Financial Information and decisions
Business finance: needs and sources
The finance department
The finance department in a business has several different responsibilities. These include the recording and preparation of financial transactions, to produce accounting information and forecast cash flows, and to make financial decisions.
The finance department in a business has several different responsibilities. These include the recording and preparation of financial transactions, to produce accounting information and forecast cash flows, and to make financial decisions.
The need for finance
Businesses need finance to start the business, expand the business, increase working capital, and to pay for wages, materials and assets. Finance is often called capital.
Businesses need finance to start the business, expand the business, increase working capital, and to pay for wages, materials and assets. Finance is often called capital.
Startup capital
The initial investment of capital in a business is called start-up capital. Start-up capital is the finance needed by a new business to pay for essential fixed and current assets before it can begin trading. Fixed assets can include buildings, machinery, land and equipment. Owners also need to obtain inventory that can be sold.
The initial investment of capital in a business is called start-up capital. Start-up capital is the finance needed by a new business to pay for essential fixed and current assets before it can begin trading. Fixed assets can include buildings, machinery, land and equipment. Owners also need to obtain inventory that can be sold.
Expanding a business
Successful businesses can be expanded to increase profit. They can be expanded by the purchase of more fixed assets, the development of new products, or buying out another business.
Successful businesses can be expanded to increase profit. They can be expanded by the purchase of more fixed assets, the development of new products, or buying out another business.
Working capital
Working capital is the finance needed by a business to pay its day-to-day costs, for example, wages, raw materials and electricity. Additional working capital is needed to pay for capital expenditure or revenue expenditure.
Working capital is the finance needed by a business to pay its day-to-day costs, for example, wages, raw materials and electricity. Additional working capital is needed to pay for capital expenditure or revenue expenditure.
Capital expenditure
This is the money spent on fixed assets. |
Revenue expenditure
This is the money spent on day-to-day expenses |
Short-term finance
This type of finance includes any source of finance with a maturity of one year or less. Some sources of finance that fit into this category include factoring of debts, and sometimes bank loans.
This type of finance includes any source of finance with a maturity of one year or less. Some sources of finance that fit into this category include factoring of debts, and sometimes bank loans.
Long-term finance
The type of finance includes any source of finance with a maturity of at least one year. Some sources of finance that fit into this category include selling debentures, and sometimes bank loans.
The type of finance includes any source of finance with a maturity of at least one year. Some sources of finance that fit into this category include selling debentures, and sometimes bank loans.
Internal sources of finance
Retained profit
The profit kept in the business after the owners and shareholders have taken their share of the profits. This does not have to be repaid and no interest has to be paid. However, new businesses do not have retained profits and small business' retained profits may be too small to finance expansion. Additionally, retained profit as a main source of finance may reduce payment to shareholders and owners.
The profit kept in the business after the owners and shareholders have taken their share of the profits. This does not have to be repaid and no interest has to be paid. However, new businesses do not have retained profits and small business' retained profits may be too small to finance expansion. Additionally, retained profit as a main source of finance may reduce payment to shareholders and owners.
Sale of existing assets
Existing assets that are redundant or surplus can be sold for money. They better use the capital in the business and do not increase debts. However, it may take some time for a business to sell assets and brand new businesses do not have surplus assets to sell.
Existing assets that are redundant or surplus can be sold for money. They better use the capital in the business and do not increase debts. However, it may take some time for a business to sell assets and brand new businesses do not have surplus assets to sell.
Sale of inventories
Inventories can be sold in order to reduce inventory levels. This way, opportunity cost is reduced and inventory storage costs are reduced. However, customers may be disappointed as there may not be enough goods available to sell.
Inventories can be sold in order to reduce inventory levels. This way, opportunity cost is reduced and inventory storage costs are reduced. However, customers may be disappointed as there may not be enough goods available to sell.
Owner's savings
A sole trader or partnership member can put their own savings into the business. This source of finance is available to the firm quickly and no interest has to be paid. However, the owner's savings may be too low to be of any use, and it increases the risk taken by owners.
A sole trader or partnership member can put their own savings into the business. This source of finance is available to the firm quickly and no interest has to be paid. However, the owner's savings may be too low to be of any use, and it increases the risk taken by owners.
