Unit 3 (Finance) Flashcards
What is the role of finance?
All businesses need money to finance activities. Need to spend money on capital expenditure and revenue expenditure.
What is capital expenditure?
Finance spent on non current assets used to generate sales revenue.
What is revenue expenditure?
Finance spent on the daily operations of the business.
What are owner’s savings?
Key sources of funds when business starts up, owners may introduce savings for business finances. Owners invest as business grows as it requires specific needs for businesses.
What are retained profits?
Profit generated in previous years not used for dividends and reinvested back into business. Used as cheap source of finance with no borrowing or interest fees. However, opportunity costs of investing money back into business as shareholders do not receive extra dividends as well as not having large capital.
What are sales of assets?
Selling business assets no longer required to generate finance, sale / leaseback arrangement used if business wants to continue using asset but needs cash.
What are adv of internal sources of finance?
Often free and arranged quickly and doesn’t involve 3rd parties who influence business decisions?
Dis of sources of finance
Significant opportunity cost once used, not available for other purposes. May not be significant to meet business’s needs.
What is share capital?
Finance raised from sales of shares in limited company through issues of shares usually entitled to share or profits when dividends declared. Also have wrote to vote in composition of BOD’s.
What are loans?
Likely available for larger businesses and repaid over 5-20 years, interest rates vary over amount of loan and can be negotiated. Failure to pay often means non current assets need to be sold and loans paid back by cash.
What are overdrafts?
Arrangement between business and bank to spend over money that has in account, limited usage and interest charge when business overdrawn. Often short term form that offers flexibility to fix cash flow issues.
What are trade credits?
Agreement between suppliers for raw materials to be paid back at later date, usually short term that is interest free and used by larger businesses.
What is leasing?
Assets made available to business in return payments, business doesn’t own business during lease periods so not responsible for maintenance and also more expensive in long term rather than buying straight up.
What is crowdfunding?
Allows business to provide large number of small investors on online platforms. Businesses need to provide persuasive business plan to convince individuals to invest in products due to heavy competition. Usually attracted by incentives like samples, discounts, memberships, early assess and shares.
What is micro finance?
Small lenders make finance directly available to businesses unable to assess finance elsewhere. Few formalities in applying for finance but amount often limited.
What are business angels?
Some businesses specialise in making investment in expanding businesses and tends to be more risk taking than banks. However relies on knowing right people so networking vital to secure deals with business angels. Angels can stake in business and directly involved in decision making and receives shares of business profits.
What is business expenditure?
Businesses need to spend money to earn money, referred to costs and the expenditure in producing good or service
What are fixed costs?
Costs that the business must pay regardless of how much it produces or sells. Must be paid even if no output.
What is variable costs?
Cost of production that changes in proportion to level of output. If output is zero then total variable costs are also zero.
What is total costs?
Total amount of costs found through the total variable costs plus the total fixed costs.
What are direct costs?
Costs that are specifically related to individual project or output of particular good or service, typically is also variable costs
What are overhead costs?
Costs that cannot be traced to production or sale of any single product, typically fixed costs however overheads difficult to identify with business activity
What is total revenue?
Money coming into the business from selling goods or services, known as sales revenue.
Fórmula for total revenue?
Price x Quantity
What are revenue streams?
Money received into the firm other than the sales revenue:
Example:
Advertising
Transportation fees
Sponsorships
Merchandise
Franchise Sales
What is contribution?
Refers to sum of money that remains after variable and direct costs have been taken away from sales revenue?
What is contribution unit formula?
Selling price - variable cost per unit
What is Break even point formula
Fixed costs / Selling price - variable cost per unit
What is unit contribution?
Proportion of selling price per each unit of output that goes towards paying of the fixed costs
What is total contribution?
Refers to quantity of output needed towards paying off total fixed costs
What is total contribution formula?
Unit contribution x output
What are purposes of break even analysis?
- Pricing strategies
- Prioritise products in portfolio
- Decide on whether to make or buy in products
- Make special order decisions
What is break even analysis?
Exists when a firm makes neither a profit or loss. Helps to determine the level of sales that must be generated for firm to earn a profit.
Benefits of break even analysis?
- Identify whether product financially worth to produce
- Determine how much profit can be generated if business idea goes to plan
What is margin of safety formula?
Actual sales / Forecast sales - BEP
What are 3 pieces of info businesses need for sales forecasting?
