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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


Internal source:


Retained profit

Sales of assets

Issue of shares (if it’s LTD/PLC)

Bank loans/Micro-finance


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


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


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


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)


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


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


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


No exact value, you must

compare with:

• Competitor businesses

• Previous years

• The targets set by the


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


• 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.