business
5. FINANCIAL INFORMATION AND DECISIONS
5.1. Needs of Capital
Finance = Capital = Money
• Main reasons why businesses need finance:
o To start up a business: the money needed to buy the
essential assets to start trading is the start-up capital
o To expand the business
o To increase working capital
• Working capital – money needed to pay day-to-day costs
• There are 2 types of finance needs:
o Short-Term Finance Needs:
Finance needs to pay things that last less than a year,
(working capital) – includes wages, rent
o Long-term Finance Needs:
long term investments (that last more than 1 year).
Money to buy Fixed Assets (i.e. buildings)
5.1.2 Sources of capital
• The main sources of capital include:
o Internal Sources – Obtained by business itself
o External Sources – Obtained from outside business
Examples:
Internal source: | external: |
Retained profit Sales of assets | Issue of shares (if it’s LTD/PLC) Bank loans/Micro-finance Grants |
• Micro-Finance – providing smaller loans to poorer people
to start up their own business.
• Micro finance is very important in developing countries
• There are also short-Term and long-term sources (don’t
get confused with short/long term finance needs)
o Short Term Sources – money that must be paid back in
less than a year
o Long Term Sources – money that can be paid back in
longer than one year
Short term | Long term |
Overdrafts – when the bank allows a business to spend more money than they have in their account (i.e. to pay employees) Trade Credit – delay paying suppliers to be in better cash position | Bank loans Issuing shares Owner’s savings Hire Purchase – When a business buys a fixed asset in monthly payments (which include interest) |
• The main factors considered in making financial choice:
o Size of business & Legal Form (type of business):
Public limited companies have larger choice of sources
of finance because they pay less interest (less risk)
o Amount of capital required: if you need just a little
money you won’t issue new shares
o Purpose of capital & time period: The general rule is
that the finance source should match the finance need:
opening bank balance (A) |
cash inflows (B) |
cash outflows (C) |
net cash flow (D) =(B – C) |
closing bank balance A + D |
If use of capital is long-term, source
should be long-term (same with
short term)
o Existing Loans: if a business already took out lots of
loans, banks will think it is too risky to finance
5.2 Cash-Flow Forecasting & Working Capital
• Cash is a Liquid Asset – it can be immediately available
to spend on goods & services
•Cash Flow– the cash inflows (money received by
business) & outflows (money paid) over a period of time
• Cash-Flow Forecast – an estimate of future cash inflows
and outflows.
• A cash-flow forecast shows the expected cash balance at
the end of each month:
• Cash flow forecasts are just little charts with values
comparing 2 different time periods (months/years etc.)
• Net Cash Flow – The difference between the cash inflow
and outflow (inflow – outflow)
• Cash flow forecasts are useful because:
o They show how much cash is available to pay liabilities
of to buy assets
o They show how much money a business might need to
borrow from a bank
o They show whether the business is holding too much
cash which could be reinvested back into business
• To complete a cash-flow forecast, just rearrange and use
the equation (net flow = inflow – outflow)
• Short-term cash-flow problems can be solved by
gathering short-term sources of finance
Working Capital
• Working capital is the money needed to pay day-to-day
costs
Working Capital = Current Assets – Current Liabilities
• A business cannot run without enough working capital
• You can measure the success of a business by seeing
how much working capital it has
• Working capital should be handled properly because it
shows investors & banks how efficient a business is and
its financial strength
5.3 Income Statements
• For most business, profit is the main objective
• Profit is the money left over after total costs have been
subtracted from the sales revenue.
The simple equation for profit:
Profit = Sales revenue – total costs
• Profit can be made by:
o Increasing the sales revenue, so that it is higher than
the production costs
o Reducing the production costs
• Profit is very important, especially for the private sector
companies (not owned by government)
o Profit is a reward for risk taking: investors &
entrepreneurs take lots of risks when investing money
o Profit is a reward for enterprise: entrepreneurs and
workers put lots of effort to make business succeed
o Profit can be re-invested back into business: the
retained profits can be put onto business to expand
o Profit indicates that the market might be successful: a
market where most businesses are making profit would
be a good market for an entrepreneur to start their
own
Profit ≠ Cash
• Profit can be in the form of cash, but it can also be in the
form of credit (customers will pay later)
• If a company makes $40,000 in sales, but only $20,000 is
in cash and the other $20k is in credit. The business only
has $20,000 in cash to pay costs.
• Credits can vary from a week to a year, it is ‘promised’
cash but not physical, and can’t pay for costs.
• So, in this case, if the business makes $40,000, and the
costs are $15,000 it will make $25,000 in gross profit
(theoretical profit), but only $5,000 in net profit
• Income Statement – A business account that records all
the incomes of a business and all the cost payed over a
year – to see if it is making profit.