Just knowing BEP not enough when deciding whether to sell a product, needs to know:
- How much profit they might make
- How much unit of output needed to produce
- How much to charge for selling price
What is total profit quantity formula?
Fixed costs + Target profit / Price - Variable cost
What are assumptions of break even point?
Costs are linear
Sales revenue is linear
Assumes all output will be sold
What are limitations of break even?
Not useful to dynamic business environment due to static nature
Bad data will lead to bad information
Ignores quantitative / qualitative factors
Only suitable for single product firms.
What are final accounts?
Comprises of profit and loss acounts and balance sheets as business needs to keep records of financial statements. Also a legal requiremetn
Why are stakeholders interested in final accounts?
Legally obliged to produce final accounts which can ensure transparency in use of company funds when reporting to stakeholders
What are profit and loss accounts?
Shows net profit or loss of a business over a trading period, usually a year
Difference between profit and surplus?
Profit after expenses taken away, distributed to rewards stakeholders through dividends or retained profits. Surplus is profit business earns after expenses paid for but non profit interest so all profit goes back into business operations
What are methods to improve gross profit or surplus?
- Increase sales revenue )Increase selling price or sell greater quantity by marketing strategies)
- Reducing cost of sales (Use cheaper supiliers, buy in bulk discount)
- Increase funcing (Seek corporate sponsors / funding strategies) - only for non profit
What are methods of improving net profit or surplus?
- Reduce rent through cheaper location
- Install effecient machinery
- find cost effective suppliers
- reducing marketing costs
- reduce salaries
- Seek volunteers for reduced labour costs (only for non profit)
What are balance sheets?
Value of a firm at one point in time, usually last day of the financial year. Legally required by firms for auditing purposes.
What are assets?
Items of monetary value owned by a business
What are liabilities?
Legal obligations of the busines to repay lenders or suppliers at a later date.
What is equity?
Shows the value of the business through share capital or retained earnings
What are intangible assets?
Non physical fixed assets that can earn revenue for a business, can account for large porportion of firms asset value although difficult to place objection and account prices on such assets.
EX:
- Brand
- Patents
- Copy rights
- Goodwill reputation
- Registered trademarks or slogan
What is depreciation?
Non current assets tend to lose value over time which is known as depreciation. Can be because of wear and tear or advance in technology or newer versions of products.
What are methods of depreciation?
Spreading purchase cost of non current asset over life time:
- Straight line method
- Units of production method
What is lifespan?
USeful life of a non current asset
What is residual value?
Estimation of value at end of the linespan
Accumulated depreciation?
Annual depreciation expense multiplied by the number of years asset will be used for
What is net book value?
Original purchase cost of an asset.
Formula for straight line method?
Purchase cost - Residual value / Lifespan
ADV / DIS of straight line method?
ADV: Simple to calculate / understand
DIS: Depreciating same amount each year not realistic as some asssets lose a much larger percentage of value at beggining of useful life.
Formula for units of production method?
Purchase cost - residual value / Expected no. of units over lifetime
ADV / DIS of units of production?
ADV: Better insights into the true running costs of a non current asset
DIS: Harder to calculate compared to straight line
What is gross profit margin formula and explanation?
Formula: Gross profit / Sales revenue * 100
Shows value of gross profit as percentage of sales revenue. Analyses profitability of firm after deducting direct costs. Higher the better as more profits twoards paying off expenses
Strategies to increase GPM?
Raise revenue:
- Increase selling price if inlastic
- Decrease selling price if elastic
- Produce products with higher GPM
Reduce costs of sales:
- Reduce direct costs by seeking alternative suppliers
- Reduce direct labour costs
What is net profit margin formula and explanation?
Formula = Profit before tax/interest / Sales revenue * 100
Shows value of net profit as percentage of sales revenue. Analyses profitablity of firm after deducting indirect costs from gross profit.
Uses profit before tax/interset as interest / tax rates change so harder to benchmark agaisnt previous or future years.
HIgher the NPM the better, morf profits twoards dividents / retained profits
What is return on capital employed and its formula?
Profit before interest / tax / Capital employed * 100.
Capital employed = non current liabilities + equity
Profitability ratio that analyses financial performance with amount of capital invested
Higher the better, can see how efficiently invested money turns into profit
Strategies to improve ROCE?
