UNIT 5

Finance and Accounting

BUSINESS FINANCE.
 Business finance

Startup Capital: the capital needed by an entrepreneur to set up a business. Example: Bank
loans and crowd funding

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

Example: Bills for fuel and raw materials, wages and business rates.

Capital expenditure: the purchase of assets that are expected to last for more than one year,
such as building and machinery.

Revenue expenditure: spending on all costs and assets other than fixed assets and includes
wages and salaries and materials bought for stock.

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

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash
without affecting its market price. Cash is the most liquid of assets, while tangible items are less
liquid.

Liquidation: when a firm cease trading and its assets are sold for cash to pay suppliers and
other creditors.
Sources of Finance available to business
The decision of which source of finance to obtain will largely depend on
the duration for which the capital is being raised for. There are three
categories of sources of finance based on that.
INTERNAL SOURCES OF FINANCE (Internal Growth)

1. Retained Profits (conflict between owners & managers)

Retained earnings are an important concept in accounting. The term refers to the historical
profits earned by a company, minus any dividends it paid in the past. The word "retained"
captures the fact that because those earnings were not paid out to shareholders as
dividends they were instead retained by the company. For this reason, retained earnings
decrease when a company either loses money or pays dividends, and increase when new
profits are created.

Advantages:

• quick and convenient

• easy access to the money
• no interest payments to make

Disadvantages
• once the money is gone, it is not available for any future unforeseen problems the business
might face

Sale of unwanted assets: Established companies often find that they have assets that are
no longer fully employed. T ese could be sold to raise cash. In addition, some businesses will sell
assets that they still intend to use, but which they do not need to own

Advantages
• can create space for more profitable uses
• can be quick
• raise money from unused equipment

Disadvantages

• might not get the full market value of the assets or even be able to sell them at all
• might need the assets in the future
EXTERNAL SOURCES OF FINANCE (External Growth)

➢ Short term

Overdraft: One of the most important external sources of short-term finance, particularly for
smaller businesses, is the overdraft. An overdraft facility allows the business to spend more
money than is deposited in the bank account. The amount of the overdraft will rise and fall as
funds are deposited and spent from the account. Features that make the overdraft popular are

Advantages
• The bank will agree to a maximum overdraft limit or facility. The borrower May not require
the full facility immediately, but may draw funds up to the
• limit as and when required which promotes flexibility.
• Legal documentation is fairly minimal when arranging an overdraft. Key elements of the
documentation will be to state the maximum overdraft limit, the interest payable and the
security required.
• Interest is only paid on the amount borrowed, rather than on the full facility.

Disadvantages
• The overdraft is legally repayable on demand, which means that the facility could be
withdrawn at any time.
• Security may be required over the business’s assets.
• Interest costs vary with bank base rates

Trade credit Trade credit is an important source of finance for most businesses. Trade credit
is the money owed to the suppliers of goods and services as a result of purchasing goods or
services on one date but paying for those goods on a later date. The management of trade
credit was discussed in the previous chapter. The amount of trade credit available will vary
depending on the nature of the industry, the product being supplied and the ability of the two
parties to negotiate.

Advantages
• Convenient/informal/cheap
• Available to organizations of any size
Factoring: Debt factoring is an external, short-term source of finance for a business. With
debt factoring, a business can raise cash by selling their outstanding sales invoices (receivables)
to a third party (a factoring company) at a discount.

Advantages
• Receivables (amounts owed by customers) are turned into cash quickly!
• Business can focus on selling rather than collecting debts
• The facility is practically limitless and therefore suits a fast-growing business.
• There is no security required – unlike a loan or overdraft.

Disadvantages

• Quite a high cost – the charge made by the factoring company, typically around 3%
• Customers may feel their relationship with the business has changed
➢ Medium Term
Leasing: Leasing and hire purchase are financial facilities which allow a business to use an
asset over a fixed period, in return for regular payments. The business customer chooses the
equipment it requires, and the finance company buys it on behalf of the business.

Advantages
• Liquidity:
• Convenience:
• Hidden Liability:
• time Saving:

Disadvantages
• The lessee gets only the right to use the asset. In case the leasing company is wound up the
asset may be taken back from the lessee thereby disrupting his operations.
• The lessee cannot make alterations or improvements in the asset without the prior approval
of the lessor. The lessor may also put some restrictions on the lessee.
• The lessee has to pay lease rentals on a regular basis to the lessor.

Hire Purchase Hire purchase (HP) or leasing is a type of asset finance that allows firms or
individuals to possess and control an asset during an agreed term, while paying rent or
instalments covering depreciation of the asset, and interest to cover capital cost.

Advantages
• Rather than one big lump sum, you can spread the purchase cost of high ticket items. These
include items such as cars, where you can pay over a period of 3 to 5 years typically. Hire
purchase is a simple way of financing and typically relatively easy to obtain.
• The interest rate on hire purchases is fixed for the duration of the agreement. This is
regardless of any changes the Bank of England make to the base rate
• As the hire purchaser, you’ll own the asset after paying the last instalment which can make
it a favorable alternative to a lease
Disadvantages
• Hire purchase contracts are usually fixed, therefore if you find yourself in financial difficulty
during that period, you may lose the asset and damage your credit rating.
• You’ll pay more for whatever it is you’re financing through hire purchase.
• You won’t own the asset until you have made the final hire purchase payment. Therefore
the vendor has the right to seize it should you fall foul of their terms..

Medium term loan :loans with a repayment period between two and five years. Usually,
these loans offer up to $500,000 in financing, a monthly or bimonthly payment schedule, and
mid-market interest rates.

Advantages
• Can be arranged quickly
• Loan can be repaid over a long period of time

Disadvantages
• Interest has to be paid in addition to the loan amount
➢ Long term sources

Debt Finance: Debt financing occurs when a firm raises money for working capital or capital
expenditures by selling debt instruments to individuals and/or institutional investors. In return
for lending the money, the individuals or institutions become creditors and receive a promise
that the principal and interest on the debt will be repaid.

Advantages
• Receivables (amounts owed by customers) are turned into cash quickly!
• Business can focus on selling rather than collecting debts
• The facility is practically limitless and therefore suits a fast-growing business.
• There is no security required – unlike a loan or overdraft.

Disadvantage’s
• Quite a high cost – the charge made by the factoring company, typically around 3%
• Customers may feel their relationship with the business has changed

a. Long term bank loan

Long-term loans: loans that do not have to be repaid for at least one year

b. Debentures
A debenture is a type of bond or other debt instrument that is unsecured by collateral.
Since debentures have no collateral backing, they must rely on the creditworthiness and
reputation of the issuer for support. Both corporations and governments frequently issue
debentures to raise capital or funds.

Advantages
• A debenture pays a regular interest rate or coupon rate return to investors.
• Convertible debentures can be converted to equity shares after a specified period, making
them more appealing to investors.
• In the event of a corporation's bankruptcy, the debenture is paid before common stock
shareholders.
Disadvantages
• Fixed-rate debentures may have interest rate risk exposure in environments where the
market interest rate is rising.
• Creditworthiness is important when considering the chance of default risk from the
underlying issuer's financial viability.
• Debentures may have inflationary risk if the coupon paid does not keep up with the rate of
inflation.

Equity Finance
Equity financing is the process of raising capital through the sale of shares. Companies raise
money because they might have a short-term need to pay bills or have a long-term goal and
require funds to invest in their growth. By selling shares, a company is effectively selling
ownership in their company in return for cash

Advantages
• No obligation to repay the money
• No additional financial burden on the company

Disadvantage’s
• You have to give investors a percentage of your company
• You have to share your profits with investors
• You have to consult with investors any time you make decisions that impact the company
Other external sources of finance

Crowdfunding is a source of finance that entails collecting relatively small amounts of money
from a large number of supporters – the ‘crowd’. It is common for businesses aiming to raise
money through crowdfunding to use the interest to communicate with potential supporters
e.g., Kickstarter

Advantages
• Great way to interact with potential consumers
• Ability to gauge public opinion on your product

Disadvantages

• In some cases, if you don't reach your funding goal, any finance that has been pledged will
be returned to your investors
• Possible damage to your start-up company's reputation

Venture capital (VC): is a form of private equity and a type of financing that investors provide
to startup companies and small businesses that are believed to have long-term growth potential.
Venture capital generally comes from well-off investors, investment banks, and any other
financial institutions.

Advantages
• The money is yours to keep.
• Venture capital can help your company grow quickly.
• VCs can connect you to other business leaders who can help you

Disadvantages
• Your investors own a stake in your company.
• Your company may not be ready to grow.
• Loss of control.
Government Grants A government grant is a financial award given by a federal, state, or local
government authority for a beneficial project. It is effectively a transfer payment. A grant does
not include technical assistance or other financial assistance, such as a loan or loan guarantee,
an interest rate subsidy, direct appropriation, or revenue sharing.

