Unit 5: Finance and accounting Flashcards
Define start-up capital
The capital needed by an entrepreneur to set up a business.
Define working capital
The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. WC = CA - CL
Why do businesses need finance?
- Setting up a business to purchase capital equipment.
- To finance working capital.
- To buy more assets and growth though developing products need finance for R&D.
- Takeover of a business.
- Decline in sales.
- Debt.
- Business survival.
Define short-term finance
Money required for short periods of time up to one year.
Define long-term finance
Money required for more than one year.
Define profit
The value of goods sold (revenue) less costs.
Define liquidity
The ability of a business to pay its short-term debts.
Define administration
When administrators manage a business that is unable to pay its debts with the intention of selling it as a concern.
Define bankruptcy
The legal procedure for liquidating a business (or property owned by a sole trader) which cannot fully pay its debts out of its current assets.
Define liquidation
When a business ceases trading and its assets are sold for cash to pay suppliers and other creditors.
What is the working capital cycle
Materials ordered from suppliers → Production converts materials into finished products → Inventory held until sold → Products sold to customers on credit → Customers pay for purchases, which leads to cash inflow.
Define current assets
Assets that either are cash or likely to be turned into cash within 12 months (inventory and trade receivables or debtors).
Define current liabilities
Debts that usually have to paid within one year.
How to manage working capital?
Inventory management:
- Keeping smaller inventory lvls.
- Using computer systems to record sales & inventory lvls.
- Efficient inventory control to reduce loss through damage.
- Getting goods to customers as quickly possible to speed up payments.
Trade payable managed by:
- Delaying payments to suppliers to increase credit period.
- Only buying goods from suppliers who offer credit.
Trade receivables:
- Only selling products for cash, not credit.
- Reducing credit period offered to customers.
Define capital expenditure
The purchase of non-current assets that are expected to last for more than one year, such as buildings & machinery.
Define revenue expenditure
Spending on all costs and assets other than non-current assets, which include wages, salaries and inventory of materials.
Define internal sources
Raising finance from the business’s own assets or from profits left in the business (retained earnings).
Define external sources
Raising finance from sources outside the business, for example banks.
Retained profits: definition + advantages + disadvantages
Profit after tax retained in a company rather than paid out to shareholders as dividends.
Advantages:
- No interest
- No repayments
Disadvantages:
- Limited funds, amount depends on past profits.
- Opportunity cost, the money can’t be used for other investments/dividends.
What are the internal sources of finance?
- Retained profits.
- Sale of unwanted assets - to raise cash.
- Sale and leaseback of non-current assets - not needed to own. Can raise capital, however lease payment becomes an additional fixed cost.
- Working capital - reducing the level of inventory releases cash into business. A disadvantage: cutting back on current assets by selling inventories or reducing trade receivables may reduce the liquidity of the business - its ability to pay short-term debts - to risky lvls.
Define non-current assets
Assets kept and used by the business for more than one year.
Define overdraft
A credit that a bank agrees can be borrowed by a business up to an agreed limit as and when required.
Define factoring
Selling of claims over trade receivables (debtors) to a specialist organisation (debt factor) in exchange for immediate liquidity.
What are the short-term external sources
- Bank overdrafts
- Trade credit
- Debt factoring.
Short term external source of finance: Overdraft (definition + advantage + disadvantage)
A short-term loan from a bank that allows a business to withdraw more money than it has in its account, up to a set limit.
Advantages:
- Flexible—can be used when needed.
- Quick access to extra funds for short-term needs.
Disadvantages:
- High interest rates make it expensive.
- The bank can ask for repayment at any time.
Short term external source of finance: Trade credit (definition + advantage + disadvantage)
When a business buys goods or services from a supplier but pays for them later, usually after 30, 60, or 90 days.
Advantages
- Helps cash flow by delaying payments.
- No interest if paid within the agreed period.
Disadvantages:
- Late payment can lead to penalties or loss of discounts.
- Suppliers may refuse future credit if payments are delayed.
Short term external source of finance: Debt factoring (definition + advantage + disadvantage)
When a business sells its unpaid customer invoices to a factoring company for immediate cash, but at a reduced value.
Advantages:
- Provides quick cash to improve cash flow.
- Reduces the risk of bad debts (unpaid invoices).
