Javi Martínez

UNIT 3: FINANCE – NOTES

1. Introduction to finance:

Finance refers to the available money that an organization has to fund its business activities.

Finance is necessary for all businesses, from starting up a new business, to upgrading its capital
equipment or to funding its expansion plans in overseas markets.

The purpose, or role, of finance can be characterized as either capital expenditure or

revenue expenditure. Revenue expenditure and capital expenditure are of equal importance
to businesses.

CAPITAL EXPENDITURE REVENUE EXPENDITURE

Definition Capital expenditure refers to business Revenue expenditure refers to business

spending on fixed assets or capital
equipment of a business. It is regarded as
expenditure on the long-term investment
of an organization on assets that offer
gains in efficiency and productivity
spending on their daily and routine
operations.
These expenses have to be paid in
order to keep the business operational,
including routine expenditure on
maintaining the firm's non-current
assets.

The finance to fund revenue

expenditure normally comes from short
term sources of finance.
Examples  Buildings  Stocks of raw materials
 Tools and equipment  Delivery costs
 Machinery  Utility bills (e.g. gas, electricity,
 Computers water and telephone bills)
 Printers  Wages and salaries to employees
 Photocopiers  Rental payments for the premises
 Vehicles  Monthly repayments on bank loans
 Research and development and mortgages
 Insurance premiums (for example,
insurance cover for buildings,
employee safety and vehicles).
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2. Sources of Finance

Sources of finance are the various ways that a business gets its money in order to run the
business. The sources of finance for a business can be classified as either internal sources or
external sources.

Businesses need various sources of finance to pay for their operational/daily costs, such as:

● the purchase of raw materials

● components and inventory

● the payment of wages, salaries, rent, insurance and utility bills (for gas, electricity, water
and telephone bills)

Internal Sources of Finance

Internal sources of finance are those that come from within the organization, from its own
resources and assets, without the help of a third party. Hence, they do not have to be repaid.

There are three main sources of internal finance:

o Rersonal funds (for sole traders)

o Retained profit, and

o Sale of assets.

1. Personal Funds
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Sole traders and partners, as types of business entities, usually rely on personal funds from
their own savings to finance their start-up businesses. They come from the savings of the
business owner(s).

ADVANTAGES
Do not need to be rapid
No interest charges incurred
Using your own money shows commitment.
Hence, there is a greater chance of being
able to borrow money.
DISADVANTAGES
Sole traders too high of a represent high risk
to secure external sources of finance
Personal funds are rarely enough to fund a
small business
Sole traders risk their entire life savings in a
business venture.

2. Retained profit.

Retained profit is an internal source of finance that comes from having a financial surplus.
These funds are reinvested in the business, rather than being distributed to the owners
(shareholders). Hence, retained profit is also known as ploughed-back profit.

ADVANTAGES
No interest charges incurred
As the money belongs to the business, it is
considered a permanent source of finance
It can be used for anything within the
business, as opposed to bank loans that are
approved for specific causes
DISADVANTAGES
Start-ups don’t have any retained profit.
It is rarely enough towards the pursuit of
growth and evolution.
Reinvesting the profit back in the business
means here is less money for shareholders’
dividends and owners.

3. Sale of Assets

An asset is anything that a business owns and has a marketable value, such as buildings,
vehicles, computers, equipment, and intellectual property. When a business is in need of cash,
it can sell off some of its fixed assets.

Fixed assets are iteming a business owns and:

 Uses for a period of more than 12 months.
 Can be used repeatedly.
 Generate income for the organization.

ADVANTAGES DISADVANTAGES
A large sum of money can be raised Selling certain fixed assets can affect a
firm’s productivity
Selling excess of resources, redundant assets Might be very time consuming to find a
or obsolete belongings. suitable buyer to a second-hand asset.
No costs involved/No interests incurred New businesses do not have this option
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External Sources of Finance

External sources of finance are those that come from outside the organization, usually with
the help of a third-party provider. Due to the higher costs, external finance is only used when
a business is unable to get enough funds from internal sources.

There are eight sources of external finance stipulated in the IB Business Management
syllabus:

1. Share capital

2. Loan capital

3. Overdrafts

4. Trade credit

5. Crowdfunding

6. Leasing

7. Microfinance providers

8. Business angels

1. Share Capital

Share capital is finance raised through the issuing of shares via the stock market.
It is a long-term source of finance for limited liability companies, obtained by selling shares
in the company.
When a limited liability company sells its shares for the very first time on a public stock
exchange, this is called an initial public offering (IPO).

