Finance - Nathalie Devillers PDF

Finance - UNIT 5 When a person wants to start their own business, they will need to consider the following. The premises, machinery and equipment needed, also called non-current assets The number of employees needed and the cost of their wages The raw materials and components nee...

Finance - UNIT 5 When a person wants to start their own business, they will need to consider the following. The premises, machinery and equipment needed, also called non-current assets The number of employees needed and the cost of their wages The raw materials and components needed The finance needed to start a business is called start-up capital. Internal growth: Where businesses expand by increasing their output and sales using their own resources. External growth: When the business increases its size through integrating with other business, either through mergers or takeovers Working capital: finance a business needs to meet its day-to-day costs, such as paying employees, paying rent on a property and paying bills. These finance needs – for starting up, expansion or additional working capital – can be divided into two major categories: 1. Finance needed for capital expenditure – Money to purchase non-current assets, which will be used for a long time 2. Finance needed for revenue expenditure – Money to pay wages and cover other day-to-day costs Internal and external sources of finance Internal: Retained profits- This is the profit that a business keeps after taxes are paid to the government and dividends are paid to the shareholders. No interest is paid. The money does not need to be paid back. It might be limited, especially for sole traders and partnerships. A new or small business does not usually have any retained profit. Keeping part of the profit as a retained profit may upset shareholders as their dividend will not be as high. Revenue from assets - This is the finance raised by a business selling some of its assets that it no longer needs (for example, buildings, machinery and equipment). It allows the business to use the capital instead of having it tied up in assets. It does not add to the business’s debt as the assets are owned by the business. The business can get capital fast. Small businesses may not have many assets to sell. An asset might be sold for less than its real value and it may take time to sell it. Revenue from inventory sales- This is the finance raised by a business selling some of the raw materials and components that it keeps as inventory. It reduces storage costs for the business. It reduces the opportunity cost of money tied up in excess inventory. If there is not enough inventory, the business may be unable to provide customers with its goods on time. If there is a sudden increase in demand for the products, the business may not be able to respond quickly enough and might lose some customers to competitors. Savings from the owner - This is the finance raised by using the business owner’s savings for additional capital when needed. This is often used by sole traders and partnerships. There is no interest on savings and the money does not need to be repaid. They are available quickly as owners can often provide the money fast. The amount of savings can be limited. There is a risk for the owners that they may lose their money. External: Bank loans – Businesses can raise finance by borrowing money from a bank; this is a common source of capital. Large sums of money can be obtained quickly. Successful companies can often negotiate a lower interest rate when borrowing a large sum of money. The business has to repay the loan to the bank with interest. The bank will usually require a security for the loan and smaller businesses may not have many assets to offer. A sole trader may have to put their personal property as a security for the loan. Issuing shares – Limited companies are able to raise finance by issuing new shares. Private limited companies can sell shares to existing shareholders and public limited companies can issue and sell new shares to the general public. Large sums of money can be raised when a company sells shares to the public. There is no interest and the money does not have to be repaid to the shareholders. The procedure is complicated and only public limited companies can sell shares to the general public. The company needs to pay dividends to the shareholders from the profits. There is a risk of a takeover of the business and a dilution (reduction in strength) of the ownership as the number of shares increases, because ownership of the business is spread to more shareholders  Debentures – Limited companies can raise finance by selling debentures (long-term loan certificates). These loans do not give voting rights but ensure that interest is paid to the debenture buyers at the end of the loan period. They are long-term loans, usually for 20–25 years. Large sums of money can be raised. The loan must be paid back, with interest, at the end of the period. The business may find it difficult to pay back a large sum of money at the end of the loan period. Debt factoring – Businesses can raise finance by selling their debt to a debt factoring company. Businesses can get rid of unpaid debts and get back most of the money owed to them by the debtors. Most of the money can be got hold of quickly. The debt-factoring company will not pay back the whole sum of the debt as it will have some expenses as part of obtaining the money back. Grants and subsidies – Businesses can raise finance through money provided by the government. This money is given to businesses that the government considers beneficial for the economy. The money does not need to be paid back and does not incur interest. The money is usually provided with certain conditions, such as relocating in an area with high unemployment. The money is only available to certain types of businesses and this depends on the priorities of the government. Short- and long-term sources of finance Short-term finance: Required for the day-to-day activities of the business and is also called working capital. It is available to the business for up to one year. There are several sources of short-term finance including: Overdraft: This is a service whereby the bank allows a business to “overdraw” (take out more money than your account contains) money, so it is able to spend more money than it has on its bank account at a certain moment. An overdraft is considered to be a flexible source of finance as the business can overdraw different amounts of money each month. It is a flexible way of borrowing money from the bank to meet the needs of the business. The money needed for day-to-day expenses can be obtained quickly. It must be paid back quickly with interest. The interest rate is usually variable and so may go up or down (whereas for bank loans it is fixed). Trade Credit: This is an agreement that a business negotiates with a supplier to delay payment for raw materials and components – paying after three or six months instead of one month. It works as an interest-free loan for the business. The supplier may refuse to provide discounts to the business if it has purchased raw materials in bulk. The supplier may lose trust in the business’s ability to pay for its supplies and may refuse to work with the business in the future. Long-term finance: Long-term finance is available to the business for more than one year. This type of finance is usually used to purchase non-current assets such as machines and buildings, for expansion or for taking over another business. Leasing: The business does not need to pay a large amount of cash to purchase the asset. The maintenance and repair of the asset is paid for by the leasing company.  