Disadvantages:
- The business receives less money than the full invoice value.
- Customers may lose trust if they have to deal with a third party.
What are the main long-term external sources of finance?
- Hire purchase & leasing
- Bank loan
- Debentures
- Share capital
- Business mortgages
- Government grants
- Venture capital
Define hire purchase
A company purchases an asset and agrees to pay fixed repayments over an agreed time period. The asset belongs to the purchasing company once the final repayment has been made.
Define leasing
Renting an asset for a set period instead of buying it. The business makes regular payments but never owns the asset. The asset is owned by the leasing company.
Define long-term loans
Loans that do not have to be repaid for at least one year.
Define debentures
Long-term bonds issued by companies to raise debt finance, often with a fixed rate of interest.
Define share (or equity) capital
Permanent finance raised by companies through the sale of shares.
Define business mortgages
Long-term loans to companies purchasing a property for business premises, with the property acting as collateral security on the loan.
Define 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 gain finance from other sources.
Long term external source of finance: Hire purchase (advantages + disadvantages)
Advantages:
- Spreads the cost over time, making expensive assets more affordable.
-The asset can be used immediately without full payment upfront.
Disadvantages:
- Total cost is higher due to interest charges.
-The business does not own the asset until the final payment is made.
Long term external source of finance: Leasing (advantages + disadvantages)
Advantages:
- Lower upfront costs compared to buying.
- Maintenance and repairs are often covered by the leasing company.
Disadvantages:
- The business never owns the asset.
- Long-term leasing can be more expensive than buying outright.
Long term external source of finance: Bank loan (advantages + disadvantages)
Advantages:
- Allows businesses to borrow large amounts for long-term growth.
- Fixed repayment schedule helps with financial planning.
Disadvantages:
- Interest must be paid, increasing overall cost.
- The bank may require collateral (e.g., property) as security.
Long term external source of finance: Debentures (advantages + disadvantages)
Advantages:
Fixed interest rates make repayment predictable.
Can raise large amounts of money for long-term projects.
Disadvantages:
- Interest must be paid even if the business is not making a profit.
- Increases the company’s debt burden, which may affect future borrowing.
Long term external source of finance: Business mortgages (advantages + disadvantages)
A long-term loan used to buy property or land, with the property serving as security for the loan.
Advantages:
- Allows businesses to buy property without paying the full amount upfront.
- Fixed or variable repayment plans help with budgeting.
Disadvantages:
- Interest increases the total repayment cost.
- The property can be repossessed if repayments are not made.
Long term external source of finance: Share/equity capital (advantages + disadvantages)
Money raised by a business through the sale of shares to investors, giving them ownership in the company.
Advantages:
- No need to repay the money or pay interest.
- Investors may bring additional expertise or connections to the business.
Disadvantages:
- Dilutes ownership and control of the business.
- Profits must be shared with shareholders as dividends.
Which ways do businesses use to sell shares to the public? (a public limited company)
- Obtain a listing on the Alternative Investment Market. Concerned w/ smaller companies that aim to raise limited amounts of additional capital.
- Apply for a full listing on the Stock exchange. Done in 2 ways:
- Public issue by prospectus - Advertises the company & its share sale price to the public. Is expensive.
- Rights issue of shares to existing shareholders - With rights issue, the ownership doesn’t change and the company raises capital cheaply. However, rights issue increases supply of shares to stock exchange.
Define collateral security
An asset which a business pledges to a lender and which must be sold off to pay a debt if the loan is not repaid.
Define rights issue
Existing shareholders are given the right to buy additional shares at a discounted price.
Long term external source of finance: Venture Capital (advantages + disadvantages)
Investment provided by firms or individuals to startups or small businesses with high growth potential, usually in exchange for equity.
Advantages:
- Provides significant funding for growth and expansion.
- Investors often provide valuable expertise and networking opportunities.
Disadvantages:
- Involves giving up a portion of ownership and control.
- Venture capitalists may expect a quick return on investment, adding pressure to grow quickly.
Advantages of loans vs share capital
LOANS
- No shares are sold so ownership of company doesn’t change and isn’t diluted by issue of additional shares.
- Loans will be repaid therefore there is no increase in liabilities for business.
