D.

CHAPTER 5. Financial Information and Decisions.

5.1 – Business Finance: Needs and Sources

Finance is the money required in the business. Finance is needed to set up the business,
expand it and increase working capital (the day-to-day running expenses).

Start-up capital is the initial capital used in the business to buy fixed and current assets
before it can start trading.

Working Capital finance needed by a business to pay its day-to-day running expenses

Capital expenditure is the money spent on fixed assets (assets that will last for more than
a year). E.g.: vehicles, machinery, buildings etc. These are long-term capital needs.

Revenue Expenditure, similar to working capital, is the money spent on day-to-day

expenses which does not involve the purchase of long-term assets. E.g.: wages, rent. These
are short-term capital needs.

SOURCES OF FINANCE

They include; long term, short term, internal and external

INTERNAL FINANCE

Is obtained from within the business itself.

1. Retained Profit: profit kept in the business after owners have been given their
share of the profit. Firms can invest this profit back in the businesses.
Advantages:
– Does not have to be repaid, unlike, a loan.
– No interest has to be paid
Disadvantages:
– A new business will not have retained profit
– Profits may be too low to finance

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– Keeping more profits to be used as capital will reduce owner’s share of profit and
they may resist the decision.

2. Sale of existing assets: assets that the business doesn’t need anymore, for example,
unused buildings or spare equipment can be sold to raise finance
Advantages:
– Makes better use of capital tied up in the business
– Does not become debt for the business, unlike a loan.
Disadvantages:
– Surplus assets will not be available with new businesses
– Takes time to sell the asset and the expected amount may not be gained for the asset

3. Sale of inventories: sell of finished goods or unwanted components in inventory.

Advantage:
– Reduces costs of inventory holding
Disadvantage:
– If not enough inventory is kept, unexpected increase demand form customers cannot be
fulfilled

4. Owner’s savings: For a sole trader and partnership, since they’re unincorporated (owners
and business is not separate), any finance the owner directly invests from his own saving
will be internal finance.
Advantages:
– Will be available to the firm quickly
– No interest has to be paid.
Disadvantages:
– Increases the risk taken by the owners.
EXTERNAL FINANCE

Is obtained from sources outside of the business.

1. Issue of share: only for limited companies.

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Advantage:
 A permanent source of capital, no need to repay the money to shareholders
no interest has to be paid
Disadvantages:
 Dividends have to be paid to the shareholders
 If many shares are bought, the ownership of the business will change hands. (The
ownership is decided by who has the highest percentage of shares in the company)
2. Bank loans: money borrowed from banks
Advantages:
 Quick to arrange a loan
 Can be for varying lengths of time
 Large companies can get very low rates of interest on their loans
Disadvantages:
 Need to pay interest on the loan periodically
 It has to be repaid after a specified length of time
 Need to give the bank a collateral security (the bank will ask for some valued asset,
usually some part of the business, as a security they can use if at all the business cannot
repay the loan in the future. For a sole trader, his house might be collateral. So there is a
risk of losing highly valuable assets)
3. Debenture issues: debentures are long-term loan certificates issued by companies.
Like shares, debentures will be issued, people will buy them and the business can
raise money. But this finance acts as a loan- it will have to be repaid after a specified
period of time and interest will have to be paid for it as well.
Advantage:
 Can be used to raise very long-term finance, for example, 25 years
Disadvantage:
 Interest has to be paid and it has to be repaid
4. Debt factoring: a debtor is a person who owes the business money for the goods
they have bought from the business. Debt factors are specialist agents that can
collect all the business’ debts from debtors.

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Advantages:
 Immediate cash is available to the business
 Business doesn’t have to handle the debt collecting

Disadvantage:
 The debt factor will get a percent of the debts collected as reward. Thus, the business
doesn’t get all of their debts
5. Grants and subsidies: government agencies and other external sources can give
the business a grant or subsidy
Advantage:
 Do not have to be repaid, is free
Disadvantage:
 There are usually certain conditions to fulfil to get a grant. Example, to locate in a
particular under-developed area.
6. Micro-finance: special institutes are set up in poorly-developed countries where
financially-lacking people looking to start or expand small businesses can get small
sums of money. They provide all sorts of financial services
7. Crowdfunding: raises capital by asking small funds from a large pool of people, e.g.
via Kickstarter. These funds are voluntary ‘donations’ and don’t have to be return or
paid a dividend.

