Unit 3: finance

 3.1: Introduction finance

Business may require finance to:

 Pay taxes to government or authorities

 Start up a business
 Finance for day to day running: working capital
 Invest in market research or strategies
 Invest in research and development of new products
 Expansion: purchase of assets, takeover

The purpose of a company´s finance may be:

Capital expenditure

 Spending made to acquire items in a business (fixed assets) that will last for more than a year
 Fixed assets will generate income in the long term and will help the business succeed to grow
 This expenditure appears in the statement of financial position of the business

Revenue expenditure

 Spending made on day-to-day running of a business (wages, raw materials, etc.)

 This expenditure appears in the business´s statement of profit or loss
 This expenditure needs to be covered immediately as it keeps the business operating
 Give immediate benefits
 A business should avoid having high revenue expenditure

 3.2: Sources of finance: where the money gets the money from for expenditures?
Internal sources: capital is obtained from within the business wither from its own profit or assets. Personal funds,
retained profit, sale of assets

 Personal funds: usually used by sole traders and is normally used to start up the business.
Maximize control over the business, has no interest payments (which are costs for businesses, provides a
strong signal to other potential Investors or banks of the entrepreneur´s commitment
However, it adds risk to the owner and is limited
 Retained profits: the profits generated by a business after taking out all the possible costs. Normally used to
reinvest in the business, in businesses that are already set
It has no interest payments, it is significant for achieving expansion, can be a permanent source of finance
(the money is regenerated as the business operate), owners retain control of the business.
However, it is not appropriate for start-up, newly formed complains or those that operate at a loss.
Moreover, if retained profits are too low, it might not be enough as a source of finance.
 Sale of assets: used by already set businesses which posses’ assets and are in a convenient position to sell
them
When the asset is sold to a leasing company, the business can still make use of it without the responsibilities
of being the owner and at the same time receives an injection of capital. It lacks of investment payments and
is appropriate for raising capital from assets which have become obsolete.
However, when selling the asset to a leasing company the business will add extra expenditures to their
current liabilities, it is not appropriate as a permanent source of finance and is not appropriate for start-ups
of newly formed businesses.
External sources: refers to the capital obtained outside the business through banks, financial institutions or
individuals. Share capital, loan (bank loan, mortgages, debentures), overdrafts, trade credit, crowdfunding, leasing,
microfinance providers, business angels, venture capitals.

Equity finance is a type of funding where the provider receives part ownership of the business in exchange for the
finance. Equity finance does not have to be repaid, and no interest is charged. Another advantage is that the risks
associated with starting and growing the business are shared among multiple (or many) owners. However, the
opportunity cost to the business of accepting equity finance is a loss of control and a loss of a portion of future
dividends.

 Business angel: A business angel is a successful, wealthy business person who invests their money into new
businesses. Business angels provide funding to businesses who are not yet listed on a stock exchange. They
often offer very early financing to a new business. In return for their investment and guidance, business
angels require part ownership of the business and a portion of future profits. It is an opportunity for starting
and small businesses to grow.
Business angels often, but not always, seek high growth and large returns on the investment. Moreover, it is
also the case that a business angel serves as a mentor to entrepreneurs, sharing expertise and business
contacts to help the new business succeed. However, there can be conflicts if the business angel wants the
business to be set up or grow differently from the entrepreneur. It is therefore very important that both
parties share the same values and objectives. The angel may ask for a percentage of profit, that will end up
reducing the profit that the entrepreneur may reinvest in the business to grow.

 Venture capital: refers to financing that pools resources from a group of investors to fund new businesses.
The fundamental difference between venture capitalists and business angels is whose money is invested.
Business angels are private individuals who risk their own money. Venture capitalists are companies that use
the money from their clients to fund investments. The aim with venture capital is to help the business grow
so that the investors can later sell their stake at a higher price.
Venture capital investors not only provide capital, but also experience, contacts and advice when required,
which distinguishes venture capital from other sources of finance. However, a significant drawback is that
providers of venture capital will not advance huge amounts to businesses, a percentage of the profit will be
lost by the entrepreneur and there can be clashes between the entrepreneur and the investor.