- Interest changes are an expense of the business and are paid out before corporation tax is deducted. However: dividends from shares HAVE to be paid.
- The lvl of indebtedness of the company increases and this gives shareholders the chance of higher returns in future.
SHARE CAPITAL
- Never has to be repaid as its permanent capital.
- Dividends don’t have to be paid every year. Directors can decide to retain more earnings by reducing dividend payments.
- It lowers the indebtedness of the business, do debt finance becomes a lower proportion of long-term finance.
Which sources of finance do unincorporated businesses use?
- Bank overdrafts + bank loan
- Microfinance
- Crowd funding
- Credit from suppliers (trade payables)
- Loans from family and friends
- Owners’ investment
- Taking on partners w/ capital to invest.
Which sources of finance is likely to be unsuccessful in incorporated businesses and why?
- Unincorporated businesses cannot raise finance from sale of shares and likely to be unsuccessful in selling debentures as they are usually unknown firms.
- Lenders are reluctant to offer loans/overdrafts unless the owners give personal savings.
- Owners may have insufficient savings.
- Family & friends may lend finance. However: its difficult to charge interest and can insist upon repayment at any time.
- Government grants.
Define microfinance
Providing financial services for poor and low-income customers who do not have access to banking services.
Microfinance: Advantages & Disadvantages
Advantages:
- Helps small businesses and entrepreneurs start or expand.
- No need for collateral, making it accessible to more people.
Disadvantages:
- Interest rates can be high.
- Loan amounts are usually small, limiting business growth.
Define crowd funding
The use of small amounts of capital from a large number of individuals to finance a new business venture.
Crowdfunding: Advantages & Disadvantages
Advantages:
- Can raise funds without taking on debt.
- Creates public interest and support for the business. Can be used to promote the business effectively.
- Raise good sums of capital from a large no. of ppl.
Disadvantages:
- No guarantee that enough money will be raised.
- Requires strong marketing to attract investors.
- Must keep accurate records of the thousands of investors to pack back interest/capital/share of profits.
Define cash flow
The sum of cash payments to a business less the sum of cash payments from the business.
Define insolvent
When a business cannot meet its short-term debts.
Define cash flow forecast
An estimate of the future cash inflows and outflows of a business.
Why are cash-flow forecasts important to entrepreneurs for starting up a business?
- New business start-ups offered shorter credit to pay suppliers than larger, well established firms.
- Banks/lenders need to see evidence of a cash flow forecast before making finance available.
- Accurate planning is more significant for business start-ups.
Define cash inflow + examples
Cash payments into a business.
- Owner’s capital injection.
- Bank loan payments.
- Cash sales from customers.
- Trade receivables payments.
Define cash outflow + examples
Cash payments out of a business.
- Lease payment for premises.
- Annual rent payment.
- Electricity, gas, water and telephone bills.
- Wages.
Cost of materials & payments to suppliers.
Define net cash flow
Difference between cash inflows and cash outflows for the period.
Define opening cash balance
Cash held by the business at the start of the month.
Define closing cash balance
Cash held by the business at the end of the month, which becomes the next month’s opening balance.
Formula for closing balance
Opening cash balance + (cash inflows - cash outflows)
Benefits of cash flow forecasting
- They show negative closing cash flows, meaning that plans can be made to source additional finance (overdraft/injection of capital).
- They indicate periods of time when negative net cash flows are excessive. The business can reduce these by taking measures to improve cash flow.
- They are essential to all business plans. A business start-up will never gain finance unless investors/bankers have access to a cash flow forecast & the assumptions behind it.
Limitations of cash flow forecasting
- Mistakes can be made in preparing the revenue and cost forecasts/they may be drawn up by inexperienced entrepreneurs or staff.
- Unexpected cost increases lead to inaccuracies in forecasts.
- Incorrect assumptions can be made in estimating the sales of the business (poor market sale research?). This makes cash flow forecasts inaccurate.
What are causes of cash flow problems?
1- Lack of planning - Financial planning is needed to predict cash flow problems so managers can know how to overcome with a lot of time.
2- Poor credit control - If credit control is badly managed, trade receivables will not be chased for payment and bad debts will be identified.
3- Allowing customers too long to pay debts - trade credit is needed to be offered by businesses to remain competitive, a customer choosing trade credit can improve cash inflow (not too long tho!)