SHORT-TERM FINANCE

Provides the working capital a business needs for its day-to-day operations.
1. Overdrafts: similar to loans, the bank can arrange overdrafts by allowing businesses to
spend more than what is in their bank account. The overdraft will vary with each month,
based on how much extra money the business needs.
Advantages:
 Flexible form of borrowing since overdrawn amounts can be varied each month
 Interest has to be paid only on the amount overdrawn

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 Overdrafts are generally cheaper than loans in the long-term

Disadvantages:
 Interest rates can vary periodically, unlike loans which have a fixed interest rate.
 The bank can ask for the overdraft to be repaid at a short-notice.
2. Trade Credits: this is when a business delays paying suppliers for some time, improving
their cash position
Advantage:
 No interests, repayments involved
Disadvantage:
 If the payments are not made quickly, suppliers may refuse to give discounts in the
future or refuse to supply at all
3. Debt Factoring: (see above)

LONG-TERM FINANCE
Is the finance that is available for more than a year
1. Loans: from banks or private individuals.
2. Debentures
3. Issue of Shares
4. Hire Purchase: allows the business to buy a fixed asset and pay for it in monthly
instalments that include interest charges. This is not a method to raise capital but gives the
business time to raise the capital.
Advantage:
 The firms doesn’t need a large sum of cash to acquire the asset
Disadvantage:
 A cash deposit has to be paid in the beginning
 Can carry large interest charges.
5. Leasing: this allows a business to use an asset without purchasing it. Monthly leasing
payments are instead made to the owner of the asset. The business can decide to buy the
asset at the end of the leasing period. Some firms sell their assets for cash and then lease
them back from a leasing company. This is called sale and leaseback.

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Advantages:
 The firm doesn’t need a large sum of money to use the asset
 The care and maintenance of the asset is done by the leasing company
Disadvantage:
 The total costs of leasing the asset could finally end up being more than the cost of
purchasing the asset!

Factors that affect choice of source of finance

 Purpose: if a fixed asset is to be bought, hire purchase or leasing will be appropriate, but if
finance is needed to pay off rents and wages, debt factoring, overdrafts will be used.

 Time-period: for long-term uses of finance, loans, debenture and share issues are used,
but for a short period, overdrafts are more suitable.

 Amount needed: for large amounts, loans and share issues can be used. For smaller
amounts, overdrafts, sale of assets, debt factoring will be used.

 Legal form and size: only a limited company can issue shares and debentures. Small firms
have limited sourced of finances available to choose from

 Control: if limited companies issue too many shares, the current owners may lose control
of the business. They need to decide whether they would risk losing control for business
expansion.

 Risk- gearing: if business has existing loans, borrowing more capital can increase gearing-
risk of the business- as high interests have to be paid even when there is no profit, loans
and debentures need to be repaid etc. Banks and shareholders will be reluctant to invest in
risky businesses.

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Finance from banks and shareholders

Chances of a bank willing to lend a business finance is higher when:

 A cash flow forecast is presented detailing why finance is needed and how it will be used

 An income statement from the last trading year and the forecast income statement for the
next year, to see how much profit the business makes and will make.

 Details of existing loans and sources of finance being used

 Evidence that a security/collateral is available with the business to reduce the bank’s risk
of lending

 A business plan is presented to explain clearly what the business hopes to achieve in the
future and why finance is important to these plans

Chances of a shareholder willing to invest in a business is higher when:

 the company’s share prices are increasing- this is a good indicator of improving
performance

 dividends and profits are high

 the company has a good reputations and future growth plans

5.2 – Cash Flow Forecasting and Working Capital

Why is cash important?

If a firm doesn’t have any cash to pay its workers, suppliers, landlord and government, the
business could go into liquidation– selling everything it owns to pay its debts. The
business needs to have an adequate amount of cash to be able to pay for all its short-term
payments.

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Cash Flow

The cash flow of a businesses is its cash inflows and cash outflows over a period of time.

Cash inflows are the sums of money received by the business over a period of time. E.g.:

 sales revenue from sale of products

 payment from debtors– debtors are customers who have already purchased goods from
the business but didn’t pay for them at that time

 money borrowed from external sources, like loans

 the money from the sale of business assets

 investors putting more money into the business

Cash outflows are the sums of money paid out by the business over a period of time. Eg:

 purchasing goods and materials for cash

 paying wages, salaries and other expenses in cash

 purchasing fixed assets

 repaying loans (cash is going out of the business)

 by paying creditors of the business- creditors are suppliers who supplied items to the
business but were not paid at the time of supply.

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The cash flow cycle:

Cash flow is not the same as profit! Profit is the surplus amount after total costs have
been deducted from sales. It includes all income and payments incurred in the year,
whether already received or paid or to not yet received or paid respectfully. In a cash flow,
only those elements paid by cash are considered.