Advantages
• Never has to paid back

Disadvantages
• Time-Consuming
• Strings Attached
• Difficult to Receive

Micro-Finance banks Microfinance: providing financial services for poor and low-income customers
who do not have access to banking services, such as loans and overdraft s offered by traditional
commercial banks

Advantages
• Collateral-free loans
• Disburse quick loan under urgency
• Help people to meet their financial needs
• Provide an extensive portfolio of loans

Disadvantage’s
• Harsh repayment criteria
• High-interest rate
• Small Loan amount
 Factors to be considered making source of finance decision

When making judgements on the most appropriate source, managers will have to take
into account a range of factors relating to the business’s internal position and the business
environment in which it is trading.

• Is the business profitable? If so, it may be able to use retained profits as a source of
finance or at least be able to provide evidence to banks and other creditors that it can
repay loans. Alternatively, it may have assets that it can sell, and lease back, or
simply sell.

• The business’s reputation. A reputation as a reliable and popular business may also
enable its managers to persuade suppliers to offer increased trade credit which can fund
short-term needs for finance. Equally, such a reputation will assist a business in
negotiating loans, possibly at favorable rates of interest, or in persuading shareholders to
purchase the company’s shares.

• Its legal structure. This will play a role in making the decision on the appropriateness of
sources of finance. Thus, only companies will be able to elect to use share capital as a
source to fund start-ups or expansions.

• The business environment. The environment in which the business is trading will also
shape the decision. If sales in a market are growing the business may be more able to
finance the repayments on a loan as its revenues should increase in the future. On the
other hand, if interest rates are high, making loan capital a relatively expensive source of
finance, businesses may seek alternative sources

• Opportunity cost. A decision to use a particular source of finance may have a cost in terms
of what has to be given up as a consequence of the decision. For example, a decision to
use sale and leaseback as a source of finance may appear a low-cost option. However,
this source of finance will commit the company to paying each month or year for the asset
that has been sold. Similarly, using retained profits for reinvestment into the company
entails an opportunity cost which can be measured in terms of the reduction in the
amount of profits that can be paid to shareholders (these are known as dividends)

• Flexibility. Some sources of finance are highly flexible and can be adapted to meet a
business’s precise needs. The most obvious example is an overdraft. This source of finance
allows a business to overspend its current account or not according to its needs (but
subject to an overall limit). Thus, a business can use its overdraft only when it is necessary
and can avoid any interest charges at times when its finances are stronger. This flexibility
has a cost however: overdrafts are an expensive source of finance
 Glossary

1. Startup Capital: the capital needed by an entrepreneur to set up a business. Example: Bank
loans and crowd funding

2. Working capital: the capital needed to pay for raw materials, day-to-day running costs and
credit offered to customers. In accounting terms working capital = current assets – current
liabilities.
Example: Bills for fuel and raw materials, wages and business rates.

3. Capital expenditure: the purchase of assets that are expected to last for more than one year,
such as building and machinery.

4. Revenue expenditure: spending on all costs and assets other than fixed assets and includes
wages and salaries and materials bought for stock.

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

6. Liquidation: when a firm cease trading and its assets are sold for cash to pay suppliers and
other creditors.

7. Overdraft: bank agrees to a business borrowing up to an agreed limit as and when required.

8. Factoring: selling of claims over trade receivables to a debt factor in exchange for immediate
liquidity – only a proportion of the value of the debts will be received as cash.

9. Hire purchase: an asset is sold to a company that agrees to pay fixed repayments over an
agreed time period – the asset belongs to the company.

10. Leasing: obtaining the use of equipment or vehicles and paying a rental or leasing charge
over a fixed period, this avoids the need for the business to raise long-term capital to buy the
asset; ownership remains with the leasing company.

11. Equity finance: permanent finance raised by companies through the sale of shares.

12. Long-term loans: loans that do not have to be repaid for at least one year. Example:
debentures issued by the company.
13. Long-term bonds or debentures: bonds issued by companies to raise debt finance, often
with a fixed rate of interest.

14. Rights issue: existing shareholders are given the right to buy additional shares at a
discounted price.

15. Venture capital: risk capital invested in business start-ups or expanding small businesses
that have good profit potential but do not find it easy to gain finance from other sources.
Example: Specialist organizations or wealthy individuals.

16. Microfinance: providing financial services for poor and low-income customers who do not
have access to banking services, such as loans and overdrafts offered by traditional commercial
banks.
Example: Many business entrepreneurs in Bangladesh and other Asian countries have received
microfinance to help start their businesses. In some of these countries, more than 75% of
successful applicants for microfinance are women.

17. Crowd funding: the use of small amounts of capital from a large number of individuals to
finance a new business venture.
Example: Small and medium-sized businesses.

18. Business plan: a detailed document giving evidence about a new or existing business, and
that aims to convince external lenders and investors to extend finance to the business.
 Sample answers
2015 June 13 B6 (a)
An international chain of coffee shops is planning to expand into a new country.
Discuss the factors that could affect the decision on how to finance this
investment [20 marks]
International expansion, although organic, requires big and long-term sources of finance to source capital
requirements to operate in another country. Since the coffee shops will need long-term finance for regular
cash - flow first of their very feasible source of finance will be retained profits. Since this chain of coffee
shops is international, it might just have. enough finance to finance the opening of new shops which make
up for an internal source. To avoid any direct costs to the business or an increase in liabilities, a second
internal source of finance would be reductions in working capital by for instance selling additional
franchises or closing less profitable branches.

However, before expanding to a new country, the chain needs to consider, whether the government of
the country offers any incentives for new business and if yes, what are the second they need to consider
what are the interest rates when opting for debt- finance. If the company plans to conserve additional
profits and not in a position to sell any of its assets, it needs to rely on external and long-term sources of
finance first of which Is a long-term loan, however, these might become very expensive in a period of
using interest rates. Second great way to -raise large sums of money would be the sale of debentures. by
This also results in no loss of ownership, however, becomes a liability as the investors need to be paid off
after the limited company, a huge sum of money can be raised by the sale of shares which result in a loss
of ownership but since it is permanent capital, it never has to be repaid hence no increase un liabilities
this or to finance is known as equity finance. All the factors. which period, amount required, cost of
finance, the legal structure of the business, size of existing borrowing, and flexibility of finance need to be
considered before opting for any source of finance.

Q. Explain the difference between revenue expenditure and capital

expenditure. [5 marks]
Capital expenditure is the purchase of assets that are long. Lasting i. e more than a year or so which might
include the buying or capital equipment (machinery), however, revenue expenditure accounts for all
current - assets purchased which include wage salaries and materials bought for stock. However, both will
be recorded differently. Revenue expenditure is recorded on the income statement which states the profit
and expenditure for a single year
Q. Define the term start-up capital. [2 marks]
Start-up capital is the initial capital used to inject into the business to start operations/productions for
e.g., capital required for buying machinery, premises, etc.

Q. Briefly explain two sources of start-up capital. [3 marks]

Two sources of start-up capital are crowdfunding and microfinance. Crowdfunding refers to the business
idea being put up on a crowdfunding website where many inventors pool in sums of money until the
specified target is reached. All these many investors are then paid back with interest or given a share in
the business. microfinance however refers to the lending of money from small banks to poor
entrepreneurs who do not have access to loans to additional banks. These loans however must be paid
back

Q. Define the term 'retained profit'. [2 marks]

Retained profits are the profits incurred y a business during a specific period of time which are then
used as a source of finance for the upcoming year. This source of finance isn't available for start-ups

Q. Briefly explain two external sources of finance that could be used to fund the
capital expenditure of a partnership. [3 marks]
A partnership is a form of an unincorporated business it has access to limited sources of finance, unlike
corporations. one external source of finance that could be used by a partnership is grants: These may be
given by specialist. agencies or the government with conditions attached. If these conditions are fulfilled,
the grant no longer have to be paid back. This reduces the risk of unlimited liability in case of a business
failure: Second sources available are medium.to long-term loans by banks. This however requires a trading
history for a business and might involve difficulties in acquiring one.

Q. Explain the importance of the business of distinguishing between revenue

expenditure and capital expenditure. [5 marks]
Revenue expenditure account for all payment of assets within one year or less however capital
expenditure is the purchase. of assets expected to last for more than a year. Its distinction is important as
capital expenditure is recorded in balance sheet while revenue expenditure is recorded in the income
statement. Secondly, CE is incurred to acquire fixed assets for operation i . e. needs long term sources of
finance whereas revenue expenditure is incurred on day - to day conduct of business i.e.. accounts for the
cash flow and needs short term sources of finance. Thirdly, capital expenditure increases the earning
capacity of the business while RE is Incurred to maintain the earning capacity.
Q. Explain the difference between ' cash' and ' profit. [2 marks]
Cash is the liquid money need to run day-to-day affairs of the business without which cashflow is hindered
and the business can decline. Profit however is the money made on a single product or overall, that is left
after all the expenses have been paid. A business can survive some lime w /D profit but not cash ...