- Reduce indirect costs
- Seek cheaper rental premise
- More effecient machinery / equipment
- Altenrative cheaper suppliers
- Cheaper forms of marketing
What are liquidity ratios?
Abililty of firm to back back short term liabilities. Important as they reveal level of working capital which firms can meet everyday obligations
What is current ratios formula and explanation?
Formula = Current assets / current liabilities
Deals with liequid assets and short term liabities of firm working capital
Helps reveal wehtehr firm can use liquid assets to cover for short term debts
How to interpret current ratios?
Ideal benchmark is 1.5:1 or 2:1, this means for every $1 of current liabilties, firm has 1.5 to 2 of current assets to pay for it
Over 1 = liquidable, higher the better but if too high business too conservative so holding too much cash thus having opportunty cost
What is the ACID test ratio formula and explanation?
Formula = Current asset - stock / current liabilties
Current ratio exepct ignores stock when measuirng short term liquid of busienss
Ideal benchmark is 1:1, this means for every 1$ of current assets, firm has 1$ of cash or debtors to pay for it
Strategies to improve liquidity ratios?
Raise value of current assets
- Encourage cahs payments by offering discounts
- Invest in stock control system to reduce amount of stock held
Reduce value of current liabilities
- Cut overdraft and use more long term loans with lower interest rates
- Avoid late payments from creditors
- Use Tran specialist to reduce tax liabilities
What are effeciency ratios?
How effecient at business managing its resources. Calcualtes vlaue of business liabitiles and debst against its equity
What is stock turnover and formula?
Number of times firm sells its stock within a time period, usuall 1 year. Indicates speed at which firm sells or replenishes stock.
Formula (no. of times) = Cost of sales / average stock (Higher the better)
Formula (no. of days) = Average stock / cost of sales (lower the better)
How to interpret stock turnover?
Important to compare with similar businesses
Differnet business will have different benchmark figure for stock turnover
Low or high not necessarily good or bad, depends on the business
Faster the stock turnover better for firm as sooner the stock can be replenished and selling can resume to earn sales revenue
Strategies to improve stock turnover?
Hold lower stock levels, requires more inventory to replenish more regularly
Divestemnt of stocks that are unpopular or slow to sell
Reduce range of products being selected by only having best selling products
What is debtors days formula and explanation?
Formula = Debtors / sales revenue * 100
measures average no. of days that it tkaes business to collect money from debtors
How to interpret debtor days?
Generally lower the better, can improve cash flow if consumers pay on time
If ratio too long can cause liquidity problems
if ratio too short can cause custoemr to seek other suppliers with better trade credit
Healthy benchmark uusally 30 to 60 days but depends on type of business
Strategies to improve debtor days?
Impose charge on later payers
Give debtors incentive to pay earlier like discounts
Refuse business with client unless payment is made
Threaten legal action
What is creditor days formula and explanation?
Creditors / cost of sales * 365
Used to meausre no. of days it takes on average for busine/ss to pay its trade creditors
Lower the better, more effecient at paying back creditors thus better cash flow
How to interpret creditor days?
Higher the better as repayments prologned so frees up cash elsewhere. however, lower also better as firms can void penalties and build strong relationship with trade creditors
Uusally 30 to 60 days
What is the gearing ratio formula and explanation?
Formula = Non current liabilities / Capital employed * 100
Assesses firm’s long term liquidity position as it examines firm’s capital employed from its non current liabilities.
How to interpret Gearing ratios?
Lower the better for firm as less money towards paying off non current liabilities.
- Highly geared is 50% or more, more vulnerable to change in interest rates as they have to pay more interest limiting cash flow of business.
- When highly geared, difficult to secure external sources of finance as financiers concerned about risks.
What are factors that affect acceptable gearing ratios for businesses?
- Size and status of business, more acceptable for bigger businesses to be higher since easier to pay off interest
- Level of interest rates economy: Low interest rates means lower payments even if gearing ratio is high
- Potential profitability: High ratio can be acceptable for high returning firms as can pay off long term liabilities more easily.
Strategies to improve gearing ratios?
- paying off long term liabilties to reduce non current liabilities
- Improve working capital / stock control / credit/debtor days, enables business to pay off debts easily thus reduces non current liabilities
- Rely more on internal finance such as retained profits and share capital
What are stakeholder interest on gearing ratios?
