Business book answers

Contents:
1. Sources of finance
2. Costs and revenue
3. Break-even analysis
4. Final accounts
5. Profitability and liquidity ratio analysis
6. Efficiency ratio analysis (HL)
7. Cash flow
8. Investment appraisal
9. Budgets (HL)

3. FINANCE & ACCOUNTS:

3.1 Sources of Finance:

Reasons businesses need to raise finance:

- Growth
- Revenue expenditure (day to day costs/ operating expenses/ current assets)
- Marketing
- Business start-up will require start-up capital to purchase capital equipment.
- Training/ recruitment
- Capital expenditure (long term assets)
- Business expansion needs finance to increase the capital assets.
- Expansion can be achieved by acquiring other businesses
- Special situations may require immediate finance to tide the business over.
- Finance often used to pay for research and development into new products or to invest in new marketing
strategies. (RnD)

❖ Revenue expenditure → the cash a business spends in sales revenue generation or the costs associated with
maintaining a revenue generating fixed asset. These are incurred on a regular basis and the benefit from these costs is
obtained over a relatively short period of time.
❖ Capital expenditure → funds used by a company to acquire or upgrade physical assets such as property, factories or
equipment. These are normally one-off purchases of tangible assets that last over a year. Gets devalued.
❖ Fixed assets → are those expected to keep providing benefit for more than one year (Eg. equipment, buildings, real
estate…)
❖ IVA → impuesto del valor añadido.
❖ Working capital: is the difference between a company's current assets and its current liabilities.
Working Capital cycle:

Left over is added value/ profit.

Working capital = current assets - current liabilities

Internal vs External sources (limited companies):

● External: - Medium long term loan

Long term: (5+ years) Short term: (>1 year)

- Share capital: - Overdraft
Sold via stock exchange and no interest, but - Bank loan
loss of ownership. eg. venture capitalists and - Creditos
business angels. - Debt factoring
- Long term loan capital.
Borrowing funds from a financier, but can ● Internal:
increase debts with interest. - Retained profit (reinvesting money in the
- Grants/ subsidies: business)
Issued normally by the government. - Sales of assets
- Reductions in working capital (making the
Medium term: (1-5 years) cycle spin faster)
- Leasing - Personal funds
- Hire purchase
- Debentures

❖ Overdraft → a line creditor that covers your transactions if your bank account balance drops below zero. Allos a
business to take more money than it has on it’s bank account (high interest rates).
❖ Debt factoring → the process of selling unpaid invoices for a percentage of their worth.
❖ Hire purchase → is an arrangement for buying expensive consumer goods, where the buyer makes an initial
down payment and pays the balance plus interest in installments. (pay over a period of time that sums up to
the total amount).
❖ Dilution of ownership → happens when selling shares.
❖ Mortgage → type of debt, secured by the collateral of specified real estate property, that the borrower is obliged to pay
back with a predetermined set of payments.
❖ Debenture → type of debt instrument unsecured by collateral. Since they have no collateral backing, debentures must
rely on the creditworthiness and reputation of the issuer for support.
❖ Trade credit → enables you to obtain goods and services from a supplier without having to pay for these immediately
(usually interest-free).
❖ Grants → financial assistance from the government. Often provided to reduce production costs or encourage
employment opportunities.
❖ Subsidies → provided in order to encourage output. These are tax breaks for subsidized businesses.
❖ Venture capitalists → institutional investors that invest in business start-ups and require right to partial ownership of
the company. (eg. dragons den).
❖ Leasing → finance fixed assets without the necessary capital expenditure. The lessor is responsible for maintaining
costs. (renting)
❖ Office angels → Wealthy individuals who invest in high-risks (risk their own personal money); can provide a vital
source of finance for small businesses that do not have access to conventional providers of finance such as banks.
❖ Bonds → is a fixed income instrument that represents a loan made by an investor to a borrower used to
finance projects and operations.
❖ Highly geared → high debt ratio; being supported by borrowing money.

