Unit 5 - Financial information and decisions (Revision Notes)

Unit 5 – Financial Information & Decisions (Revision Notes)

Why do businesses need finance? Use of finance can be split into 2 categories:

To start up (buy machinery etc) 1. Capital expenditure

Money spent on purchasing fixed assets (premises,
To expand (e.g. moving to a larger factory)
machinery etc) that will be used in the business for a
For takeovers (must pay to buy firm) period of more than 1 year.
For new premises/technology
2. Revenue expenditure
For research and development Money used to cover short term day to day expenses
To manage daily operations and to help generate sales (stock purchases, wages,
advertising expenses etc).

Short term sources of finance are used to purchase items Short term internal sources of finance:
that last for less than 1 year e.g. stock, salaries
1. Working capital
Long term sources of finance are used for growth and
2. Sale of assets
expansion, for research and development, to purchase
items that last for longer than 5 years e.g. machinery,
factory etc, or for mergers/takeovers

Long term internal sources of finance: Short term external sources of finance:

Owner’s funds Debt factoring

Retained profits Trade credit
Sale of assets Overdrafts

Long term external sources of finance: Debt and equity

Share issues Debt – this involves using money that must be repaid
Bank loans with interest e.g. bank loans
Grants
Debentures Equity – this most commonly refers to raising money by
Venture capital selling shares in the company. It can also refer to
Hire purchase owners’ funds
Leasing
Sale and leaseback

Whether a firm uses debt or equity to finance a business Advantages of debt compared to equity:
depends upon:
✔ Owners retain full control of the firm
✔ Profits are not shared with a lender (no dividends)

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 Unit 5 - Financial information and decisions (Revision Notes)

✔ owners’ willingness to sell shares (may fear loss of ✔ Relatively easy for most firms to get a bank loan (if
control) they have collateral)
✔ the availability of debt (whether it is possible to get a
bank loan etc)
✔ the cost of debt i.e. the rate of interest.

Disadvantages of debt compared to equity Advantages of equity compared to debt

× Unlike equity, debt must at some point be repaid ✔ Benefits from shared ownership and shared risk
× High interest costs means that much more will have ✔ No monthly repayments compared to bank loan
to be repaid than borrowed ✔ Payment often only necessary once a firm starts to
× Security (collateral) required to receive loan make a profit

Disadvantages of equity compared to debt Revenue definition

× Owners must give up some control of the business Money received by a business for the sale of its products
× Owner must share profits or services. Formula: quantity sold * price per unit
× Usually only available to Ltds and PLCs

INTERNAL SOURCES OF FINANCE

Owners’ funds: Retained profit:

Money put into the business by the owner themselves Some/all of the profit made by a business can be
e.g. to start up a sole trader or partnership. re-invested into the business (rather than returned to
the owners/shareholders).
Advantages:
✔ Provides a quick, interest-free source of finance. Advantages:
✔ Provides an interest-free source of funds
Disadvantages:
× There is financial risk for the owners. Business Disadvantages:
owners must be willing to face considerable risks – × Not always available. A firm needs to make profits to
some even use their personal credit cards to pay for reinvest them.
business expenses. × Owners receive less reward for their risk (profit goes
back into business rather than returned given to
owners/shareholders as dividends).

Working Capital: Sales of Assets:

The money available to businesses for the day to day A business can sell its building, vehicles etc to raise
running of a firm i.e. to pay for raw materials etc. finance.

Advantages: Advantages:
✔ Efficient management of cash is good business ✔ It can enable a business to release large sums of
practice money.

Disadvantages: Disadvantages:
× The firm loses the use of the asset

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 Unit 5 - Financial information and decisions (Revision Notes)

× Money is not always available. (A firm may need its × Finance is only available if an asset can be sold
working capital to cover immediate expenses.) (which may take time).
× A firm must ensure it still has sufficient stock to meet
customer demand.
SHORT TERM EXTERNAL FINANCE

Overdraft:
A firm can have an arrangement with a bank to allow it to withdraw more from its bank account than it has in the
bank account – the bank account will go negative.

Advantages:
✔ Cheaper than a bank loan (if overdraft is repaid quickly)
✔ A flexible way for businesses to borrow small amounts for very short periods of time.