4- Expanding too rapidly - needed to pay for expansion/wages/material before it receives cash from more sales. Overtrading leads to cash flow shortages.
5- Unexpected events - Leads to (-) net cash flow. Could make cash flow forecast inaccurate.
Define credit control
Monitoring of debts to ensure that credit periods are not exceeded.
Define bad debt
Unpaid customer’s bills that are now very unlikely to be repaid.
Define overtrading
Expanding a business rapidly w/ obtaining all necessary finance, resulting in cash flow shortage.
How to improve net cash flow?
- Increase cash inflows.
- Reduce cash outflows.
What are the methods to increase cash inflows and their drawbacks?
- Overdraft
Drawbacks:
Interest rates are high & may be an arrangement fee.
Overdrafts can be withdrawn by the bank, which causes insolvency. - Short-term loan
Drawbacks:
Interest costs & loans have to be repaid by due date. - Sale of assets - cash receipts can be obtained from selling off redundant assets, which boosts cash inflow.
Drawbacks:
Selling assets quickly results in low prices.
The assets might be required at a later date for expansion/used as collateral for future loans. - Sale and leaseback - Assets can be sold but they have to be leased back to owner.
Drawbacks:
Leasing costs add to annual overheads.
Loss of potential profit if assets rise in price.
Assets could be used as collateral for future loans.
How to improve cash flow by managing trade receivables
- Not extending credit to customers or asking customers to pay more quickly.
Evaluation: Many customers expect credit, may go elsewhere if not offered. Makes business less competitive. - Selling claims on trade receivables to specialist financial institutions called debt factors - businesses will buy debts from other concerns who need cash.
Evaluation: Costly, debtors don’t pay 100% of value. - Offering a discount to customers who pay promptly.
Evaluation: Cash is paid quickly/discounts reduce profit margins.
How to improve cash flow by managing trade payables (reducing cash outflow)
- Purchasing more supplies on credit and not on cash.
Evaluation: Discounts from suppliers for quick cash payment stopped/won’t offer credit terms. - Extend the period of time taken to pay (easier for larger firms).
Evaluation: Slow payment by larger businesses is a burden for small businesses to supply them/Suppliers reluctant to supply products or good service if business is a late payer.
What are methods to reduce cash outflows and their drawbacks?
- Delay capital expenditure - not buying equipment/vehicles, cash not paid by suppliers.
Drawbacks:
Efficiency falls if inefficient equipment isn’t replaced.
Expansion becomes difficult. - Use leasing of capital equipment - leasing company owns the asset and no large cash outlay is required.
Drawbacks:
Asset not owned by the business.
Leasing charges include interest cost + add to annual overheads. - Cut overhead costs that do not affect output.
Drawbacks:
Future demand may be reduced by failing to promote products effectively.
Define break-even point
The level of output at which total costs equal total revenue, when neither profit or loss is made.
What are the uses of cost information?
- Calculation of profit/loss.
- Pricing decisions.
- Measuring performance.
- Setting budgets.
- Resource use.
Define cost centre
The section of a business, such as a department or a product, that incurs the costs.
Define direct costs
These costs can be clearly identified with each nit of production and can be allocated to a cost centre.
Define indirect costs (overheads)
Costs that cannot be identified with a unit of production or allocated accurately to a cost centre.
Define fixed costs
Costs that do not vary with the level of output in the short-run, for example, the rent of a factory or shop.
Define variable costs
Costs that vary with output. for example, the direct cost of materials used in making a washing machine or the electricity used to cook a fast-food meal.
Define total cost
Variable cost + fixed cost
What are problems in classifying costs?
- Labour costs are often variable & direct costs. They become fixed costs, however, when labour is unoccupied due to lack of orders. Becomes an overhead cost.
- Salaries of administration, selling, and non-productive employees are indirect costs. They do not vary w/ output and are fixed.
- Example: Electricity costs in a busy factory is directly allocated to each product made.
Examples of cost centres?
- In a manufacturing business: products, departments, factories, stages of production.
- In a hotel: restaurant, reception, bar, room letting and conference section.
- School: different subject departments.
Examples of profit centres?
- Each branch of chain of shop.
- Each department of a production store.
- In multi-product firm, each product is overall portfolio of the business.
