3.1 Sources of Finance
Capital Expenditure - Expenses spent to acquire or significantly improve the capacity or capabilities of the business. It includes payments for fixed assets such as land, buildings, equipment, and machinery.
Revenue Expenditure - Revenue expenses are incurred when a business purchases products or services necessary for generating revenue in the short term. It includes payments for the daily operations of a business, such as wages, raw materials, rent and electricity.
Personal Funds - When owners use their savings to fund business operations.
Retained Profits - The value of profits that the business reinvests into its operations, after paying taxes, bonuses, and dividends to its shareholders. The main benefit of retaining as much profit as possible is that it is a source of finance that does not incur any interest charges.
Sale of Assets - Businesses can sell dormant or inessential assets, such as old equipment and machinery, or land they own. However, businesses usually only tap into the sale of fixed assets when severe liquidity problems arise, as it is a short-term fix and they would have to purchase the fixed assets after the problem diminishes.
Share Capital - Finance raised from the sale of shares in the company. This is particularly useful for public limited companies who are able to sell its shares on a stock exchange. To repeatedly earn money from selling shares, businesses tend to perform stock buybacks using retained profits just to sell the stock again once its value rises.
Loan Capital - Finance obtained from commercial lenders such as banks, which tend to be weighed against collateral. Taking a loan is the easiest way for businesses to obtain urgent financing, but businesses face interest charges on the capital they borrowed.
Overdrafts - Businesses can temporarily overdraw on the money available in its bank account. This tends to only be used in emergencies, as overdrafts incur high interest charges, but allows a business to access immediate funds whenever needed.
Trade Credit - Businesses can pay suppliers in credit, allowing them to manage cash flow accounts or redirect cash to other operations if required.
Grants - Government financial gifts to support business activities, especially during times of economic hardship. Grants do not need to be repaid but are typically reserved for small local businesses rather than large businesses.
Subsidies - Government aid to reduce costs of production for businesses in a certain industry when the government feels they bring extended benefits to society, such as for essential products and services. However, subsidies usually come in agreement that the business lowers its prices, therefore the business does not typically stand to gain from subsidies from the government.
Debt Factoring - A financial service that allows businesses to ‘sell’ the debts owed to them in return for the cash amount up front, less the service fee of debt factors. This is used by businesses when urgent cash inflow is required.
Leasing - Businesses can choose to lease equipment and machinery rather than buy them. Business will only have to pay rental income to continue leasing assets from the lessor, who remains the legal owner of the assets. This is used by businesses who do not have the initial capital to buy expensive assets, but who are confident that the new assets will enable them to generate more profits to cover the cost of the lease.
Venture Capital - Capital obtained from venture capital firms in a form of loans or the sale of shares to the firm. This is most commonly used by businesses in the incubation phase, enabling them to obtain the capital required to start up. The business will also benefit from the advice and mentorship received from the venture capitalists, who want to see their investments in the business gain value.
Business Angels - Capital obtained by selling shares to extremely wealthy individuals who recognise the growth potential of the business. Like venture capitalists, business angels will take an interest in the performance and development of their investment, so the business can gain from the experience and guidance of the angel investors.
3.2 Costs and Revenues
Fixed Costs - Costs of production that are independent of the scale of output.
Variable Costs - Costs of production that change in proportion with the level of output or sales.
Semi-Variable Costs - Costs that only change when production or sales exceeds a certain level of output.
Direct Costs - Costs that can be attributed to the output of a particular product or a specific cost center; without which the costs would not be incurred.
Indirect Costs (Overheads) - Costs that cannot be clearly traced to the production or sale of any single product.
Advertising Revenue - Renting out space on platforms, such as roadside billboards, blogs, e-commerce websites and video streaming platforms, for promotional activities. Digital advertising is a major revenue stream for social media platforms and other tech giants such as Google and YouTube.
Transaction Fees - A markup in price or commission for the sale of goods.
Franchise Costs and Royalties - Franchisees pay a licensing fee and royalty payments based on sales revenue to franchisors.
Sponsorship Revenue - A below-the-line promotion whereby the sponsor financially supports an organisation in return for prominent promotional display of the donor’s brand trademark.
Subscription Fees - A regular collection of fees from customers for the use and access to a good or service.
Merchandise - Companies with large brand names can rely on merchandise sales, where their trademark increases the value of regular goods.
Dividends - Being a shareholder of other companies entitles a business to payments of any declared dividends.
Donations - Financial gifts from individuals or other organisations.
Capital Gains - Interest earned on accounts in banks or a gain in the value of assets such as land or stocks in other companies.
