3.

1 Sources of finance
Startup capital: capital needed by an entrepreneur to set up a business

Working capital: the capital needed to pay for raw material, day-to-day running costs and
credit offered to customers. In accounting terms:
working capital = current assets - current liabilities

- Setting up a business will need a start up capital of cash injections

- Businesses need to finance their working capital

Capital expenditure: is the purchase of assets that are expected to last more than one year.
(buildings and machinery)
Revenue expenditure: spending on all costs and assets other than fixed assets and includes
wages and salaries and material and materials bought for stocks.

Sources of finance:
Internal sources:
Retained profit: represents profits generated from sales once after dividends, tax and interests
are paid.
- No borrowing costs
- No rise in debt levels
- Owners control is not diluted
- Owners may take out all the spare cash

Sale of assets
- No borrowing costs
- Items can only be called once

Using working capital more effectively: working capital is the money tied up in the business
used to finance its day to day needs
- no borrowing costs
- Suppliers and customers may not be happy waiting for money or paying upfront

External sources: (long term)

Share capital: money put in the business by its investors. It is a long term source of finance and
should be used long term source of finance and should be used for long term needs
- no interest payments
 - If no profits made no dividends have to be paid
- Shareholders will require dividends
- Can change control if new shares are bought by investors

Debentures: long term loans. They are similar to shares in that a certificate is issued to all the
holders. Debentures holders do not have ownership or voting rights (loans)
- have to pay interests

Loan capital: funding provided from a bank or other lenders. Provided for a fixed period of
time, with repayments evenly spread out over the length of the loan. Interest is paid regularly.
- easier to access and use for specific purposes
- If interest rate rise it will be very good form of finance
- Lenders have to be paid even if there are no profits
- If interest rate fall, loans will be too high
- If default lenders can control decision making
- Is a loan is secured against an asset then it can be seized

Venture capitalist : are bankers who share risks of business by investing in the share capital as
well as providing loan capital for businesses with expansion potential
- Thy provide business help and contacts
- Thy sit as non executive directors protect their investments and ensure that there is a
planned exit for the investment in 5 or 7 years
- Disadvantages for the shareholders. Venture capitalists impos profit or sales targets. If
the business fail

Grants of soft loans: provided by governments or other organizations. May b for small
businesses or to help an economic activity in regions or industries that are going through
problems

Subsidies: the purpose is to reduce the cost of production

Donations: financial gifts

Sponsorships : when an organization gives financial support for another business in return for
displaying the sponsor brand.

Trade credit: buy now pay later

Bank overdraft: is repayable on demand only for short term needs.
- Is a flexible source of finance. Changes in overdraft limits can be easily
- The cost of an overdraft will vary as interest change in the economy. This makes
budgeting costs a little difficult.
- Overdrafts are often secured on a personal guarantee from the owners or on the assets
of the business

Factoring: a factor agent is a company that buys the current unpaid invoices of a business at a
discount amount. They pay cash immediately to business and hopes that it can recover the full
amount in order to make profit.
- Business receives cash upfront and can use this money to fund expansion and working
capital needs
- Administration cost to the business of chasing up its customers is removed
- Business is giving up some of its profit margin

Leasing: when purchasing assets

- Business does not need to find a large amount to buy the asset, and can pay for the
asset from its own revenue
- Has to pay high level of interest

Hire purchase: the business can pay the assets in installment. Once all payments have been
made, the item then belongs to the business but in the interim the assets is legally property of
the hp firm
- The ownership of the asset does not pass to the business until the last payment
- Has to pay high level of interest

Business angels: they invest in the company and they receive long term payment with interest.
They don't make decisions.

Microfinance: provision of very small loans

3.7 Cash flow

Working capital: the capital needed to pay for raw materials, day-to-day running costs and
credit offered to customers.

Working capital=current assets−current liabilities

(current assets: things that you own and are going to keep for less than 1 year)
(current liabilities: things that you owe)

Liquidity: the ability of a firm to be able to pay its short term debts.

Working capital cycle

● The period between spending cash on the production process and receiving cash
payments from customers.
● The longer this cycle takes to complete the more working capital a business will need.

Cash flow
The CASH FLOW of a business is the CASH INFLOW and OUTFLOWS over a period of time

CASH INFLOWS: are the sums of money received by a business during a period of time
CASH OUTFLOWS: are the sums of money paid out by a business during a period of time

Inflows:
● By the sale of goods for cash
● Through payments made by debtors
● By borrowing money from an external source
● Through the sale of assets of the business
● From investors putting more money into the business

Outflows:
● By purchasing goods or materials for cash
● By the payment of wages, salaries and other expenses in cash
● By purchasing fixed assets
● By repaying loans
● By paying creditors of the business
CASH FLOW CYCLE: shows the stages between paying out cash for labour, materials, etc.
And receiving cash from the sale of goods.

Insolvency: when a profitable business run out of cash

How is it possible?
● By allowing customers too long a credit period
● By purchasing too many fixed assets at once
● By purchasing or producing too high level of stocks when expanding too quickly.
Overtrading.