 Share capital: is money that is raised through the issue of shares to new investors on a stock market. The
initial public offering results in the company becoming a public limited company. As owners of the business,
shareholders usually receive a portion of the profits earned, called a dividend. Usually adopted by business
that wants to expand.
Although a company will be expected to pay an annual return to shareholders (dividends), the level of this
payment is not fixed and in an unprofitable year it may be possible for the company to avoid making any
payment. However, the stakeholders will have influence in the operations and decision making of the
 business and the original owner may lose the control over it. There may be disagreements between the
owners. Moreover, the prosses to reissue shares by a business means an important expenditure.

Debt finance is money that is borrowed from a bank or other financial institution. The borrowed money is made
available quickly to fund investments. In exchange for the finance, the business usually pays an interest rate to the
lender.

 Loan capital: is money that is borrowed from a bank or other financial institution. The borrowed money is
made available quickly to fund investments. In exchange for the finance, the business usually pays an
interest rate to the lender. Usually used for investments that will help the business generate more money to
pay back the loan
→ A loan is a medium or long-term source of finance, often used to buy fixed assets.
→ A mortgage is a special type of long-term loan that is used to purchase land or buildings. Other bank loans
are usually considered medium-term loans and may be used to purchase capital equipment.
→ To receive a loan, businesses usually provide collateral. Collateral is an asset that is offered to a lender in
the event that the business does not pay back the loan. Many small- and medium-sized businesses,
especially in low-income countries, do not have collateral. Therefore, they may find it difficult to acquire a
loan.
The key advantage of a loan is that money is available immediately for investments, but is repaid in small
chunks, over a period of years. Businesses can use loans to buy profit-generating assets, such as trucks or
machines, immediately and pay for them
However, the business has to pay back with high interest rates and entrepreneurs or small businesses may
be rejected by banks or financial institutions. Many business may also need to provide a collateral

 Overdraft: a high-cost, short-term loan, attached to a bank account. An overdraft allows the account holder
to withdraw an amount of money that is greater than they currently hold.
Overdrafts are useful because they enable businesses to meet day-to-day expenses while they are waiting
for revenue from selling goods and services.
The overdraft allowance will be limited, and the bank will charge a very high interest rate. Overdrafts are one
of the most expensive forms of borrowing.

 Microfinance: involves providing financial services to individuals who have very limited income and assets
and are not able to get services from traditional banks.
It gives small business the chance to access to finance which they otherwise would not have by normal
institutions.
The interest rates are typically high, but are lower than those charged by unethical lenders. If the borrowers
don’t succeed in their use of the money, they will not be able to pay back and will make their situation
worse.

 Trade credit: involves a business receiving goods and services from a supplier immediately, but paying for
them at a later date
Using trade credit gives a business time to sell the goods and services they produce; they can then use that
revenue to pay their suppliers. Both the business and the supplier benefit from trade credit.
If the money isn’t paid as expected, bad relations may be forged between the suppliers and the business.

Other source of finance:

 Leasing: Leasing involves renting (hiring) a fixed asset over a period of time, rather than buying it.
The key advantage of leasing is that a business can use an asset without having to fully finance it up front.
However, the business does not own the asset. Therefore, if the business wants to continue using the asset,
it must continue to pay the leasing fee.
  Crowdfunding: form of finance whereby many people, perhaps thousands, invest small amounts of money
to fund a business or project. There are several different types of crowdfunding
It is beneficial because money can be raised without having to be repaid and without interest rates.
However, it may be difficult to convince people to provide finance as there are many cases of fraud.

Factors to consider when selecting a source of finance

 Purpose of the finance

 The costs behind the choice of source of finance.
 The status of my business (plc, sole trader, small or large business)
 Is the owner willing to lose control or wishes to retain it?
 Amount required
 Does my business have other existing debts?
 External factors beyond the control of the business.

 3.3: costs and revenues

Types of costs

Anything a business spends money on is a cost. There are endless things that businesses need to buy in order to
produce goods and services. These range from large capital expenditures, such as buying land for a new factory, to
everyday expenditures, such as purchasing fuel for delivery vehicles. These everyday expenditures are known as
revenue expenditures.

Generally speaking, businesses work to reduce their costs of production. Lower costs can lead to higher profits for
the business, helping to sustain the activities of the business over time.

Classifying costs can help businesses identify and track costs more easily, which should help reduce them. Costs can
be classified into two broad sets of categories:

 fixed costs and variable costs

 direct costs and indirect costs/overheads

Fixed and variable costs

‘Does the cost increase directly with production?’ If the answer is yes, then the cost is a variable cost. If the answer is
no, then the cost is a fixed cost.

