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Business > 5. Financial Information and Financial Decision > Flashcards

5. Financial Information and Financial Decision Flashcards

1
Q

Why business need finance?

A
  • Starting up a business
  • Expansion of an existing Business
  • Additional working capital
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2
Q

Start-up capital

A

the finance needed by a new business to pay for essential non-current and current assets before it can begin trading

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3
Q

Working capital

A

the finance needed by a business to pay its day to day costs

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4
Q

Capital expenditure

A

Money spent on non-current assets which will last for more than one year

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5
Q

Revenue expenditure

A

Money spent on day-to-day expenses which do not involve the purchase of long term asset for example: Wage or rent

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6
Q

difference between short-term and long-term finance needs

A

Short term Finance options are bank overdraft, short term loans, line of credit, etc. Short term financing arises with an attempt to finance current assets. It can help to finance working capital, paying suppliers or even increase inventory. Long term financing is used for overall improvement of the business.

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7
Q

Internal finance

A

Is obtained from within the business itself

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8
Q

Examples

A
  • retained profits: Profits kept after owners taken their share of profits
  • Sale of existing assets: Item of value which are no longer needed by the business (redundant buildings)
  • Sale of inventories to reduce inventory levels
  • Owners savings: Sole trader or member of a partnership can put more of their savings into the unincorporated business
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9
Q

Retained profits

A

Advantages:
-Retained profit does not have to be repaid, unlike a loan
-No interest to pay, Capital is raised within the business
Disadvantages:
-New business not have any retained profits
-Many small firms profits might be too low to finance the expansion needed
-Keeping more profits in the business reduces payments to owners

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10
Q

Sale of existing assets

A

Advantages:
-Makes better use o capital tied up in the business
-Does not increase debts of the business
Disadvantages:
-Take Time to sell assets, amount raised never certain until assets are sold
-This source of finance is not available for the new business as they have no surplus assets to sell

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11
Q

Sale of inventories to reduce inventory levels

A

Advantages:
-Reduces the opportunity cost and storage cost o high inventory levels
Disadvantages:
-Must be done carefully to avoid dissapointing customers if not enough goods are kept as inventory

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12
Q

Owners savings

A 
Advantages:
-Should be available to the firm quickly
-No interest is paid
Disadvantages:
-Savings may be too low
-It increases the risk taken by owners as they have unlimited liability
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13
Q

External Finance examples

A
  • issue of shares: Only possible for limited companies
  • Bank Loans: Sum of money obtained from bank, repaid on which interest is payable
  • Selling debentures: Long-term certificates issued by limited companies
  • Factoring debts: Debtor is a customer who owes money to a business for goods bought. Debt factors are specialist agencies that buy claims on debtors of business for immediate cash
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14
Q

Issue of shares

A

Advantages:
-A permanent source of capital, no need to repay the money to shareholders. no interest has to be paid
Disadvantages:
-Dividends have to be paid to the shareholders
-If many shares are bought, the ownership of the business will change hands. (The ownership is decided by who has the highest percentage of shares in the company)

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15
Q

Bank loans

A

Advantages:
-Quick to arrange a loan
-Can be for varying lengths of time
-Large companies can get very low rates of interest on their loans
Disadvantages:
-Need to pay interest on the loan periodically
-It has to be repaid after a specified length of time
-Need to give the bank a collateral security (the bank will ask for some valued asset, usually some part of the business, as a security they can use if at all the business cannot repay the loan in the future. For a sole trader, his house might be collateral. So there is a risk of losing highly valuable assets)

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16
Q

Debenture issues

A

Advantage:
-Can be used to raise very long-term finance, for example, 25 years
Disadvantage:
-Interest has to be paid and it has to be repaid

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17
Q

Debt factoring

A

Advantages:
-Immediate cash is available to the business
-Business doesn’t have to handle the debt collecting
Disadvantage:
-The debt factor will get a percent of the debts collected as reward. Thus, the business doesn’t get all of their debts

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18
Q

Grants and subsidies

A

Government agencies and other external sources can give the business a grant or subsidy
Advantage:
-Do not have to be repaid, is free
Disadvantage:
-There are usually certain conditions to fulfil to get a grant. Example, to locate in a particular under-developed area.