3.3 Contribution Analysis
Contribution - Sum of money that remains after all direct and variable costs have been taken away from the sales revenue. It is the amount available to contribute towards paying for fixed costs of production.
Contribution Per Unit = price - average variable costs
Product Portfolio Management - By identifying the profitability of products in the business’ portfolio, managers will be able to decide which products should be given investment priority.
Pricing Strategy - Businesses can alter the pricing strategy of a product to ensure contributions are significant enough to cover fixed and indirect costs.
Make-or-Buy Decisions - Analysing potential contributions of a product can help a business decide whether it should produce the materials to build the product itself, or purchase them from suppliers.
Margin of Safety - The difference between a firm’s sales volume and the quantity required to break-even. The greater the positive MOS, the greater the profits for the business, whereas a negative MOS equates to a loss.
3.4 Final Accounts
Shareholders - The owners of a company will be interested to see where their money was spent and the return on their investments.
Potential Investors - Similar to shareholders, potential investor will assess whether investing in the business will be financially worthwhile.
Employees - Staff will be interested in the likelihood of a pay increase or performance-related bonus.
Managers - Managers use finance accounts to judge the operational efficiency of the organisation, and to map out their targets and strategic planning for the next fiscal year.
Competitors - Rivals are interested in benchmarking their own performance against others in the industry.
Government - Authorities will examine accounts to ensure they are not committing fraud.
Financiers - Financial lenders will scrutinise financial accounts to assess the risk of a loan, this will decide the amount of capital they will be willing to loan, and the interest they will charge.
Suppliers - Suppliers will examine financial accounts to determine whether trade credit should be given to the business.
Done in Hindsight - Shows historical performance of the business, and makes no forecast of its future performance.
Window Dressing - Legal manipulation of financial accounts, is a common practice to deceive potential investors and other stakeholders that the business is more financially successful than reality.
Accuracy - The figures are only estimations of the value of assets and liabilities. The market value of an asset is not necessarily the same as its book value, meaning the business will likely not be able to sell any fixed assets for as much as they are valued in the balance sheet.
Incomprehensive - Intangible assets and the value of human capital are not included in the balance sheet.
Intangible Assets - Non-physical fixed assets that have the ability to earn revenue for a business. They are legally protected by intellectual property rights, and can be used solely by the business.
Common Intangible Assets
Brand - Recognition and loyalty help to drive global sales.
Patents - Innovations cannot be replicated by competitors, giving the business a competitive edge.
Copyright - Provides legal protection for original artistic work. Anyone who seeks to use such works must pay a licensing fee to the business.
Goodwill - The value of an organisation’s image and reputation.
Trademarks - Like copyrights and patents, trademarks provide legal protection against replications, and a licensing fee must be paid for use.
Depreciation - Fall in value of fixed assets over time, usually due to wear and tear of assets, and obsolescence due to changing market trends and innovations.
3.5 Profitability and Ratio Analysis
Profitability Ratio - Quantitative analysis examinining profits in relation to other figures, such as sales revenue. Stakeholders use these ratios to scrutinise the financial performance of the business. The two main ratios used are the Gross Profit Margin (GPM), and Net Profit Margin (NPM).
Gross Profit Margin - Value of gross profit as a percentage of sales revenue, it measures the significance of direct costs on the profitability of a product.
GPM = (gross profit / sales revenue) x 100
Net Profit Margin - Value of net profit as a percentage of sales revenue, it measures the significance of direct and indirect costs on the profitability of a product.
NPM = (net profit before interest and tax / sales revenue) x 100
Efficiency Ratio - Quantitative analysis examining how well a firm’s resources have been used, such as the amount of profit generated from the available resources of the business. The main ratio used is the return on capital employed.
Return on Capital Employed - Measures the financial performance of a business as a percentage of the amount of capital employed. Capital employed is the sum of all sources of finance, such as shareholders’ funds, retained profits and long-term liabilities.
ROCE = (net profit before interest and tax / capital employed) x 100
Capital Employed = loan capital + share capital + retained profit
Liquidity Ratio - Quantitative analysis measuring the ability of a firm to pay its short-term liabilities, such as by comparing working capital to short-term debts. The main two ratios used are the current ratio and acid test ratio.
Current Ratio - Measures the firm’s current assets against its liabilities, to reveal whether the firm has adequate liquid assets to cover short-term debts.
Current Ratio = current assets / current liabilities
Acid Test Ratio - Measures the firm’s current assets less unsold stocks, against its liabilities. Unlike the current ratio, the acid test ratio considers unsold stocks to not be easily converted into cash.
Acid Test Ratio = (current assets - stock) / current liabilities
Employees and Trade Unions - Use ratios to assess whether a pay rise or bonuses are deserved if there is a marked improvement in financial performance.