Define profit centre
A section of a business to which both costs and revenues can be allocated, so profit can be calculated.
Benefits of using cost and profit centres?
- Managers & employees have targets to work towards.
- These targets can be used to compare with actual performance and help identify areas that are/aren’t performing well.
- Individual performances of divisions & their managers can be assessed and compared.
- Work can be monitored and decisions made about the future. For example: should profit centre be open or price of product to increase?
What are the main 4 groups of indirect costs (overheads)?
- Production overheads - factory rent & rates, depreciation of equipment/power.
- Selling & distribution overheads - including warehouse, packing and distribution costs, and salaries of sales employees.
- Administration overheads - office rent & rates, clerical and executive salaries.
- Finance overheads - interest rate on loans.
Define average cost
Total cost divided by the no. of units produced.
Define full costing
A method of costing in which all indirect and direct costs are allocated to the products, services or divisions of a business.
How to use the full-costing technique?
- Identify and add up all indirect costs.
- Calculate total overheads of the business for a given time period.
- Add total direct costs of making the product.
- Calculate average cost of producing each product by dividing total costs by output.
Advantages/uses of full costing
- More relevant for single-product businesses. No uncertainty abt share of overheads to be allocated to the product.
- All costs are allocated so no costs are left out of the calculation of total full cost or unit full cost.
- Full-costing is good for pricing decisions in single-product firms. If full unit cost is calculated, this is cost plus pricing.
- Full costing data can be compared from one time period to another to assess performance.
Limitations to full costing
- No attempt to allocate each overhead cost to cost centres or profit centres on basis of actual expenditure incurred.
- Inappropriate methods of overhead allocation can lead to inconsistencies between departments and products.
- Risky to use this cost method for making decisions. Figures may be misleading.
Define contribution costing
Costing method that allocates only direct costs to cost centres and profit centres, not overhead costs.
Define marginal cost
The additional cost of producing one more unit of output.
What are the dangers of special order decisions (where a customer offers a special order contract at a price below full unit cost, but leads to increased profits as overheads costs are being paid and extra contribution increases profit) - (linked to contribution costing)?
- Existing customers may realize lower prices are being offered to new customers and demand a similar price. Could lead to a loss.
- If high prices were key in establishing exclusivity in a brand, offering lower prices ruins the hard-won image.
- When there is no excess capacity, sales at a price based on contribution cost could reduce sales based on full cost price.
In which situations should contribution costing be used?
- Can be used in setting prices that cover direct costs of production.
- In decision-making over whether to close a cost/profit centre as they are made on the basis of contribution to indirect costs.
- Excess capacity can be effectively used if special orders/contracts make a positive contribution are accepted. Can be used in decision-making on special order decisions.
In which situations should contribution costing NOT be used?
- When making decisions abt business expansion or developing new products.
- Contribution costing doesn’t take into account how some products result in higher indirect costs than others. Not suitable for single-product firms, as they have to cover fixed costs w/ revenue from the single-product.
- May lead managers to choose to maintain production of goods bc of positive contribution, however a brand-new product can be launched that can make an even greater contribution.
- Qualitative factors should be considered.
Define break-even analysis
Uses cost and revenue data to determine the break-even point of production.
Define margin of safety
The amount by which the current output level exceeds the break-even level of output.
Define contribution cost per unit
The price of a product less the direct (variable) costs of producing it.
Benefits of break-even analysis
- Charts are easy to construct & interpret.
- Analysis provides useful guidelines to management on break-even points, safety margins and profit/loss lvls at dif rates of output.
- Comparisons can be made between different options by constructing new charts to show changed circumstances.
- Break-even analysis can be used to assist managers in important decision making (location decisions, whether to but new equipment & which project to invest in).
Limitations of break-even analysis
- Costs and revenues aren’t always linear. Some variable costs do not change directly with output.
- The revenue line may be influenced by price reductions needed to sell a higher level of output, could lead to 2 BE points.
- Not all costs can be classified into fixed/variable (esp semi-variable costs).
- BE chart makes no allowance for inventory lvls. Assumes all units produced are sold (usually unlikely).
- For new businesses, BE charts are based on forecasts (inaccurate).
Define budgeting
Planning future activities by establishing performance targets, especially financial ones.
