Unit 3

3.1 Business finance

Finance is the money required in the business.

Finance is needed to set up the business, expand it and to provide working capital to pay the day-to-day operating
expenses.

Start-up capital is the initial capital used in the business to buy fixed and current assets before it can start trading.

Short-term sources of finance are needed to meet day to day costs such as paying bills, suppliers and employee wages.
They are likely to be relatively small amounts and are rarely needed beyond a year. Where revenue from sales does not
cover these expenses sources such as an overdraft or trade credit may be useful.

Longer-term sources of finance are needed to fund the purchase of non-current assets such as buildings and other types
of capital resources or to acquire other businesses. These are likely to be large sums that may be required for a
significant period of time. Where retained profit is not sufficient to meet these needs, businesses may consider taking
out long-term loans, mortgages or raising share capital.

Financing business Expansion - as a business grows more finance may be needed to purchase capital equipment.
It may require more machinery, buildings, IT infrastructure or vehicles which help the business to increase output. If a
business wants to grow by developing new products large amounts may need to be invested in research and
development (R&D).

Sources of finance

https://youtu.be/DAZi6XcTZzE

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Internal sources of finance refer to money that comes from within a business. There are several internal methods a
business can use, including personal savings, retained profit and selling assets.

External sources of finance refer to money that comes from outside a business. There are several external methods a
business can use, including family and friends, bank loans and share capital.

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 NOTE: may receive
product samples
instead of profits -
also, if the full
amount is not raised
the donations are
returned to the
investors.

Venture capital is money invested by an individual or group that is willing to take the risk of investing in a business in
exchange for equity (shares). The venture capitalist will expect a good return on their investment and may also attempt
to influence decision -making.

Advantages Disadvantages

Can raise substantial sums of money The venture capitalist requires a high rate of return

Provides finance that may not have been available elsewhere Loss of control – shares owned the venture capitalist

Businesses may benefit for investors expertise

3.2 Cash flow forecasting

https://youtu.be/4SNWA_HbF6U?list=PLftmziinjwVQCnLC4WZIrm5y2d6ILD96p

Why is cash important?

https://www.youtube.com/watch?v=n4gBRWcLHwU&list=PLftmziinjwVQCnLC4WZIrm5y2d6ILD96p&index=17&pp=iAQB

If a business doesn’t have any cash to pay its workers, suppliers, landlord and government, the business could go
into liquidation– selling everything it owns to pay its debts. The business needs to have an adequate amount of cash to
be able to pay for all its short-term payments.

Cash v Profit

Profit and cash are different financial terminologies

 Profit is calculated at a specific point in time

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  While a business may ultimately make a profit, they may lack cash at times because some customers may not
actually have paid them yet

Profit is the difference between revenue generated and total business costs during a specific period of time. Profit can
be an important indicator of a company's financial health and long-term sustainability as it helps to assess the
effectiveness of a company's operations.

Cash is measured by taking into account the full range of money flowing in and out of a business. This includes revenue
from sales, operating expenses, investments, loans, and any other cash-related transactions.

Cash-poor businesses will struggle to pay employees, suppliers and meet rent payments.

Therefore, a profitable business is likely to fail if it does not have sufficient cash.

The cash flow of a businesses is its cash inflows and cash outflows over a period of time.

Cash inflows are 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
 the money from the sale of business assets
 investors putting more money into the business

Cash outflows are 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)
 by paying creditors of the business- creditors are suppliers who supplied items to the business but were not paid
at the time of supply.

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Benefits of cash flow forecasts

 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 etc.

 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).

Drawbacks of cash flow forecasts

 Forecasts are usually based on estimates and in reality, inflows and outflows may differ significantly from the
estimates – due to changing external influences.

 A lack of expertise – e.g. small business owners - cash flow forecasts require appropriate skills, insight, research
and time to prepare and update adequately.

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  Some customers may not pay on time – delays cash inflows.

How can cash flow problems be overcome?

When a negative cash flow is forecast (lack of cash) the following methods can be used to correct it:

 Bank overdraft: are where a business or person uses more money than they have in a bank account. This means
the balance is in minus figures, so the bank is owed money. Overdrafts should be used carefully and only in
emergencies as they can become expensive due to the high interest rates charged by banks.

 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.