Advantages of equity finance:

- It never had to be repaid
- Dividends do not have to be paid every year while interest must be paid when demanded by the lender.
- Much larger amounts of finance can possibly be raised than through debt factoring.

Six factors influencing choice of finance:

● Cost:
- May have an opportunity cost
- Loans may become very expensive during a period of rising interest rates.
- Stock exchange floatation can cost millions of dollars in fees and promotion of the shares.
● Flexibility:
- When a firm has a variable need for finance, flexible forms of finance are better than long-term and
inflexible sources.
● Amount required:
- Share issues and sales and debentures would generally only be used for large capital sums.
- It’s easier to borrow small amounts of money because there’s not a high risk.
● Size of existing borrowing:
- The higher the existing debts, the greater the risk of lending more (gearing).
● Legal structure and desire to retain control:
- Can only be issued by limited companies
- If owners want to retain control, then this is unwise.
3.2 Costs and Revenues:

Costs:
Any spending the company occurs in the production of goods and services.
- Fixed/ overhead/ indirect:
costs that are not affected by the amount of trade done by the firm or by the output produced. (eg. rent,
mortgage repayments, salaries…).
- Variable/ direct:
costs that change in direct proportion to the amount of trade done or the number of goods produced. (eg.
raw materials, petrol, maintenance…).
- Semi-variable:
mixture of fixed and variable costs (eg. phone bill, water, electricity…).
- Average costs:
how much, on average, it costs to make each unit produced.
- Marginal costs:
the cost of producing ONE extra unit of output.

Maximum efficiency:
Economically firms should operate as efficiently as possible. This occurs when the average cost is at a minimum.
Companies try to reduce TC and increase Total Revenue in order to make profit.

❖ Profit = TR - TC (if +ve then you’re making profit). Break even is when TR = TC.

Contribution:
A product may be unprofitable in the short-term, but still worth producing because it makes a contribution to fixed
costs. If a product is making a positive contribution then it is worth producing until a better product can be found;
otherwise, the contribution would have to be found elsewhere.

❖ Contribution is how much is left from the price that goes into the fixed costs.
CONTRIBUTION = Price - Variable cost per unit.

Revenue (Turnover):
It’s the total amount of income generated from the sale of goods and services. It’s not the same as cash in a
cash-flow unless all goods have been sold. Not the same as profit as all the costs have to be subtracted from the
TR.
Total Revenue (TR) includes revenue streams as well as sales.

Revenue streams:
- Sales
- Insurance
- Rent
- Subsidies/ subventions
- Government grants
- Fund-raising
- Interest/ dividends
- Sale of assets

3.3 Break-Even Analysis:

Break even output:

The level of output at which total sales revenue equals the total costs of production.
- Costs > Revenue → loss
- Costs < Revenue → profit
- Costs = Revenue → break even

Assumptions for a break even model:

In the real world this is not exactly true.
- Fixed costs must be paid regardless of level output.
- Variable costs increase with output, but at a constant rate. (eg. 1 unit cost 5€, then 10 units 50€)
- Every unit is sold.
- Selling price remains constant regardless of units sold (no discounts, liquidation…)

Break even analysis:

Is a method for finding out the level of sales necessary for a firm to not make a loss and start making profit.
3 methods:
- Using a table
- Using a graph
 - Using a formula

❖ Break even quantity (BEQ) → when costs = revenue and there is no loss or profit.
❖ Break even revenue (BER) → the level of sales revenue being earned by the firm at the break even level of output.
❖ Break even point (BEP) → the position where the TC and TR lines cross.