Q. Define the concept of liquidity. [2 marks]

liquidity is a business ability to pay its short-term debts. It is affected by the amount of business working
capital, without which a business will be forced into Liquidation.

Q. Explain how a manufacturing company could finance its expansion [8 marks]

To choose appropriate source of finance, the current financial standing of the business needs to be
considered i.e., whether there are enough retained profits, However, this might put further pressure on
the business if a huge amount is required depending on the size of expansion and machinery required.
External sources need to be heavily relied on instead of internal sources for e.g., a great Source could be
equity finance if it's a public limited company however it would result in a loss of ownership. Second
source could be long-term loans from banks as it would be easier to obtain as the company is already
established. third source could be hire purchase or leasing for equipment for expansion depending on
whether the equipment is to be owned or not.

Q. Explain how a public limited company might finance a large capital

investment project. [5 marks]
The amount of finance and its source must appropriately be chosen keeping in mind the amount required
and whether it is for the short or long -term. However, for large capital investment, requires long-term
finance: The biggest source of finance that exists for a public limited company is the availability of equity
finance; e. sale of share ex. A huge number of shares could be sold however this might result in a loss of
ownership. Another source could be debentures where investment is raised by other forms or local people
in exchange for a certificate for a limited time period after which they are repaid with interest.
 Short questions

1. Define the term ‘retained earnings’.[2[

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.2 Briefly explain the distinction between short-term and long-term sources of business finance [3]

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3. Define the term ‘crowd funding.[2]

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4. Briefly explain two advantages of crowd funding for a new business.[3]

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5. Define the term ‘debt factoring’.[2]

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6. Briefly explain two disadvantages of using debt factoring to improve the cash flow of a business.[3]
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7. Briefly explain one advantage and one disadvantage of grants as a source of business finance.[2]
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8.. Analyze the disadvantages to a business of using debt factoring to improve its cash flow.[3]
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Forecasting and managing cashflow
The Need for Cash
In business cash is required to:

• Buy materials to produce

• Pay staff to make products
• Pay bills

Without cash a business will be unable to survive for

long. Cash is part of Working CAPITAL, so managing
this must be a priority

In financial accounting, a cash flow statement, also known as statement of cash flows, is a
financial statement that shows how changes in balance sheet accounts and income affect cash
and cash equivalents, and breaks the analysis down to operating, investing, and financing
activities. A cash flow statement (CFS) is a financial statement that summarizes the amount of
cash and cash equivalents entering and leaving a company. The CFS measures how well a
company manages its cash position, meaning how well the company generates cash. The CFS
complements the balance sheet and the income statement.

Why do businesses prepare cash flow forecast?

• Identifying the timing of cash flow forecast and shortage
• Supporting applications for funding
• Enhancing the planning process
• Monitoring cash flow
Difference between cash and profit
Cash (often synonymous with revenue) refers to the amount of money currently or soon-to-be
available. It's the money coming into the organization either from investors or direct business
activity and serves as the resource to pay expenses. Profit is the amount of money left over after
all expenses are paid.
Ways to increase cashflow and their possible drawbacks

1. Lease, Don’t Buy

Since leasing supplies, equipment, and real estate usually ends up being more expensive than
buying, doing so may seem counterintuitive to someone who is only paying attention to
the bottom line, or your income after expenses are paid off. But unless your company is flush
with cash, you’re going to want to maintain a cash stream for day-to-day operations.

2. Improve Your Inventory

Take an inventory check. Make a list of those goods you buy that aren't moving at the same
pace as your other products. They tie up a lot of cash and could hurt your cash flow. Instead
of buying more of what doesn’t sell, get rid of it even if you need to sell it at a discount. It's
hard to walk away from products you fall in love with, hoping that someday you'll magically
see heightened demand, but that almost never happens. Be objective, not emotional.

3. Pay Suppliers Less

If you maintain friendly, regular communication with suppliers, you will have a better chance
of landing better terms with them. Offer suppliers early payments if they're willing to give
you a discount in return. Learning to master the art of negotiation is an essential part of doing
business and could help you convince your suppliers to offer you a better deal.

4. Increase Pricing
Increasing your prices is a concept that scares many business owners. They're worried it will
lead to reduced sales. But it's OK to experiment with pricing to find the perfect number—how
high are customers willing to go? There's no way to know unless you take a chance.

5. Get Customers to Pay Invoices on Time

Another key to increasing your cash flow is getting your customers to pay their invoices on
time. We know this is easier said than done, but there are plenty of practical strategies to
increase the likelihood of getting paid faster.

6. Delay spending on capital equipment

By not buying equipment, vehicles, etc. cash will not have to be paid to suppliers
Causes of cash flow problems

1. Lack of planning: They help in predicting potential cash flow problems for the future to
overcome them in time.

2. Poor credit control: Monitoring of debts to ensure

that credit periods are not exceeded and does not
result in Bad DEBTS.

3. Allowing customers too long to pay: Trade credit to

remain competitive can be offered to customers,
reducing short–term cash inflows for the business.

4. Expanding too rapidly (overtrading): Even though a

business can be expanding, it can lead to overtrading
and cash flow shortages.

5. Unexpected events: Unforeseen costs can arise.

Inventory Management

Inventory, which is often not ready in its sellable form, is considered to be an illiquid asset
which takes up a large chunk of the company’s cash in its management. Excessive levels of
inventory will leave the business short of cash to meet its liabilities. Therefore, inventory should
be managed in the following ways:

• Smaller levels of inventory.

• Using computer systems to record sales, and therefore,
inventory levels.
• Efficiency inventory control: inventory use and handling to
reduce losses through damage, wastages
• Just-in-time: by producing only when orders are received,
resulting inworking capital tied up in inventories to be
minimized
Cash Management
Cash can be managed by:
• Use of cash-flow forecasts can help the
management of cash-flows and working
capital needs.

• Wise use or investment of excess cash.

• Planning for periods when there may be

too little cash and arranging for overdraft facilities to avoid liquidity crisis.

Working Capital
• It is working capital that produces profit for a business.
• No “correct” level of working capital for a business. Depends on the length of the
working capital cycle.

Example: Supermarkets can manage on much lower levels of working capital.

• Too much liquidity is wasteful of resources.

• Less liquidity can lead to business failures.
• Managing working capital is more than managing cash–timings of cash received and
spent are important and so are other features of management

Working capital = current Assets - current liabilities

Limitations of Cash Flow Forecast
• Numerical mistakes can be made: Can be made in preparing the revenue and cost
forecasts or they be drawn up by inexperienced staff members.

• Based on predictions: Wrong assumptions can be made in estimating the sales, making
the forecast inaccurate.

• Unexpected costs may occur unexpected cost increases can lead to major inaccuracies
in forecasts
 Glossary
1. Cash flow: the sum of cash payments to a business (inflows) less the sum of cash payments
(outflows).
Example: Timing of payments to workers and suppliers and receipts from customers.

2. Liquidation: when a firm cease trading and its assets are sold for cash to pay suppliers and
other creditors.

3. Insolvent: when a business cannot meet its short-term debts.

4. Cash inflows: payments in cash received by a business, such as those from customers
(trade receivables) or from the bank, e.g., receiving a loan.

5. Cash outflows: payments in cash made by a business, such as those to suppliers and
workers.

6. Cash-flow forecast estimate of a firm’s future cash inflows and outflows.

7. Net monthly cash flow: estimated difference between monthly cash inflows and cash
outflows.

8. Opening cash balance: cash held by the business at the start of the month.

9. Closing cash balance: cash held at the end of the month becomes next month’s opening
balance.

10. Credit control: monitoring of debts to ensure that credit periods are not exceeded.

11. Bad debt: unpaid customers’ bills that are now very unlikely to ever be paid.

12. Overtrading: expanding a business rapidly without obtaining all of the necessary finance
so that a cash-flow shortage develops.

13. Creditors: suppliers who have agreed to supply products on credit and who have not yet
been paid
 Practice answers

1. Discuss why a new business should focus more on managing its cash than
making a profit. ( 12 )
Cash is the liquid money used to run the day-to-day affair of business however profit is the money
made on a single product of the overall production after the expenses (cost of sales of overheads)
have been paid of Both are equally important for a new business depending on the phase of the
life cycle the product is in.