3.3 Costs and break-even analysis

https://www.youtube.com/watch?v=iNflEO5ar5A&list=PLftmziinjwVQCnLC4WZIrm5y2d6ILD96p&index=13&pp=iAQB

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https://www.youtube.com/watch?v=0FDgbz9err0&list=PLftmziinjwVQCnLC4WZIrm5y2d6ILD96p&index=12&pp=iAQB
- revenue video

Profit & loss

https://www.youtube.com/watch?v=bT5xspR4s_Y&list=PLftmziinjwVQCnLC4WZIrm5y2d6ILD96p&index=14&pp=iAQB

Profit is a surplus that remains after business costs have been subtracted

 If costs exceed revenue the business makes a loss

Most businesses have the main objective of making a profit

 Profits help new businesses to survive and break-even

 It is a reward for risks taken by entrepreneurs and investors

Established businesses can use profit to fund long-term growth.

 The simplest formula for calculating profit is: Total Revenue – Total Cost

Break-even analysis
https://youtu.be/7RocdGhTd6Q?list=PLftmziinjwVQCnLC4WZIrm5y2d6ILD96p

Break-even is the point at which a business is not making a profit or a loss i.e. it is just breaking even

At this point total costs must be the same as total revenue

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Total Revenue = Total Costs

Break-even output is the number of items that a business must sell to reach this point.
 Before reaching break-even a business is operating at a loss
 After reaching break-even each additional unit sold will contribute towards profit

Calculating the break-even point - there are two ways to calculate the break-even point.

The two ways are as follows:

The contribution method

Producing a break-even chart

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Margin of safety is how much actual output is above the break-even level of output

Calculated as: Actual output level – break-even level of output

 Actual output = 160 units

 Break-even point = 100 units
 Margin of safety = 60 units

3.4 Financial documents

The Statement of Comprehensive Income records the income and costs of a business incurred over a period of time
(usually one year)

 It is also known as a profit-and-loss account or income statement

 It is one of the key financial statements provided in the annual report

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The Statement of Financial Position shows the financial structure of a business at a specific point in time

 It is included as a key financial statement in the annual report

 It identifies a businesses assets and liabilities and specifies the capital (equity) used to fund the business
operations
 The Statement of Financial Position is also known as the Balance Sheet
 It is called the balance sheet as the net assets are equal to the total equity

Calculations in the Statement of Comprehensive Income

Two types of profit are calculated in the income statement

Gross Profit

Gross profit is made when revenue is greater than the cost of sales

Calculated by Revenue - Cost of Sales

Revenue is money generated through selling goods and services

 Calculated by Quantity sold x Selling price

Cost of Sales is the cost of raw materials and labour used in producing or buying in the goods actually sold by the
business during a time period

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  Calculated by Variable Cost per unit x Quantity Sold

 In 2023, Toys & Trikes Ltd earned revenue of $274,000 and its cost of sales was $169,000

$274,000 - $169,000 = $105,000

Operating Profit

Operating profit is profit made by a business after all costs have been deducted from revenue

Calculated by Gross Profit - Expenses

Expenses are costs that are not directly related to the production of goods or purchasing stock for sales

 In 2023, Toys & Trikes Ltd made a gross profit of $105,000 and had expenses of $48,000

$105,000 - $48,000 = $57,000

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How might the Statement of Comprehensive Income be used in decision-making

A Statement of Financial Position

It shows the value of a business on a particular date - what the business owns and owes (its assets and its liabilities).
 Assets are those items of value owned by the business.
 Fixed/non-current assets (buildings, vehicles, equipment etc) are assets that remain in the business for more
than a year.
 Short-term/current assets (inventory, trade receivables (debts from customers), cash etc) are turned into cash
within 12 months.
 Liabilities are the debts owed by the business to its creditors.
 Long-term/non-current liabilities (loans, mortgages etc)- they do not have to be repaid within a year.
 Short-term/current liabilities (trade payables (to suppliers), overdraft etc)- these need to be repaid within a
year.
 Working capital (current assets – current liabilities)

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How might it be used by different businesses?

 Shows the value of the business on a given day (net assets) - can be compared to previous years and other
businesses in the same market.
 It indicates how the business has been financed e.g. has the business predominately used retained profit and
share capital or it has been forced to borrow a lot of money.
 It indicates the businesses liquidity position i.e. working capital (current assets – current liabilities)
If current assets are higher than current liabilities (will be able to pay short term debts)
 Can be used to demonstrate the businesses strong financial position – e.g. may help to attract investors and to
aid bank loan applications