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19
Q

Micro-finance

A

Special institutes are set up in poorly-developed countries where financially-lacking people looking to start or expand small businesses can get small sums of money. They provide all sorts of financial services

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20
Q

Crowdfunding

A

Raises capital by asking small funds from a large pool of people, e.g. via Kickstarter. These funds are voluntary ‘donations’ and don’t have to be return or paid a dividend.

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21
Q

Short-term finance

A

provides the working capital a business needs for its day-to-day operations.

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22
Q

Overdrafts

A

Similar to loans, the bank can arrange overdrafts by allowing businesses to spend more than what is in their bank account. The overdraft will vary with each month, based on how much extra money the business needs.
Advantages:
-Flexible form of borrowing since overdrawn amounts can be varied each month
-Interest has to be paid only on the amount overdrawn
-Overdrafts are generally cheaper than loans in the long-term
Disadvantages:
-Interest rates can vary periodically, unlike loans which have a fixed interest rate.
-The bank can ask for the overdraft to be repaid at a short-notice.

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23
Q

Trade Credits

A

This is when a business delays paying suppliers for some time, improving their cash position
Advantage:
-No interests, repayments involved
Disadvantage:
-If the payments are not made quickly, suppliers may refuse to give discounts in the future or refuse to supply at all

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24
Q

Long-term finance

A

the finance that is available for more than a year.
-Loans: from banks or private individuals.
-Debentures
-Issue of Shares
-Hire Purchase: allows the business to buy a fixed asset and pay for it in monthly instalments that include interest charges. This is not a method to raise capital but gives the business time to raise the capital.
Advantage:
The firms doesn’t need a large sum of cash to acquire the asset
Disadvantage:
-A cash deposit has to be paid in the beginning
-Can carry large interest charges.

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25
Q

Leasing

A

This allows a business to use an asset without purchasing it. The business can decide to buy the asset at the end of the leasing period.
Advantages:
-The firm doesn’t need a large sum of money to use the asset
-The care and maintenance of the asset is done by the leasing company
Disadvantage:
-The total costs of leasing the asset could finally end up being more than the cost of purchasing the asset!

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26
Q

Factors that affect choice of source of finance

A 
Purpose
Time-period
Amount needed
Legal form and size
Control
Risk- gearing: if business has existing loans, borrowing more capital can increase gearing- risk of the business- as high interests have to be paid even when there is no profit, loans and debentures need to be repaid etc. Banks and shareholders will be reluctant to invest in risky businesses.
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27
Q

Purpose

A

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

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28
Q

Time-period

A

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

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29
Q

Amount needed

A

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

30
Q

Legal form and size

A

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

31
Q

Control

A

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

32
Q

Risk- gearing

A

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

33
Q

Finance from banks and shareholders

A
  • A cash flow forecast is presented detailing why finance is needed and how it will be used
  • An income statement from the last trading year and the forecast income statement for the next year, to see how much profit the business makes and will make.
  • Details of existing loans and sources of finance being used
  • Evidence that a security/collateral is available with the business to reduce the bank’s risk of lending
  • A business plan is presented to explain clearly what the business hopes to achieve in the future and why finance is important to these plans
34
Q

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

A
  • the company’s share prices are increasing- this is a good indicator of improving performance
  • dividends and profits are high
  • the company has a good reputations and future growth plans
35
Q

Why cash is important to a business

A

Cash is a liquid asset, immediately available for spending on goods and services.

If business has too little cash, or runs out completely, Business will face:

  • Being unable to pay workers, suppliers, landlords and government
  • Production of goods and services will stop, workers will not work without being paid, suppliers will not supply goods if they are not paid
  • Business may be forced to liquidation, selling up everything it owns to pay its debts.
36
Q

Cash flow

A

The cash inflow and outflow of a business over a period of time.

37
Q

Cash inflow and outflow

A

Cash inflow: the sums of money received by the business over a period of time.

  • Sales revenue from sale of products
  • Payment from debtors– debtors are customers who have already purchased goods from the business but didn’t pay for them at that time
  • Money borrowed from external sources, like loans

Cash outflow: the sums of money paid out by the business over a period of time

  • Purchasing goods and materials for cash
  • Paying wages, salaries and other expenses in cash
  • Purchasing fixed assets
  • Repaying loans (cash is going out of the business)
38
Q

Cash flow cycle:

A
  1. Cash needed to pay for
  2. Materials, wages, rents
  3. Goods produced
  4. Goods sold
  5. Cash payment received from goods sold

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

39
Q

What a cash-flow forecast is, how a simple one is constructed and the importance of it

A

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

  • How much cash is available for paying bills, purchasing fixed assets or repaying loans
  • How much cash the bank will need to lend to the business to avoid insolvency (running out of liquid cash)
  • Whether the business has too much cash that can be put to a profitable use in the business
40
Q

Closing cash balance

A

Amount of cash held by the business at the end of each month, becomes next months opening balance

41
Q

Opening cash balance

A

Amount of cash held by the business at the start of each month.