What happens if a business doesn’t do financial planning?
- No direction/purpose.
- Unable to allocate scarce resources effectively.
- Have demotivated employees with no plans/targets to work towards.
- Unable to measure its progress by measuring the plans against performance.
Benefits of using budgets
- Planning - Budgeting process needs to be considered by managers carefully so realistic targets are set.
- Allocating resources - Effective way of making sure the business doesn’t have to spend more than it has to.
- Setting targets - This motivation can increase if the budget holder/profit centre manager delegated accountability of reaching budget lvls.
- Coordination
- Controlling & monitoring a business - Checks should be undertaken to regularly control/monitor performance of budget holder & department.
- Measuring & assessing performance - As budget period ends, variance analysis is used to compare actual performance w/ original budgets.
Define budget holder
The individual responsible for the initial setting and achievement of a budget.
Define variance analysis
Calculation of the differences between budgets and actual figures, and analysis of the reasons for such differences.
Limitations/drawbacks of using budgets
- Lack of flexibility - Unexpected changes in the external environment makes them unrealistic. This demotivates the budget holder & other employees.
- Focus on the short-term - (for next 12 months): short-term decisions are taken which isn’t in the long-term interest of the business.
- Unnecessary spending - If managers underspent their budgets before the end of budgeting period, they may spend unnecessarily so the same level of budget can be justified next year.
- Training on budgets.
- Budgets for new projects - difficult & inaccurate esp if not undertaken before.
Key features of effective budgeting
- A budget isn’t a forecast but a plan to fulfil.
- May be established for any part of an organization as long as outcome of operation is measurable.
- Coordination between departments when establishing budgets.
- Budget setting should involve participation. Decisions abt them should be made with managers who are responsible for meeting targets and those fulfilling a budget are involved in setting it. This sense of ownership helps to motivate the department to reach targets (known as delegated budgets).
- Budgets are used to review performance of each manager controlling cost/profit centre. (Managers successful/unsuccessful, appraised, etc).
Define delegated budgets
Budgets which junior managers have been given some authority for setting and achieving.
Define incremental budgeting
Uses last year’s budget as a basis, and an adjustment is made for the coming year.
Define zero budgeting
Sets budgets to zero each year and budget holders have to argue their case for target levels and to receive finance.
Benefits/disadvantages of zero budgeting?
Advantages:
- Adds incentive to managers to defend the work of their own section.
- Changing situations can be reflected in dif budget levels every year.
Disadvantages:
- Time-consuming due to review of work & importance of each budget-holding section needed each year.
Define flexible budgeting
Cost budgets for each expense are allowed to vary if sales or output vary from budgeted levels.
Define favorable variance
A change from the budget that leads to higher than planned profit.
Define adverse variance
A change from the budget that leads to lower than planned profit.
Benefits of flexible budgets
- More motivating for budget-holding managers as they won’t be criticized for adverse variances.
- Flexible targets are more realistic.
- Flexible budgets make it easier to produce valid & accurate variance analyses as they indicate changes in efficiency, not output.
What is a variance analysis and why is it important to calculate/analyze reasons for the variance?
- Variance is the difference between a budget and the actual figures achieved at the end of the budget period.
It is important to calculate these because:
- Variances measure differences from planned performance of each department over a given period.
- Can help set more realistic budgets in the future.
- Helps the business take better decisions.
- The performance of each individual cost/profit centre may be appraised in an accurate/objective way.
What are possible causes of adverse variances?
- Revenue is below budget bc either fewer units were sold/SP had to be lowered due to competition.
- Raw materials costs are higher than planned bc either output was higher than budgeted or cost per unit of materials increased.
- Labour costs are above budget because wage rates raised due to shortages of workers or labour time taken to complete work took longer than expected.
- Overhead costs are higher than budgeted.
What are possible causes of favorable variances?
- Revenue is above budget due to higher economic growth/competitor closing down.
- Raw material costs are are lower because either output was below budget or unit cost of materials was below budget.
- Labour costs are below budget because of either lower wage rates or quicker completion of work.
- Overhead costs are lower than budgeted.
What are benefits of regular variance analysis?
- Identifying potential problems early so that remedial action can be taken.
- Allowing managers to concentrate their time & efforts on major problem areas, known as management by exception.