When a new business, is operating in the introduction phase of its life cycle, after the products
have been manufactured and are out for sales. At this moment, the business needs to focus more
on cash than profit to cover up for the money they have already invested in product
manufacturing and research and development. In this start phase, the business the sole aim is to
survive in the new market that it has opened up in. This requires each, not profit to attend to the
day. to- day affairs for example maintaining stocks, etc. It is further needed as in early stages,
bank confidence is low so acquiring a loan might not be easy, hence internal, cash plays a vital
role in that as obtaining a loan would've encountered other liabilities of the business

managing a good cash flow saves a business from losing suppliers' confidence since there is
enough money to pay back trade payables on time, making future supplies easily obtainable
Although sales might be high and profit -margin is great, if there is not enough cash, production
might also be ceased. since the business is unable to pay the wages of workers for example Debt
on a new business obviously becomes expensive As if not paid on time with late fees, etc. which
can cause unnecessary stress for the business but with a steady cash flow, the manager can easily
plan for debt repayments and make better decisions regarding how much debt to take on.
2. To what extent would drawing up a cash-flow forecast increase the chances
of this business being successful? (12)

Cash flow is the sum of cash payment to a business (inflows) less the sum of cash payment
(outflows) which basically implies to identify the financial health of a business for the current
month, which is money in hand, collectively referred to as the net monthly cash flow. For the
success of business. cash flow alone might not help as there are many determining factors for a
business success. However, cash-flow forecasting might be vital to address the cash needs of the
business that it might incur in the near future.

Cash- flow forecasting allows managers to anticipate any cash shortages the business might incur
for example Sayuri and korede drew up a cash flow forecast, hence could easily arrange for
overdraft. or short - term source of finance to maintain liquidity in cases of negative closing
balances for the months of April and May. Secondly, a cash-flow forecast easily allows managers
(Sayuri and Korede) to anticipate any surpluses at any time, so that the access excess money
could be wisely invested in buying as to investing to gain higher returns. A cash - flow forecast
also helps to attract any potential investors in the business as relevant information might be
gained from it regarding the business liquidity possible in the upcoming times. Leading for a
business if further input led without effective market research. with a forecast, a company might
disregard any unforeseen factors that might be encountered by the business for e.g., while
drawing up a forecast, Sayuri and Korede would not: have added any additional costs that might
be incurred for e.g., the breakdown of a manufacturing plant, adding to each outflow. They might
also make improper decisions based on just a forecast for e.g., they might decide to spend too
much on adverb living and sales promotion, assuming that all their products Considering it, cash-
flow forecasting might not solely be relied upon for the success of a business
 COST

.
Business Costs
Direct costs: these costs can be clearly identified with each unit of production and can be
allocated to a cost center

Indirect costs: costs that cannot be identified with a unit of production or allocated
accurately to a cost center.
Indirect costs are often referred to as overheads. Examples
are:

• One indirect cost to a farm is the purchase of a tractor.

• One indirect cost to a supermarket is its promotional
expenditure

Fixed costs: costs that do not vary with output in the short
run.

Variable costs: costs that vary with output.

Marginal costs: the extra cost of producing one more unit of output

Break even
the level of output at which total costs equal total revenue, neither a profit nor a loss is made.
Example: Choosing between two locations for a new factory.

The formula for break-even is:

Contribution
Contribution is the amount of earnings remaining after all direct costs have been subtracted
from revenue. This remainder is the amount available to pay for any fixed costs that a
business incurs during a reporting period. Any excess of contribution over fixed costs equals
the profit earned.

• A production may be unprofitable in the short term bust still bs worth producing
because it is making a positive contribution toward fixed costs this is because stopping
production would mean its contribution would have to be found elsewhere
• In the longer business would look to change the profitability of the product

Contribution = price per unit – variable cost per unit

Margin Of Safety
Margin of safety: the amount by which the sales level exceeds the break-even level of
output.

Margin of safety = total output – break even output

Break even analysis

Once a firm knows its total costs and revenue it can calculate the break-even point
This is defined as:

“Break even occurs when total cost are equal to total revenue “
Breakeven is a point where a business us neither making a loss nor a profit hus total reveue minus total
cost is equal to zero
 Glossary
1. Direct costs: these costs can be clearly identified with each unit of production and can be
allocated to a cost center.
Example: wages paid to employees on production line

2. Indirect costs: costs that cannot be identified with a unit of production or allocated
accurately to a cost center.
Example: management salaries and wages paid to security staff

3. Fixed costs: costs that do not vary with output in the short run.
Example: management salaries and interest payments made by the business.

4. Variable costs: costs that vary with output.

Example: Expenditure on fuel, raw materials and components

5. Marginal costs: the extra cost of producing one more unit of output.
Example: the direct costs of materials and labor

6. Break-even point of production: the level of output at which total costs equal
total revenue, neither a profit nor a loss is made.
Example: Choosing between two locations for a new factory.

7. Margin of safety: the amount by which the sales level exceeds the break-even level of
output.
Example: if the break-even output is 400 units and current production is 600 units, the margin
of safety is 200 units. Th is can be expressed as a percentage of the break-even point.
Production over break-even point = 200/400= 50.0 %

8. Contribution per unit: selling price less variable cost per unit.
PRACTICE QUESTIONS BREAKEVEN:

1. The variable cost of the electric kettle manufactured by Fair Oak Domestic Appliances Ltd is
£4. The company, which sells its kettles direct to retailers for £10, expects its net profit for the
year just ending to be £270,000 after allowing for fixed costs of £90,000. The productive
capacity of the company is under-utilized, and the marketing manager suggests that a 10 per
cent reduction in selling price will bring about a 25 per cent increase in sales.
(a) Define the term 'contribution'. What is the contribution per unit in the above case?

(b) What level of sales is necessary to break even?

(c) If profits are £270,000 after allowing for fixed costs of £90,000, what is the current volume of
output and sales?
(d) Calculate the:

(i) sales revenue at this volume of sales; *

(ii) profit resulting from the implementation of the marketing manager's proposal.

(e) Calculate the price elasticity of demand in the above case

2. the Richardson Pen Company produces a range of products, including a popular brand of
steel-tipped pen. It has the capacity to produce six million such pens per year, although at
present it is operating at less than full capacity. The pens are sold to wholesalers at 50 pence
each. The production of each pen involves variable costs of 30 pence. Fixed costs at the current
output level of five million pens are 10 pence per pen.
(a) Calculate the contribution per pen.

(c)Using arithmetical rather than graphical means, calculate the:

(i)break-even output.
(ii)margin of safety.
(iii)profit at full capacity.
3. Joanne Williams, a student, believed she could make some money during the summer
holidays by operating as a mobile ice-cream vendor. She hired a purpose-built van from one of
the national ice-cream producers. This cost £200 per week. The variable costs price-cream cone
was 30p. Joanne was under contract to sell ice-cream cones for 80peach. To analyze the profit
potential at different sales levels she drew up a break-even chart
(a) Draw a break-even chart for Joanne Williams.

(b) Using your chart state:

(i) the number of cones needed to break-even.

(ii) the profit she would make if she sold 700 cones.

(c) On your chart show the margin of safety if 700 cones were sold.

4. The variable cost of the electric kettle manufactured by Fair Oak Domestic Appliances Ltd is
£4. The company, which sells its kettles direct to retailers for £10, expects its net profit for the
year just ending to be £270,000 after allowing for fixed costs of £90,000. The productive
capacity of the company is under-utilized, and the marketing manager suggests that a 10 per
cent reduction in selling price will bring about a 25 per cent increase in sales.
(a) Define the term 'contribution'. What is the contribution per unit in the above case?

(b) What level of sales is necessary to break even?

(c) If profits are £270,000 after allowing for fixed costs of £90,000, what is the current volume of
output and sales?
(d) Calculate the:

(i) sales revenue at this volume of sales; *

(ii) profit resulting from the implementation of the marketing manager's proposal.

(e) Calculate the price elasticity of demand in the above case

 Sample answers
1.Explain why it is important for a business to be able to identify and calculate
its costs.

"A business needs to be able to identify and calculate its costs for a number of reasons, the first
of which is to make effective sales forecast. The costs and selling prices make calculation the
quantity needed to be produced for a specified profit to be made This makes the quantity to be
produced specific, so money is not wasted on additional products if they incur a loss. Secondly,
it is useful when deciding whether a new product is going to be viable ie: can the required
quantity be realistic. produced and sold, giving way for the objectives to be changed
accordingly, if not. Thirdly, it can be used to see how changes to any one of the variables will
affect the break-even point: these factors could be price for instance how profits are affected
by an increase in costs. how profits are affected by an increase in cost of price is kept the same
Breakeven. analyses can be used by asset managers in making important decisions such as
location or new projects for instance an expensive location might affect the fixed costs
allocated to each product. This makes up for business decision-making along with other factors
for e.g. pricing strategies.