Disadvantages:
× Interest rates charged as very high - Interest is charged on a daily basis so therefore if an overdraft is run for a
number of months it is very expensive

Trade credit: Debt factoring:

Time taken for buyer to pay for their goods after they Selling debt to debt collectors from customers who will
have been delivered. not pay (bad debtors) for about 80% of the amount
owed.
Advantages:
✔ Interest-free and easily available Advantages:
✔ Provides businesses with quick access to funds.
Disadvantages: ✔ The firm gets most of their money when they might
× Start-ups and young firms may not be offered credit not have got any if they didn’t sell the debt.
as they have not proven their ability to pay.
× Trade credit needs to be carefully managed to avoid Disadvantages:
overtrading and cash flow crisis. × The firm may not receive 100% of the debt.
× Early payment discounts if accounts are settled (paid) × The riskier a debt is, the lower the percentage
before the deadline is lost if a firm takes its time received.
paying their supplier.

LONG TERM EXTERNAL FINANCE

Bank Loans: Share issue:

Money borrowed from a bank that has to be repaid each When Ltds and Plcs sell shares in their business.
month over a period of years with at an interest rate.
Advantages:
Advantages: ✔ Provides ability to raise a large amount of money
✔ Quick and easy to arrange (if a firm has collateral) ✔ No interest rate has to be paid
✔ Can be arranged for different amounts and
timeframes (periods). Disadvantages:
× May lead to loss of ownership by present majority
Disadvantages: shareholders
× Depending on the interest rate and amount loaned, × Dividends have to be paid to shareholders.
bank loans can be expensive.

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× Banks usually require some form of security on the

loan (a business building or, in the case of a sole
trader a personal asset such as a house).
× If the business is unable to repay the loan, the bank
will repossess (claim) the asset.

Leasing: Hire purchase:

By leasing (hiring) an asset (machine, vehicle etc) instead Similar to leasing, but it gives the firm the option of
of purchasing it a business reduces the amount of finance owning the asset when the lease period is up.
they need to raise.
Advantages:
Advantages: ✔ The firm owns the asset once all payments are
✔ There is lower initial capital requirement (less money made.
needed) to gain use of an asset.
✔ It spreads the impact on cash flow. (Instead of one Disadvantages:
large purchase payment, the business makes smaller × The firm is usually responsible for maintenance (and
payments over time.) replacement) of the asset.
✔ The firm does not have to worry about care and × The total cost of hire purchase is usually higher than
maintenance of the asset. the cost of purchasing the asset.
✔ The firm can replace the asset regularly.

Disadvantages:
× The total cost of leasing is usually higher than
purchasing the asset.

Venture Capital: Sale and leaseback:

Venture capitalists are specialist financial providers to Businesses sell an asset (such as a building) and then
start up or young businesses that are short of funds. lease it back from whom it sold it to in order to raise
short term cash if it has a cash flow crisis.
Advantages:
✔ It may be one of the few sources of finance available Advantages:
to a start-up business. ✔ The firm gains a large injection of capital.
✔ Venture capitalists often offer management advice ✔ The firm retains use of the asset.
and consultancy as part of the loan.
Disadvantages:
Disadvantages: × The cost of leasing the asset back will be high.
× Firms have to share ownership and profit with the × The leasing arrangement may not include
venture capitalists. maintenance.
× Venture capital is usually only available to
high-potential businesses with strong growth
prospects.

Grants: Debentures:
Grants are money given to a business by the government Long term loans to Ltds or Plcs (not by banks) which
usually to set up in a economically deprived area which have a fixed interest rate and are repaid over a specified
has high unemployment. period of time (15 – 25 years).

Advantages: Advantages:
✔ Grants provide a free source of funds. ✔ Provide a source of very long-term finance.

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✔ Interest rates may be cheaper than bank loans.

Disadvantages:
× Often only available for specific types of businesses Disadvantages:
or specific areas of a country. × Only available to a large Ltd and Plc companies.

OTHER SOURCES OF FINANCE

Joint ventures: Change in business status:

When two or more businesses joint together to finance a Changing from a sole trader to a partnership or from a
new venture or product. Usually happens when one firm partnership to a Ltd to increase the amount of
wants to expand into a new market where the other firm additional funding from more owners/shareholders that
has expertise. the business will have access to.

