Business Finance

Why does a business require finance?

• To buy machinery, capital equipment while set-up of the business. It is called start-up capital

• To fund its day-to-day expenditure. It is called working capital

• While business expansion 

• Needed to merge/acquire other businesses

• Unforeseen expenses and difficulties 

• Fund research and development

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Capital expenditure 

• Long term spending (more than one year) like purchase of assets 

Revenue expenditure 

• Short term, day-to-day expenditure like wages, salaries, insurance

Working capital 

• It is the finance required to pay for day-to-day expenses

• It is the lifeblood of the business 

• Without sufficient working capital, a business will become illiquid (cannot repay its short-term debts) 

• Working capital = current assets - current liabilities 

How much working capital is required?

• Too high of working capital leads to opportunity cost of too much capital being tied up and can be used elsewhere 

• Working capital requirement of a business is determined by its working capital cycle 

• Longer the cycle, greater the amount required

Internal sources 

1. Profits retained in the business 

• The retained earnings of a business can be used as a source of finance to fund expansion, purchase of assets 

• These do not have to be repaid and are a permanent source of finance 

• But they may not be enough and new businesses may not have this option

2. Sale of assets 

• Assets which are no longer needed/fully employed can be sold in order to get funds

• It will help raise permanent capital for the business

• They can be sold to a leasing company and leased back for business use. But, through this fixed cost will rise 

• Also, these assets could have been used as collateral or be used during future expansions

3. Reductions in working capital  

• Lowering the amount tied up in working capital may free up some money to be used elsewhere

• It will help reduce the opportunity cost of tying up money in current assets like inventories and trade receivables 

• But this may negatively affect the company’s liquidity position, affecting stakeholders like potential investors, bankers, etc

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External sources 

Short term sources

1. Bank overdrafts 

• Most flexible 

• The bank allows the business to overdraw its account 

• High interest rates 

• Bank can ask the business to repay anytime 

2. Trade credit 

• The business can lower the credit period provided to trade receivables and ask for greater period from trade payable 

• Customers may switch to competitors if they provide greater credit period 

• Suppliers may not provide discounts 

3. Debt factoring 

• This involves selling of a company’s trade receivable claims to a debt factor for immediate money 

• Lowers risk for the business 

• Full amount is not given

Medium-term sources 

1. Hire purchase 

• It is a way of purchasing an asset for credit where money is paid in instalments over the time 

• It helps avoid large initial cash payment 

• Ownership of asset is obtained 

2. Leasing 

• It allows a business to obtain the use of an equipment by paying a fixed rental charge, instead of buying the asset 

• Leasing company is responsible for maintenance and repairs 

• No ownership is gained, can’t be used as collateral during bank loans 

3. Medium-term bank loan

Long term sources 

1. Long-term bank loans 

• Maybe given for fixed/varying interest rates 

• Fixed provide greater certainty but maybe more expensive

• Companies will have to provide collateral/security to obtain the loan 

• They require a business plan and cash flow forecast 

2. Debentures 

• A company can issue bonds to potential investors and pay a fixed rate of interest for the life of the bond

• No collateral security is required

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Sale of shares – equity finance

• Limited companies issue shares when first formed and use it to purchase necessary assets

• They can sell shares anytime required up to a limit of their authorised capital

• It is a method of permanent finance

• Way to sell shares:

  • Public issue by prospectus: company advertises its share sale and invites interested people to apply for them. It is very expensive

  • Arranging a placing of shares with institutional investors without the expense of a full public issue: this is done by the means of a rights issue. The short-term share price falls which reduce shareholders confidence

Debt or equity capital – evaluation 

• Debt finance benefits:

  • Ownership is not diluted 

  • No permanent increase in liabilities as the loans will be repaid 

  • Lenders have no voting rights 

  • Interest is paid before corporation tax 

• Equity benefits:

  • Never needs to be repaid 

  • Dividends must be paid whenever the business has enough profits

Other sources of long-term finance 

1. Grants 

• Grants may be given with certain conditions up on number of jobs, location, etc 

• They do not need to be repaid 

2. Venture capital

• It is the risk capital invested by wealthy individuals in business start-ups which have good profit potential but can’t find other sources of finance 

• Venture capitalists provide advice for the business owners 

• But they may expect a part of ownership in the business

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Finance for unincorporated businesses 

• Unincorporated = sole trade & partnership 

• Can not raise finance from the sale of shares 

• Unsuccessful in raising finance through sale of debentures 

• Sources of finance –

  • Overdrafts

  • Loans 

  • Credit from suppliers 

  • Borrow from friends and family 

  • Own savings 

  • Grants 

  • Crowdfunding 

  • Microfinance

Microfinance 

• Involves selling financial services to poor, low-income customers or small businesses who do not get finance from banks 

