business
Liabilities
A financial obligation of a business that it is
required to repay in the future
Shareholders’
equity
Shareholders’ equity: Total value of assets - total
value of liabilities
Share capital
The total value of capital raised from
shareholders by the issue of shares
Types of shares:
Ordinary
Preference
Deferred
Fixed assets
Tangible assets (e.g. not brands) that have a
physical existence and are expected to be
retained and used by a business for more than 12
months; e.g., land, buildings, vehicles and
machinery
Current assets
Cash and other assets expected to be exchanged
for cash or consumed within a year; e.g.,
inventories, accounts payable (debtors) and cash/
bank balance
Current liabilities
Debts of a business that are generally paid within
one year
Working capital
Working capital = current assets - current liabilities
Long-term liabilities
Financial obligations that will take the business
more than one year to repay.
Intangible assets
Long-term assets (e.g., patents, trademarks,
copyrights) that have no real physical form but do
have value
Goodwill
Arises when a business is valued at or sold for
more than the balance sheet value of its assets
Intellectual
property
An intangible asset that has been developed from
human ideas and knowledge
Market value
The estimated total value of a company if it were
taken over
Depreciation
The decline in the estimated value of a non-
current asset over time
Straight line
depreciation
A constant amount of depreciation is subtracted
from the value of the asset each year
Net book value
The current balance sheet value of a non
current asset.
Net book value = original cost - accumulated
depreciation
Reducing balance
method
Calculates depreciation by subtracting a fixed
percentage from the previous year’s net book
value
The value of closing
stock is a major
factor influencing:
- The value of a company’s balance sheet
- The profit recorded - the higher the value
given to closing stock, the lower will be the
costs of goods sold, and, therefore, the higher
the profit
Last in first out
(LIFO)
Valuing closing stocks by assuming that the last
one purchased is the first out
First in first out (FIFO)
Valuing closing stocks by assuming that me last ones bought in were sold first
Dividends
The share of the profits paid to shareholders as a
return for investing in the company
Share price
The quoted price of one share on the stock
exchange.
Gross profit
Sales revenue - cost of goods sold
Net profit
The amount left after operating expenses are
subtracted from the gross profit
Capital employed
Formula
(non-current assets + current assets) - current
liabilities
Capital employed
alt. Formula
non-current liabilities + shareholders equity
Liquidity ratios
Measures the ability of a firm to meet its short-
term debts (e.g., current ratio & acid test ratio)
Liquid assets
Current assets - stocks
Current ratio
A short-term liquidity ratio that calculates the
ability of a firm to meet its debts within the next 12
months.
Acid test ratio
A liquidity ratio that measures a firm’s ability top
meet its short-term debts. This ratio ignores stocks
when calculating because some stocks (e.g.
Ferraris) cannot be quickly and easily turned into
cash
Stock turnover ratio
(days)
Measures the average number of days that money
is tied up in stocks.
Stock turnover ratio
An efficiency ratio that measures the number of
times a firm sells its stocks within a year.
Debtor days ratio
An efficiency ratio that measures the average
number of days it takes for a business to collect
the money owed from its debtors.
Creditor days ratio
An efficiency ratio that measures the number of
days it takes, on average, for a business to pay its
creditors. The higher the ratio is, the better it
tends to be for business.
Dividend yield ratio
(%)
A shareholders ratio which shows the dividends
received as a percentage of the market price of
the share. This ratio can be compared to other
shares in comparable companies or to the
prevailing market interest rate.
Earnings per share
A shareholders ratio which shows the amount of
money that shareholders could receive per share
if the company allocated all of its after tax profits
to shareholders.
Gearing
A long-term liquidity ratio that measures the
percentage of a firm’s capital employed that
comes from long-term liabilities, such as
debentures and mortgages. Firms that have at
least 50% gearing are said to be highly geared.
Net profit margin
A profitability ratio that shows the percentage of
sales revenue that turns into net profit. The
difference between a firm’s gross profit margin
and net profit margin indicates its ability to
control business expenses.