ADVANTAGES DISADVANTAGES
It is permanent capital as it does not need to Shareholders need to (at some point) be paid
be repaid. Hence, does not involve debt dividends if the company earns a profit.
There are no interest payments made to Ownership and control may be diluted
shareholders, thus this reduces the expenses
of the company.
Any public limited liability company can Only available to limited liability companies
raise further finance by selling additional
shares (a process known as a share issue).

THE STOCK MARKET

A stock exchange is a well-organized and highly regulated marketplace where individuals
and businesses can buy and sell shares in public limited companies. Shares in private
limited company cannot be traded on a stock exchange, as their shares are not sold to the
public.
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2. Loan Capital

Loan capital, also known as debt capital, refers to borrowed funds from financial lenders,
such as commercial banks. It is typically a long-term source of external finance, and is
usually for the purchase of fixed assets.

ADVANTAGES
Enables the borrower to repay in regular
instalments, making it more accessible and
affordable
Large businesses are often able to negotiate
lower rates of interest (financial economy of
scale)
Does not dilute control or ownership
DISADVANTAGES
Interest is charged on the amount of
borrowed funds.
In many cases, businesses have to offer
collateral (security) before loans can be
approved. Failure to repay the loan can lead
to the lender being able to legally seize the
firm’s assets
Firms that borrow loan capital on variable
interest rates may suffer from liquidity
problems if the rate of interest increases

3. Overdrafts

An overdraft is a banking service that enables customers (personal and business customers) to
withdraw more money from their account than exists in the account.
This can help businesses to meet their short-term liquidity needs, especially in emergency
situations.

ADVANTAGES DISADVANTAGES
Easy to obtain Higher rates than ordinary bank loans
Provide a quick solution to liquidity Banks lend a limited amount of money to
problems solve a situation. Not enough to purchase
fixed assets or pursuit growth, for example
Can be used for anything when needed Banks can ask for overdrafts to be repaid at
very short notice.

4. Trade Credit

Trade credit enables a customer to purchase and obtain goods and services but to pay for
these at a later date. The supplier provides the trade credit to the customer (another business
organization), which helps the purchaser’s cash flow as they can obtain supplies without
having to pay for these immediately.

The typical trade credit period is between 30 to 90 days, depending on the industry in
question. This means that it is possible to sell the goods bought before actually having to pay
for them. Hence, trade credit can be an important external source of finance for businesses
struggling with cash flow.
Buying goods and services on trade credit does not incur any interest charges if the amount
owed is paid in full within the trade credit period. This makes trade credit relatively attractive
compared to overdrafts.
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5. Crowdfunding

Crowdfunding is an external source of finance that involves raising small amounts of money
from a large number of people to fund a particular business project or venture. Typically,
equity crowdfunding involves the sale of a stake in a business to a number of investors in the
crowd. This works in a similar way to the sale of shares or finance raised by business angels,
although the amount of money from each person is much lower.

Usually, if the fundraiser doesn’t reach the targetted fund value, the money is given back to
each individual in the crowd. On the other hand, it may also be donation- based crowd
funding.

ADVANTAGES
Small risk and impact if the business project
fails to succeed
Avoids time-consuming bureaucratic
processes
Individuals in the crowd do not take any
controlling interest in the organization.
Cheaper than share capital
DISADVANTAGES
Requires transparency, holding annual
meetings with investors, and publication of
annual reports. This adds costs to the
business
Theft of intellectual property is likely.
There are a lot of cases of crowdfunding
scams. The loose regulatory requirements
for crowdfunding in many parts of the world
exposes investors to fraud.

6. Leasing

Leasing involves the business or customer (known as the lessee) drawing up a contract with
the leasing company (known as the lessor) to use particular fixed assets for an agreed fee.
Examples of leased fixed assets included: machinery, tools, equipment, photocopiers,
computers, or vehicles.
It is a common option for businesses to access fixed assets without the high costs of capital
expenditure.

Generally, it is considered a short-term source of finance. However, long-term lease

contracts exist, usually lasting three or more years with an option to buy the asset at the end
of the lease agreement.