Cash Flow Forecasts

A cash flow forecast is an estimate of future cash inflows and outflows of a business, usually
on a month-by-month basis. This then shows the expected cash balance at the end of each
month. It can help tell the manager:

 how much cash is available for paying bills, purchasing fixed assets or repaying loans

 how much cash the bank will need to lend to the business to avoid insolvency (running out
of liquid cash)

 whether the business has too much cash that can be put to a profitable use in the business

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Example of a cash flow forecast for the four months:

The cash inflows are listed first and then the cash outflows. The total inflows and outflows
have to be calculated after each section.

The opening cash/bank balance is the amount of cash held by the business at the start of
the month

Net Cash Flow = Total Cash Inflow – Total Cash Outflow

The net cash flow is added to opening cash balance to find the closing cash/bank
balance– the amount of cash held by the business at the end of the month. Remember, the
closing cash/bank balance for one month is the opening cash/bank balance for the next
month!

The figures in bracket denote a negative balance, i.e., a net cash outflow (outflows >
inflows)

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Uses of cash flow forecasts:

 When setting up the business the manager needs to know how much cash is required to
set up the business. The cash flow forecast helps calculate the cash outflows such as rent,
purchase of assets, advertising etc.

 A statement of cash flow forecast is required by bank managers when the business
applies for a loan. The bank manager will need to know how much to lend to the business
for its operations, when the loan is needed, for how long it is needed and when it can be
repaid.

 Managing cash flow– if the cash flow forecast gives a negative cash flow for a month(s),
then the business will need to plan ahead and apply for an overdraft so that the negative
balance is avoided (as cash come in and the inflow exceeds the outflow). If there is too
much cash, the business may decide to repay loans (so that interest payment in the future
will be low) or pay off creditors/suppliers (to maintain healthy relationship with
suppliers).

How can cash flow problems be overcome?

When a negative cash flow is forecast (lack of cash) the following methods can be used to
correct it:

 Increase bank loans: bank loans will inject more cash into the business, but the firm will
have to pay regular interest payments on the loans and it will eventually have to be repaid,
causing future cash outflows

 Delay payment to suppliers: asking for more time to pay suppliers will help decrease
cash outflows in the short-run. However, suppliers could refuse to supply on credit and
may reduce discounts for late payment

 Ask debtors to pay more quickly: if debtors are asked to pay all the debts they have to
the firm quicker, the firm’s cash inflows would increase in the short-run. These debtors will
include credit customers, who can be asked to make cash sales as opposed to credit sales

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for purchases (cash will have to be paid on the spot, credit will mean they can pay in the
future, thus becoming debtors). However, customers may move to other businesses that
still offers them time to pay

 Delay or cancel purchases of capital equipment: this will greatly help reduce cash
outflows in the short-run, but at the cost of the efficiency the firm loses out on not buying
new technology and still using old equipment.

In the long-term, to improve cash flow, the business will need to attract more
investors, cut costs by increasing efficiency, develop more products to attract customers
and increase inflows.

Working Capital

Working capital the capital required by the business to pay its short-term day-to-day
expenses. Working capital is all of the liquid assets of the business– the assets that can
be quickly converted to cash to pay off the business’ debts. Working capital can be in the
form of:

 cash needed to pay expenses

 cash due from debtors – debtors/credit customers can be asked to quickly pay off what
they owe to the business in order for the business to raise cash

 Cash in the form of inventory – Inventory of finished goods can be quickly sold off to build
cash inflows. Too much inventory results in high costs, too low inventory may cause
production to stop.

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5.3 – Income Statements

Accounts are the financial records of a firm’s transactions.

Final Accounts are prepared at the end of the financial year and give details of the profit or
loss made as well as the worth of the business.
Profit

Profit = Sales Revenue – Total cost

When the total costs exceed the sales revenue, then a loss is made.

How to increase profit?

 Increase sales revenue
 Cut costs
Why is profit important to a business?

 It is a reward for enterprise: entrepreneurs start businesses to make a profit

 It is a reward for risk-taking: entrepreneurs has to take considerable risks when they
invest capital in a venture, and profits are a compensation/reward to them for taking these
risks (paid in the form of profits or dividends)

 It is a source of finance: after payments to owners, profits are reinvested back into the
business for further expansion (this is called retained earnings)

 It is an indicator of success: more profits indicate to investors that the business/industry

is worth their time and money, and they will invest more either int he firm or new firms of
their own, in the hopes of gaining good returns on their investment

For social enterprises, profit is not one of their primary objectives, but welfare of the
society is. However, they will also strive to make some profit to reinvest it back into the
business and help it grow.