Drawing a graph:
1. Extract the data → FC. VC, Price per unit.
2. Calculate BEQ ( Fixed cost / (Price - Variable cost) )
3. Draw X-axis quantity (if you don’t have a max capacity → double the break even amount)
4. Draw Y-axis revenue & costs
5. Plot TR (starts at 0)
6. Plot FC
7. Plot TC
8. Label the axis and put a title
9. Optional: add margin of safety; loss & profit.
eg:

Advantages vs disadvantages:

- Focuses entrepreneurs on how long it will take before a start-up reaches profitability.
Eg. what output or total sales is required.
- Helps entrepreneur understand the viability of a business proposition, and also those who will lend money
to, or invest in the business
- Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are
incurred
 - Helps entrepreneur understand the level of risk involved in a start-up
- Illustrates the importance of a start-up keeping fixed costs down to a minimum (higher fixed costs = higher
break-even output)
- Calculations are quick and easy – great for giving quick estimates

However:
- Unrealistic assumptions – products are not sold at the same price at different levels of output; fixed costs
do vary when output changes.
- Sales are unlikely to be the same as output – there may be some build up of stocks or wasted output too.
- Variable costs do not always stay the same.
Eg. as output rises, the business may benefit from being able to buy inputs at lower prices (buying power),
which would reduce variable cost per unit.
- Most businesses sell more than one product, so break-even for the business becomes harder to calculate
- Break-even analysis should be seen as a planning aid rather than a decision-making tool.

3.4 Final Accounting:

❖ Income statement = profit and loss account (past) → looks at revenue, expenses, gains, and losses.
❖ Balance sheet (present) → an accounting statement that records the values of a business’s assets, liabilities and
shareholders’ equity at one point in time.
❖ Cashflow forecast (future) → is a way of estimating the flow of cash coming in and out of your
business, across all areas, over a given period of time.

Stakeholders & accounting info:

L lenders → VC’s, Banks, Debentures, etc.

E employees → job security
G government → legal
S shareholders → dividends
+ S suppliers → trade creditors
+ C competitors → buying?, etc.

Why do shareholders care:

Managers:
- Measure the performance of a business against targets, previous time periods and competitors.
- Help them with decisions (eg. new investments, branch closures, launching new products).
- Control and monitor the operation of each department, branch and division.
- Set targets for the future and review against actual performance.
Banks:
- Decide whether to lend money to a business.
- Access whether to allow for an increased overdraft facility.
- Decide whether to renew sources of finance (overdraft, loans, etc).
Creditors (eg. suppliers):
 - Assess whether the business is secure and liquid enough to pay off its debts.
- Assess whether the business is a good credit risk.
- Decide whether to press for early repayment of outstanding debts.
Investors (eg. shareholders):
- Assess the value of the business and their investment in it.
- Establish whether the business is becoming more or less profitable.
- Determine the share of the profits investors are receiving.
- Decide whether the business before making an investment and/or purchasing shares in a company.
- To consider whether they should sell all or part of their holder.
Customers:
- Assess whether a business is secure.
- Determine whether they will be assured of future supplies of the good they are purchasing.
- Establish whether there will be security of spare parts and service facilities.
Government & tax authorities:
- Calculate how much tax is due from the business.
- Determine whether the business is likely to expand and create more jobs.
- Assess whether the business is in danger of closing down, creating economic problems.
- Determine whether the business is staying within the law in terms of accounting regulations.

❖ Profit centre → where revenue is received

❖ Cost center → capital expenditure (legal)

Profit = Sales Revenue - Total cost

Revenue > Costs = Profit
Revenue < Costs = Loss

Why do you need a profit & loss account:

- Legal requirement.
- Summarises all the yeat’s transactions.
- It shows the financial ‘health’ of the busines.
- Can be used to compare trade this year with trade last year.

Calculate profit & loss:

At the end of the financial year.
- Sales (turnover; total revenue) → total amount of money a business receives from selling good and services.
- Cost of sales → how much it costs to make goods you sell.
- Expenses → rent and rates; admin cost; heating and light; advertising → the overheads (fixed costs) that have to be
paid.