Creditors: Highly geared means less likely to lend money to firms as they higher risk
Shareholders / investors: Assess level of risk for investment, loans repaid before dividends so less profitability for investors in highly geared firms
What is insolvency?
When business unable to settle debts due to lack of funds or cash in bank account. Firms can recover from insolvency through debt restructuring.
What is bankrupty?
Legal declaration of firm’s inability to settle its debts. Business owes so much all its assets not enough to settle its debts.
Business has failed and unable to continue trading.
Last resort when all attempts failed, can severely damage credit rating of owners, hindering ability to borrow money years after.
What is cash flow?
Financial document that shows expected movement of cash in and out of a business over a period of time. Contains 3 key features:
- Cash inflows
- Cash outflows
- Net Cash flow
Cash flow vs profit and loss statement?
Cash flow cycle doesn’t use profit, for financial transactions activity is recorded on transaction completed. However cash payment is made for transaction can be on a different date on the cash flow cycle which is due to trade credits creating creditors or debtors
What is working capital cycle?
Difference between firm paying cash for its cost of production and reducing cash from sales to customers
Working capital formula?
Current assets - Current liabilities
What is liquidity?
Refers to how quickly a asset can be turned into cash, relatively liquid assets are current assets whilst illiquid assets are non current assets
What is the best case financial outcome?
1) Positive cash flow -> Liquidity
2) Invest with fixed assets to increase output
3) Generate higher levels of profits
4) More profits eventually leads to more positive net cash flow
What is the worst case financial outcome?
1) Consistent negative cash flow, leads to poor bank balance
2) Prevents firm from making investments
3) Lack of ongoing investment, thus lower productivity
4) Leads to reduced profits or losses causing negative net cash flow
Strategies to deal with cash flow problems?
- Stop trying to increase output through over trading, selling too many products
- Over borrowing, needs to repay bank loans through interest
- Over stocking leads to increased raw material cost
- Poor credit control by offering too many credits to customers
- Changes in external enviornments
Methods to reduce cash outflows?
- Better credit terms
- Seek alternative suppliers
- Better stock control
- Reduce expenses
- Leasing rather than buying
Methods to increase cash inflows?
- Tight credit control with customers
- Cash payments only
- Changing price policies
- Improve firm’s product portfolios
What are investment appraisals?
Non current assets with potential to yield future financial benefits. Refers to quantitative and qualitative approaches to evaluate costs and benefits of investment decision.
What is pay back period?
Refers to time it takes for investment project to earn enough profit to repay cost of an investment
What are adv of pay back period`
- Simple and quick method
- Useful for firms with cash flow problems, can see how fast investment repaid back
- Can see whether it will break even before it needs to be replaced
- Can be used to compare investment projects
- Assesses only short terms, less prone to errors
What are dis of pay back period?
- Only encourages short term approach
- Contribution per month unlikely to be constant because demand prone to fluctuations
Average rate of return?
Calculates average profit on investment project as a percentage on the amount invested, can be used to compare with the interest rate.
Average rate of return formula?
(Total returns - Capital costs) / (years of use)) / Capital costs * 100
Adv of average rate of return?
Enables easy comparison between projects and aids decision making
Dis of average rate of return?
Ignores timings of cash inflows and more to forecasting errors when considering seasonal factors
Calculating based on projects useful lifespan which might be a pure guess
What is net present value?
Used to work out present value of return on investment, used to see how much investment is worth today. This is due to inflation.
Formula for net present value?
Sum of present values - Originial costs.
What are cost centres?
Departments with only costs and not involved in generating profitsW
What are profit centres?
Departments of business that incur both costs and revenuesWht
What are adv of having both costs and profit centres?
- Accountability of messages
- Identifies areas of weakness
- Promotes team spirit
- Eliminates cost classification into fixed / variable and direct / indirect costs
- Benefits from benchmarking
- Improves motivation from delegation of responsibility
What are dis of having both costs and profit centres?
- Subjective allocation of indirect costs
- Departmental profits misleading due to apportionment of fixed costs across centuries
- Time consuming data collection for accurate cost and profit allocations
What is a budget?
Financial plan of expected revenue and expenditure for organization or department for given time period
What is variance?
Difference between budgeted figure and actual expenditure
- Favorable: Difference benefits the business
- Adverse: Difference harmful to the business