2016 June 11 A (26:

Briefly explain two types of business costs.
direct costs are the costs directly incurred by a business with each unit of production and can
be allocated to a cost center: such as the raw materials for the production are direct costs
incurred by the business on one unit of production. Indirect costs however are costs that do not
vary with each unit of production for e.g.one example of indirect cost can be admin staff for
manufacturing business
2015 June 13 A (3 a)
Explain how cost data can be used to monitor and improve business
performance.
Cost data of business can include its total sales revenue, it's fixed costs variable costs etc. with
all the costs in hand the business could analyze how much of a profit is it making on a particular
product by deducting the cost of sales from the total revenue. If it isn’t enough the business
could cut back on cost of sales by using cheaper materials to improve gross profit margin hence
improving business performance. Apart from monitoring profit levels alone, the business could
make use of the cost data to plot a break-even graph. By the break - even analysis, the business
would get to know about the break - even level of production. the point / level of output where
costs equal revenue hence no profit of loss is made This makes it easier for the business to
identify the ideal level of output and the level of output as which the business stops making any
profit or starts going into a loss. Thirdly, the cost data is helpful in generating the year's income
statement which gives an evaluation of how well the business has performed in the last year so
that it's performance can be improved the next year.
 Short questions
1. Define the term ‘marginal cost[2]
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2. Briefly explain, with examples, two other types of business costs[3]

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3. Briefly explain two other types of business costs.[3]

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4. Explain why accurate cost data is important to a business[5]

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5. Analyze the benefits to a new business of using break-even analysis.[8]

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The meaning and purpose of budgets
Do you ever sit down and think about your income and spending plans for the next week or
month? Do you make changes to these plans so that you do not overspend? At the end of the
week or month, do you compare your actual income and spending with your original plans? If
you do all of this, then you are budgeting! Financial planning for the future is important for all
businesses. If no plans are made, a business will:
• be without a direction or purpose
• be unable to allocate the scarce resources of the business effectively
• have demotivated employees with no plans or targets to work towards
• be unable to measure its progress by measuring the plans against actual performance.

Planning for the future must take into account the financial needs and likely consequences of
these plans. This is the budgeting process: setting and agreeing financial targets for each section
of a business. Budgets should be set for sales, revenue and costs. It is usual for each cost center
and profit center to have budgets set for the next 12 months, broken down on a month-by-month
basis.

Benefits of using budgets

• Planning: The budgetary process makes managers consider future plans carefully so that
realistic targets can be set. With a clear sales budget, for example, departments in the business
will know how much to produce or how much to spend on sales promotion.

• Allocating resources: Budgets can be an effective way of making sure that the business does
not spend more resources than it has access to. Without a detailed and coordinated set of plans
for allocating the business’s money and resources, who would decide ‘who gets what’?

• Setting targets: Most people work better if they have a realistic target to aim for. This motivation
will be greater if the budget holder or profit center manager has been delegated some
accountability for setting and reaching budget levels.

• Coordination: Discussion about the allocation of resources to different departments and

divisions requires coordination between these departments. Once budgets have been set, people
will have to work effectively together if targets are to be achieved.
• Controlling and monitoring a business: Plans cannot be ignored once they have been set and
agreed with the budget holder. Checks must be undertaken regularly to control and monitor the
performance of the budget holder and their department. Many factors might have changed since
the budget was set. Managers cannot assume that the budget target will be achieved without
careful control and monitoring.
• Measuring and assessing performance: Once the budgeted period ends, variance analysis is
used to compare actual performance with the original budgets. This is an important way of
assessing managers’ performance. It would not be possible to assess how well individual
departments had performed without a clear series of targets to compare actual performance
with.

Potential drawbacks of using budgets:

• Lack of flexibility: If budgets are set with no flexibility built into them, then sudden and
unexpected changes in the external environment can make them very unrealistic. Unrealistic
budgets will demotivate the budget holder and other employees.
• Focus on the short term: Budgets tend to be set for the relatively short term, for example, the
next 12 months. Managers may take a short-term decision to stay within budget that may not be
in the best long-term interests of the business. For example, cutting the size of the workforce to
stay within the labor budget may restrict the ability of the business to increase output if sales rise
quickly in the future.
• Unnecessary spending: If managers have underspent their budgets just before the end of the
budgeting period, they might make decisions to spend unnecessarily so that the same level of
budget can be justified next year. If a large surplus exists at the end of the budget period, how
could managers justify the same level of resources next year?
• Training on budgets: Setting and keeping to budgets is not easy and all managers with delegated
responsibility for budgets will need extensive training in this role.

• Budgets for new projects: Setting budgets for big new projects is very difficult and often
inaccurate. This is particularly true if similar projects – like a super-fast train line – have not been
undertaken before

Key features of effective budgeting

• A budget is not a forecast but a plan that businesses aim to fulfil. A forecast is a prediction of
what could occur in the future given certain conditions.
• Budgets may be established for any part of an organization as long as the outcome of its
operation is measurable. This means most cost centers and profit centers will have budgets set,
including budgets for sales, capital expenditure, labor costs and profit.
• Coordination between departments when establishing budgets is essential. This should avoid
departments making conflicting plans.
• Budget setting should involve participation. Decisions regarding budgets should be made with
the managers who will be responsible for meeting the targets. Those who are responsible for
fulfilling a budget should be involved in setting it. This sense of ‘ownership’ not only helps to
motivate the department concerned to achieve the targets but also leads to the establishment of
more realistic targets. This approach to budgeting is called delegated budgets.
• Budgets are used to review the performance of each manager controlling a cost or profit center.
The managers will be appraised on their effectiveness in reaching targets. Successful and
unsuccessful managers can therefore be identified.

Flexible budgeting
Most budgets are fixed for the time period under review. This means that they are based on the
assumption that the level of output remains at the predicted or budgeted level. If actual output
falls or rises above this level, then this could lead to obvious variances from the fixed budgets.
However, these variances do not necessarily indicate real efficiency problems

This shows a favorable variance of $2 000 because direct materials are lower than budgeted.
Lower costs should increase profit. However, this ignores the fact that output is 20% below
budget. This lower output should lead to lower material use anyway. A more realistic direct
materials budget would adjust for the lower output figure. This is called flexible budgeting, which
sets new budgets depending on the actual output level achieved.

shows a new flexible budget for direct materials based on the lower output level. The actual level
of direct materials now gives an adverse variance of $2 000. This shows that materials seem to
be used less efficiently or are costing more per unit than originally budgeted. Flexible budgets are
more motivating for budget-holding managers as they will not be criticized for adverse variances,
which might occur just because output was lower than budgeted. The flexible targets are more
realistic. Also, flexible budgets make it easier to produce valid and accurate variance analyses as
they indicate changes in efficiency, not changes in output
Variance analysis:
A variance is the difference between a budget and the actual figures achieved at the end of the
budget period. It is important to calculate and analyze the reasons for these variances because:
• Variances measure differences from the planned performance of each department over a given
period. Measuring performance is a key benefit of budgets.
• Finding out the reasons for variances can help set more realistic budgets in the future.

• Finding out the reasons for variances can help the business take better decisions. For example,
if the revenue variance for a business was negative because of lower sales caused by an economic
recession, then reducing prices might be the right decision to make.
• The performance of each individual cost center and profit center may be appraised in an
accurate and objective way

If the variance has had the effect of increasing profit above budget, then it is called a favorable
variance. If the variance has had the effect of reducing profit below budget, then it is called an
unfavorable or adverse variance Managers may need to respond quickly to both adverse and
favorable variances. Trying to find cheaper material supplies or increasing labor productivity will
help to reduce adverse variances in future. Favorable 75 variances need analyzing too. They may
reflect a poor and inaccurate budgeting process where cost budgets were set too high. A favorable
direct cost variance caused by output being much less than planned for is not a sign of success –
why were sales and output lower than planned for?

‘
The variance calculations for WIC can be verified by checking the operating profit variance ($2
500 adverse) against the net sum of the other variances ($3 500 adverse – $1 000 favorable = $2
500 adverse).

