Internal and External Finance

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Questions and Answers

Explain how reducing working capital can act as a source of internal finance for a business. What are the potential drawbacks of relying too heavily on this method?

Reducing working capital frees up cash tied up in day-to-day operations. However, excessive reduction may lead to operational inefficiencies, such as stockouts or delayed payments to suppliers.

A business is considering two sources of external finance: a bank loan and issuing debentures. What factors should it consider when deciding between these options?

Factors include the interest rate, repayment terms, security required, and the impact on the company's gearing ratio. Debentures may offer a lower interest rate but dilute ownership if convertible, while bank loans are more straightforward but might demand collateral.

Differentiate between fixed and variable costs, providing an example of each. Subsequently, explain how a significant increase in variable cost might affect a business's pricing strategy.

Fixed costs remain constant (e.g., rent), while variable costs change with production volume (e.g., raw materials). A large increase in variable costs may force the business to raise prices, potentially affecting demand.

A small retail business has fixed costs of $5,000 per month. The selling price per unit is $25, and the variable cost per unit is $15. Calculate the break-even point in units. Explain what would happen if fixed costs were reduced.

<p>Break-even point = Fixed Costs / (Selling Price - Variable Cost) = $5,000 / ($25 - $15) = 500 units. A reduction in fixed costs would lower the break-even point.</p>
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Explain the difference between the Profit and Loss account and the Balance Sheet. What key information does each provide to stakeholders?

<p>The Profit and Loss account shows financial performance (revenues, costs, and profits) over a period, while the Balance Sheet provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. Stakeholders use them to assess performance and financial position.</p>
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Define Gross Profit Margin and Net Profit Margin. Explain why a significant difference between these two might be a cause for concern.

<p>Gross profit margin is (Gross Profit / Revenue) x 100, and net profit margin is (Net Profit / Revenue) x 100. A large difference suggests high operating expenses are eroding profitability.</p>
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Explain what Return on Capital Employed (ROCE) measures and what a high ROCE indicates about a company's performance.

<p>ROCE measures how efficiently a company is using its capital to generate profit. A high ROCE signifies that the company is effectively using its investments to create profits.</p>
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Differentiate between the current ratio and the acid-test ratio (quick ratio). Why might the acid-test ratio provide a more conservative view of a company's liquidity?

<p>The current ratio includes all current assets, while the acid-test ratio excludes inventory. The acid-test ratio provides a more conservative view because inventory is not always easily converted to cash.</p>
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Explain what the stock turnover ratio measures and why a high stock turnover ratio is generally desirable. What are the potential downsides of a very high stock turnover ratio?

<p>Stock turnover ratio measures how quickly a company sells its inventory. A high ratio suggests efficient inventory management. However, a very high ratio might indicate insufficient stock levels, leading to potential lost sales.</p>
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What do debtor days measure? Explain the potential impact of long debtor days on a business's cash flow.

<p>Debtor days measure the average number of days it takes for a business to receive payment from its customers. Long debtor days can strain cash flow, increasing the risk of liquidity problems.</p>
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Explain the gearing ratio and what it indicates about a company's financial risk. How might a high gearing ratio affect a company's ability to obtain additional financing?

<p>The gearing ratio measures the proportion of a company's capital that comes from debt. A high gearing ratio suggests higher financial risk. It may make it more difficult for the company to secure further financing as it is already heavily indebted.</p>
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Describe the difference between cash inflows and cash outflows. Give two examples of each.

<p>Cash inflows are money coming into the business (e.g., sales revenue, investments). Cash outflows are money leaving the business (e.g., wages, rent).</p>
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What is a cash flow forecast and why is it important for business planning? Explain the interrelationship between the cash flow forecast and the final accounts.

<p>A cash flow forecast projects expected cash inflows and outflows over a period. It's important for identifying potential cash shortages. The cash flow forecast provides data that is summarized in the final accounts.</p>
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Explain the payback period method of investment appraisal. What are its limitations and how would it impact decision making?