External sources of finance
Issue of shares
Shares can be issued by limited companies. This source of finance does not have to be repaid to shareholders, and no interest has to be repaid. However, shareholders may expect dividends and dividends must be paid after tax. Additionally, there may be many shareholders who expect payment from the business
Shares can be issued by limited companies. This source of finance does not have to be repaid to shareholders, and no interest has to be repaid. However, shareholders may expect dividends and dividends must be paid after tax. Additionally, there may be many shareholders who expect payment from the business
Bank loans
Money can be borrowed from banks. This is quick to arrange, the repayment period may vary and low interest is offered for large sums of money borrowed. However, the bank loan will have to be repaid with interest, and the bank may ask for something else if the firm fails to repay the loan.
Money can be borrowed from banks. This is quick to arrange, the repayment period may vary and low interest is offered for large sums of money borrowed. However, the bank loan will have to be repaid with interest, and the bank may ask for something else if the firm fails to repay the loan.
Selling debentures
Long-term loan certificates issued by limited companies. Debentures can raise very long-term finance, for example, periods up to 25 years. However, the original loan must be repaid with interest.
Long-term loan certificates issued by limited companies. Debentures can raise very long-term finance, for example, periods up to 25 years. However, the original loan must be repaid with interest.
Factoring of debts
Specialist agencies buy business debts - this gives the business immediate cash. The agency may give the business 90% of the debt value and keep 10%. This provides an immediate injection of cash for the business and the risk of the debt transfers from the business to the agency. However, the firm does not get 100% of the value of its debts.
Specialist agencies buy business debts - this gives the business immediate cash. The agency may give the business 90% of the debt value and keep 10%. This provides an immediate injection of cash for the business and the risk of the debt transfers from the business to the agency. However, the firm does not get 100% of the value of its debts.
Grants and subsidies
Outside agencies may lend the business money, for example, the government. These do not have to be repaid, but they are given with 'strings attached', for example, the government may demand that the firm locate in a particular area.
Outside agencies may lend the business money, for example, the government. These do not have to be repaid, but they are given with 'strings attached', for example, the government may demand that the firm locate in a particular area.
Cash flow forecasting
What is cash flow?
Cash flow is the movement of money in and out of a business. A cash flow forecast shows the opening balance at the start of each month and the closing balance at the end. Cash flow forecasts are normally produced monthly by the finance department but they can be in any time frame. The closing balance for the previous month will be the opening balance for the next month.
Cash flow is the movement of money in and out of a business. A cash flow forecast shows the opening balance at the start of each month and the closing balance at the end. Cash flow forecasts are normally produced monthly by the finance department but they can be in any time frame. The closing balance for the previous month will be the opening balance for the next month.
Cash flow forecasts
|
Cash flow solutions (short-term)
- bank loans will provide a business with cash, but loans have to be repaid with interest
- delaying payments to suppliers will decrease cash outflows in the short term, but suppliers could get angry and refuse to supply or reduce discounts for late payments
- asking debtors to pay more quickly will increase cash inflows in the short term, but customers may change to another business that offers them more time to pay
- delaying or canceling the purchase of capital equipment will decrease cash outflows in the short term, but the long-term efficiency of the business could decrease without up-to-date equipment
Cash flow solutions (long-term)
- attracting new investors will provide a business with more cash, but may affect the ownership of the business
- cutting costs may increase efficiency, but it may negatively impact product quality
- developing new products may attract more customers, but this could take a long time and requires investment
Working capital
The term working capital refers to the amount of capital which is available to a business. Working capital is the difference between liquid assets and the short-term debts of the business. Working capital can be calculated using this equation:
The term working capital refers to the amount of capital which is available to a business. Working capital is the difference between liquid assets and the short-term debts of the business. Working capital can be calculated using this equation:
- working capital = current assets - current liabilities
Income statements
What is profit?
Profit is the extra money made by the business when a product is sold for a higher price than it took to make it. Profit is very important to all businesses as it can be seen as a reward for risk taking/entrepreneurship as well as a source of finance. Profit is the main source of finance in most companies in the private sector.
Profit is the extra money made by the business when a product is sold for a higher price than it took to make it. Profit is very important to all businesses as it can be seen as a reward for risk taking/entrepreneurship as well as a source of finance. Profit is the main source of finance in most companies in the private sector.
Profit and cash flow
There is a clear difference between profit and cash flow. Although goods may have been sold, the business may only have received payment for 50% of them. Customers buying goods on credit will pay cash for them in later months.
There is a clear difference between profit and cash flow. Although goods may have been sold, the business may only have received payment for 50% of them. Customers buying goods on credit will pay cash for them in later months.
Income statements
Income statements indicate to managers, business owners and other account users whether the business has made a profit or loss over a period of time. This time period is usually one year but income statements could be constructed monthly too.