❖ Closing stock → value of the stock left at the end of the year, which is passed onto the next (opening stock).
❖ Assets → items of monetary value that are owned by a business. (what you own)
❖ Liabilities → a financial obligation of a business that is required to pay in the future. (what you owe)
❖ Capital → the money invested by the owner.
❖ Share capital → total value of capital raised from shareholders by the issue of shares.
Balance sheet:
(present) an accounting statement that records the values of a business’s assets, liabilities and shareholders’
equity at one point in time.
Assets = Liabilities + equity

Fixed assets: Current liabilities:

- Last a long time (buildings, vehicles, - Amounts owed which are due to be repaid
computers…) within a year.
- Cost a lot of money - Money the business owes to suppliers
- Could be sold to increase capital (creditors) for goods purchased on credit.
- Short term loans.
Current assets:
- Items used and replaced regularly (raw Long term liabilities:
materials, stock) - Amounts owed which are due to be repaid in
- Customers who owe money (debtors) for more than years time.
goods they have bought. - Mortgages normally payable over a 25 year
- Money in the current bank account. period.
- Long term bank loans.

Working capital:
Business will want to get round the cycle as quickly as possible.
Speed of the working capital cycle:
- Creditors:
People a business owes money to. They speed up the cycle.
- Debtors:
People who owe the business money. They slow down the cycle.

Structure:
Net assets section:
1. Business name and date
2. Fixed assets are listed and then added up
3. Current assets are listed and totalled.
4. Current liabilities are listed and added up.
5. Net current assets or Working capital (current assets - current liabilities) (if a minus figure u take away)
6. Long term liabilities are listed and totalled.
7. Net assets (fixed assets + working capital - long term liabilities)
Shareholder capital section:
1. Financed by shows where the money comes from.
2. Net assets = capital employed.
Who uses a balance sheet:
- It shows the health of the business.
- Stakeholders will be interested in the balance sheet (LEGS)
- This is because when used with the income statement it shows how well the business is doing.

Depreciation (HL):
The fall in value of a fixed asset.
Fixed assets do not last forever; they lose value and this has to be shown in a balance sheet.
- Straight line method:
Reduces an asset by the same amount each year.

Original Cost −Expected Value

Depreciation=
Expected years of ownership
- Reducing Balance method:
Reduces the value of an asset by the same percentage each year.

n❑
Final Value=Original Cost (1−r )

Eg: Business purchases a machine for 20 000€ and wants to keep it for 3 years. Depreciated by 40%
each year.
Year 1 → 20 000 - (20000 x 40%) =12 000€
Year 2 → 12 000 - (12 000 x 40%) = 7200€
Year 3 → 7200 - (7200 x 40%) = 4320€

- Effects of depreciation:
It is an expense so it’s shown in the trading, profit & loss account.
The new value is shown in the balance sheet.
Value of intangible assets:
Goodwill, patents, copyrights, brand names and capital spent on research and development into the new product
are examples of intangible assets. They do not exist in physical sense, yet they add value to a company. The
value of intangible assets can fluctuate widely.

❖ Patent → a stamp for something you created/ your own idea so that they can’t be copied.

3.5 Profitability and liquidity ratios:

Shareholder Funds=ShareCapital + Reserves

Profitability ratios:
They examine the profit in relation to other figures (eg. sales revenue). Profitability ratios help assess the financial
performance of a business.
- Managers, employees and potential creditors will be interested because it shows how well a firm has
performed in financial terms.
1. ROCE:
- This compared net profit to the amount of money in the business.
- The higher this figure the better. Eg. A ROCE of 12% means that for every $1 invested, a firm makes
12 cents net profit.
- This can be used to compare the performance of the business with the interest from a bank account.
If the ROCE is higher than the interest rate of a bank, it would be more profitable to invest your
money in the firm.