42
Q

Net cash flow

A

The difference, each month, between inflow and outflow.

-Net Cash Flow = Total Cash Inflow – Total Cash Outflow

43
Q

Uses of cash flow forecast:

A

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

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

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

44
Q

How can cash flow problems be overcome?

A
  • Increase bank loans: bank loans will inject more cash into the business, but the firm will have to pay regular interest payments on the loans and it will eventually have to be repaid, causing future cash outflows
  • Delay payment to suppliers: asking for more time to pay suppliers will help decrease cash outflows in the short-run. However, suppliers could refuse to supply on credit and may reduce discounts for late payment
  • Ask debtors to pay more quickly: if debtors are asked to pay all the debts they have to the firm quicker, the firm’s cash inflows would increase in the short-run. These debtors will include credit customers, who can be asked to make cash sales as opposed to credit sales for purchases (cash will have to be paid on the spot, credit will mean they can pay in the future, thus becoming debtors). However, customers may move to other businesses that still offers them time to pay
  • Delay or cancel purchases of capital equipment: this will greatly help reduce cash outflows in the short-run, but at the cost of the efficiency the firm loses out on not buying new technology and still using old equipment.

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

45
Q

The concept and importance of working capital

A

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

  • Cash needed to pay expenses
  • Cash due from debtors – debtors/credit customers can be asked to quickly pay off what they owe to the business in order for the business to raise cash
  • Cash in the form of inventory – Inventory of finished goods can be quickly sold off to build cash inflows. Too much inventory results in high costs, too low inventory may cause production to stop.
46
Q

Accounts

A
  • Accounts: are the financial records of a firm’s transactions.
  • Final Accounts: are prepared at the end of the financial year and give details of the profit or loss made as well as the worth of the business.
47
Q

How a profit is made

A

Profit = Sales Revenue – Total cost
(When the total costs exceed the sales revenue, then a loss is made).

How to increase profit

  • Increase revenue by more than costs
  • Cut costs
  • Combination of both
48
Q

Importance of profit to private sector businesses, e.g. reward for risk-taking/enterprise, source of finance

A
  • It is a reward for enterprise: entrepreneurs start businesses to make a profit
  • It is a reward for risk-taking: entrepreneurs has to take considerable risks when they invest capital in a venture, and profits are a compensation/reward to them for taking these risks (paid in the form of profits or dividends)
  • It is a source of finance: after payments to owners, profits are reinvested back into the business for further expansion (this is called retained earnings)
  • It is an indicator of success: more profits indicate to investors that the business/industry is worth their time and money, and they will invest more either int he firm or new firms of their own, in the hopes of gaining good returns on their investment

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

49
Q

Difference between profit and cash

A
  • Profit is the surplus amount after total costs have been deducted from sales. It includes all income and payments incurred in the year, whether already received or paid or to not yet received or paid respectfully.
  • In a cash flow, only those elements paid in cash immediately are considered.
50
Q

Main features of an income statement,

e.g. revenue, cost of sales, gross profit, profit and retained profit

A

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

  • Sales revenue: total sales
  • Cost of sales: Total variable cost of production + (opening inventory of finished goods – closing inventory of finished goods)
  • Gross profit: Revenue - cost of sales
  • Net profit: Gross profit - Expenses
  • Profit after Tax = Net Profit – Tax
  • Dividends: share of profit given to shareholders; return on shares
  • Retained Profit for the year = Profit after Tax – Dividends. This retained earnings is then kept aside for use in the business.
51
Q

Use simple income statements in decision- making based on profit calculations

A

Income statements are used by managers to:

  • Know the profit/loss made by the business
  • Compare their performance with that of previous years’ and with that of competitors’. If profit is lower than that of last year’s why is it falling and what can they do to correct the issue? If it is lower than that of competitors’ what can they do to be more profitable and be competitive in the market?
  • Know the profitability of individual products by preparing separate income statement for each product. They may decide to stop production of products that are making losses.
  • Help decide what products to launch by preparing forecast income statement for the first few years. Whichever product is forecast to have a higher profit, the business will choose to launch that product
52
Q

Statement of financial position

A

Shows the value of. business’s assets and liabilities at a particular time

53
Q

Assets

A

Those items of value owned by the business.