If a business is making a profit managers will want to ask themselves:
Income statements indicate to managers, business owners and other account users whether the business has made a profit or loss over a period of time. This time period is usually one year but income statements could be constructed monthly too.
If a business is making a profit managers will want to ask themselves:
- is it higher or lower than last year?
- if it's lower why is profit falling?
- is it higher or lower than other similar businesses?
- if it's lower what can we do to become as profitable as other businesses?
- is this a long or short term problem?
- are similar businesses also making losses?
- what decisions can we take to turn losses into profits?
Balance sheets
What is a balance sheet?
A balance sheet is a financial statement which shows the assets, liabilities and capital of a business a particular date (what it owns and what it owes).
A balance sheet is a financial statement which shows the assets, liabilities and capital of a business a particular date (what it owns and what it owes).
Why produce a balance sheet?
- It shows the owner what their investment has been used for and gives an idea of what the business is actually worth
- Shows financial health of a business
- It shows where the money has come from and what it has been spent on
Assets and liabilities
|
Analysis of accounts
Gross profit
The gross profit of a business is how much money it is making from selling things without subtracting the cost of making the things it is selling.
The gross profit of a business is how much money it is making from selling things without subtracting the cost of making the things it is selling.
- sales revenue - cost of goods sold
Net profit
The net profit of a business is how much money it is making from selling things after the cost of making the things it is selling is subtracted.
The net profit of a business is how much money it is making from selling things after the cost of making the things it is selling is subtracted.
- gross profit - fixed and variable expenses
Gross profit margin
This shows the percentage profit from sales which is available to pay for overheads. If the ratio is falling over time it could be due to a failure to pass on cost increases to customers or an attempt to increase market share by keeping prices down.
This shows the percentage profit from sales which is available to pay for overheads. If the ratio is falling over time it could be due to a failure to pass on cost increases to customers or an attempt to increase market share by keeping prices down.
- (gross profit ÷ sales revenue) x 100
Gross profit margin
a poem by Petra Fairweather
Sales revenue
minus
the cost of goods sold
equals the gross
Profit.
a poem by Petra Fairweather
Sales revenue
minus
the cost of goods sold
equals the gross
Profit.
Net profit margin
This shows the percentage profit from sales that is left over after all the business’ expenses have been paid. If the ratio is falling over time it could be due to a rise in the running costs of the business or a drop in the level of productivity or efficiency of the workforce.
This shows the percentage profit from sales that is left over after all the business’ expenses have been paid. If the ratio is falling over time it could be due to a rise in the running costs of the business or a drop in the level of productivity or efficiency of the workforce.
- (net profit ÷ sales revenue) x 100
Return on capital employed
This is also a measure of operational efficiency. If ROCE is lower than interest rates then it is unsatisfactory since it indicates the business would be better by depositing the money in the bank!
This is also a measure of operational efficiency. If ROCE is lower than interest rates then it is unsatisfactory since it indicates the business would be better by depositing the money in the bank!
- (net profit ÷ capital employed) x 100
Current ratio
This measure how easily a business can meet its immediate financial obligations. Should be between 1.5 and 2. If the ratio is too low the business may have difficulty paying it’s debts. If it is too high then it suggests money is being tied up unprofitably.
This measure how easily a business can meet its immediate financial obligations. Should be between 1.5 and 2. If the ratio is too low the business may have difficulty paying it’s debts. If it is too high then it suggests money is being tied up unprofitably.
- (current assets ÷ current liabilities)
Acid test ratio
If a high proportion of current assets is held in inventory it may be difficulty to liquidate these quickly. Taking inventory away from current assets gives a better measure of liquidity. As a rule the ratio should be 1.
If a high proportion of current assets is held in inventory it may be difficulty to liquidate these quickly. Taking inventory away from current assets gives a better measure of liquidity. As a rule the ratio should be 1.
- current assets - inventory ÷ current liabilities
Liquidity
Liquidity refers to how easily assets can be turned to cash. It can also refer to the ability of a business to pay its debts. It is safer to invest in liquid assets than illiquid ones because it is easier for an investor to get his/her money out of the investment.
Insolvency
A profitable business can run out of money. This situation is called insolvency. Insolvency occurs when a business allows its customers too long a credit period or if it buys too many fixed assets, which results in too little working capital. Insolvency describes a situation when a business is unable to pay its debts.
A profitable business can run out of money. This situation is called insolvency. Insolvency occurs when a business allows its customers too long a credit period or if it buys too many fixed assets, which results in too little working capital. Insolvency describes a situation when a business is unable to pay its debts.