The benefits to be gained from regular variance analysis include:

• Identifying potential problems early so that remedial action can be taken. Perhaps, in this case,
a new competing computer retailer has opened up and WIC will have to quickly introduce
strategies to combat this competition.
• Allowing managers to concentrate their time and efforts on the major problem areas. This is
known as management by exception. In this case, it seems that managers should quickly
investigate the likely causes of the lower-than-expected sales figures.
 Short questions

1 Explain one difference between a budget and a forecast. [3]

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2 Define the term ‘incremental budgets’. [2]

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3 Define the term ‘flexible budget’. [2]
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4 Explain one advantage of setting budgets. [3]

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5 Explain one possible drawback of budgets. [3]

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6 Analyze one use of budgets in a business. [5]
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7. Explain one reason why a business that depends on tourists might be advised to use flexible budgeting[5]
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8. Explain one possible reason for an unfavorable revenue variance. [3]

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Financial statements
Income Statement

At the end of each accounting period – usually one year – the finance department will draw up the financial
statements for the business. This is an essential business process as the summary of financial transactions
will the business to assess their performance and make future decisions. Income statement is one part of
these financial statements which calculates the profit or loss that the business generates form their
activities. This is also known as Profit and Loss Account.

Uses of Income Statement

The information contained in these statements can be used in a number of ways:
• It can be used to measure and compare the performance of a business over time or with other firms,
and ratios can be used to help with this form of analysis

• The actual profit data can be compared with the budgeted profit levels of the business.

• Bankers and creditors of the business will need the information to help decide whether to lend money
to the business.

• Prospective investors will use the profit performance of the business as a guide to whether to buy
shares in it or not

Contents of the statement:

Trading Account

i. Sales Revenue: is the income to a business during a period of time from the sale of goods or service ii.

Cost of Goods Sold: is the cost of producing goods or buying in the goods actually sold by the business
during a time period
iii. Gross Profit: is made when sales revenue is greater than the cost of goods sold

• Profit and Loss Account

iv. Operating Profit – also known as net profit, i.e. gross profit minus expenses v. Profit for the year –
operating profit minus interest costs and corporation tax

• Appropriation Account - this shows how the profit for the year is distributed between the owners in
the form of dividends i.e. the share of profit paid to the shareholders and as Retained Earnings i.e. the
profit left after all deductions, including dividends.

The impact of a change on the statement of profit or loss

Statement of Financial Position:
Statement of financial position is one part of financial statements which records the value of the assets
and liabilities that the business owns and owes. This statement basically records the net worth or
shareholders’ equity of a business at one moment in time. The business aims to maximize the shareholders
equity by raising the value of assets owned by more than the increase in the value of its liabilities.

Contents of SOFP:

Assets: are those items of value which are owned by the business. These may be non-current or current
assets.

Non-Current Assets: assets that are to be kept and used by the business for more than one year. These
may be tangible such as land, building or may be intangible such as patents, copyrights etc.

Intangible assets also become part of firms’ intellectual capital that is the amount by which the market
value of firm exceeds its tangible assets less liabilities. Current Assets: assets that are likely to be turned
into cash before one year

• Liabilities: a financial obligation of a business that it is required to pay in the future

o Current Liabilities: debts of the business that will usually have to be paid within one year
o Non-Current Liabilities: value of debts of the business that will be payable after more than one year

• Shareholders’ Equity: It is represented by the shareholders funds in the form of share capital, retained
earnings and other reserves.

Amendments to statements of financial position:

Relationship between the financial statements:

Inventory valuation:
Inventories are unsold goods. They might also be in the form of raw materials and components that have
not yet been made into completed units. Some inventories will be in the form of work-in-progress. How
should these unsold goods and materials be valued on the business statement of financial position?
Accountants are quite clear on this: inventories should be recorded at their purchase price (historical cost)
or their net realizable value (NRV), whichever is the lower.
Net realizable value is calculated as follows:

net realizable value = the amount for which the existing inventory can be sold – cost of selling it

Depreciation:
Role of depreciation in the accounts
Depreciation is the fall in the value of non-current assets over a period of time. This is mainly due to wear
and tear through usage and also due to technological advancements. Nearly all fixed assets will decline in
value over a period of time. It seems reasonable, therefore to record only the value of each years’
depreciation as a cost on each years’ income statement. This will overcome both of the problems referred
to above:

• The assets will retain some value on the statement of financial position each year until fully
depreciated or sold off. This is the net book value, calculated as follows: original cost less accumulated
depreciation
• The profits will be reduced by the amount of that year’s depreciation and will not be under- or
overrecorded.

Impact of depreciation on accounts (straight-line method only)

The straight-line method of depreciation assumes a constant rate of depreciation. It calculates
how much a specific asset depreciates in one year, and then depreciates the asset by that amount
every year after that
Example

A machine is purchased for $20,000. It is expected to last for six years and have a residual value of $2000.
o Calculate the annual depreciation charge using straight line method. o How much will the asset be worth
after one, two, three, four and five years? o If the machine is sold off at the end of year 3 for $13,000, as
it is no longer required, how much profit or loss on disposal has the firm made?

Compared to other depreciation methods straight-line is easy to calculate and understand, it is widely used
by limited companies. This is used for those noncurrent assets which are expected to perform at a steady
rate over the years such as furniture. However, this method of depreciation will requires estimations about
useful life and the residual value. Any errors in these estimates lead to inaccurate depreciation charges
being calculated.
Analysis of Published Accounts
Liquidity Ratios:
Liquidity is a measure of how easily a business could meet its short-term debts or liabilities. Liquidity ratios
are an important measure of the ability of a business to continue trading. They are concerned with the
working capital of the business. If there is too little working capital, then the business could become illiquid
and be unable to pay short-term debts. Suppliers would refuse to deliver more materials and banks would
refuse more loans. If the business has too much money tied up in working capital, then this could be used
more effectively and profitably by investing in other assets.

The meaning and importance of liquidity

Liquidity is a measure of how easily a business is able to pay off their short-term debts or liabilities.
Liquidity ratio are an important measure of the ability of a business to continue trading. They are
concerned with the working capital of the business. If the business is having too little working capital then
the business could be illiquid and be unable to pay short term debts. Suppliers would refuse to deliver
more materials and banks would refuse more loans. If the business has too much money tied up in working
capital, then this could be used more effectively and profitably by investing in other assets.

Current ratio

The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term
liabilities with its current assets. The current ratio is an important measure of liquidity because short-term
liabilities are due within the next year.

Current Ratio: Current Assets/Current Liabilities

Acid Test/Quick Ratio:

The Acid-test or quick ratio or liquidity ratio measures the ability of a company to use its near cash or quick
assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets
that presumably can be quickly converted to cash at close to their book values.

Acid Test/Quick Ratio: Current Assets – Inventory/Current Liabilities

Profitability Ratios:
As profit is a major objective for many businesses, it is important to be able to measure profit against the
targets the managers set. A high level of profit does not necessarily mean a high level of profitability if
sales and capital invested are also very high.

Gross profit margin ratio

Gross profit is the profit a company makes after deducting the costs associated with making and
selling its products, or the costs associated with providing its services. Gross profit will appear on
a company's income statement and can be calculated by subtracting the cost of goods sold (COGS)
from revenue (sales). These figures can be found on a company's income statement. The metric is
an indication of the financial success and viability of a particular product or service. The higher the
percentage, the more the company retains on each dollar of sales to service its other costs and obligations.

gross profit margin ratio: Gross Profit Marin: G.P/Sales *100

Operating profit margin ratio

Net profit is the amount of money your business earns after deducting all operating, interest, and
tax expenses over a given period of time. To arrive at this value, you need to know a company’s
gross profit. If the value of net profit is negative, then it is called net loss. profit margin is one of the
most closely followed numbers in finance. Shareholders look at net profit margin closely because it shows
how good a company is at converting revenue into profits available for shareholders.

Net Profit Margin: N.P/Sales * 100

Return on Capital Employed:

Return on capital employed (ROCE) is a financial ratio that measures a company's profitability and the
efficiency with which its capital is employed. A higher ROCE indicates more efficient use of capital

Return on Capital Employed: N.P (before interest)/Capital Employed

Methouds of improving profit margin:

Financial efficiency ratios:
The meaning and importance of financial efficiency
There are several ratios that can be used to assess how efficiently the assets or resources of a business are
being used by management. High levels of financial efficiency are important as it means that managers
are using the assets of the business effectively and minimizing the amount that needs to be borrowed.
Reducing the capital required to operate the business reduces the cost of financing its operations. The
three most commonly used financial efficiency ratios are: rate of inventory turnover, trade receivables
turnover and trade payables turnover.

Inventory turnover:
In principle, the lower the amount of capital used in holding inventories, the better. Modern Inventory
control theory focuses on minimizing investment in inventories. It should be remembered.

• the result is not a percentage but the number of times inventory turnover in the time period – usually
one year
• The higher the number, the more efficient the managers are in selling inventory rapidly.
• The normal result for a business depends very much on the industry it operates in.
• For service sector businesses, this ratio has little relevance
Inventory Turnover (Days): Average Inventory/Cost of Sales * 365
Inventory Turnover (Times): Cost of Sales/Average Inventory

Non-Current Asset Turnover: The Non-current assets turnover ratio shows how efficiently the nonassets
of the business have been used to generate sales for the business.