• It will be used by managers, banks and other investors to
see if a business is making profit:
o to compare with previous years – if it is greater than
the year before
o To see if it is higher than competitors
• The main features of an income statement include:
o Revenue
o Costs
o Gross Profit – the profit made after costs of goods
sold are taken away from sales revenue
o Net Profit (AKA ‘Profit’) – the profit made after
taking away all expenses and overhead costs (other
expenses)
o Retained Profit – the net profit after taking away
taxes and payments to owners – which is reinvested
back into the business
Profit TypeEquation
Gross Profit Sales Revenue – Costs of goods sold
Net Profit Gross Profit – Overhead Costs
(wages, electricity, rent, marketing)
Retained
Profit Net Profit – (tax + dividends)
• Income statements are very important in decision
making in a business
• If a business is thinking to relocate a factory, they will
make a forecast income statement in both locations and
compare
5.4 Balance Sheets:
• Balance Sheet – a document that shows the value of the
business’ assets and liabilities in a point in time
• A balance sheet
• Assets – Items of value owned by a business
• Liabilities – Debts owed by business
• There are 2 types of assets:
o Current Assets – (Short-term Assets) Items owned by
business for less than 1 year
i.e. Raw material, cash
o Non-Current Assets – (Long-term Assets) Items owned
by business for more than 1 year
i.e. Buildings, land, company cars
• There are also 2 types of liabilities:
o Current Liabilities – (Short Term Liabilities) Debts
owed by business for less than 1 year
i.e. Bank overdrafts, wages
o Non-Current Liabilities – (Long Term Liabilities) Debts
owed by business for more than 1 year
i.e. Long-term bank loans, creditors (money that
business owes to suppliers)
• the Total Equity (AKA Shareholders’ funds) is how much
a business is worth. (only for Limited companies)
Shareholders’ Funds = Total Assets – Total Liabilities
• The shareholders’ funds is the total amount of money
invested in a business by the shareholders/owners
• If the total equity of a business has increased/fallen, the
shareholder’s stake of the company will be worth
more/less, respectively
From a balance sheet, you can calculate the
Working Capital = Current Assets – Current Liabilities
You can also calculate the Capital Employed – the long-
term capital invested in a business
Capital Employed = Non-Current Assets + Total Equity
Total Equity = Shareholders’ funds
5.5 Analysis of Accounts
• Using all of the documents and information from cash
flow forecasts, balance sheets and income statements
you can rate the performance of a business
• Analysis of accounts is interpreting these
accounts/documents to see how a business is doing
• To rate a company’s performance, you can use 5 ratios
• There are 2 types of ratios:
o Profitability Ratios – how profitable a business is
o Liquidity Ratios – how able a business is to pay its
short-term debts (current liabilities)
• Profitability Ratios:
o Gross Profit Margin (%) – how good a company is at
converting sales into gross profit. A percentage
GPM (%) = 100 × Gross Profit / Sales Revenue
o Net Profit Margin (%) – how good a company is at
converting sales into net profit. A percentage
NPM (%) = 100 × Net Profit / Sales Revenue
o Return on capital employed – how profitable a
company is compared to the amount of money used
RoCE (%) = 100 × Net Profit / Capital Employed
• One profitability ratio isn’t useful by itself. You need to
use all the profitability ratios and compare it with
previous years of the business.
• Liquidity Ratios:
o Current Ratio – how good a company is to pay off its
current liabilities with its current assets
Current Ratio = Current Assets / Current Liabilities
Acid Test Ratio – measures the ability of a company to
pay off its liabilities without depending on the sales of
inventory
Acid Test Ratio = Current Assets – Inventories (Stock)
Current Liabilities
• The acid test ratio is used to measure if a business is
likely to survive in the future
• The good and bad values of these ratios:
gross profit margin net profit margin ROCE | No exact value, you must compare with: • Competitor businesses • Previous years • The targets set by the business |
current ratio | Should be above 1.5 to be safe |
acid test ratio | Should be above 1, unless you are dealing with cash sales in which it can be above 0.75 (cash is liquid – pays of liabilities easily) |
• Liquidity – Ability for a business to pay off it short term
debts
• If a business’ assets can’t be easily converted to cash,
then they are Illiquid
• Current Assets are liquid.
• Having lots of stock may mean that the company might
be illiquid because inventories are hard to convert to
cash easily
• Liquidity is very important for a business:
o If they can’t convert their assets into cash, they won’t
be able to pay their suppliers (current liabilities)
o Not paying suppliers will force them to stop trading to
pay back their debts
5.5.3 Why and how accounts are used:
• Limited companies must publish their accounts for the
public to see. IT is used for ratio analysis.
• All types of stakeholders will be interest in seeing these
accounts to see how well the business is doing. i.e.:
o Managers: to keep an eye on the performance of the
business. Compare ratios with competitors & previous
years to make decisions.
o Shareholders & potential investors: They will see how
profitable a business is using the ratios to see if it is
worth investing in it. See how much business is worth
o Banks: see if business is performing well to calculate
the risk on whether to give out a loan or not.
o Employees: to see how safe the business (and their
jobs) are.
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