ADVANTAGES DISADVANTAGES
Particularly beneficial if the company only The lessee never actually owns the asset.
needs to use the fixed capital for a short
period of time
The lessor takes responsibility for the Over a long period of time, leasing can be
maintenance of the capital equipment. This more expensive than buying the asset
cuts costs for the lessee. outright due to the accumulated costs of
leasing the asset over time.
The lessor does not have to purchase the
equipment. Instead, its money can be used
for revenue expenditure purposes.
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7. Microfinance Providers

Microfinance providers are for-profit social enterprises that offer a financial service to those
without a job or on very low incomes. These members of society would not ordinarily be able
to secure bank loans.
The concept of microfinance was developed by Nobel Prize winner Muhammad Yunus in
2006, in association with the Grameen Bank.

ADVANTAGES
May allow you to become financially
independent
Poverty relief
They help to empower entrepreneurs of
small businesses, especially women and the
underprivileged working and living in low-
income countries.
Creates benefits for the wider community
Is a socially responsible source of finance
Fosters a culture of entrepreneurship and
economic independence
DISADVANTAGES
Can be seen as unethical as they earn profits
from low-income individuals
Only works on a small scale
Increases the debts of entrepreneurs, who
may therefore struggle in their business
venture
Hard to retain employees for the provider
due to the low profitability.

8. Business Angels

Business angels (or angel investors) are wealthy and successful private individuals who risk
their own money in a business venture that has high growth potential.

ADVANTAGES
Essential for start-ups and small businesses
The business can benefit from the expertise
and experience of the angel investor
Particularly useful for privately held
companies
DISADVANTAGES
For the angels investors, such business
ventures are extremely high risk, especially
as they risk losing their personal money
There are no guarantees that angel investors
will earn a satisfactory ROI
Business angels will dilute the firm’s
control and ownership as the angel investors
will want a share and say in the organization
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Appropriateness of short- or long-term sources of finance for a given

situation

Short-term finance:
Short-term finance refers to sources of finance needed for the day-to-day running of a
business, i.e. its revenue expenditure. It is also often used to solve cash flow (working
capital) problems. Short-term sources of finance are funds that do not last longer than one
year from the balance sheet date.

Examples (or sources) of short-term finance include:

 Personal saving
 Sale of assets
 Overdrafts
 Trade credit

Long-term finance:
Long-term finance refers to sources of finance of more than one year from the balance sheet
date. The finance is used mainly to pay for fixed assets, i.e. capital expenditure such as the
purchase of capital equipment, machinery, and motor vehicles. It is used to purchase long-
term fixed assets (such as property) or to fund the growth of a business in overseas markets
(such as setting up factories or production facilities in other countries).

Examples (or sources) of long-term finance include:

 Share capita
 Loan capital, such as mortgages
 Leasing
 Business angels
 Microfinance providers
 Crowdfunding

Appropriateness of sources of finance for a given situation

The appropriateness of different sources of finance depends on numerous factors, which can
be remembered by the acronym SPACED:

Size of the business

Purpose (use) of funds
Amount required
Cost
External environment
Duration

1. Size of the business

The larger the size of a business, the greater the choice of finance there tends to be. For
example, public limited companies can obtain finance from selling shares, whereas sole
traders cannot. A larger business is also likely to have more retained profit. It is also easier
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for a large business to obtain bank loans and mortgages to finance its growth, especially as it
has more collateral (security) that can be used to qualify for lower interest rates (financial
economies of scale).

2. Purpose of funds

The purpose of funds refers to what the finance is specifically to be used for. For example, if
finance is needed for the purchase of a new factory or office building, then long-term sources
of finance are more appropriate, such as mortgages. The sale of assets, such as computer
equipment, would be suitable if a business wishes to upgrade its obsolete fixed assets. For
short-term, day-to-day running costs of the business, trade credit and overdrafts would be
more appropriate.

3. Amount required

If a business only needs a small amount of finance, it is likely to consider short-term sources
of finance, such as bank overdrafts. By contrast, for larger amounts, the business is likely to
use long-term sources such as loan capital from commercial banks, mortgages, or even a
share issue.

4. Cost

Costs have an implication on all business decisions, such as the choice of sources of finance.
So, businesses need to consider the costs associated with obtaining a certain source of
finance. For example, an IPO will be relatively expensive, whereas using personal funds or
retained profits will not be. In the long term, leasing assets is more expensive than an outright
purchase.

5. External environment

The external environment refers to factors that affect a business but which it has no control
of. For example, the central bank or monetary authority is responsible for interest rates in the
economy. Higher interest rates make loan capital and overdrafts expensive. Hence, this is
likely to reduce the demand for loan capital to finance business expenditure. Economic
factors might also affect the amount of finance that business angels and venture capitalists are
willing to make available for investment purposes.

