5 Financial information and decisions

Business nance: needs and sources

Why Businesses Need Finance
• Start-up capital — To set up the business.
• Working capital — To cover day-to-day expenses (e.g., wages, raw materials, fuel).
• Capital expenditure — To purchase or upgrade non-current assets (e.g., machinery, buildings).
• Technology investment — To stay competitive with the latest innovations.
• Business expansion — To nance growth into new markets or larger operations.
• Research and development — To create new products or explore new markets.

Short-term vs. Long-term Finance

• Short-term nance (less than 1 year): For smaller, immediate needs (e.g., buying new computers).
• Long-term nance (more than 1 year): For larger, long-term investments (e.g., building a factory).

Main Sources of Finance

• Internal nance — Raised from within the business.
• External nance — Raised from outside the business.

Internal Sources of Finance

1. Owner’s savings — Personal money invested in the business.
2. Retained pro ts: Reinvesting pro ts instead of distributing them as dividends.
• Bene t: No borrowing costs.
• Limitation: Only available if the business is pro table.
3. Sale of non-current assets: Selling unused assets or doing a sale and leaseback.
• Bene t: Can raise large amounts of money.
• Limitation: May lose useful assets or face future leasing costs.
4. Use of working capital: Reducing inventory levels or trade receivables.
• Bene t: Frees up cash.
• Limitation: Can reduce liquidity and increase business risk.
5. Cash balances: Using surplus cash for investment.
• Risk: Might not have enough left for day-to-day expenses.

External Sources of Finance

1. Short-term sources (less than 1 year):
• Overdrafts: Flexible, but high interest costs.
• Trade credit: Delaying payments to suppliers.
• Debt factoring: Selling unpaid customer invoices to a factoring company for immediate cash (but at a discount).

2. Long-term sources (more than 1 year):

• Bank loans: Fixed or variable interest rates, but may be harder for small businesses to get.
• Leasing: Renting assets instead of buying.
• Hire purchase: Paying for assets in installments, owning them after nal payment.
• Mortgage: Loan secured against property.
• Debentures: Bonds that raise large sums of money but require repayment with interest.
• Share issue (for limited companies only): Selling shares to raise permanent capital.
• Private limited companies: Sell shares to private investors.
• Public limited companies: Sell shares to the general public.
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 3. Alternative sources of nance:
• Government grants: Non-repayable funds to support business growth.
• Micro- nance: Small loans for entrepreneurs in underdeveloped areas.
• Crowd-funding: Raising money from many small investors via online platforms.

Debt vs. Equity Financing

Debt nancing:
• No ownership changes.
• Interest payments required (even if pro ts are low).
• The amount borrowed must be repaid.
Equity nancing:
• No repayment required.
• Dividends only paid if the business makes a pro t.
• Dilutes ownership, meaning less control for existing owners.

Factors In uencing the Choice of Finance

1. Size and legal form of the business:
• Sole traders and partnerships can’t issue shares and may struggle to get large loans.
2. Amount required:
• Large amounts Share issues, debentures.

• Smaller amounts Bank loans, leasing, hire purchase.

3. Timeframe:
• Short-term needs Overdrafts, trade credit.

• Long-term needs Mortgages, share issues, debentures.

4. Existing borrowing:
• High existing debt may make further borrowing dif cult or expensive.
5. Pro tability:
• Pro table businesses can use retained pro ts and are more attractive to lenders.
6. Purpose of nance:
• Some sources are for speci c uses (e.g., mortgages for property, leasing for equipment).
7. Ownership control:
• Issuing shares or taking on investors may reduce owner control.
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 Cash- ow forecasting and working capital
The importance of cash and cash- ow forecasting
• “Cash is King”: Without cash, a business can’t pay:
• Employee wages
• Suppliers for goods and services
• Rent, utilities, and other operational costs
• Cash Shortages Lead to Failure: If a business can’t cover its costs, it risks closure.

Cash-Flow Management
• Goal: Ensure enough cash comes in to cover out ows.
• Example: If cash from sales isn’t enough to pay suppliers, the business may run into trouble.

What is a Cash-Flow Forecast?