If the business chooses to purchase the asset later (after leasing it), the overall cost will be much more than if it had purchased the asset to start with. Alternative sources: 1. Micro finance 2. Crowd-funding Choosing a source of finance: The size and type of the business The purpose and time period The amount needed Cash and Cash flow forecasting: Cash is the most liquid asset of a business. This means that cash can readily be used to pay the short-term debts of a business, such as the purchase of raw materials and components, overdrafts to the bank and wages to employees. Cash flow is the amount of cash that goes in and out of the company. The cash that goes into the business is called cash inflow and the cash that goes out of the business is called cash outflow. Cash inflows can come from: Products sold for cash Trade receivables paying money back for the products they purchased earlier on trade credit Money borrowed from an external source, such as a bank overdraft or short-term loan New investors or existing shareholders putting more money into the business Selling assets such as unused fixed assets or inventory Cash outflows are: Rent payments and payments for utilities, such as electricity and water Purchase of raw materials and components needed for production Payment to trade payables Wages and salaries of employees  Purchases of fixed assets, such as machines and equipment Repayment of loans and interest on loans Payments of other expenses (for example, phone bills) Main causes for cash flow problems: Delaying trade payables Too many trade receivables Overtrading Having too much inventory Borrowing to much money form banks Unforeseen circumstances Working capital: Working capital is the amount of capital readily available to a business. Working capital = Current assets – Current liabilities. Working capital = (Cash + Trade receivables + Inventory) – (Overdrafts + trade payables + Tax) Income statements: A profit is made when a business has money left after covering all its costs. The profit of a company can be calculated using the following formula. Profit = Revenue – Total costs Revenue is the money a business makes from selling their goods and services. The income statement is produced at the end of the accounting period, usually a year. It is a financial record of revenue and expenses and consists of the following elements. Gross profit = Sales revenue – Costs of goods sold (COGS) COGS = Opening inventories + Purchases – Closing inventories The income statement can be used by managers for: Decision-making – Managers can compare income statements from consecutive years to find ways to reduce costs and increase sales revenue. Benchmarking – Managers can also compare the performance of the business with the best companies in the field. Setting specific objectives – Managers can use the income statement to set objectives, such as reducing costs or increasing sales revenues, and inform strategies on how to achieve those. Financial position: The statement of financial position, is like a photograph of a business’s financial position – it records the value or the worth of the company at a given moment in time, usually at the end of the financial year. Assets: Assets are items of value that the business owns. - Non-current assets: items such as buildings, equipment, machines and vehicles that will be used by a business for a period longer than 12 months. All non-current assets, except land, depreciate in value over time. - Current assets- Current assets are items that a business will use within a 12-month period, such as cash , inventories and trade receivables from other businesses. Liabilities: Liabilities are items that the business owes to other organisations. Again, they can be classified in the following way. - Current liabilities- Current liabilities consist of money that the business has to pay (or pay back) within 12 months, such as trade payables (accounts payable) and bank overdrafts - Non- current liabilities- Non-current (long-term) liabilities are long-term loans that will be repaid over a period longer than 12 months (for example, long-term bank loans). Equity: Equity is the money that a company raises from its shareholders and invests in assets, usually non-current assets. Equity does not need to be repaid to shareholders, but shareholders will expect to receive dividends as a reward for the risk they take by investing in the company. Analysis of Accounts: Profitability: Profitability is the ability of a company to make a profit from its business activities. Profitability ratios show if a business makes effective use of its resources. They show the ability of the company to generate profits from sales. There are three profitability ratios: 1. Gross profit margin Gross profit Gross profit margin = _______________ × 100 Sales revenue 2. Profit margin Profit before interest and tax Profit margin = _________________________ × 100 Sales revenue 3. Return on capital employed Profit before interest and tax ROCE = _______________________ × 100 Capital employed Liquidity: Liquidity can be defined as the ability of a business to cover its short-term debts with cash or assets it owns. If a business is unable to pay its debts when these payments are due, it may get into trouble and be forced to close by trade payables. A business’s liquidity is therefore crucial to its survival.  Current ratio: The current ratio shows a firm’s ability to pay off its short-term debts using its current assets. Current assets Current ratio = _______________ Current liabilities Acid test ratio: The acid test ratio is a more immediate calculation of the company's ability to pay off its short-term debt. It excludes the inventory (stock) figure from the current assets because the inventory cannot be easily turned into cash – it is considered the least liquid asset. Current assets – Stock Acid test ratio = ______________________ Current liabilities