Cash flow forecasts: is an estimate of future cash inflows and outflows of a business, usually
on a month by month basis. This will then show the expected cash balance at the end of each
month.
Can be used to tell the manager:
● How much is available for paying bills, repaying loans or for buying fixed assets
● How much the bank might need to lend in order to avoid insolvency
● Whether the business is holding too much cash which could be put to a more profitable
use

Uses of cash flow forecasts:

● Starting up a business: how much cash will be needed
● Keeping the bank manager informed: before they lend money
● Running an existing business
● Managing cash flow

Solving cash flow problems:

● Arrange with your bank to borrow money over the time when you have a negative cash
flow
● Reduce or delay some of your planned expenses
 ● Increase your forecasted cash income
● Delay paying for some of your expenses until cash is available

Methods to increase inflows:

Methods to reduce outflow:

OPENING CASH BALANCE: is the amount of cash held by the business at the start of the
month

NET CASH FLOW: is the difference, each month, between inflows and outflows

CLOSING CASH
BALANCE: is the amount
of cash held by the
business at the end of
each month. This
becomes next month’s
opening cash balance.

Month

Opening balance (1st→

savings/capital)
(2nd last closing balance)

Inflows
 Outflows

Net cash flow

(inflows - outflows)

Closing balance
(Opening Balance + Net Cash flow)

3.8 Investment appraisal

Investment: refers to the purchase of an asset with the potential to yield future financial
benefits
Investment appraisal: quantitative technique used to calculate the financial costs and benefits
of an investment decision.

Qualitative factors:
- Personal factors
- Objectives
- Image
- Risk
Quantitative factors:
- Payback period
- Accounting rate of return (ARR)
- Net present Value (HL)

Payback period: period of time for an investment project to earn enough profits to repay the
cost of the initial investment.

Initial investment ($)

Payback period = [(mejor ponerlo en años) → (misma
Contribution per year ∨month( $)
ganancia)]

Additional cash inflow needed

Payback period = → (cambia la ganancia)
Annual cash flow ∈ year x /12

Advantages Disadvantages

- Simple method - May encourage short-term approach

- Allows a business to see whether ot investment
 not it will break even on the purchase
of an asset before it needs to be
replaced
- Can be used to different investment
projects
- Help to assess projects which yield a
quick return to shareholders
- Contribution per months is unlikely to
be constant
- Payback focuses on time as the key
criterion for investment rather than on
profits

ARR: Calculates the average profit on an investment project as a percentage of the amount
investment.

Total profit during project /Number of years

ARR= ×100
Initial amount invested ( $)

Advantages Disadvantages

- Measures profitability - The length of the project or the

- Uses all cash flows
- Easy to understand
- Easy to compare percentage returns
with other investment opportunities
lifespan of a machine maybe an
estimate
- Ignores the timing of cash flows
- Ignores the “time value” of money
- Ignores the risk factors associated
with a long payback period of
liquidity

NPV (Net Present Value):

Discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using
the concepts of the time value of money. DCF is used to calculate the value of future cash
flows in terms of an equivalent value today. All future cash flows are estimated and
discounted to give their present values (PVs).

Discount factor: used to convert the future Net cash flow to its present value

NPV: is calculated by the sum of all future expected net cash flows minus the investment cost.
NPV =∑ of present values−Original cost
 + NPV is positive→ the project earns more than the discount rate. The
project has “passed” this test, and may be considered further.
0 NPV is zero→ the project earns exactly the discount rate. It may or
may not be rejected.
- NPV is negative→ the project earns less than the discount rate. The
project will be rejected.

Advantages Disadvantages

- Considers all cash flows - Complex to calculate

- Accounts for the time value of money
and therefore considers the
opportunity cost
- It is more scientific than the other
methods
- Only as good as the original data. If
the estimates of cost or net cash
inflow w are going wrong, so will the
npv
- The selection of the discount factor is
crucial, but it is mostly guesswork as
this rate in constantly changing
- Ignores all and any non-financial
factors
Break even

Quantity Fixed costs Variable Total costs Total revenue Profit

costs

First input=0 (always the (is given/ u (Fixed + (Price x (Total

Then BEQ=? same amount need to + Variable Quantity) revenue -
Sales of money) materials and costs) Total costs)
volume= ? workforce)

Multiplied by
the quantity

Costs and revenue

Profit = total revenue - total cost

Total revenue= price x quantity

Total cost= fixed costs + variable cost

Costs:
- Fixed costs: do not change as output does (indirect)
- Variable costs: do not change as output does (direct)
- Semi-variable costs: made up of fixed and variable
- Direct costs: directly related to output
- Indirect costs (overhead): costs that are indirectly related to output
- Average cost: cost per unit

Contribution of fixed cost

Contribution a product makes to the overall profitability of the business

Total contribution = total revenue - total variable costs

Contribution per unit = price - variable cost (per unit)

Break even analysis:

- To calculate the minimum product that has to be sold for the business to cover its costs
- Break even point is where the quantity and total cost meet
- Break even quantity is the quantity number were the break even point is

Total costs= total revenue

Fixed costs + variable costs = price x quantity

Margin of safety: is the difference between actual sales and break even sales.