Variable costs

The types of variable costs will depend on the business, but will normally include things such as:

 materials
 packaging
 delivery
 piece-rate wages and sales commission (Subtopic 2.4)
 cleaning (hotels, for example)

A variable cost is defined by its cause-and-effect relationship with output. To be a truly variable cost, an increase in
output must lead to increased costs of production for the business. So, if there is no production, the variable costs
must be zero.

Sometimes, but not always, payments to workers are considered variable costs too. For example, some workers are
paid piece-rate wages, which are wages that vary depending on the amount the employee produces. Other
employees may be paid commission. Commission is when sales employees are paid a small amount, often a
percentage, for every item they sell.

Graphing variable costs

 Variable costs (VC) can be graphed using data on quantities
of cups of coffee produced and the total variable costs at
different quantities. For example, assume it costs $1 to make
a single cup of coffee. The total variable costs can be
calculated at different quantities, as shown in Table 1 and
then being expressed in a graph.

Fixed costs

Fixed costs (FC) are those that stay the same at different levels of output. In the short term (the period during which
it is difficult to change resources), there are items that need to be paid for no matter the level of output. These will
not change quickly over time. For example, rental contracts for a physical space are usually for a set period of time,
such as a year or more. This will stay the same, regardless of how much the business produces.

These are examples of fixed costs:

 salaries and wages of staff that are not dependent on output

 rent and mortgage payments
 machines and other capital equipment
 fixtures and fittings
 insurance

Graphing fixed costs

In a graph, the representation of the fixed costs stays

constant as they stay the same even if the quantity
produced increases or decreases.

Total costs

Total costs (TC) refer to all the variable costs and fixed costs that a business pays to produce its product.
Direct and indirect costs

This method of classifying costs relates to the parts of the business that deal with budgets. Some costs relate directly
to the sale of the goods, while some relate to other parts of the business. Complex businesses will have a huge
number of costs. In order for these costs to be tracked, they need to be allocated to the correct department.

Direct costs

Large companies may divide themselves into sections so they can keep track of what is being spent in the business.
Each section will have a budget attached to it and must take care to stay within those allocated amounts.

Direct costs are those that can only be attributed to a single part of the business – that is, directly linked to the sale
of the goods or the provision of the service. Examples include:

 staffing cost of employees in that particular section of the business

 utility costs of a single branch of a chain store
 material costs for a product line
 running costs of a single store to be allocated to the correct department

Indirect costs

Indirect costs are more difficult to allocate than direct costs. Using the example of the clothing retailer, all costs from
the head office would be referred to as an indirect cost for the 15 retail branches. The activities carried out in the
head office affect all the branches, so it makes sense to split the costs of the head office between the branches.

Indirect costs are different in different companies, but examples may include:

 nationwide advertising campaigns

 accountancy and auditors’ fees
 salaries of the board of directors
 expenses of running a central human resources department
 ICT and infrastructure costs

Revenues and revenue streams

Businesses should aim to at least cover their costs with the revenue they earn from selling their products. This is
called breaking even. If a business cannot break even, or earn more revenue than its costs, it may become insolvent.
So, for a business, revenues are just as important as costs of production.

However, as with costs, it is important to note that the way social enterprises approach revenue may be different
from the way commercial enterprises approach revenue. Revenues may be lower for social enterprises than for
equivalent commercial enterprises. This is because social enterprises aim to maximise impact and may offer their
goods and services at a lower, affordable price than commercial enterprises. This will make their socially or
ecologically beneficial products more widely available to consumers.

Revenue

Revenue is the income that a business earns from selling goods and services. If a for-profit enterprise is going to
survive, it needs to generate revenue.
Notice the point where total revenue and total costs intersect. This is known as the break-even point.

Revenue streams

A revenue stream is one specific way that a company generates income. To take the coffee shop example again, it is
likely that the shop sells more than just cups of coffee. It might also offer tea, soft drinks, cakes, sandwiches or other
food.

When a business has multiple and diverse revenue streams, it becomes more resilient. Thus, when the revenue from
one area declines, for example due to changes in the external environment (such as a pandemic), the business may
still be earning revenue from other streams. Like a biodiverse ecosystem, a diverse set of revenue streams will make
a business better able to withstand disruptions.

 3.4: final accounts

Financial statements compiled by businesses at the end of a particular accounting period. The statement of profit
and loss: records the revenue, costs and profit of a business over a given period of time

Statement of profit or loss

The statement of profit or loss, also known as an income statement, shows the profit or loss that is generated by a
business from its trading activities. The statement of profit or loss is constructed differently depending on whether
the business is a for-profit enterprise or a non-profit enterprise.