Advantages: Advantages:
✔ It spreads the risk across two businesses. Often, the ✔ Can be a way of raising funds and spreading the risk
costs will be split as well so if the entry into a new of ownership.
market fails, each individual business will have lost ✔ Original owners can benefit from new ideas and
less money. input.
✔ One business may have expertise and experience that
the other business will benefit from, which means Disadvantages:
the venture is more likely to succeed × Original owners risk losing control of the business.
× Converting to a private or public limited company
Disadvantages: takes time and can be expensive.
× The potential revenues and profit will have to be split
between two business.
× The two businesses may have different ideas about
certain situations and decision making may take
longer. This may make it difficult for a business to run
the expansion in the way they would like.

Franchising: Micro financing:

A business can franchise its idea whereby individuals can Used in developing countries, micro finance allows
pay the business for the right to set up a franchise using people on very low incomes (who would not normally
the businesses name and products (the franchisee will be be able to borrow from banks) to borrow small amounts
closely controlled by the franchisor). of money to start up a small business.

The franchisor is therefore able to grow their business Crowd sourced finance:
without significant capital investment. Often used to generate money for micro finance
projects, crowd sourced financing utilises the internet to
help small businesses launch creative or
environmentally friendly projects.

Factors affecting the choice of finance used by firms: Cash flow definition:
1. Availability of internal funds (using profit reduces Cash flow is the money businesses have available to pay
dividends) for their day to day expenses i.e. paying for raw
2. Time materials and wages. It is not the same as profit. Cash
Purchase of long term asset should be done by long term flows into and out of a business.
source of finance

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3. Cost of borrowing (higher cost = less likely to borrow) Cash inflows:

4. Type of business (sole trader has limited range of Money coming into a business from sales, bank loans or
options, Plc – many options) share capital
5. Control (how much control does the shareholders of
Ltds and Plcs want to give up if using equity for finance) Cash outflow:
6. Current level of gearing 7. Collateral available Cash outflow is money leaving a business to pay wages,
bills, loan repayments etc. It is important that a business
forecasts its outflows to ensure that they have enough
cash in place to cover its expected costs.

Type of inflow Where it comes from What it might be used for

Sales revenue This is the money that the business receives Businesses normally use revenue to
from its customers for the product or service cover the costs of running the
that it sells to them. business, such as paying suppliers
and bills.

Loan This is a one-off inflow borrowed from a bank. Businesses normally use loans to pay
for a one-off item such as upgrading
machinery.

Share capital This is normally a one-off inflow from selling Businesses normally use share capital
more shares. to pay for business growth and
investments.

Types of cash outflows: Cash flow forecasts definition

1. Payments to suppliers Cash flow forecasts are financial statements that predict
2. Loan repayments the movement of money into and out of the business
3. Payment of overheads over a specified period of time.
4. Wages/salaries etc

The benefits of preparing a cash flow forecast: Why adequate cash flow is important to a business:

*By forecasting the timing of its cash flow (inflows and Needed to pay day to day suppliers bills, without which
outflows) a business can ensure it has enough money to production would stop
pay its bills when they fall due.
Needed to pay employees, without which production
*Forecasting can help a business plan for the future and would stop
predict when it might have enough cash to afford growth
and investment opportunities. If cash flow is negative a firm may be forced into
liquidation, even if it is making a profit

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 Unit 5 - Financial information and decisions (Revision Notes)

Dealing with cash flow problems (short term methods): Dealing with cash flow problems (long term methods):

1. Securing a bank overdraft (brings money into the 1. Emphasis cost management (decreases amount of
business). This will allow the business to run a negative money leaving the business)
cash balance on their bank account. However, interest
charges are high. 2. Leasing rather than buying a fixed asset/renting
rather than buying a building
2. Extending trade credit from suppliers
A business can ask for more time in which to pay its 3. Sell off unwanted fixed assets (brings money into the
suppliers (creditors) (stops money going out of the business)
business as quickly).
However, it may lose discounts for paying on time.

3. A business can ask its customers/debtors (firms that

owe it money) to pay more quickly (brings money into
the business more quickly).
However, customers may not like paying early and may
not buy from the business again.

4. A bank loan (brings money into the business)

However, it has to repaid with interest.

Working capital cycle:

Working capital definition:

Working capital is money a business has for use in the

short term. It is effectively the businesses’ cash flow.
Working capital is used to pay for day to day expenses.