Th formula method
- Break even quantity = fixed costs / contribution per unit
- contribution = price - variable cost per unit

Margin of safety: current sales - break even quantity.

Budgeting:
A budget is a detailed financial plan for the future
Benefits for setting budgets
1. Planning
2. Effective allocation of resources
3. Setting targets to be achieved
4. Coordinations: once the target has been agreed people will have to work effectively
together if targets set are to be achieved
5. Monitoring and controlling
6. Modifying
7. Assessing performance

Preparation of budgets
Stage 1: set objectives for the following year, based on previous performance, external
changes and sales forecast
Stage 2: identify the key factor to be successful
Stage 3: formulate the sales budget with sales managers (discussion)
Stage 4: sales budget is prepared
Stage 5: coordinate budgets in all departments to ensure consistency
Stage 6: a master budget is prepared including all budgets and concludes with a P&L forecast
and balance sheet
Stage 7: budget is presented to board of directors for its approval

Types of budget
Incremental budget: uses the past year’s budget as a basis and an adjustment is made for the
coming year
Zero budgeting: setting budgets to zero each year and budget holders have to argue their case
to receive any finance

Limitations of budgeting
· Likely to any changes that can cause large differences between thee budgeted figure and the
actual outcome.
· Natural tendency to overestimate budget
· Rigid and poorly allocated budget can result in low quality
· Since finances are limited one person’s gain is another one’s loss
· Ignorees qualitative factors

Cost and profits centres

· A cost centre is a production unit that generates costs but no revenues.

· A profit centre is a production unit that generates profits where both revenues and costs can
be identified and quantified.

Benefits of centres
· business can focus production on a particular unit
· it can monitor costs, revenues and profits more effectively
· it can discontinue production on failing units
· it can switch resources more easily to cope with changes in demand

Disadvantages of centres
· calculating costs and profits can be complex
· the bigger picture is lost
· the may be unhealthy competition between centres
· the focus on figures may hide other qualitative issues
Depreciation
· During their operations, fixed assets are consumed and its value is used up
· Depreciation: this measure of consumption or any other reduction is the useful economic life
of a fixed asset
· NET BOOK VALUE=Original value−Depreciation

Why might fixed assets depreciate?

· they suffer wear and tear. They deteriorate
· the new technology makes assets obsolete
· lack of maintenance. hardly used and poor maintained.
· the passing of time.

Reasons for a depreciation

· Show the accurate value of assets
· Depreciation is a cost and it is subtracted from profit
· To set up a provision for future replacements
· Writing off: is the accounting process of reducing the original value by the amount of the
depreciation

2 methods to calculate depreciation:

· straight line
· reducing balance

Straight line method

original cost−residual value
· depreciation ¿
useful life of assets
· a constant amount of depreciation is subtracted from the value of the asset each year
· Example: let’s assume a delivery van costs 45,000 and has an expected life of five years and
a residual value of 5,000. What is the annual depreciation charge and what is the value of the
van in the balance sheet at the end of yer 2?
45000
5 years
RV= 5000
(45000-5000)/5= 8000 depreciation per year
Yr 1: 45000-8000= 37000
Yr 2: 37000-8000= 29000
 Year Depreciation (shown in p&l) Net book value (shown in balance sheet)

The reducing balance method

· This method is based on a fixed percentage depreciation charge. The fall in value will be high
in the early yearly and less as the asset reaches the end of its useful life
· Depreciation %: (1− √
n
residual value/ price) ×100
· assume the van is bought for $45,000 and it has 4 years of useful life. Its expected residual
value is $5,832. Annual depreciation of 40%

Year Depreciation (shown in p&l) Net book value (shown in balance sheet)

Straight line Reducing balance

Advantages · Easy to calculate. · Reflects more accurately

· In the first years lower
depreciation charges lead to
higher income to be
distributed among
shareholders.
the real value of the asset in
the balance sheet of those
assets that lose far more
value in the first years.
· Balances the higher
maintenance cost as the aset
ages

Disadvantages · It requires very accurate · It is not very simple to

estimations of expected calculate.
useful life and residual value. · Reduces profit at the early
· Assets tend to depreciate years.
more quickly in the first and
second years.
Final accounts
- Done at the end of each accounting period
- 3 main accounts:
- Cash-flow statement: where cash was received from and what is spent on
- Profit and loss account: the gross and net profit. Details of how the net

· Net assets = Capital employed.

· Net assets = Fixed assets+Working capital.
· Working Capital = Current assets–Current liabilities.

Final accounts.
Balance sheet and P&L:
➔ Ratios:
➔ Profitability:
gross profit
◆ Gross profit margin= x100
sales revenue
net profit before interest ∧tax
◆ Net profit margin= x100
sales revenue
➔ Liquidity
current assets−stocks
◆ Current ratio= > 1,5
current liabilities
◆ Acid test=
➔ Efficiency

◆ ROCE (return on capital employed=

net profit
❑