• High interest rates 

Crowd-funding 

• Crowdfunding websites allow entrepreneurs to promote their business and encourage individuals to each invest a small amount 

• Effective form of promotion 

• Investors may expect a return on investment 

• Investors, when the business is successful will receive: initial capital plus interest, equity stake in the business

• Must keep accurate records of thousands of investors 

• Increased risks of idea being copied

Importance of business plan 

• Business plan is a detailed document giving information about a business to convince external stakeholders to lend money to the business 

• Helps gain loans and credit facilities 

• Helps lower risks

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Financial Stakeholders

Costs

Uses of cost information

• Helps calculate accurate profit and losses, calculate profitability, liquidity 

• Helps make informed pricing decisions – marketing department 

• Allows comparisons to be made, identify cost cutting techniques and implement required strategies 

• Help set future budgets 

• Managers can make decisions about resource allocation 

• Help in decision making

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Classification of costs 

1. Direct costs – costs which can directly be identified with one unit of output. Ex. raw materials

2. Indirect costs – costs which can not be directly identified with one unit of output. Ex. rent

3. Fixed costs – costs which do not change with output in the short run. Ex. rent, insurance 

4. Variable costs – costs which vary directly with the output. Ex. raw materials, wages 

5. Marginal costs – cost of producing one extra unit of output

Break even analysis 

• Break even point is where neither profit nor loss is made. Total revenue = total costs 

• Below the break even point, a business makes losses and above the break even point the business makes profits 

Margin of safety 

• The amount by which current sales level exceeds the break-even point 

• Indicates how much sales could fall without the firm going into losses 

Break even equation 

• Break-even level of output = fixed cost/contribution per unit 

• Contribution per unit = selling price – variable cost per unit 

Break even analysis – uses 

• Easy to construct and interpret 

• Managers can redraw the graph to see effect of changes in costs and prices on profits and break-even points 

• Helps in decision making 

• Gives information relating the margin of safety 

Break even analysis – evaluation 

• Assumption that costs and revenue is represented by straight lines is unrealistic 

• Not all costs can be classified between fixed & variable 

• No allowance for inventory levels 

• Unlikely that fixed costs remain unchanged throughout

Accounting Fundamentals

Accounting concepts and conventions

1. Double-entry principle

   1. Every transaction has 2 effects – debit and credit

2. Accruals

   1. All prepayments and overdues must be recorded in the books of accounts

3. Money-measurement principle

   1. Only items with a monetary value should be recorded

4. Conservatism – prudence concept

   1. Accountants should provide for all losses but never anticipate a gain

5. Realisation concept

   1. Revenue and profits should only be recorded when the legal title of the goods is transferred.

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Income statement 

• A record of the company’s profits, revenue and expenses over a given time period 

• Trading account – shows gross profit and cost of sales 

• Profit and loss account – shows overall profit and overhead expenses 

• Appropriation account – shows dividends and retained earnings 

Uses of income statement 

• Measure and compare the performance with competitors or over time 

• Actual profit can be compared with estimated profit 

• Banks & creditors need the information to decide whether or not to lend the business 

• Prospective investors assess the level of risk and earnings on investment 

• Low quality & high-quality profit is identified

Statement of financial position 

• Records a business’s assets, liabilities and capital at a certain point of time 

• Sources of shareholder’s equity:

• Selling of shares – share capital 

• Retained earnings of a company

Non-current assets 

• Assets kept for long term use

• Ex. land, machinery

• Intangible assets – goodwill, copyrights, patents

Current assets 

• Short term assets which can easily be turned into cash 

• Ex. trade receivables, cash, bank balance, inventory 

Current liabilities 

• Short term debts 

• Ex. overdrafts, trade payables 

Working capital

• Current assets – current liabilities 

Shareholder’s equity 

• Share capital + retained earnings 

Non-current liabilities 

• Long term debts 

• Ex. loans, debentures, bonds

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Other published accounts 

1. Cash-flow statement – 

   1. Focuses on the cash available in the business

   2. Includes a company’s cash inflows and outflows over the year 

2. Chairman’s statement –

   1. General report about the company’s major achievements and future plans 

3. Chief executive’s report –

   1. More detailed analysis of the previous year

4. Auditor’s report 

5. Notes to accounts

Profitability ratios

1. Gross profit margin – compares gross profit with revenue. How successful the company is in maintaining its cost of sales

Gross profit margin = gross profit/revenue * 100

1. Operating profit margin – compares operating profit with revenue. How successful is the company in maintaining its overhead costs?