<p>The payback period calculates the time it takes to recover the initial investment. A project with shorter payback period is more desirable. Limitations include ignoring the time value of money and cash flows after the payback period, potentially leading to suboptimal decisions.</p>
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Describe the average rate of return (ARR) method of investment appraisal. What are its advantages and disadvantages?

<p>ARR is the average annual profit as a percentage of the initial investment. An adequate return on investment would deem it a worthwhile project. Advantages: easy to understand. Disadvantages: does not account for the time value of money or varying profitability over the duration of the project.</p>
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Explain the concept of net present value (NPV) in investment appraisal. Why is it considered a more sophisticated method than payback period or ARR?

<p>NPV calculates the present value of future cash flows, discounted to reflect the time value of money. It's more sophisticated because it considers the timing and risk of cash flows, providing a more accurate assessment of project profitability.</p>
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How do decision trees assist in investment appraisal? Describe the key components of a decision tree and how they are used in the analysis.

<p>Decision trees visually represent different options, outcomes, probabilities, and expected values. They help in evaluating the potential consequences of each decision and selecting the option with the highest expected value. The key components are decision nodes, chance nodes, branches, and payoffs.</p>
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Imagine a business has a rapidly growing debt balance and is seeking a loan. What information, beyond the balance sheet and profit & loss statement, might a lender want to evaluate?

<p>A lender might want to evaluate cash flow forecasts, the age and repayment history of existing debts, collateral available to secure the loan, and a comprehensive business plan demonstrating how the debt will be repaid.</p>
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What are some ethical considerations a business should keep in mind when preparing its Final Accounts?

<p>Ethical considerations include accurately representing financial performance, avoiding misleading or fraudulent accounting practices, and ensuring transparency in financial reporting to all stakeholders. Financial information needs to be true and fair.</p>
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A company's current ratio is high, but its cash flow is consistently negative. What might be the cause of this discrepancy, and what steps can the company take to address it?

<p>This discrepancy might be caused by slow-moving inventory, long debtor days, or large capital expenditures. The company could improve cash flow by speeding up inventory turnover, shortening debtor days, negotiating longer payment terms with suppliers and deferring unnecessary capital expenditures.</p>
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Flashcards

Internal Finance

Money from within the business, such as retained profits or selling assets.

External Finance

Money from outside the business, like loans or share capital.

Fixed Costs

Costs that do not change with the level of production.

Variable Costs

Costs that change directly with the level of production.

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Total Revenue

Price per unit multiplied by the number of units sold.

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Profit

Total revenue minus total costs.

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Break-even Point

The point where total revenue equals total costs.

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Break-even Output

Fixed Costs / (Selling Price Per Unit - Variable Cost Per Unit)

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Profit and Loss Account

Financial statement showing revenues, costs, and profits over a period.

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Balance Sheet

Financial statement showing assets, liabilities, and equity at a specific time.

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Gross Profit

Sales revenue minus the cost of goods sold.

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Net Profit

Gross profit minus operating expenses.

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Equity

Assets minus liabilities; the owner's stake in the company.

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Gross Profit Margin

Percentage of sales revenue remaining after deducting the cost of goods sold.

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Net Profit Margin

Percentage of sales revenue remaining after deducting all expenses.

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Return on Capital Employed (ROCE)

Measures how efficiently a company is using its capital to generate profits.

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Current Ratio

Measures a company's ability to pay its short-term obligations.

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Acid-Test Ratio

Like the current ratio, but excludes inventory from current assets.

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Cash Flow

Shows the movement of cash both into and out of a business.

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Payback Period

Time required for an investment to generate enough cash to cover its initial cost.

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Study Notes

  • There are two primary categories of finance: internal and external.