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Profit is not the same as cash flow!

Profit is the surplus amount after total costs have been deducted from sales. It includes all
income and payments incurred in the year, whether already received or paid or to not yet
received or paid respectfully. In a cash flow, only those elements paid in cash immediately
are considered.

Income Statement

An income statement is a financial document of the business that records all income
generated by the business as well as the costs incurred by the business and thus the profit
or loss made over the financial year. Also known as profit and loss account.

A simple Income Statement

Sales Revenue = total sales

Cost of Sales = total variable cost of production + (opening inventory of finished goods –
closing inventory of finished goods)
Gross Profit = Sales Revenue – Cost of Sales
Expenses: all overheads/fixed costs
Net Profit = Gross Profit – Expenses

Profit after Tax = Net Profit – Tax

Dividends: share of profit given to shareholders; return on shares
Retained Profit for the year = Profit after Tax – Dividends. This retained earnings is then
kept aside for use in the business.

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Only a
very small portion of the sales revenue ends up being the retained profit. All costs, taxes
and dividends have to be deducted from sales.

Uses of Income Statement

Income statements are used by managers to:

 know the profit/loss made by the business

 Compare their performance with that of previous years’ and with that of competitors’. If
profit is lower than that of last year’s why is it falling and what can they do to correct the
issue? If it is lower than that of competitors’ what can they do to be more profitable and be
competitive in the market?

 Know the profitability of individual products by preparing separate income statement

for each product. They may decide to stop production of products that are making losses.

 Help decide what products to launch by preparing forecast income statement for the
first few years. Whichever product is forecast to have a higher profit, the business will
choose to launch that product

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5.4 – Statement of Financial Position

The balance sheet, along with the income statement is prepared at the end of the financial
year. It shows the value of a business’ assets and liabilities at a particular time. It is
also known as ‘statement of financial position’.

Assets are those items of value owned by the business.

 Fixed/non-current assets (buildings, vehicles, equipment etc.) are assets that remain in
the business for more than a year – their values fall over time in a process
called depreciation every year.

 Short-term/current assets (inventory, trade receivables (debts from customers), cash etc)
are owned only for a very short time.

 There can also intangible (cannot be touched or felt) non-current assets like copyrights
and patents that add value to the business.

Liabilities are the debts owed by the business to its creditors.

 Long-term/non-current liabilities (loans, debentures etc.)- they do not have to be repaid

within a year.

 Short-term/current liabilities (trade payables (to suppliers), overdraft etc.)- these need
to be repaid within a year.

CURRENT ASSETS – CURRENT LIABILITIES = WORKING CAPITAL

This is because the liquid cash a company has with them will be the liquid (short-term)
assets they own less the short-term debts they have to pay.

Shareholder’s Equity is the total amount of money invested in the company by

shareholders. This will include both the share capital (invested directly by shareholders)
and reserves (retained earnings reserve, general reserve etc.).
Shareholders can see if their stake in the business has risen or fallen by looking at the total
equity figure on the balance sheet.

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Check whether the equations on the right are satisfied in this balance sheet!

SHAREHOLDERS EQUITY = TOTAL ASSETS – TOTAL LIABILITIES

TOTAL ASSETS = TOTAL LIABILITIES + SHAREHOLDERS EQUITY

CAPITAL EMPLOYED = SHAREHOLDERS EQUITY + NON-CURRENT LIABILITIES
This is because non-current liabilities like loans are also used for permanent investment in
the company.

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Uses of a statement of financial position

 When the current assets subtotal is compared to the current liabilities subtotal, investors
can estimate whether a firm has access to sufficient funds in the short term to pay off its
short-term obligations i.e., whether it is liquid

 One can also compare the total amount of debt (liabilities) to the total amount of equity
listed on the balance sheet, to see if the resulting debt-equity ratio indicates a dangerously
high level of borrowing. This information is especially useful for lenders and creditors,
(especially banks) who want to know if the firm will be able to pay back its debt

 Investors like to examine the amount of cash on the balance sheet to see if there is enough
available to pay them a dividend

 Managers can examine its balance sheet to see if there are any assets that could
potentially be sold off without harming the underlying business. For example, they can
compare the reported inventory assets to the sales to derive an inventory turnover level,
which can indicate the presence of excess inventory, so they will sell off the excess
inventory to raise finance