Operating profit margin = operating profit/revenue * 100

Liquidity ratios 

1. Current ratio 

• Current assets/current liabilities 

• Safe ratio between 1.5-2

• Depends on the industry 

2. Acid test ratio/quick ratio 

• Current assets – inventory/current liabilities

• Safe ratio between 1-1.5 

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Limitations of ratio analysis 

• Incomplete analysis 

• Limited use on its own. Must be compared with other business or over time 

• Some may be window dressed 

• Ignored qualitative information 

• Only provides the problem, doesn’t suggest solution

Users of accounting information 

1. Managers 

• Measure business performance

• Compare against targets, previous time periods and competitors

• Assist in decision making 

• Control and monitor the operation of each department

• To set targets or budgets for the future and review these against actual performance.

2. Banks:

• To decide whether to lend money to the business

• To assess whether to allow an increase in overdraft facilities

3. Creditors, such as suppliers:

• To see if the business is secure and liquid enough to pay off its debts

• To assess whether the business is a good credit risk

• To decide whether to press for early repayment of debts.

4. Customers:

• To assess whether the business is secure

• To determine whether they will be assured of future supplies

• To establish whether there will be security of spare parts

• and service facilities.

5. Government and tax authorities:

• To calculate how much tax is due from the business

• To determine whether the business is likely to expand and create more jobs and be of increasing importance to the country’s economy

• To assess whether the business is in danger of closing down,

• creating economic problems

• To confirm that the business is staying within the law in terms of accounting regulations.

6. Investors, such as shareholders in the company:

• To assess the value of the business and their investment in it

• To determine what share of the profit’s investors are receiving

• To decide whether the business has potential for growth

• If they are potential investors, to compare these details with those from other businesses before making a decision to buy shares in a company

• If they are actual investors, to decide whether to consider selling all or part of their holding.

7. Workforce:

• To assess whether the business is secure enough to pay wages and salaries

• To determine whether the business is likely to expand or be reduced in size

• To determine whether jobs are secure

• To find out whether, if profits are rising, a wage increase can be afforded

8. Local community:

• To see if the business is profitable and likely to expand, which could be good for the local economy

• To determine whether the business is making losses and whether this could lead to closure.

Limitations of published accounts 

• Future plans 

• Performance of each department/division 

• Company’s effect on the environment 

• Research & development plans 

Accuracy of published accounts 

• Window dressed accounts 

• Done to influence stakeholders to lend money/invest

Forecasting and Managing Cash Flows

Cash flow 

• It is the difference between a company’s cash inflows and cash outflows 

• Without sufficient cash flow, a business can become insolvent and force the business into liquidation 

• Cash flow forecast is the estimate of a firm’s cash inflows and outflows 

• Net monthly cash flow is the estimated difference between inflows and outflows 

• Opening cash balance is the amount a business has at the beginning of each month

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Need for cash flow planning for entrepreneurs

• New businesses have less credit time 

• Banks may not be willing to lend 

• Limited finance at the beginning 

Cash VS Profit 

• A profitable business may fail due to insufficient cash 

• Having enough cash – short term goal 

• Good profits – long term goal

Cash inflows

1. Owners capital 

2. Bank loans 

3. Customer cash purchase 

4. Trade receivables payments 

Cash outflows

1. Annual rent 

2. Lease payment 

3. Electricity, water bills 

4. Labour costs 

5. Variable costs 

Cash flow forecasts – limitations 

• Inaccurate figures if inexperienced 

• Unexpected costs may arise 

• Wrong assumptions as a result of poor market research

Causes of cash flow problems 

1. Lack of planning – cash flow forecasts help us plan for the future in terms of the amount of cash needed. Without planning a business may have insufficient cash reserves.

2. Poor credit control – inefficient management of trade receivables. A business must keep reminding its credit customers about the amount they owe, if not they may become bad debts.

3. Allowing customers too long to pay debts – the business may offer too long credit periods when compared to what it receives from suppliers 

4. Expanding too rapidly – overtrading will increase cash outflows causing cash flow shortage

5. Unexpected events – only estimates, not 100% accurate. There maybe unforeseen rise in outflows or fall in inflows

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Ways to improve cash flow

1. Increase cash inflow

Management of trade receivables

• Not providing credit to customers. May lead to fall in competitiveness and loss of sales 

• Selling claims to a debt factor. May not receive full payment 

• Identify credit worthiness of customers 

• Offer discounts for prompt payments 

Management of trade payables 

• Increasing the range of goods bought on credit. Suppliers may not provide discount or may refuse to provide further supplies

• Extend the period of time taken to pay. Suppliers may be reluctant to supply 

Management of inventory 

• Maintain small inventory levels 

• Using computer systems to record inventory 

• JIT inventory system

Cash management 

• Use cash flow forecast 

• Plan for future and range external finance when needed 

Working capital increase – permanent

• Long term loans

• Issue of shares