Gross profit margin
A profitability ratio that shows the percentage of
sales revenue that turns into gross profit.
Liquidity cirisis
Refers to a situation where a firm is unable to pay
its short-term debts; i.e., current liabilities exceed
current assets and, therefore, the acid test ratio is
less than l:1.
Liquid assets
Refer to the assets of a business that can be
turned into cash quickly, without losing their
value; i.e., cash, stock and debtors.
Return on capital
employed
An efficiency ratio (reveals a firm’s profitability)
that measures the profit of a business in relation
to its size. The higher the ROCE figure, the better
it is for business as it shows more profit being
generated from the amount of money invested in
the firm.
Balance sheet order of stating
- Fixed assets
- Accumulated depreciation
- net fixed assets
- Current assets
- Cash
- Debtors
- stock
- Current liabilities
- Overdraft
- Creditors
- short term loans
- total current liabilities
- net current assets (working capital)
- Total assets less current liabilities
- Long-term liabilities (debt)
- Net assets
Financed by:
• share capital
• accumulated retained profit - Equity
Profit & loss account order of stating
- sales revenue
- Cost of goods sold
- gross profit
- Expenses
- net profit before interest and tax
- Interest
- net profit before tax
- Tax
- net profit after tax and interest
- Dividends
- Retained profit
Trading accounts
Snows gross profit/loss from trading activities of the business
Includes:
Sales revenue
Cost of goods sold
Gross profit
Profit & loss part of income statement
Calculates net profit/loss and profit/loss after taxes are paid
Includes:
Expenses
Net profit before, interest and tax
Interest
Net profit before tax
Tax
Net profit after tax and interest
Appropriation accounts
Shows how profits after tax are distributed (appropriated) to the
owners or shareholders
Includes:
Dividends
Retained profit
Ordinary shares
Ordinary shares: The most common type of share issued. The size of the dividend
depends on how much profit is made and how much the directors decide to retain
in the business. When a share is first sold, it has a nominal value shown- its original
value. However, share prices change as they are bought and sold again and again.
Preference shares
Preference shares: The owner of these shares receives a ‘ fixed rate of return when a
dividend is declared, and usually they are held by the share owners of the business.
They can be redeemable if there is a possibility of the business buying them back
from their owner.
Deferred shares
Deferred shares: These are not often used. The founders of the company usually hold
these. These shareholders only receive a dividend after the ordinary shareholders
have been paid a minimum amount.
Capital cost
Amount of money spent on the new investment
Payback period formula
(Payback in best negative year)/ (net cash flow in first positive year) * 12
Problems with working capital
poor control of debtors: This is either due to businesses failing to collect debes on time
or due to them giving credit to firms that fail, leaving the debt unpaid. This could
be corrected by running a credit control system or hiring a credit rating agency.
Overstocking and understocking: Keeping too much stock means the business is being
run inefficiently - the managers failed to see that less stock could be held. This will
increase costs and prolong lag 3, mentioned above.
Overtrading: This refers to business having an insufficient working capital for its level
of turnover. For example, a business might accept orders from customers, but be
limited by trade credit limits set by its suppliers. Therefore it cannot order enough
stock to complete the orders. Overdraft might be a solution, but bankers might
refuse because of the risk of failure of the business.
Overborrowing: Businesses can borrow too much in the short term and trade too much
credit from suppliers. If the business fails to pay on time, it can lose the business
discounts for paying on time or even refusal by suppliers to supply in the future.
Overdraft might be a solution but bankers might refuse for the same reason as
above.
Downturns in demand: When the economy goes into recession, orders and sales of
businesses fall, because businesses do not react quickly enough. This can cause
overstocking which can also lead to cash flow problems.
Direct cost definition
Direct costs are expenses that can be easily traced and assigned to a particular product, service, or project. They are incurred during the production process and include things like raw materials and direct labor costs.