5.5 – Analysis of Accounts

The data contained in the financial statements are used to make some useful
observations about the performance and financial strength of the business. This is the
analysis of accounts of a business. To do so, ratio analysis is employed.
Ratio Analysis

 Profitability Ratios: profitability is the ability of a company to use its resources to

generate revenues in excess of its expenses. These ratios are used to see how profitable
the business has been in the year ended.
 Return on Capital Employed (ROCE): this calculates the return (net profit) in terms of
the capital invested in the business (shareholder’s equity + non-current liabilities) i.e.
the % of net profit earned on each unit of capital employed. The higher the ROCE the

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better the profitability is. The formula is:

 Gross Profit Margin: this calculates the gross profit (sales – cost of production) in
terms of the sales, or in other words, the % of gross profit made on each unit of sales
revenue. The higher the GPM, the better. The formula is:

 Net profit Margin: this calculates the net profit (gross profit-expenses) in terms of the
sales, i.e. the % of net profit generated on each unit of sales revenue. The higher the
NPM, the better. The formula is:

 Liquidity Ratios: liquidity is the ability of the company to pay back its short-term
debts. It if it doesn’t have the necessary working capital to do so, it will go illiquid (forced
to pay off its debts by selling assets). In the previous topic, we said that working capital =
current assets – current liabilities. So a business needs current assets to be able to pay off
its current liabilities. The two liquidity ratios shown below, use this concept.
 Current Ratio: this is the basic liquidity ratio that calculates how many current assets
are there in proportion to every current liability, so the higher the current ratio the
better (a value above 1 is favourable). the formula is:

 Liquid Ratio/ Acid Test Ratio: this is very similar to current ratio but this ratio
doesn’t consider inventory to be a liquid asset, since it will take time for it to be sold
and made into cash. A high level of inventory in a business can thus cause a big
difference between its current and liquidity ratios. So there is a slight difference in the

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formula:

Uses and users of accounts

 Managers: they will use the accounts to help them keep control over the performance of
each product or each division since they can see which products are profitably performing
and which are not.
 This will allow them to take better decisions. If for example, product A has a good
gross profit margin of 35% but its net profit margin is only 5%, this means that the
business has very high expenses that is causing the huge difference between the two
ratios. They will try to reduce expenses in the coming year. In the case of liquidity, if
both ratios are very low, they will try to pay off current liabilities to improve the ratios.
 Ratios can be compared with other firms in the industry/competitors and also with
previous years to see how they’re doing. Businesses will definitely want to perform
better than their rivals to attract shareholders to invest in their business and to stay
competitive in the market. Businesses will also try to improve their profitability and
liquidity positions each year.
 Shareholders: since they are the owners of a limited company, it is a legal requirement
that they be presented with the financial accounts of the company. From the income
statements and the profitability ratios, especially the ROCE, existing shareholders and
potential investors can see whether they should invest in the business by buying shares.
A higher profitability, the higher the chance of getting dividends. They will also compare
the ratios with other companies and with previous years to take the most profitable
decision. The balance sheet will tell shareholders whether the business was worth more at
the end of the year than at the beginning of the year, and the liquidity ratios will be used to
ascertain how risky it will be to invest in the company- they won’t want to invest in
businesses with serious liquidity problems.
 Creditors: The balance sheet and liquidity ratios will tell creditors (suppliers) the cash
position and debts of the business. They will only be ready to supply to the business if they

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will be able to pay them. If there are liquidity problems, they won’t supply the business
as it is risky for them.
 Banks: Similar to how suppliers use accounts, they will look at how risky it is to lend to
the business. They will only lend to profitable and liquid firms.
 Government: the government and tax officials will look at the profits of the company to fix
a tax rate and to see if the business is profitable and liquid enough to continue operations
and thus if the worker’s jobs will be protected.
 Workers and trade unions: they will want to see if the business’ future is secure or not.
If the business is continuously running a loss and is in risk of insolvency (not being liquid),
it may shut down operations and workers will lose their jobs!
 Other businesses: managers of competing companies may want to compare their
performance too or may want to take over the business and wants to see if the takeover
will be beneficial.

Limitations of using accounts and ratio analysis

 Ratios are based on past accounting data and will not indicate how the business will
perform in the future
 Managers will have all accounts, but the external users will only have those published
accounts that contain only the data required by law- they may not get the ‘full-picture’
about the business’ performance.
 Comparing accounting data over the years can lead to misleading assumptions since
the data will be affected by inflation (rising prices)
 Different companies may use different accounting methods and so will have different
ratio results, making comparisons between companies unreliable.

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