Finance and accounting
Sources of Finance
Every entrepreneur needs start-up capital in order to set up a business.
Working capital: the capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.
External sources of finance
Short term sources of finance
Factoring: Selling of claims over trade receivables to a debt factor in exchange for immediate liquidity.
Long term sources of finance
Long term loans: Loans that do not have to be repaid for at least one year.
Debentures: loan stock
Equity finance: permanent finance raised by companies through the sale shares.
Internal sources of finance
Retained earnings: Remaining finance after paying shareholders and tax
Sale of assets
Sale and leasing back: Selling assets to a leasing specialist and leasing it back over time
Reductions in working capital: Reducing working capital and using that finance for other uses.
Trade credit: Delaying the payment for goods or services received.
Overdraft: Bank lends a business and agreed amount when required.
Medium term sources of finance
Hire purchase: An asset is sold to a company that agrees to pay fixed repayments over a period of time, the asset belong to the company.
Leasing: Obtaining the use of equipment or vehicles by paying a rental or leasing charge over a period of time. Ownership remains with the leasing company.
Grants: Agencies fund businesses to help businesses grow, but some conditions set by agencies have to be met for the business not to have to pay back the grant.
Venture capital: Risk capital invested in business start-ups or expanding small business that find it difficult to find sources of finance.
Microfinance: Providing financial services for poor and low-income customers who do not have access to banking services.
Crowd funding: The use of small amounts of capital from a large number of individuals to finance a new business.
Factors influencing finance choice
Use to which finance is to be put: Long term of short term needs?
Cost: The cost of obtaining finance is very important. E.g.: Interest rates
Amount required
Legal structure: Only limited companies can sell to the general public.
Size of existing borrowing: The higher the existing debts of a business the less likely banks and lenders will be willing to lend more finance.
Costs
Accurate cost data is important so that accurate profits and losses can be calculated, for pricing decisions, helps set budgets for the future, helps in decision making. If businesses do not keep an accurate record of their costs they will not be able to make effective and profitable decisions.
Types of costs
Fixed costs: Costs that do not vary with output in the short run. e.g.: rent
Variable costs: Costs that vary with output. e.g.: direct materials
Marginal costs: The extra cost of producing one more output.
Direct costs: Costs that can be clearly identified with each unit of production and can be allocated to a cost centre.
Indirect costs:Costs that cannot be identified with a unit of production. e.g.: Tractor for a farm
Problems in classifying costs
When labour is unoccupied because lack of orders most businesses will continue to pay workers in the short run. Wages then become an overhead cost, which cannot be directly allocated to any output.
Break even analysis
Break even point of production: the level of output at which total costs equal total revenue, neither profit or loss is made
Margin of safety: the amount by which the sales level exceeds the break-even level of output. Production/break even point.
Advantages: Charts are relatively easy to construct and interpret. Analysis provides useful guidelines to management. Comparisons can be made between different options. Assists managers when making important decisions.
Disadvantages: The assumption that costs and revenues are always represented by straight lines is unrealistic. Not all costs can be classified into variable or fixed costs. It is assumed that all units are produced and sold.
Accounting Fundamentals
Income statement: records the revenue, costs and profit of a business over a period of time, this information helps compare businesses, banks will need this data in order to lend money, measure performance
Cost of sales: this is the direct cost of the goods that were sold during the financial year
Gross profit: the profit a company makes after deducting the cost of making and selling the products
Operating profit: gross profit minus overhead expenses
Profit of the year: operating profit minus interest costs and corporation tax
Retained earnings: the profit left after all deductions, including dividends have been made
The statement of financial position: an accounting statement that records the values of a business's assets, liabilities and shareholder's equity at one point in time
Non-current assets: assets to be kept and used by the business for more than one year
Current assets: assets that are likely to be turned into cash before the next balance-sheet date
Current liabilities: debts of the business that will have to be paid within one year
Working capital: the capital of a business which is used in its day-to-day trading operations
Net assets: Total assets - Total liabilities
Non-current liabilities: debts of the business that will be payable after more than one year
Shareholder's equity: Total value of assets - Total value of liabilities
Profitability ratios
Gross profit margin: (Gross profit/revenue)*100. How effectively managers have added value to the cost of sales.
Operating profit margin: (Operating profit/revenue)*100. How well the business is turning revenue into profit, before tax and dividends.
Liquidity ratios: the ability of a business to pay its short term debts
Current ratio: Current assets/Current liabilities.
Acid-test ratio: liquid assets/current liabilities
Limitations: The ratios give an incomplete analysis of the business's financial position. New business cannot use this since results need to be compared with previous years.
Ways to increase liquidity: sell off fixed assets for cash, sell of inventories for cash, increase loans and working capital to inject cash into the business
Limitations of published accounts
What it does not include: Details of the sales and profitability of each good, the research and development of the business, precise future plans, performance of each department, future budgets or plans.
Window dressing: presenting the company accounts in a favourable light to flatter the business performance
Forecasting and Managing Cashflows
Cash vs. Profit: A business needs cash all the time in order to survive in the short-term, but is able to survive for a while without making any profit. Profit is necessary in the long-term.
Not having enough cash: A business will not be able to pay its short term debts and banks will not be willing to lend money to that business. This applies especially to new businesses since they have no trading record. Not having enough cash can be life threatening to a business
Cash-flow forecast: estimate of a firm's future cash inflows and outflows.
Cash inflow forecasts: Owner's own capital injection, bank loan payments, customers' cash purchases, trade receivables payments.
Cash outflow forecasts: Annual rent repayment, lease payment for premises, bills, labour payments, variable cost payments.
Structure of cashflow forecasts
Section 1: Cash inflows
Section 2: Cash outflows
Section 3: Net monthly cash flow and opening and closing balance
The accuracy of the cash flow forecasts depends on how accurate the business is in their demand, revenue and material cost forecasts
Businesses can use cashflow forecasts to plan ahead. If negative cash flow appears then plans can be made to reduce these, with bank overdrafts, injecting more owner's capital, cutting down on material costs etc.
Limitations: Mistakes can be made in preparing the revenue and cost forecasts, unexpected cost increases, wrong assumptions can be made.
Causes: Lack of planning, poor credit control, allowing customers too long to pay debts, expanding too rapidly, unexpected events
Ways to improve cashflow: increase cash inflows or reduce cash outflows
Trade receivables: not extending credit to customers, being careful to discover whether new customers re credit worthy, offering discounts to customers who pay promptly
Overdraft: flexible loans on which businesses can draw up necessary capital
Short-term loan: A fixed amount borrowed for an agreed amount of time
Sale of assets
Sale and leaseback
Reduce credit terms to customers
Debt factoring