• Forecasting Cash In ows & Out ows: Helps predict periods of cash shortages or surpluses.
• Net Cash Flow: The difference between cash in ows and out ows.
• Positive net cash ow = more cash coming in than going out (good)
• Negative net cash ow = more cash going out than coming in (problematic)

Managing Cash Shortages

-Identify Problems Early: Forecasting helps spot when a business might run out of cash.
-Solutions for Short-Term Cash Shortages:
• Delay big purchases (e.g., postpone buying a delivery van)
• Find alternative nancing (e.g., loans, hire purchase, leasing)
• Arrange an overdraft (but this can be expensive)

Financing Cash Shortfalls

• Speed up receivables: Offer discounts for faster customer payments.
• Negotiate with suppliers: Ask for longer payment terms.
• Delay non-essential expenses: Wait to buy assets until cash ow improves.

Working Capital & Liquidity

• Working Capital: The cash a business needs for day-to-day operations (current assets - current liabilities).
• Liquidity: The ability to pay short-term debts.
The Working Capital Cycle:
1. Buy raw materials (may be on credit).
2. Produce goods.
3. Sell goods (sometimes on credit).
4. Receive cash from customers.
Ways to Improve Working Capital:
• Reduce inventory levels (less cash tied up in stock).
• Negotiate better supplier terms (delay payments).
• Collect customer payments faster (shorten credit periods).

Why It All Matters

• Running out of cash = high risk of failure.
• Good cash- ow forecasting helps businesses make better decisions, avoid unnecessary borrowing, and survive
tough times.
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 Income statements
What is Pro t?
Pro t is the difference between revenue (money made from sales) and total costs (money spent to run the
business).

3 Types of Pro t:
1. Gross Pro t = Revenue - Cost of Sales
• Pro t from selling products, before subtracting expenses.
2. Pro t (Net Pro t) = Gross Pro t - Expenses
• The nal pro t after all costs and expenses are deducted.
3. Retained Pro t
• Pro t kept in the business for reinvestment instead of paying it out to owners.

Pro t Formulas:
• Revenue = Selling Price × Quantity Sold
• Gross Pro t = Revenue - Cost of Sales
• Pro t (Net Pro t) = Gross Pro t - Expenses

Pro t is essential for:

• Rewarding Owners for their investment and risk.
• Measuring Success of the business and management.
• Funding Growth (buying assets, expanding operations).
• Attracting Investors for future nancing.

Pro t vs Cash — What’s the Difference?

• Cash increases, but pro t doesn’t: When a business borrows money or gets investments.
• Cash decreases, but pro t doesn’t: When buying assets (like machines).
• Pro t increases, but cash doesn’t: When selling on credit (pro t is recorded, but cash comes later).

Key Insight:
• Cash is needed for daily operations.
• Pro t is vital for long-term success.

Income Statements
a nancial report showing a business’s revenue, costs, and pro t over a period of time (at least annually). And
helps businesses and stakeholders understand nancial health.

Why Income Statements Matter:

• Owners/Shareholders — Pro t shows their return on investment (ROI).
• Shareholders — Higher pro t = higher dividends and potential share price increase.
• Employees — Higher pro t means job security, pay raises, and bonuses.
• Lenders — Want to see enough pro t to cover loan repayments and interest.
• Government — More pro t = more taxes paid to the government.
• Suppliers — A pro table business is more likely to keep buying supplies.
• Managers — Use pro t data to assess performance and guide future decisions.
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Statement of nancial position
Main Parts of a Statement of Financial Position
Purpose:
• Shows the nancial position of a business at a speci c point in time.
• Records the business’s assets and liabilities.
• Shows how a business nances its operations.
• Limited companies are legally required to produce this statement annually.

Assets (What the Business Owns)

Non-current (Fixed) Assets:
• Resources the business will use for more than one year.
• Examples: land, buildings, machinery, computers, vehicles.
Current Assets:
• Resources expected to turn into cash within 12 months.
• Examples: inventories, trade receivables (debtors), cash.
• Important for liquidity (ability to pay short-term debts).

Liabilities (What the Business Owes)

Current Liabilities:
• Short-term debts due within one year.
• Examples: trade payables (creditors), bank overdrafts, taxes, dividends.
Non-current (Long-term) Liabilities:
• Long-term debts not due within a year.
• Examples: long-term bank loans, mortgages, debentures.