54
Q

Liabilities

A

Debts owned by the business. May be non-current liabilities (long term) or Current liabilities (short-term)

55
Q

Non-current assets

A

Items owned by the business for more that one year

56
Q

Current assets

A

Owned by a business and used within one year

57
Q

Non-current liabilities

A

Long-term debts owed by the business, repaid over more than one year

58
Q

Current liabilities

A

Short-term debts owed by the business, repaid in less than one year

59
Q

Working capital

A

CURRENT ASSETS – CURRENT LIABILITIES = WORKING CAPITAL

60
Q

Shareholder’s Equity

A

The total amount of money invested in the company by shareholders. This will include both the share capital (invested directly by shareholders) and reserves (retained earnings reserve, general reserve etc.).
Shareholders can see if their stake in the business has risen or fallen by looking at the total equity figure on the balance sheet.
SHAREHOLDERS EQUITY = TOTAL ASSETS – TOTAL LIABILITIES

61
Q

Totals assets

A

TOTAL ASSETS = TOTAL LIABILITIES + SHAREHOLDERS EQUITY

62
Q

Capital employed

A

CAPITAL EMPLOYED = SHAREHOLDERS EQUITY + NON-CURRENT LIABILITIES

63
Q

Uses of a statement of financial position

A
  • When the current assets subtotal is compared to the current liabilities subtotal, investors can estimate whether a firm has access to sufficient funds in the short term to pay off its short-term obligations i.e., whether it is liquid
  • One can also compare the total amount of debt (liabilities) to the total amount of equity listed on the balance sheet, to see if the resulting debt-equity ratio indicates a dangerously high level of borrowing. This information is especially useful for lenders and creditors, (especially banks) who want to know if the firm will be able to pay back its debt
  • Investors like to examine the amount of cash on the balance sheet to see if there is enough available to pay them a dividend
  • Managers can examine its balance sheet to see if there are any assets that could potentially be sold off without harming the underlying business. For example, they can compare the reported inventory assets to the sales to derive an inventory turnover level, which can indicate the presence of excess inventory, so they will sell off the excess inventory to raise finance
64
Q

Profitability

A

ability of a company to use its resources to generate revenues in excess of its expenses.

65
Q

Return on Capital Employed (ROCE):

A

calculates the return (net profit). The higher the ROCE the better the profitability is.
-(Net profit / Capital employed) *100

66
Q

Gross Profit Margin:

A

calculates the gross profit (sales – cost of production) in terms of the sales. The higher the GPM, the better.
-(Gross profit/ Revenue) * 100

67
Q

Net profit Margin:

A

calculates the net profit (gross profit-expenses) in terms of the sales. The higher the NPM, the better.
- (Net profit / revenue) * 100

68
Q

Liquidity Ratios:

A

liquidity is the ability of the company to pay back its short-term debts.

69
Q

Current Ratio:

A

Calculates how many current assets are there in proportion to every current liability, so the higher the current ratio the better.
- (Current Assets / Current liabilities) *100

70
Q

Liquid Ratio/ Acid Test Ratio:

A
  • [(Current assets - Inventories) / Current liabilities]* 100
71
Q

Uses and users of accounts

A

Managers: they will use the accounts to help them keep control over the performance of each product or each division since they can see which products are profitably performing and which are not.

  • This will allow them to take better decisions.
  • Ratios can be compared with other firms in the industry/competitors and also with previous years to see how they’re doing.

Shareholders:
-Existing shareholders and potential investors can see whether they should invest in the business by buying shares. A higher profitability, the higher the chance of getting dividends. They will also compare the ratios with other companies and with previous years to take the most profitable decision.

Creditors: If there are liquidity problems, they won’t supply the business as it is risky for them.

Banks: Similar to how suppliers use accounts, they will look at how risky it is to lend to the business. They will only lend to profitable and liquid firms.

Government: the government and tax officials will look at the profits of the company to fix a tax rate and to see if the business is profitable and liquid enough to continue operations and thus if the worker’s jobs will be protected.

72
Q

Limitations of using accounts and ratio analysis

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

Business (6 decks)

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