Unit 5: Financial information and decisions

Question 1

Why do businesses need finance?

Answer 1

• To set up the business (working capital).
• To pay the day to day expenses of the business such as wages, suppliers of raw materials and fuel expenses (working capital).
• To finance expansion of the business.
• To purchase buildings and other non-current fixed assets.

Question 2

Define start-up capital

Answer 2

The capital needed by an entrepreneur when first starting up a business.

Question 3

Define working capital

Answer 3

The capital needed to finance the day to day expenses and to pay short term debts of a business.

Question 4

Define non-current fixed assets

Answer 4

Resources owned by a business which will be used for a period longer than one year, example: buildings, machinery.

Question 5

Define capital expenditure

Answer 5

Spending by a business on non-current assets such as machinery or buildings.

Question 6

Define long-term finance

Answer 6

Debt or equity used to finance the purchase of non-current fixed assets or finance expansion plans, not expected to pay back in less than 5 years.

Question 7

Define short-term finance

Answer 7

Loans or debts that a business is expected to pay back within one year.

Question 8

Internal source of finance: Retained profits, definition, advantages, disadvantages

Answer 8

Profits remaining after all expense, taxes and dividends have been paid and which have been ploughed back into the business.

Advantages:
- It provides an interest free source of funds.
- Can fund capital expenditure projects.

Disadvantages:
- Not always available.
- Owners may receive lower dividends if too much gets re-invested.

Question 9

Internal source of finance: Owner’s savings, advantages and disadvantages

Answer 9

Advantages:
Quick, interest free source of funds.

Disadvantages:
- Greater financial risk for owners.
- Business owners may need to pay from their personal expenses.

Question 10

Internal source of finance: Sale of non-current fixed assets, definition, advantages and disadvantages

Answer 10

The sale of land or buildings to a new owner, where the new owner can rent back the property to the old owner.

Advantages:
- Raises a large amount of money.
- No cost to business.

Disadvantages:
- Firm loses possession of asset.
- Takes time to sell non-current asset.

Question 11

Internal source of finance: Working capital, definition, advantages, disadvantages

Answer 11

It’s the money available for immediate use in the business, includes reducing inventory levels, cash balances and reducing trade receivables.

Advantages:
- Efficient management of cash reflects good business practice.

Disadvantages:
- Business may not be able to free up cash from working capital.
- Firm may not be able to reduce inventory levels as its needed to meet consumer demand.

Question 12

Overdraft, definition, advantages, disadvantages

Answer 12

An agreement with the bank which allows a business to spend more money than it has on its bank account up to an agreed limit.

Advantages:
- Quick, flexible source of finance because businesses are able to change amount of borrowing at short notice.

Disadvantages:
- Very high rates; needs to be paid very fast.

Question 13

Trade credit, definition, advantages, disadvantages

Answer 13

Where businesses buy most of their resources (raw materials and components) on credit.

Advantages:
- Can negotiate terms of borrowing with supplier and delay payment if needed to.

Disadvantages:
- Supplier may refuse deliveries to the business until payment has been made.
- Supplier could demand payment.

Question 14

Debt factoring, definition, advantages, disadvantages

Answer 14

Selling trade receivables to improve business liquidity. A debt factoring company buys debt from another company on a discount, and makes profit from the original payment.

Advantages:
- A lender can receive funds sooner that it had expected to receive.

Disadvantages:
- Can be costly. The original lender can lose a lot by selling their debt on a discount.

Question 15

Define trade receivables

Answer 15

Amount owed to a business by its customers who bought goods on credit.

Question 16

Bank loan, definition, advantages, disadvantages

Answer 16

Provision of finance by a bank which the business will repay with interest over an agreed date.

Advantage:
- If interest rate is fixed, then business is certain about repayments.

Disadvantages:
Small firms may struggle getting a loan than larger firms (they are seen as a greater risk with banks).

Question 17

Leasing, definition, advantages, disadvantages

Answer 17

Where machinery is lent as an asset, In return business pays fixed amount.

Advantage:
- Fixed amount of payment for use of the item.

Disadvantage:
Business never owns the item - returns it after period passes.

Question 18

Hire purchase, definition, advantage, disadvantage

Answer 18

Machinery is lent as an asset. In return business pays a fixed amount and owns the item after period.

Advantage:
- The asset is owned by the business during the period.

Disadvantage:
- The business is paying for use of an asset they don’t yet own.

Question 19

Define equity financing

Answer 19

Permanent finance provided by the owners of a limited company.

Question 20

Benefits and limitations of equity financing

Answer 20

Benefits:
- It never has to be repaid and there is no ongoing cost. If business makes a loss, it doesn’t have to pay dividends to shareholders.

Limitations:
- The increase in shareholders ‘dilutes’ the ownership of the company.

Question 21

Benefits and limitations of debt financing

Answer 21

Benefits:
- Does not change the ownership of the company. Lenders have no say of the running of the business.

Limitations:
- Interest is charged on the amount borrowed and this increases business costs. Interest must be paid if business makes a loss.

Question 22

Define micro-financing

Answer 22

Small amounts of capital loaned to entrepreneurs in countries where business finance is often difficult to obtain. These loans are obtained after a short period of time.

Question 23

Define crowd-funding

Answer 23

Financing a business idea by obtaining small amounts of capital from a large number of people, mostly using the internet and other social media networks.

Question 23

Define capital expenditure

Answer 23

Money spent on fixed assets such as buildings or machinery which last for over a year.

Question 24

Define revenue expenditure

Answer 24

Money spent on day to day expenses; for example wages or rent.

Question 25

Define cash

Answer 25

A liquid asset immediately available for the business to use and spend.