Managers and Directors - Assess whether the firm has reached its financial and efficiency targets, enabling them to identify areas of improvement in the business.
Financiers and Suppliers - Assess ability of firms to pay on time before negotiating a deal.
Shareholders and Potential Investors - Use ratios to assess the return of their investment, and whether investing in the business is financially worthwhile.
Historical Accounts - Ratios measure historical data, and do not forecast the performance of the business in the future.
Window Dressing - No standardised way to report ratio analysis, so businesses often find unethical ways to improve the statistics and make the business appear more financially stable and successful as in reality.
3.6 Efficiency Ratio Analysis
Stock Turnover - Measures the number of times a firm sells its stock within a time period, usually over the fiscal year. It assesses the speed at which a firm sells and replenishes all its stock.
Stock Turnover (number of times) = cost of goods sold / average stock quantity
Stock Turnover (number of days) = (average stock quantity / cost of goods sold) x 365
Debtor Days - Measures the number of days it takes a firm, on average, to collect money from its debtors, otherwise known as the debt collection period. Debtors refer to customers who have purchased items on trade credit.
Debtor Days = (debtors / sales revenue) x 365
Creditor Days - Measures the number of days it takes, on average, for a business to pay its trade creditors.
Creditor Days = (creditors / cost of goods sold) x 365
Gearing Ratio - Used to assess a firm’s long-term liquidity position, by measuring how much of the firm’s capital employed is financed by long-term debt.
Gearing Ratio = (long-term liabilities / capital employed) x 100
Gearing Ratio = (loan capital / capital employed) x 100
3.7 Cash Flow
Cash - Liquid asset used to cover revenue expenditure and short-term liabilities.
Profit - The positive difference between a firm’s total revenue and its total costs of production.
Profit and cash flow are essential elements of a healthy and sustainable business, but they do not come hand-in-hand. A profitable business may still not be generating sufficient cash flow to operate, grow, or even survive.
When making a purchase, customers may have the option of paying by cash or credit. If they pay by cash, the business’ profit increases in hand with its cash inflow. However, if the customer pays by credit, the profit of the business increases, but without immediate payment, there is no cash inflow. Therefore, it is possible for a firm to be profitable but cash deficient if its debtor days ratio is too high.
Working Capital - The cash or liquid assets available to cover revenue expenditures, it shows the funds available for immediate access to cover costs. A lack of working capital means that the firm has insufficient cash to fund its daily operations.
Working Capital = current assets - current liabilities
Working Capital Cycle - The interval between cash payments for costs of production, and cash receipts from customers. For most businesses, there is a delay between paying for costs of production, and receiving the cash from the sale of the final product, and this delay is due to the time taken during the production process.
Overtrading - When a business attempts to expand too quickly, without sufficient reserve capital to fund the increasing scale of operations. For example, when a business accepts more orders than it has the capacity to handle, thereby increasing the production costs without immediate cash inflow to cover the costs due to the working capital cycle.
Overborrowing - The larger the proportion of capital raised through external sources of finance, the more interest costs incurred by the business, leading to greater outflows in the future, which the business may not be able to cover.
Overstocking - Producing too much stock that does not sell will waste the resources used to produce the goods and storage capacity.
Reducing Cash Outflow
Seek preferential credit terms - Businesses can negotiate extended credit terms with suppliers and creditors to lengthen the time taken before the business has to pay the full amount.
Seek alternative suppliers - Globalisation has opened access to suppliers from around the globe for a business. This competition among suppliers will lead to more competitive offers from each supplier. Seeking alternative suppliers that are cheaper or who offer preferential credit terms can help reduce costs, but may result in a drop in quality of output.
Better stock control - An accurate forecast of appropriate stock levels to meet market demands will reduce liquidity being tied up in unsold stocks.
Reduce expenses - Businesses can cut costs wherever possible, especially overhead costs that will not affect the quality of the product.
Leasing - Rather than investing a large amount of capital in new fixed assets, businesses can choose to lease machinery and equipment and pay in installments instead.
Improving Cash Inflow
Tighter Credit Control - Firms can limit trade credit to their customers or reduce the credit period in order to improve its debtor days ratio and shorten the working capital cycle; the earlier cash inflow will balance out the cash outflow from the costs of production within the trading period.
Cash Payments Only - Requiring customers to pay only by cash will significantly shorten the working capital cycle. However, this will put the firm in a disadvantage to competitors who offer trade credit.
Looking for Additional Sources of Finance
Sale of Assets - Businesses can sell dormant or inessential assets, such as old equipment and machinery, or land they own. However, businesses usually only tap into the sale of fixed assets when severe liquidity problems arise, as it is a short-term fix and they would have to purchase the fixed assets after the problem diminishes.