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 Unit 5 - Financial information and decisions (Revision Notes)

Liquidity definition: Consequences of liquidity problems for a business/why

Liquidity is the extent to which a business can meet its having working capital is important:
short-term debts (liabilities) i.e. bills it has to pay. A liquid
business will have enough cash to pay its bills on time. 1. Suppliers are not paid on time.
Firm will not receive a discount for early payment.

2. Bank loans repayments may not be paid on time. This

will incur extra charges from the bank or repossession of
the asset which acted as collateral for the loan.

3. A business may be forced to use long term sources of

finance to pay off short term cash flow problems.

How to improve poor liquidity: Definition of profit

1. Extending trade credit from suppliers Sales revenue – costs (revenue expenditure) = profit.
However, it may lose discounts for not paying on time.
The money a business keeps after all costs have been
2. A business can ask its customers/debtors (firms that paid over a particular period of time (usually one year).
owe it money) to pay more quickly. However, customers
may not like paying early and may not buy from the It is the main objective of private sector businesses.
business again.
Profit is the reward to the entrepreneur for taking a risk
3. Emphasis cost management (decreases amount of when starting a business
money leaving the business)

4. Avoid further investment as it drains cash from a

business

Why profit is important to a business: Sales revenue/turnover definition

It is the reward to the owner/shareholder for taking the Money coming in to the business from sales
risk of investing in the business
Selling Price X Quantity Sold = Sales Revenue
It can be used to reinvest in the business

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Its presence will help attract additional investors

Gross profit = sales revenue – cost of sales.

The profit made by the business once the cost of the goods has been
deducted from revenue

Cost of sales are costs that are directly linked to the production of a good or
service e.g. raw materials, labour

Net profit = gross profit – overheads (it’s the more important figure)

Overheads are expenses/costs not directly linked to the production of a good

or service e.g. salaries, rent, marketing costs, electricity, loan repayments etc

Net profit is either:

Retained within the business for investment after all business costs are deducted from revenue
Distributed to shareholder as dividends

Profit vs Cash - what is the difference? Income statement definition:

Cash: An income statement details the Gross and Net Profit a

Money that flows into and out of a business firm makes over a particular period of time.
Is shown by the bank balance or cash in hand
Is recorded in the Balance Sheet as a Current Asset It is calculated by subtracting a business’ revenue
expenditure (both cost of sales – for Gross Profit and
Profit: overheads – for Net Profit) from its sales revenue.
Calculated: sales revenue less total costs = profit (at the
end of a period of time)
Is recorded in the income statement

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 Unit 5 - Financial information and decisions (Revision Notes)

Businesses usually have ‘increasing profit’ as an Balance sheet definition:

objective. Therefore, it will target things that will
decrease costs or increases sales revenue as a way of A balance sheet shows how much a company is worth
increasing profit, such as: (its assets) and it should always equal/balance with its
✔ Increasing the amount of sales revenue. liabilities (what it owes). It shows what a company owns
✔ Selling a greater quantity of goods and how it has paid for it (sources of finance). It is a
✔ Changing the price of the good (impact on sales snapshot of one moment in time i.e. on the 2th of July
revenue depends upon elasticities of demand) 2019.

Improving productive efficiency

This means producing at a lower unit cost

Cutting down on overheads

Choose a cheaper electricity supplier, reduce the size of
the salaried workforce

Ordering raw materials in bulk (or try to gain

other economies of scale)
Use cheaper raw material
Decreases cost of sales, however may affect the quality of
the finished product.

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 Unit 5 - Financial information and decisions (Revision Notes)

Assets Non-current assets

Things a business owns. Can be either: Large, one off purchases that are expected to last for
longer than one year e.g. machinery, property, vehicles,
Non-current assets fixtures and fittings

Current assets Current assets:

Items a business owns that it will use with a year. E.g.
Inventory, trade receivables (debtors), bank balance,
cash in hand

Trade receivables (debtors) definition:

Individuals or businesses which owe a firm money for goods or services received and not paid for yet.