Owner’s Equity (The Owner’s Investment)

• Money invested by the owners + retained pro ts.
• For limited companies, this is called shareholders’ equity or shareholders’ funds.

Interpreting a Statement of Financial Position

• Useful for stakeholders to understand:
• The assets the business owns.
• What the business is owed.
• What the business owes.
• How the business nances its activities.
• Key points to remember:
• It’s just a snapshot of the business’s nancial position on a speci c date.
• Figures can change quickly, especially current assets and liabilities.
• Non-current assets may be valued differently on the market than in the statement, so the statement doesn’t
always show the true market value of the business.
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 Analysis of accounts
How to Interpret Financial Statements
Why Businesses Check Their Performance:
• Identify strengths and weaknesses.
• Decide if strategies or policies need changes.
• See if objectives are being met.
• Improve future business performance.

Questions Stakeholders Might Ask:

• Will the business have pro ts to reinvest?
• Will it survive in the future?
• Are future pro ts likely to rise or fall?
• Can it pay its debts and repay long-term borrowing?

Measuring Business Performance

Pro tability:
• Shows how well a business is making a pro t.
• Includes gross pro t margin, pro t margin, and return on capital employed (ROCE).
Liquidity:
• Measures whether a business can pay its short-term debts.
• Includes current ratio and acid test ratio.

Pro tability Ratios

1. Gross Pro t Margin:
• Shows gross pro t as a percentage of revenue.
• Formula: Gross Pro t Margin% = Gross Pro t/Revenue*100
Ways to improve:
• Increase revenue without increasing costs (e.g., raise prices).
• Reduce cost of sales without lowering revenue (e.g., buy cheaper supplies).
2. Pro t Margin:
• Shows pro t as a percentage of revenue.
• Formula: Pro t Margin% = Pro t\Revenue*100
• Measures how well a business converts revenue into pro t.
Ways to improve:
• Improve gross pro t margin.
• Reduce expenses.
3. Return on Capital Employed (ROCE):
• Shows pro t as a percentage of capital invested in the business.
• Formula: ROCE% = Pro t before/Capital employed*100
• Measures ef ciency and how much pro t is earned per $1 invested.

Liquidity Ratios
1. Current Ratio:
• Measures current assets against current liabilities.
• Formula: Current Ratio = Current Assets\Current Liabilities
• Ideal range: 1.5:1 to 2:1.
• A ratio below 1.5:1 could signal cash ow issues.
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 2. Acid Test Ratio:
• Measures liquid assets (excluding inventories) against current liabilities.
• Formula: Acid Test Ratio = Current Assets - Inventories\Current Liabilities
• Ideal ratio: 1:1.
• A lower ratio may mean the business can’t meet short-term liabilities.

Balancing Pro tability and Liquidity

• Pro tability: Comes from non-current assets (e.g., machinery).
• Liquidity: Comes from current assets (e.g., cash, inventory).
• Key takeaway: A business needs a balance to survive long term; enough liquidity to meet short-term needs but
enough pro t to grow.

Bene ts & Limitations of Ratio Analysis

Bene ts:
• Helps compare performance over time and against competitors.
• Highlights key nancial info (e.g., pro tability, liquidity).
• Reveals trends and areas for improvement.
Limitations:
• Based on past data, not future forecasts.
• Doesn’t show non- nancial factors (e.g., employee skills, brand reputation).
• Financial statements might be prepared differently, making comparisons tricky.
• Doesn’t re ect external factors (e.g., market changes, regulations).

How Stakeholders Use Financial Statements

1. Owners/Shareholders:
• Want to see pro ts and ROI.
• Compare dividends and business growth.
2. Potential Investors:
• Assess pro tability and expected returns.
3. Managers:
• Track progress toward nancial goals.
• Use retained pro ts for business development.
4. Employees:
• Link pro ts to job security, wages, and bonuses.
5. Trade Payables (Suppliers):
• Assess liquidity to ensure timely payments.
• Check pro tability to see if future orders are likely.
6. Lenders:
• Ensure the business can repay loans and interest.
7. Government:
• Higher pro ts = higher tax revenue.
• Pro table businesses create jobs, reducing government support costs.
8. Customers:
• Pro tability can lead to better products, services, and lower prices.
• A stable business ensures long-term product availability.
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