For a for-profit enterprise

 Step 1: Calculate gross profit (green section).

 Step 2: Calculate the profit or loss (yellow section).
 Step 3: List how the profits are distributed (orange
section).
 The first section of the statement of profit or loss is used to calculate the gross profit of the business. The net is
the sales revenue minus the cost of sales.

Gross profit = sales revenue – cost of sales

The second section of the statement of profit or loss takes the gross profit amount and subtracts the indirect costs,
or expenses. These include rent, administration costs and other expenses that are not directly attributable to the
production of the product. Profit can be calculated as follows:

Profit before interest and tax = gross profit – expenses

The third section of the statement of profit or loss shows how the profits are distributed, between dividends and
retained profit

For non-profit enterprises

A non-profit social enterprise works to improve social or environmental outcomes. To qualify for non-profit status,
organizations typically need to prove their social or environmental purpose to the government. They are required by
law to reinvest any surplus that is generated into the business, in order to increase its impact.

The document doesn’t include the section of dividends

Non-profit social enterprises need to keep records of their transactions and record their surplus or losses.

It uses the following information:

 Number of students: 9000

 Average fees per student: $900
 Cost of sales: $5 000 000
 Expenses: $2 750 000
 Interest: $100 000

Statement of financial position

Accounting statement that records the values of a business’s assets, liabilities and shareholders’ equity at one point
in time.

Outlines the assets, liabilities and equity of a firm at a specific point in time.

In the balance sheet: ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

Components of a balance sheet:

1- Assets
2- Liabilities
 3- Equity

Assets: resources of value that a company owns or are owed to it. Can be current or non-current. Non-current assets
may be tangible (property, vehicles, equipment, machinery) or intangible (trademarks, copyrights, patents, brands,
goodwill). Current assets refer to stock (materials, semifinished or finished goods), cash or debtors (accounts
receivables or trade receivables).

Liabilities: refer to the firms´ legal debts or what it owes to other firms, institutions or individuals. Can be current or
non-current. Non-current liabilities may be long term loans, debentures issued by the firm or mortgages. Current
liabilities may be short-term loans, trade creditors or bank overdrafts.

Equity: capital invested by shareholders into the business plus the retained earnings. Within equity we have share
capital and retained earnings. Share capital is the original capital invested into the business through shares bought
by shareholders, it only applies to profit-making entities. Retained profit is the profit ploughed back or reinvested
into the business. Also known as reserves.

TOTAL ASSESTS = total current assets + total non-current assets

TOTA LIABILITIES = total current liabilities + total non-current liabilities

NET ASSETS = total assets – total liabilities

A statement of financial position balances when net assets = equity.

WORKING CAPITAL (money for day-to-day operations, it is not a way of financing) = current assets – current liabilities

WORKING CAPITAL = net current assets

Left-hand column registers the values of the different components of the statement of financial position. Right-hand
column: the totals of key figures

Accumulated depreciation: shows the fall in value of non-current assets over time.
Working capital = 1215 – 1849 = $(634)

Net assets = 10183 – 6475 = $3708

The main difference between the statement of financial position of a for-profit organization and a non-profit
organization is that the last one doesn’t have share capital.

The purpose of accounts to different stakeholder groups

 Shareholders (internal)
o Sales revenue
o Profit
o Retained profits
o Dividends
 Managers (internals)
o Revenue and profits
o Retained profit
o decision-making
 Employees (internal)
o Profits after tax
o Financial security
o Possible pay rises
 Government (external)
o Tax liabilities
o Standards and regulations
o Decisions by managers
 Suppliers (external)
o Cash position
o Trends in revenue and profits
 Customers (external)
o Profits as a proportion of revenue
o Financial security
 Pressure groups (external)
o Issues such as ethics and sustainability
 Investors (external)
o Historical financial performance
o Financial security

Depreciation

Depreciation happens when fixed assets (mainly tangible) see their value decline over time.

Property and equipment net may also be called net book value.

Depreciation also appears as a non-cash expense in the statement

of profit or loss before determining the operating profit.

Methods to calculate depreciation

 Straight line method: reduces the value of a non-current asset by the same amount each year until is no
longer used and is sold or scrapped.
Residual value: the estimated cost of the asset when the business doesn’t want to keep it any longer.