Net Profit Before Tax

Returnon Capital Employed (ROCE)= × 100
Capital Employed
2. Gross Profit Margin:
- Compares gross profit with the sales made.
- The higher the figure the better. Eg. gross profit margin of 56% means that for every 1$ the firm
makes 56 pence gross profit.

Gross Profit
Gross Profit Margin= × 100
Sales Revenue
3. Net Profit Margin:
- Compares net profit with the sales made.
- The higher the better. Eg. a net profit margin of 32% means that for every $1 a firm makes 32 pence
net profit.

Net Profit
Net Profit Margin= ×100
Sales Revenue
Liquidity ratios:
They look at the ability of a firm to pay its short-term liabilities, such as comparing working capital to
current liabilities.
- Creditors and financial lenders will be interested in these ratios to help them assess the likelihood of being
repaid.
1. Current ratio:
- Measures the ability of a business to pay its debts over the next year.
- Answer given as a ratio.
- A figure between 1.5 - 2 would be seen as normal, but it varies across industries.
- If the number is high (over 2) it would be considered bad liquidity management.
- If the number is low (less than 1) it would be risky liquidity management (receiving less cash than
what goes out).

Current Assets
Current Ratio=
Current Liabilities
2. Acid Test Ratio:
- It measures the ability of a business to pay its debts immediately.
- A figure of around 1 is seen as normal.
- You take stock away because it is not liquidity.

Current Assets−stock
Acid Test Ratio=
Current Liabilities
Efficiency ratios (HL):
Show how well a firm is using its resources (eg. how long does it take a firm to sell its stocks or collect money
from its debtors).
1. Stock Turnover:
- Measures how quickly a firm sells its stock.
- The lower the figure the better.
- Answer is in days.
- How many days? → first formula.
- How many times? → second formula.

Stocks Cost of goods sold

Stock Turnover= x 365 Stock turnover x׿
Cost of sales average stock
2. Debt collection period:
- Measures how quickly a firm is able to collect money it is owed.
- The lower the figure the better cash flow.
- Answer is in days.

debtors
Debt collection period= x 365
turnover
3. Creditor payment period:
- Measures how quickly a firm pays its debt.
 - A high figure may help to improve cash flow, but too high may indicate cash flow problems or lead
to problems with suppliers.

creditors
creditor payment period= x 365
turnover
4. Gearing ratio:
- Measures how reliant a firm is on borrowed money.
- High gearing means higher interest costs.
- The lower the figure the better.
- May affect value of dividends to shareholders and the ability to obtain borrowed funds.

Loan capital
Gearing ratio= x 100
capital employed
Limitations of Ratio Analysis:
- Having sufficient data in order to be meaningful to compare with historical data or similar firms.
- Changes in the external environment (eg. PESTLE).
- Differences in accounting techniques (firms may use different accounting principles).

3.7 Cash Flow:

❖ Liquidity → how easily an asset can be turned into cash.

❖ Cash flow forecast → estimate of the firm’s future cash inflow and outflows.
❖ Net monthly cash flow → difference between cash inflows and outflows.
❖ Opening cash balance → cash held by the business at the start of the month.
❖ Closing cash balance → cash held at the end of the month becomes next month’s opening balance.

Cash Flow forecast:

Estimate of the firm’s future cash inflow and outflows. It is a very important business document which shows
when cash is expected to flow into and out of a business over a period of time.
Inflows: money received. Outflows: money paid to suppliers.
- Owner’s own capital injections - Rent payments
- Bank loan payments - Annual rent payment
- Customers cash purchases - Electricity, water and telephone/ internet bills
- Debtors payments - Labour cost payments
- Variable cost payments (raw materials).
Advantages:
- Influences a businesses decisions about the Disadvantages:
future - The business has to make sure figures are
- Alerts banks to potential problems in the accurate
future - Lots of research is required
- Helps a business plan ahead - It is only a forecast
Why do a Cash Flow:
- Banks can see how money is flowing in the business.
- The business can also plan to see if they can cut costs or increase revenue.
- Businesses can decide whether they want to expand or shrink.
- Businesses can decide if they need to invest more or less.