Internal Finance

  • Internal finance includes retained profits, sales of assets, and reductions in working capital.
  • Internal finance methods do not require repayment or involve interest charges.
  • Internal finance may be limited in the amount available.

External Finance

  • External finance is sourced from outside the business.
  • Common sources of external finance: bank loans, overdrafts, share capital, debentures, trade credit, leasing, and government grants.
  • The choice of external finance depends on cost, duration, and the company's financial situation.

Cost Classification

  • Costs are classified as either fixed or variable.

Fixed Costs

  • Fixed costs remain constant regardless of the level of output.
  • Examples of fixed costs are rent and salaries.

Variable Costs

  • Variable costs fluctuate in direct proportion to production volume.
  • An example of a variable cost is raw materials.

Revenue and Profit

  • Total revenue is calculated as the product of price per unit and the number of units sold.
  • Profit is the positive difference between total revenue and total costs.
  • Understanding costs and revenues indicates the financial health of a business.

Break-Even Analysis Formula

  • Break-even analysis determines the sales volume required to cover all costs.
  • Break-even output is calculated by dividing fixed costs by the difference between the selling price per unit and the variable cost per unit.

Break-Even Charts

  • A break-even chart illustrates costs and revenue at various output levels.
  • The break-even point is where the total revenue line intersects with the total costs line on a break-even chart.
  • Break-even analysis is useful for planning.
  • Break-even analysis assumes constant conditions, which may not be realistic.

Financial Statements

  • The two main financial statements are the Profit and Loss account and the Balance Sheet.

Profit and Loss Account

  • The Profit and Loss account shows revenues, costs, and profits over a period of time.

Balance Sheet

  • The Balance Sheet presents a company's assets, liabilities, and equity at a specific point in time.

Key Financial Figures

  • Gross profit is calculated by subtracting the cost of goods sold from sales revenue.
  • Net profit is derived by subtracting expenses from gross profit.
  • Equity is the difference between assets and liabilities.

Importance of Financial Accounts

  • Financial accounts help assess a company’s financial performance.
  • Financial accounts are important for investors and banks.

Profitability Ratios

  • Profitability ratios evaluate a business’s financial performance.
  • Gross profit margin indicates the percentage of sales revenue retained as gross profit.
  • Net profit margin shows the proportion of net profit generated from sales revenue.
  • Return on capital employed (ROCE) measures the efficiency of capital utilization in generating profit.

Liquidity Ratios

  • Liquidity ratios measure a firm's ability to meet its short-term debts.
  • The current ratio assesses the ability to pay short-term debts with current assets.
  • The acid-test ratio is similar to the current ratio but excludes inventory.
  • Inventory is excluded from the acid-test ratio because it may not be easily converted into cash.

Efficiency Ratios

  • Efficiency ratios assess how well a business utilizes its resources.
  • Stock turnover ratio measures the rate at which inventory is sold.
  • Debtor days indicate the average time it takes for customers to pay.
  • Creditor days measure how long the business takes to pay its suppliers.
  • Gearing ratio shows the percentage of finance that comes from debt.
  • Lower debtor days and higher stock turnover indicate more efficient operations.

Cash Flow

  • Cash flow represents the movement of money into and out of a business.
  • Cash inflows include sales and investments.
  • Cash outflows include wages and bills.
  • A cash flow forecast helps in planning and shows expected inflows, outflows, and the projected surplus or deficit.
  • Closing balance is calculated as the opening balance plus net cash flow.
  • Profitable businesses can fail if they do not manage their cash flow effectively.

Investment Appraisal

  • Investment appraisal assesses the financial viability of investment projects.
  • Payback period calculates the time required to recover the initial investment.
  • Average rate of return (ARR) shows the average annual profit as a percentage of the initial investment.
  • Net present value (NPV) considers the value of future cash flows, using a discount rate to reflect time and risk.
  • Decision trees visualize options, outcomes, probabilities, and expected values.
  • Decision trees guide investment decisions.

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