business

Posted on Oct 12, 2023 in Economy

 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:

• 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

• 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:

• 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:

• 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.