6. Duration

The longer the finance is needed, the more likely the firm will need to provide a guarantee
(collateral or security) to the lender, in case the borrower defaults on the loan. By contrast, an
overdraft would be more suitable for firms needing a small amount of money for only a short
time period, usually to deal with short-term liquidity issues.
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3.3. Costs and Revenues

TYPES OF COSTS

Costs are the charges that an organization incurs from its operations.
Types of costs:
- Fixed costs
- Variable costs
- Direct costs
- Indirect costs

1. Fixed costs (TFC)

Fixed costs of production do not change
with the level of output, they are
independent of how much is produced or
sold.
Examples include rent payments, insurance
premiums on buildings, leasing costs of
machinery and equipment, and salaries to
management.

2. Variable costs
Variable costs of production are items of a
firm's expenditure that change with the level
of output. These costs rise when the firm's
output or sales volume increases, meaning
that it is directly proportional to the output
level.
Examples of variable costs include: the cost
of purchasing raw materials and components
for production, commission paid to sales staff,
and the wages paid to employees.

TOTAL COST OF PRODUCTION

TC = TFC + TVC

AVERAGE COSTS (AC)

TC
AC= where Q is the output or number of units produced.
Q

AC= AFC + AVC

A decline in average cost as output rises shows the organization experiences economies of
scale.
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3. Direct costs
Direct costs are the items of expenditure that can be evidently and explicitly associated with
the output or sale of a certain good, service, or business operation.

EXAMPLES:
- Variable costs, such as direct raw materials and direct labour costs.
- Fixed costs, such as third party motor insurance and depreciation costs for taxi
drivers. Rent is another example of a direct cost if this fixed cost is for a production
facility.

4. Indirect costs
Indirect costs are those that are not directly related with the sale or production of a specific
good, service, department, or business operation.

EXAMPLES
- Rent on premises
- Salaries for administrative staff
- Fees paid for legal and accounting services, as well as utility bills (gas, electricity, and
water)
- General insurance for third parties, fire, and theft
- Costs involved with maintaining and running the organization.

TOTAL REVENUE AND REVENUE STREAMS

Revenue refers to the money coming into a business from the sale of goods and services.

Revenue streams refers to the various sources of revenue for a business.

Total Revenue
Total revenue (TR) is the sum of income received by a business from its trading activities.

TR=Price ×Q uantity

In case the company sells more than one product, TR is calculated as the sum of the sales
revenue for each product.

Average Revenue
Average revenue (AR) is the amount a business receives from its customers per unit of a
good or service sold. Average revenue is mathematically the same value as the price per unit.
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Revenue Streams
The term revenue streams refers to the various sources of revenue for a business. Sales
revenue is the most common form of revenue stream for businesses. However, most
businesses will have more than one revenue stream (sources of revenue). Examples of various
revenue streams include:

o Transaction fees charged to customers

o Membership fees
o Royalties
o Merchandise sales
o Sponsorship revenues
o Subscription charges imposed on customers
o Dividends from shareholdings in other companies
o Donations/gifts
o Interest earnings from cash savings in a bank account
o Grants and subsidies from the government

3.4. Final Accounts

1. Purpose of accounts to different stakeholders

STAKEHOLDER PURPOSE
Managers - Measure the performance of the company.
- Benchmark indicators
- Help with decision-making and target setting.
- Assist strategic planning
Employees - Check their jobs are secure
- Can be used to negotiate with labour unions to discuss pay rises
Shareholders - Measure the profitability of the business
- Calculate the ROI and growth prediction
Financers - Decide whether to lend money to the business
Suppliers - Assess whether the business has enough liquidity to pay back its
debts
Customers - Determine whether the business offers security and reliability in
its services; otherwise, customers will go elsewhere and purchase
by rival suppliers.
The government - Verify tax payment
- Measure the extent to which the company creates employment
- Ensure everything is legal
Competitors - Compare their own financial accounts to judge performance
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The Profit & Loss account

The profit and loss account shows a firm’s profit (or loss) after all production costs have been
subtracted from the organization’s revenues, each year.

For Non-Profit
Swapping “profit” with “surplus”
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The Statement of Financial Position

The balance sheet (also known as the statement of financial position) is an essential set of
final accounts that shows the value of an organization’s assets, liabilities, and the owners’
investment (or equity) in the business at a particular point in time.