Non-Current Asset Turnover: Sales/Total Non-Current Assets

Trade Receivable Days (turnover):

The trade receivables turnover (days) measures how long, on average, it takes a business to recover
payment from customers who have bought goods on credit (the trade receivables). The shorter this time
period is, the better the management is at controlling its working capital.
It should be remembered that;
• There is no right or wrong result – it will vary from business to business and industry to industry.

• A high days sales in trade receivables may be a deliberate management strategy as the customers will
be attracted if they are given extended credit period.
• The value of this ratio can be reduced by giving shorter credit period or by improving credit control.
This could involve refusing to offer credit terms to frequent late payers. The impact on sales revenue
of such policies must be considered.

Trade Receivable Days (turnover): Trade Receivable/Sales *365

Trade Payable Days (turnover):

The trade payables turnover (days) measures the average length of time the business takes to pay its
suppliers. The longer this period is, the lower the working capital needs of the business will be. The formula
can use either credit purchases or cost of goods sold.

Trade Payable Days (turnover): Trade Payables/Credit Purchases *365

Methods of improving financial efficiency:

Gearing Ratio:
The gearing ratio measures the degree to which the capital of a business is financed from debts.
The greater the reliance of a business on loan capital, the more highly geared it is said to be.

• A gearing ratio of 50%+ is considered to be a highly geared business.

• Highly geared business runs the risk of not being able to repay debts or the interest on the,
especially if profits fall significantly.
• If a business is highly dependent on loans then it may become difficult to attract new investors
as they might not want to risk their amounts in a highly geared business.
• A low gearing is an indication of safe business but the growth rate may be slower as compared
to highly geared and financed business. This is because the finance raised from loans will be
used to grow and therefore it is a possibility that a company getting high amount of loans may
be able to give higher returns to the shareholders.
• Also, if a business takes on new bank loans then they will have to pay interest. Even though
interest will increase fixed costs, which is risky, but this interest will be treated as an expense
in the income statements which will decrease the profits and will give tax savings to the
business.
• Debt financing is generally considered to be a cheaper source of finance as compared to
equity and this is because the investors on shares expect higher returns due to the risk are
taking for investing in the shares of the company.

Calculation and interpretation of Gearing Ratio:

• Gearing: non-current liabilities/shareholders equity+ non-current liabilities*10

• Interest Cover: operating profit (before tax and interest)/annual interest paid

This ratio assess how many time a firm could pay its annual interest charges. The higher this figure is, then
the less risky the current borrowing levels are for business
Methods of improving gearing

Investment ratios:

The meaning and importance of return to investors

Shareholders and potential shareholders will analyses company accounts very carefully to assess whether
continued or additional investment in the company is worthwhile investment ratios are of particular
interest to existing shareholders and prospective investors in a business. Returns to investors (or
shareholders) are important. Buying shares in a company has the potential for two kinds of financial
return. Capital gains can be made by the share price rising. In addition, companies pay annual dividends
to shareholders unless profits are too low or losses are being made. The investor ratios give an indication
of the prospects for financial gain from both of these sources. Buying shares in the company has the
potential for two kind of financial returns. Capital gains can be made by the share price rising. In addition
a companies pay annual dividends to shareholders unless profits are too low or losses are being made.
The investor ratios gives an indication of the prospects for financial gain from both of these sources.

Dividend yield ratio:

The dividend yield ratio measures the percentage rate of return a shareholder receives from the dividend
per share at the current share price. The dividend yield ratio is measured by the formula.

Dividend Yield Ratio: dividend per share/current share price *100

It should be remembered that;

• If the share price rises, perhaps due to improved prospects for the business, then with an unchanged
dividend the dividend yield will fall.

• If the directors propose an increased dividend, but the share price does not change then the dividend
yield will increase.

• This rate of return can be compared with other investments, such as bank interest rates and dividend
yield of other companies.

• The results needs to be compared with previous years and with other companies in an similar industry

• Potential shareholders might be attracted to buy shares with a high dividend yield as long as the share
price is not expected to fall.

• Directors may decide to pay dividends from the reserves even when profits are low or loss has been
made in order to keep shareholders loyalty.

• Directors may allow to reduce dividends even if profits have not fallen in order to increase retained
earnings – this could be to encourage further re-investment into the business.

Dividend cover ratio:

The dividend cover ratio is the number of times the ordinary share dividend could be paid out of current
profits after tax and interest: the profit for the year. The higher this ratio, the more able the company is to
pay the proposed dividends. A high ratio leaves a considerable margin for re-investing profits back into the
business

Dividend Cover Ratio: profit for the year/annual dividend

Points to note:

• If directors decided to increase dividends to shareholders, with no increase in profits, then the
dividend cover ratio would fall. Potential investors might start to query whether this level of dividend
can be sustained in future.

• A low result means the directors are retaining low profits for future investment and this could raise
doubts about the company’s future expansion.
Price/earnings ratio:

The price/earnings ratio (P/E ratio) is a vital ratio for shareholders and potential shareholders. It reflects
the confidence that investors have in the future prospects of the business. In general, a high P/E ratio
suggests that investors are expecting higher earnings growth in the future compared with companies with
a low P/E ratio. A ratio result of 1, for example, would mean that investors had very little confidence in the
future earnings power of the company

Price Earnings Ratio (P/E Ratio): current share price/earnings per share
Points to note:

• A high price earnings ratio suggests that investors are expecting higher earning growth in the future
compared with companies with low p/e ratio.
• The ratio should only be compared with other companies of same industry as investors may have
different levels of optimism about the prospects for different industries.

Earnings Per Share (EPS):

It represents the average earning per share that the company has generated in a certain period of time.
Higher the EPS better the shareholders will consider.

Earnings Per Share (EPS):profit for the year/number of ordinary shares issued

Methods of improving investor returns:

The most effective way to improve returns to investors is to increase profits. Higher profit levels allow for
increased dividends, which raise the dividend yield. The prospect of business growth and increased
profitability is likely to increase the share price of the company. Shareholders will therefore benefit from
higher dividends and a higher share price.

There might be a short-term trade-off, however.

• To increase profit might require investment in the business to buy more assets.

• If the company directors decided to reduce dividends to increase retained profit, this will increase
internal finance for the company.

• However, this will obviously reduce returns to shareholders in the short term.

• If the new investment in expanding the business is successful, then profit should rise in the long term.
So, dividends and share price will benefit shareholders, but only in the long term.
 Short questions

1. Define the term ‘liquidity ratio’.[2]

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2. Explain two limitations of using accounting ratios.[5]

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3. Discuss the usefulness of accounting ratios to a business considering entry into new market[12]
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4. Discuss how liquidity ratios could be useful for external stakeholders of a business[12]
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Investment Appraisal
The need for investment appraisal
Investment appraisal means assessing the profitability of an investment decision. This is usually
undertaken by using quantitative techniques. Managers use investment appraisal methods to assess
whether the likely future returns on projects will be greater than the costs and by how much. Nonfinancial
issues can also be important and therefore qualitative appraisal of an investment project is often
undertaken too. All business investments involve capital expenditure as a cash outflow. Investment
projects are undertaken because the business expects there to be a return from them, in the form of cash
inflows. These are received over the useful life of the assets purchased. Quantitative methods of appraisal
make comparisons between the cash outflows or costs of the project and the expected future cash inflows.
Before making a certain investment decision the business will have to appraise that whether the likely
future returns on projects will be greater than the costs and by how much.

Quantitative investment appraisal: what information is necessary?

When appraising the profitability of investment projects using quantitative techniques, the following
information will be required:

• initial capital cost

• The life expectancy of the project – that is for how many years the results can be expected.

• The residual value of the investment – at the end of life assets may still have scrap value.

• The forecasted net returns or net cash flows from the project (Inflows – Outflows)
• Several cash flows will be the forecast and cannot be 100% accurate.

• Longer the life expectancy of a project, the more uncertainty will be involved when estimating future
cash flows.

• The external factors such as economic changes or political changes must always be considered
collectively.

• It must be remembered that there is a different between cash inflows and annual revenues earned.
Similarly the cash outflows and operating costs can be different.
Quantitative techniques of investment appraisal
The basic quantitative methods of investment appraisal are:
• payback period
• accounting (or average) rate of return.

payback period
This is the time period taken by the project to payback the original cost of the investment from its net
cash inflows. Earlier the payback, the better it is for the business. For example, a project with an
investment of $12m and annual net cash inflow of $3m will have a payback of four years. o If we need
to calculate in months, then following formula can be used; (Additional net cash inflow required/Net
cash inflow in next year) *12 o Discounted payback is when uses discounted cash flows are used to
calculate the payback period of the capital cost. The management will want to have an earlier payback
due to the following reasons: A business may have borrowed the finance and long payback period can
increase interest cost. Even if the internal finance is used, the management will want an early payback
so the capital can be used for other projects. The longer the payback period, the riskier an investment
will be as the investment will become more uncertain. Cash flows received in the future have less real
value than cash flows of today, due to inflation. The more quickly money is returned to an investing
company, the higher will be the real value.