3.5 Accounts analysis

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https://www.youtube.com/watch?v=hH9-
xlRJ0hc&list=PLcWPAWkNIoiDBHSVNzH5YWj36TDawlRE3&index=28&pp=iAQB - gross profit margin

https://www.youtube.com/watch?
v=Z82E4z1zfoY&list=PLcWPAWkNIoiDBHSVNzH5YWj36TDawlRE3&index=29&pp=iAQB – operating profit margin

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(iii) Return on capital employed

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(iv) Mark-up

Liquidity ratios

The Current Ratio is a quick way to measure liquidity

https://www.youtube.com/watch?
v=lKWOQYpQNw0&list=PLcWPAWkNIoiDBHSVNzH5YWj36TDawlRE3&index=9&pp=iAQB

 The outcome is expressed as a ratio

 All types of current asset are included in calculating this ratio
 The result indicates how many £s (or other currency units) of current assets are available to cover each £1 (or
other currency unit) of short-term debt
 It is calculated using the formula

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Using the current ratio

It is one of two main liquidity ratios which are used to help assess whether a business has sufficient cash or equivalent
current assets to be able to pay its debts as they fall due.

 A ratio of 1.5:1 (up to 2:1) is seen to be the ideal ratio.

 A ratio of less than 1 is a cause for concern, as it means that the business cannot generate enough cash to pay
their short-term debts.

 A business that finds that it does not have the cash to settle its short-term debts becomes insolvent.

 A limitation of this ratio is that it assumes that the business sells all its stock. This may not happen for a number
of different reasons.

The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of
inventory.

https://www.youtube.com/watch?
v=ekCwyaElrxU&list=PLcWPAWkNIoiDBHSVNzH5YWj36TDawlRE3&index=10&pp=iAQB

 It is expressed as a ratio
 It is also known as the liquid capital ratio
 The least liquid form of current assets (inventory) is deducted so the acid test ratio provides a
more realistic measure of the businesses ability to meet short-term debts quickly
 It often takes time to sell inventory so it is excluded
 The Acid Test is calculated using the formula:

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Using the Acid test ratio

It is a more severe test of a firm’s capabilities to meet its debts.

The formula is the same as the current ratio but does not take into account the stock currently held by the business.

This is because it assumes that stock:

• may be perishable

• may go out of date

• may go out of fashion or become obsolete (i.e. not be sold)

In other words, the business may be left with stock it cannot sell and therefore the current ratio may provide a false
indication of the businesses liquidity position.

Therefore, the acid test is whether a business can still pay its short-term debts even if none of the existing stock is sold.
A ratio of 1:1 is the ideal ratio

Accounting ratio benefits

 Accounting ratios help compare current performance with previous records – to assess the performance of
managers in the last financial year
 Accounting ratios help compare a firm’s performance with similar competitors
 Accounting ratios help monitor and identify issues that can be highlighted and resolved e.g. poor liquidity
 Accounting ratios help with future decision making e.g. whether to prioritise reducing costs.

Accounting ratio drawbacks

 The Statement of Financial Position (SOFP) is just a snapshot of the business on one selected day – the ratios
could change significantly during the financial year.
 The ratios are only as good as the information provided in the SOFP and SOC – e.g. has window dressing taken
place, such as delaying making payments to make the ratios look stronger
 The ratios need comparison: For example, 45% on its own means nothing but a rise from 45% to 87% means
something – at least 5 years data is required

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The use of financial documents to inform decision-making
Business owners (current shareholders) want to analyse Final Accounts to find out answers to the following questions:

 What is the current value of the business?

 What is the current value of their investment in the business?
 Does the business have potential for growth in the next few years?
 Should they decide to buy more shares in the business?

Managers want to analyse Final Accounts to find out answers to questions such as:

 Did the company achieve its sales revenue targets?

 Did the company achieve higher or lower sales revenue comparing with previous years?
 How well were the costs of production and fixed costs controlled?
 Did the company achieve its profit targets?
 Are the profits rising or falling comparing with the previous year?
 How much Retained Profit can the business keep to finance its future projects?

Employees want to analyse Final Accounts to find out answers to the following questions:

 Are our jobs secure?

 Is the business stable enough to continue paying us wages?
 Is the business likely to expand to create more opportunities for development, or be reduced in size so
opportunities will be limited?
 Are profits rising so a wage increase can be afforded?

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Governments wants to analyse Final Accounts to find out answers to the following questions:

 How much TAX is due from the business?

 Is the business staying within the law in terms of accounting regulations?
 Is the business violating any accounting regulations?
 Is the business going to pay more taxes in the future to support the country’s economy?
 Is the business going to expand creating more jobs?
 Is the business in danger of closing down causing economic problems?

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