Liabilities: Non-current liabilities:

A debt – something that is owed by a business. Can be Amount of money borrowed that will take longer than
either: one year to repay e.g. mortgage, long term loan,
debentures
Non-current liabilities
Current liability:
Current liabilities Short term debt that will have to be repaid within one
year e.g. Overdraft, trade payables (creditors)

Equitable funds definition: Capital employed:

Equitable funds are made up of: How much money has been invested into the business
Share capital or shareholders’ funds (money put into from equity (shareholders’ funds, reserves) and
the business by the owner) non-current liabilities (long term loans).
Retained profit (profit made by the business that
should normally be returned to the shareholders in
the form of dividends, however it has been retained
by the firm for investment).

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 Unit 5 - Financial information and decisions (Revision Notes)

Income statement shows profit (a measurement of Measuring profitability: Income Statement

profitability and performance) Two ratios are used:

Balance sheet shows liquidity (a measure of the ability to Gross profit margin (how much as a percentage a firm
pay short term day to day debts of running the business) keeps as Gross profit)

Net profit margin (how much as a percentage a firm

keeps as Net profit)

Evaluation of profitability ratios Measuring liquidity: Balance Sheet

✔ The higher the figures are the better The two ratios for measuring liquidity are:
✔ The gross profit ratio figure is useful, but the net
Current ratio
profit ratio figure is far more important.
✔ Better if they are compared to previous years to see if
the figures are improving or not.
✔ Need to be compared to similar firms in the same
industry to judge performance

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 Unit 5 - Financial information and decisions (Revision Notes)

A current ratio figure of 2:1 is considered good. This

means that for every $1 of current liabilities a firm has it
has $2 of current assets to cover them.
Acid test ratio

An acid test ratio figure of 1.2:1 is considered good. This

means that for every $1 of current liabilities a firm has it
has $1.2 of current assets - inventory to cover them.

Evaluation of liquidity ratios: Return on Capital Employed (ROCE)

Although the current ratio is useful, the acid test ratio Capital employed = the amount of money that has been
is far more important. invested in the business and includes non-current
Anything less than 1:1 for either ratio suggests that liabilities and equity. A measurement of the
the business has liquidity problems that require performance of the business in using capital to gain net
immediate attention. profit
The type of business is very important when judging
the ratios. A supermarket will have lots of inventory The ‘return’ is the profit made by the business.
therefore its acid test ratio may be quite low
A high figure (say 3:1) is not good either as it means ROCE = Net Profit x 100%
that a firm has a lot of current assets which is usually Capital Employed
inefficient.

Evaluation of ROCE Overall evaluation of a business’s performance:

The higher the figure the better
Must be compared to previous years to see if the All the ratios are important. However, poor liquidity
figures are improving or not. ratios threaten the very existence of the business,
Needs to be compared to similar firms in the same therefore particular attention should be paid to these
industry to judge performance (particularly the Acid Test).

Who uses an income statement? Who uses the balance sheet?

Lenders Lenders
To access if a firm can repay any loan it has applied for Assess whether the business has enough assets that the
bank can use as collateral (security) on any loan. Also, it
Current shareholders would want to assess the firm’s gearing.
Assess if enough profit has been made. See how much
profit has been returned as dividends. Investors/shareholders
View the firm’s assets, and how they have been
Potential shareholders financed.
Assess if enough profit has been made. See how much
profit has been returned as dividends. Creditors (suppliers)
Assess whether the firm has enough working capital to
Other companies’ managers pay them
Compare profit ratios as a measure of performance

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 Unit 5 - Financial information and decisions (Revision Notes)

Government
Assess whether enough corporation tax has been paid

Can the success of a business be assessed by using a balance sheet?

Answer – partially:

A Balance Sheet:
✔ Measures the assets of the business and shows its value
✔ Measures its liquidity and therefore its ability to pay its debts when they are due

However, an Income Statement is needed to measure profitability:

× GPM measure the proportion of SR a firms keeps after variable costs are paid for
× NPM measure the proportion of SR a firm keeps after its variable and fixed costs (expenses) are paid for
× These are both important when measuring the performance of a business.

Conclusion:
A Balance Sheet and an Income Statement are needed to truly measure the performance of a business. They are
both needed to produce a ROCE ratio

Problems that a fall in profits might cause for a Inventory

company: The amount of raw materials, work in progress and
✔ Lack of profit for reinvesting in the company (money finished goods held by a business that are intended for
may have to be borrowed instead) sale.
✔ Less dividends for shareholders. May lead to them
selling their shares and share price fall.
✔ Lenders unwilling to lend money to company whose
profit is low (non-existent).

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