Assets The possessions of a Current Possessions of an organization with a

business that have a monetary value but intended to be liquidated
monetary value. (turned into cash) within twelve months of
the balance sheet date.
- Cash
- Debtors
- Stock (raw materials, semi-finished &
finished goods)
Non-current (also known as fixed assets) are the long-term
assets or possessions of an organization with
a monetary value but are not intended for
resale within the next twelve months of the
balance sheet date

Liabilities The debts of a business Current Short-term debts of a business, which need to
be repaid within twelve months
Non-current Long-term debts of a business, falling due
after 12 months of the balance sheet date

Equity refers to the value of the owners' stake in the business, i.e. what the business is worth
at the time of reporting the balance sheet. Equity is comprised of both share capital and
retained earnings.

Intangible assets are a type of fixed asset except they are non-physical assets with a
monetary value to the business. These include:

 Goodwill is the reputation and established networks (know-how) of an organization.

 Patents are the official rights given to a business to exploit an invention or process for
commercial purposes. They give a registered patent holder the exclusive right to use the
innovation for a limited time period. These create a unique selling point (USP)

 Copyrights give the registered owner the legal rights to creative pieces of work.
Copyrights cover the work of authors, musicians, conductors, playwrights (scriptwriters)
and directors.

 Trademarks are a form of intellectual property, the value of which may be reported on
the balance sheet. They give the listed owner the legal and exclusive commercial use of
the registered brands, logos, and/or slogans (catchphrases).
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3.5.
Ratio
Analysis

Ratio analysis
is a financial
analysis tool
used in the
interpretation
and
assessment of
an
organization's
final accounts

Profitability ratios examine the level and value of a firm’s profits, thereby enabling different
stakeholders to measure the financial returns on their investments. Profitability ratios also express a
firm’s profits as a percentage of its sales revenue.

There are three types of profitability ratios:

1. Gross profit margin
2. Profit margin
3. Return on capital employed (ROCE)
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Ratio Definition Formula

Gross profit margin A profitability ratio that measures an
organization’s gross profit expressed
as a percentage of its sales revenue. It Gross profit
GPM= ×100
is also an indicator of how well a Salesrevenue
business can manage its direct costs
of production.

Profit margin The profit margin is a profitability

ratio that measures a firm’s overall Profit before interest ∧tax
PM = × 100
profit (after all costs of production Sales revenue
have been deducted, i.e., profit before
interest and tax) as a percentage of its
sales revenue.
Return on capital Profitability ratio that measures a
employed (ROCE) firm’s efficiency and profitability in
relation to its size

Capital employed is the value of all

sources of finance available for a
business at a point in time, including Profit before interest∧tax
ROCE= ×100
internal and external finance. Capital employed
The formula for calculating capital
employed is therefore:
Capital employed = non-current
liabilities + Share capital + Retained
earnings
Or Capital employed = Non‐current
liabilities + Equity

How to improve profitability ratios

Ratio Method of improvement

Gross profit margin - Increasing sales revenue and reducing direct costs
- Changing promotional strategies to attract customers.
- Launching new products with higher GPM
- Reducing prices
- Outsourcing production
Profit margin - Reduce any type of excessive and unnecessary expenses.
(Insurance, phone and internet payments, utility bills…)
ROCE - Any combination to improve profit before interest and tax.
- Increase sales revenue.
- Reducing costs of production
- Selling obsolete assets to improve operational efficiency and
liquidity
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Liquidity Ratios are financial ratios that asses and organization’s ability to pay its short-term
debts and liabilities.
These include:

1. Current Ratio
2. Acid Test Ratio

Ratio Definition Formula

Current Ratio Short-term liquidity ratio used to
calculate the ability of an
organization to meet its short-term
debts.

Liquid assets:
- Cash
- Stock
- Debtors

Current liabilities:
- Overdrafts
- Trade creditors
- Short-term loans
Acid test (or quick) The acid test ratio (or quick ratio) is
ratio a short-term liquidity ratio used to
measure an organization’s ability to
pay its short-term debts without the
need to sell any stock

How to improve liquidity ratios

Ratio Method of improvement

Current ratio - Increase current assets + reduce currents liabilities
- Increase sales revenue + reduce costs
- Attracts more customers
- Encourage customers to pay by cash (no credit)
- Negotiate with suppliers for an extended trade credit period
Acid test - Improve stock control management system.