Question 26

Problems if business has too little cash

Answer 26

• Cannot pay employees and suppliers.
• Production of goods stop.
• Cannot pay short term debts such as lighting, heating and other premises.

Question 27

Define cash flow

Answer 27

Money going into and out of a business over a period of time.

Question 28

Examples of cash inflow

Answer 28

• Sales from products and services.
• Money received from bank loans and sale of assets.
• Capital raised from selling shares.

Question 29

Examples of cash outflow

Answer 29

• Purchase of non-current fixed assets such as buildings/machinery.
• Purchasing of stocks/inventory.
• Employee wages and salaries.

Question 30

Define cash flow forecast

Answer 30

An estimate of the future cash inflows and outflows of a business and shows expected balance at the end of each month.

Question 31

Define net cash flow

Answer 31

Cash inflow - cash outflow

Question 32

What is closing balance

Answer 32

The expected amount of cash a business is expected to have at the end of each month.
If negative, there is cash shortage.

Closing balance = net cash flow + opening balance

Question 33

How to finance a short term cash shortage

Answer 33

• Asking for trade receivables to pay for goods more quickly by giving discounts to consumers.
• Delay purchase of non-current fixed assets.
• Negotiating longer credit terms with suppliers.
• Secure a bank overdraft.
• Secure a bank loan.
• Find other sources of finance for the sale of non-current fixed assets.

Question 34

Define liquidity

Answer 34

The ability of a business to pay its short term debts.

Question 35

Define credit sales

Answer 35

Goods sold to customers who will pay for it at a later date.

Question 36

How can a business improve its working capital

Answer 36

• Negotiating longer credit terms with suppliers.
• Reducing inventory levels.
• Reducing trade receivables (the amount of time taken to receive goods on credit from customers who have been supplied goods on credit term).

Question 37

Why do businesses need sufficient working capital

Answer 37

• Pay employees wages and salaries.
• Ensure they have enough cash for daily operations.
• Pay debts.
• To figure out if it is in a good financial position to purchase supplies that are on sale.

Question 38

Define profit, and explain how it is made

Answer 38

The difference between revenue and total costs.
P = TR - TC
OR
Profit = Gross profit - expenses
A business earns a profit by selling its products to customers which is higher than the total cost of making it.

Question 39

Define gross profit

Answer 39

The difference between revenue and cost of sales.

Gross Profit = Revenue - Cost of sales

Question 40

Define total costs

Answer 40

Cost of sales + expenses

Question 41

Define revenue

Answer 41

The amount a business earns from the sale of its products.

Revenue = selling price x quantity sold

Question 42

Why is profit important to private sector businesses

Answer 42

• Measures success of business.
• Measure the performance of managers.
• Finance purchases of non-current fixed assets, expand the business, etc.

Question 43

Define income statements

Answer 43

A financial statement which records the revenue, costs and profit of a business for a period of time (1 year).

Question 44

Define statement of financial position

Answer 44

An accounting statement which records the assets, liabilities and owner’s equity at a particular date.

Question 45

Define assets

Answer 45

The resources owned by a business.

Question 46

Define liabilities

Answer 46

Debts of the business that will have to be paid sometime in the future.

Question 47

Define non-current (fixed) assets

Answer 47

Resources that a business owns and expects to use for more than 1 year, example land, buildings, machinery.

Question 48

Define current assets

Answer 48

Resources that a business owns and expects to convert into cash before the date of the next financial position.

Question 49

Define current liabilities

Answer 49

Debts of the business which it expects to pay within the next date of financial position.

Question 50

Define trade receivables

Answer 50

The amount of money owed to a business by customers who have been sold goods on credit.

Question 51

Define trade payables

Answer 51

The amount of money a business owes to suppliers for goods bought on credit.

Question 52

Define non-current liabilities

Answer 52

Debts of the business which will be payable after more than 1 year.

Question 53

Define owners equity

Answer 53

The amount owed by a business to its owners; includes capital and retained profits.

Question 54

What is gross profit margin % and how can a business increase it

Answer 54

Ratio between gross profit and revenue.
= gross profit/sales revenue x 100

Businesses can improve gross profits by:
- Increasing revenue by increasing the price.
- Reducing cost of sales without decrease in revenue by buying cheaper supplies.

Question 55

What is profit margin %

Answer 55

Ratio between profit before tax and revenue (profit as a percentage of revenue).

= profit/revenue x 100

To improve profit margin:
- Reduce expenses.
- Increase gross profit margin.

Question 56

What is return on capital employed (ROCE)

Answer 56

Ratio between profit before tax and capital employed. It tells us how much profit is earned for every $1 invested in the business.

ROCE = Profit/capital employed x 100

Question 57

Define liquidity

Answer 57

The ability of a business to pay its short term debts, if it doesn’t have the necessary working capital to do so, it will go illiquid (forced to pay off its debts by selling assets).

Question 58

What is current ratio

Answer 58

Ratio between current assets and current liabilities. The higher the current assets than current liabilities the better. If not, business risks liquidity problems.

Current ratio = current assets / current liabilities.

Question 59

What is acid test ratio

Answer 59

Ratio between liquid assets and liquid liabilities.
It is more precise and accurate than current ratio (better measure of liquidity) as it excludes inventories from current assets.

Acid test ratio = current assets - inventories / current liabilities.

Question 60

Benefits and limitations of ratio analysis

Answer 60

Benefits:
- Users can compare ratios and identify trends.
- Users can compare results with similar businesses to see how well a business is doing against competitors.

Limitations:
- Ratios compare past data. Stakeholders are more interested in future.
- Financial statements do not include all strengths and weaknesses of a business, such as the quality and skills of employees. These factors affect business performance and may lower business liquidity.