Share Capital - Finance raised from the sale of shares in the company. This is particularly useful for public limited companies who are able to sell its shares on a stock exchange. To repeatedly earn money from selling shares, businesses tend to perform stock buybacks using retained profits just to sell the stock again once its value rises.
Loan Capital - Finance obtained from commercial lenders such as banks, which tend to be weighed against collateral. Taking a loan is the easiest way for businesses to obtain urgent financing, but businesses face interest charges on the capital they borrowed.Overdrafts - Businesses can temporarily overdraw on the money available in its bank account. This tends to only be used in emergencies, as overdrafts incur high interest charges, but allows a business to access immediate funds whenever needed.
Debt Factoring - A financial service that allows businesses to ‘sell’ the debts owed to them in return for the cash amount up front, less the service fee of debt factors. This is used by businesses when urgent cash inflow is required.
Venture Capital - Capital obtained from venture capital firms in a form of loans or the sale of shares to the firm. This is most commonly used by businesses in the incubation phase, enabling them to obtain the capital required to start up. The business will also benefit from the advice and mentorship received from the venture capitalists, who want to see their investments in the business gain value.
Business Angels - Capital obtained by selling shares to extremely wealthy individuals who recognise the growth potential of the business. Like venture capitalists, business angels will take an interest in the performance and development of their investment, so the business can gain from the experience and guidance of the angel investors.
3.8 Investment Appraisal
Investment Appraisal - Quantitative techniques used to calculate the financial costs and benefits of an investment decision. The three main methods of investment appraisal are: payback period, average rate of return and net present value.
Payback Period - the amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment.
PBP = initial investment cost / contribution per month
Advantages
Forecasting - Businesses can measure how long it would take for the cash outflow used in the investment to be recouped, allowing it to forecast potential cash flow problems.
ROI - Businesses can determine whether they will be likely to breakeven on the purchase of an asset before it becomes obsolete and needs to be replaced.
Disadvantage
Static - Makes the assumption that contribution per month will be constant, ignoring changing market demands and business environments.
Average Rate of Return - Calculates the average profit on an investment project as a percentage of the amount invested. The ARR is usually compared to the market interest rate to assess whether the rewards of the investment outweigh the risks.
Average Profit per Year = total profit of investment / number of years of project
ARR = (average profit per year / initial amount invested) x 100
Net Present Value - The sum of all discounted cash flow minus the cost of a particular investment project. Due to inflation, money perceived in the future is worth less than if it were today, the net present value adjusts the potential cash inflow of the investment to projected inflation.
3.9 Budgets
Budget - Financial plan of the expected revenue and expenditure of an organisation for a given time period. Budgets are required to prevent reckless financial decisions and ensure the business stays on target to meet its objectives.
Main Reasons for Budgeting
Planning and Guidance - Budgeting requires managers to forecast financial situations and anticipate financial problems before they occur, so that businesses can be better prepared to overcome problems.
Coordination - Budgeting enables managers to take control of how the business uses its capital, by making budget allocations for each department and project.
Control - Budgeting helps to limit business expenditure, and makes managers and budget holders accountable for their expenditure.
Cost Center - A department or unit of a business that incurs costs but is not involved in making any profit. Assigning a unit of the business as a cost center will make the managers of that unit aware and accountable for their contribution towards the total costs of production for the firm, thereby motivating them to practice better cost control.
Profit Center - A department or unit of a business that incurs both costs and revenues. Assigning a unit of the business as a profit center will allow management to identify the most and least beneficial units to the business’ finances, and the financial accountability motivates managers of units to practice better cost control and increase revenues.
Advantages
Motivation - Managers of cost and profit centers are accountable for their department’s contribution to the costs and revenues of the organisation, motivating them to strive for better cost control and for improved productivity.
Aids Decision-Making - Management can identify the strengths and weaknesses of the organisation based on the positive or negative impact of each center, enabling management to focus investments on decisions that will improve the financial situation of the organisation.
Disadvantage
Profit-Oriented - Departments are less likely to consider social responsibilities and ethical objectives if they are run as profit and cost centers, as the significant objective would be their financial contribution to the organisation..
Variance - The difference between the budgeted figure and the actual outcome. It helps managers control budgetary planning by investigating the causes of any variance.
Variance = actual outcome - budgeted outcome
Favourable Variance - When discrepancies between budgeted outcome and actual outcome are financially beneficial to the organisation.
Adverse Variance - When discrepancies are financially detrimental to the organisation, and either costs are higher than expected or revenue is lower than forecasted.