Advantages and Disadvantages of Payback technique

Accounting Rate of Return (ARR):

This measures the annual profitability of an investment as a percentage of the average investment.
Higher the ARR given by a certain project, more preferable it is considered. ARR is very similar to
Return on Capital Employed
Accounting Rate of Return (ARR):Annual Profit/Initial capital *100
 Why is the ARR of a project important

What does this result mean? It indicates to the business that, on average over the lifespan of the
investment, it can expect an annual return of 20% on its investment. This could be compared with

• the ARR on other projects

• the minimum expected return set by the business. This is called the criterion rate. (In the example
above, if the business refused to accept any project with a return of less than 18%, the new vehicle
fleet would satisfy this criterion.)

• the annual interest rate on loans. If the ARR is less than the interest rate, it will not be worthwhile
taking a loan to invest in the project.

Net Present Value (NPV)

What is Discounting of Cash Flows?

Managers definitely appraise the different projects based on profits and the size of cash flows. However
the managers should also consider the timings of the cash flows. The real value of money keeps on
decreasing due to inflation over the period of time. Nominally, the value may remain the same but in Real
terms the value will fall. For example, a $500 may not be able to purchase the same amount of goods
after five years which it can purchase today. So in order to consider this concept, we need to discount
future cash flows to calculate what their present value is. Discounting is done using the discount factors
and the discount chart which will be given in your exam. The discounting and the real value of money is
directly linked to interest rates in an economy, Higher the interest and inflation rates, the less value future
cash has in today’s money. In order to discount the net cash flows, we will have to multiply the discount
factor of a certain year with the net cash flows of that period.

The meaning of NPV:

This calculates the todays’ value of the estimated cash flows resulting from an investment is calculated by
subtracting the capital cost of the investment from the total discounted cash flows. To calculate the NPV
follow the following steps; Calculate discounted cash flows Add all the discounted cash flows Subtract the
capital cost. If the NPV of the project is positive, then it can be selected as the present values of cash
inflows will be exceeding the present values of future cash outflows. The discount rates used in discounting
will generally be equal to the interest rates prevailing. If the discount rate is increased then the real value
of money would decrease at a higher rate and therefore the NPV would decrease. The use of interest rate
as discount factor would mean that if the NPV is positive, the business would be getting financial benefit
even after the payment on loans. Even if internal finance is used, the finance will have an opportunity cost
and it must be considered.

Comparison of investment appraisal methods

Qualitative Investment Appraisal:
Non-financial factors cannot be ignored while taking important investment decisions. These are the
qualitative factors considered at the time of investment decisions and may include the following; The
impact on the environment and the community – growing concern about the environmental issue is
forcing businesses to consider carefully plans for development in sensitive areas. The aims and objectives
of the business such as a business may not be willing to move from labor intensive production techniques
to capital intensive techniques mainly because the objective of the business may be to serve the society
to the fullest The risk appetite of different managers may lead to different dictions. No amount of positive
quantitative data will convince some managers, perhaps as a result of high risk involved or due to previous
experiences. The legal factors such as licensing, may have to be considered before making investment in a
certain project.
Finance and Accounting Strategy
Why keep financial (accounting) records?
Keeping financial records of every transaction a business makes is essential. The process of
keeping these accounting records is not part of this Business course. We are only concerned with
the financial or accounting statements that summaries the net result of all these transactions.
However, it is useful to ask: Why is it necessary to keep accounting records? Financial statements
are the summary of financial transactions the business has carried out in a certain accounting
period. Financial statements can also be referred to as Annual Accounts, Published Accounts or
Final Accounts. The annual accounts will include a statement of profit and loss, statement of
financial statements, the statement of changes in equity, the statement of cash flows and some
other information.

Usefulness of an Annual Report

Users of financials statements can be divided into internal and external users.

Internal Users: Users which are part of the business itself. These are.
a). Business Managers:

I. To assess performance of the business to compare against targets, previous time periods and
with competitors.

ii. To help make new decisions, such as new investments, closing branches and launching new
products.
iii. To control and monitor the operations of each department and each division of the business.
iv. To set targets or budgets for the future and review these targets on a continuous basis.

External Users: Users which are not part of the business. These are.
Banks
i. To decide whether to lend money to the business.
ii. To assess whether to give or extend an overdraft facility.
b. Creditors

i. To see if business can pay off its existing debts

ii. To assess whether to allow credit period

iii. To decide whether to press for early repayment of outstanding debts

Customers

i. To assess whether the business is secure

ii. To assess whether they will be assured of future supplies of the goods they are purchasing

iii. To establish whether there will be security of spare parts and service facility.

Government and Tax authorities

i. To calculate how much tax is due

ii. To assess the importance of business to the economy

iii. To assess whether the business is in need of support iv. To confirm that the business is staying within
the law in terms of accounting regulations

Investors

i. To assess the value of the business and their investment in it

ii. To determine the share of profit investors are getting

iii. To establish whether the business is becoming more or less profitable iv. To assess gearing ratio.

Local Community

i. To see if business is profitable and likely to expand, which could be goods for the local economy.

ii. To see business’s effort for the community.

The use of Accounting data and Ratio Analysis:

Assessment of business over time and against competitors The results of the ratios calculated for a
company can be compared with past time period as well as with other competitors. This will help to
analyze that whether the performance is improving and whether the business is better or worse as
compared to their competitors.

The impact of accounting data and ratio analysis on business strategy the results of the ratios will have a
direct impact on the strategy that the business adopts. The decision making of the business will be
influenced by the ratios that have been calculated. Some examples of this can include: If the profit margins
are declining for a company, they may have to design strategies on how to increase prices or how to cut
down on overheads. If the gearing ratio is high the business may decide not to go for further debt
financing. Also the company can decide to cut down the dividend so the finance retained in the company
can be used to pay off some debt. o Change inventory holding in response to the inventory turnover days.
Finishing credit offers in response to the trade receivable days.

The impact of Debt or Equity decisions on ratio results A business might need financing in various
situations and if the business wants to raise long term external finance then there are mainly two sources
Debt (loans) or Equity (shares). The existing gearing ratio will play a very important role in deciding
between these two sources of finance.

The impact of changes in dividend strategy on ratio results. Shareholders in a public limited company
expect regular dividends from the company as a return on their investments. Company directors decide
the level of dividends every year. The level of dividends paid out to shareholders each year will depend
on the profitability and liquidity position of the business.

The impact of business growth on ratio results. A business decision to expand their operations can have
a direct impact on the results of different ratios. Some of the examples could include If a business takeovers
another business there might be some rationalization and this can lead to cutting down overheads and
operating profit margins could increase. If a business decides to launch a new product into the market
then in the short term liquidity and profitability may decrease due to the burden on expenses but in the
longer run the performance can significantly improve ratios.
Limitations of Financial Statements
Limitations of Ratio Analysis:

• Ratio analysis is just concerned with financial aspect of the company performance. A business
will have to consider several other non-financial aspects of the business as well for best
analysis.
• Different formulas can be used for the same ratio and care must be taken when comparing
the results of different companies.
• Different companies may be using different policies when valuing their assets, resulting in
different values of capital employed and therefore comparison can be difficult. Deliberate
window dressing of accounts can also make some of the ratios look more favorable.
• It must be ensured that inter-firm comparison should be taken between the companies in
same industry. Financial year end at different times of the year for business can make
comparison difficult.
• Anyone of the ratios in isolation is not very useful. Different inter-linked ratios should be used
collectively for most effective analysis.
• Ratios analysis can help the management to highlight the issues that needs attention, but this
analysis cannot suggest solutions or strategies to resolve such problems. Different managers
can come up with different strategies using the same results of ratios.

Limitations of Annual Accounts

• Companies are required to publish their financial statements by law. It must be seen that the
companies will only release the absolute minimum of accounting information, as laid down
by the company law. Companies would obviously not wish to reveal information that is
sensitive or confidential or even will try to hide as much as negative information as possible.

• The data given in financial statements are all past data for the last financial year and this past
information is not a guarantee of success for the future

• Accounting information is based on several estimates and judgments and hence the data can
be altered with little changes in judgments and estimates.

• Window Dressing – the company tries to present the accounts in the most favorable light.
This might be done to influence the users’ decisions.