Structure:
Each month has its own column.
Each column has 3 parts:
- inflows/ receipts (A)
- outflows/ payments (B)
- Net in/ out flow (A-B)
- Bank brought forward/ opening balance
- Bank carried forward/ closing balance
Golden rules:
- Money is only recorded when cash changes hands
- It tells nothing about profit
- The closing balance of one months is the opening balance of another month.
- A negative closing balance does not mean that the firm is bankrupt.

Preventing cash flow problems:

Reducing cash outflows:
- Preferential credit terms
- Alternative suppliers
- Better stock control
- Reduce unnecessary expenses
- Leasing or renting
Improving cash inflows:
- Tighter credit control
- Cash payments only
- Change pricing policy
- Broaden product portfolio
Alternative finance:
- Overdraft
- Sale of fixed assets
- Debt factoring
- Government assistance

3.8 Investment Appraisal:

There are 3 ways a business can spend money: invest in fixed assets, buy raw materials, pay overheads.

❖ Investment → purchasing capital goods (Eg. equipment, vehicles, new buildings…) and improving fixed assets.
Expenditure on capital goods. 3 main reasons for capital investment:
 - To acquire additional capital assets for expansion (eg. increase unit production, create new
products..).
- To take advantage of new technology or advancements in equipment and machinery → increase efficiency
and reduce possible long term costs.
- To replace existing assets that have reached their life expectancy.

Investment Appraisal:
Evaluating the profitability or desirability of an investment project. It’s undertaken by using qualitative and
quantitative techniques.

Quantitative techniques:
Refers to judging whether an investment project is worthwhile through numerical (financial) means. This includes:
- Initial capital costs of investment.
- Estimated life expectancy.
- The expected residual value (additional net returns from the sale of assets at the end of its useful life).
- Forecasted net returns or net cash flows from the project (expected returns less running costs).

Payback period:
Is the length of time it takes for the net cash inflows to pay back the original costs of the investment.
Eg: if a project costs 2 million and is expected to pay back 500000, the payback period will be 4 years.
Advantages: Disadvantages:
- Simple - Cash earned after the payback method is
- Useful where technology changes rapidly ignored.
- Helps prevent cash flow problems since - It does not account for the real value of
money will be recovered as quickly as money
possible.

Average rate of return:

Measures the annual profitability of an investment as a percentage of the initial investment.
4 stages in calculating ARR:
- Add up all the positive cash flows
- Subtract cost of investment
- Divide by lifespan
- Calculate the % return to find the ARR.
Factors in assessing the ARR in % value:
- The ARR on other projects (opportunity cost)
- The minimum expected return set by the business (criterion rate).
- The annual interest rate on loans as ARR needs to be greater.

Net Return( profit ) per annum

ARR (%)= × 100
Capital Outlay (Cost )
Advantages: - The opportunity cost of investment can be
- It clearly shows the profitability of a project. taken into account.
- It allows easy comparison between projects.
Disadvantages:
 - more complex than payback - It does not take into account the effects of
inflation on the value of money over a time
period.

Net present value (using discounted cash flow) HL:

- Measures today’s value of the estimated cash flows resulting from an investment.
How external factors influence revenue forecast: How internal factors influence revenue forecast:
- Economic recession could reduce demand - Key employees leaves taking major clients
- Increase in oil prices may increase costs of - A new CEO proves to be very unpopular
production driving staff turnover up and negatively
- Interest rates may decrease affecting staff morale and productivity.
- A new competitor enters the market

Other factors to take into account when investing:

- Inflation on the value of money over the period of time.
- A high rate of return could mean a risky investment.
- If borrowing from a bank, make sure the interest rate is lower than the rate of return so that it is profitable
during its life expectancy.