Page 17 final accounts ppt:

Annual straight-line depreciation: 30.000 – 6.000 / 4 = 6.000

Book value in 3 years: 6.000 x 3 = 18.000, 30.000 – 18.000 = $12.000

 Units of production (or use) methods: the value of a non-current asset is reduced in any year according to
the value of production undertaken by the asset.

Page 19 final accounts ppt:

1- (20m / 100m) x (50.000 - 0 ) = $10.000

2- 50.000 – 10.000 = $40.000

Page 20: exercise 2

2.

Year 1: (8.000 / 25.000) x (250.000 – 50.000) = 64.000

Book value: 250.000 – 64.000 = 186.000

Year 2: (12.000 / 25.000) x (250.000 – 50.000) = 96.000

Book value: 186.000 – 96.000 = 90.000

Year 3: (5.000 / 25.000) x (250.000 – 50.000) = 40.000

Book value: 90.000 – 40.000 = 50.000

 3.5: profitability and liquidity

Ratio analysis

Ratio analysis is a technique useful to analyse a business financial performance by comparing two pieces of financial
information. This way informed judgments about a business can be made. It provides:

 Access to the liquidity of the firm

 Access to how successful the management of a business has been at converging sales revenue into gross and
net profit
  Access to the profitability of a business (ROCE)
 How significant is external loan finance as a source of finance to my business
 How efficiently is the working capital of my business being managed

Profitability ratios

Profitability ratios show a company’s profit in relation to other financial figures.

Gross profit margin: indicates how effective managers have added value to the cost of sales

Strategies to improve GPM

 Diversification
 Lowering prices (increase sales and revenue by benefiting from economies of sscale)
 Increasing prices (especiall with little competition, to increase revenue)

Profit margin: indicates how effectively has management turned revenue into net profit

How to improve the profit margin?

 By differentiation they can create unique products and make higher prices as only they have the product.
 Lowering expenses: Lower salaries for workers. This would bring problems regarding demotivation and
conflicts with the workers. Also, reduce rent, and for this you must change the place. You must change the
logistics

ROCE (Return on capital employed): This ratio measures the profitability and efficiency of a business’s invested
capital as it assesses the returns it is making from its capital employed.

What is capital employed? It refers to the total capital invested in the business.

Capital employed = Total assets - Current liabilities

Capital employed = non-current liabilities + Equity

Capital employed = Working capital + Fixed assets

What can a business do to improve ROCE?

 Increase sales revenue to increase profit before interest and tax.

 Reduce cost of sales and expenses to increase profit before interest and tax
 Sell unused and obsolete assets
 Reduce long-term liabilities
 Reduce share capital and retained profit (equity).
Liquidity ratios

These ratios assess the ability of an organization to pay off its short-term debts. Therefore, they are concerned with
the working capital of the firm

Current ratio

The current ratio is a liquidity ratio that calculates the business’s current (short-term) assets relative to its current
(short-term) liabilities.

Current assets include cash, debtors and stock (inventory). Cash is the most liquid of these assets, followed by
debtors, and then finally stock. Current liabilities include overdrafts, trade creditor and short-term loans. The current
ratio is calculated using the formula:

If current ratio is below 1:1, this means that the business’s current liabilities are bigger than its current assets and,
therefore, might not be able to pay back its short-term debts. Management may: sell redundant assets, take out
long-term loans and cancel short term loans, among other measures. Very high current ratios are also a problem:

1. Too much cash that could be invested in non-current assets to increase efficiency.

2. Too many debtors.

3. Too much stock being held which incurs in high storage costs.

If it is 1, assets are equal to liabilities. However, in assets it is included the stock which are not surely going to be
sold, so there is risk of insolvency.

Acid test ratio

it is an indicator of whether the company has enough short-term assets to cover its short-term liabilities. However, it
differs from the current ratio as it does not take into consideration inventories (stocks), which have not been sold
and it is uncertain when this will happen. These are the least liquid of the current assets.

 If acid test ratio is below 1:1, the company does not have enough liquid assets to pay its current liabilities
(especially if demanded at short notice).
 Very high acid test ratios indicate that cash has accumulated and it is idle. Therefore, it should be reinvested
or put into productive use or returned to shareholders
 Much lower acid ratio than current ratio: indicates the business is highly reliant on inventories.
 Important: take into consideration the industry. Retailers tend to have low acid test ratios.