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Unit 3: Business Finance
Mastery Needs revision
Chapters
Chapter 25 | Sources of Finance
Internal Sources of Finance
External Sources of Finance
Chapter 26 | Cash Flow Forecasting
Why Cash Flow Forecasts are important
Chapter 27 | Costs
Chapter 28 (Break-Even Analysis)
Benefits and Limitations of Break-even charts
Chapter 29 | Statement of Comprehensive Income
How might the Statement of Comprehensive Income be used in Decision Making?
Chapter 25 | Sources of Finance
Internal finance
finance generated by the business from its own means
Retained profit
profit held by a business rather than returning it to the owners and which may be
used in the future
External finance
finance obtained from outside the business
Bank overdraft
agreement with a bank where a business spends more money than it has in its
account (up to an agreed limit)
Trade payables
buying resources from suppliers, such as raw materials and components, and paying
for them at a later date (sometimes called trade credit)
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Venture capitalists
specialist investors (individuals or companies) who provide money for business
purposes, often to new businesses
Crowd funding
where a large number of individuals (the crowd) invest in a business venture using
an online platform and therefore avoiding using a bank
The Need for Funds
1. Short-term Needs
Once a business starts trading it will earn revenue. This money can be used to meet
the day-to-day running costs of the business, such as wages, raw materials,
components, and premises and utility bills. It is usually repaid within one year.
2. Long-term Needs
Businesses often raise money and take much longer than one year to repay what is
owed. This is called long-term finance. Other long-term sources may be borrowed
from financial institutions, such as banks.
3. Start-up Capital
Funds are most needed when first setting up a business. This is because a lot of
resources are needed before trading can begin.
4. Expansion
Owners may want to:
expand capacity to meet growing orders
develop new products
branch into overseas markets
diversify.
Internal Sources of Finance
1. Personal Savings
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When a business is set up the owners are usually required to contribute some
finance. For many small businesses, the capital provided by the owners comes from
personal means. Some entrepreneurs have saved for many years in the hope that
one day they might have enough money to start their own business.
2. Retained Profit
Retained profit is profit that has not been returned to the owners. It is retained by the
business. A business can then use this source at a later date.
Retained profit does not have to be repaid.
There is no interest to pay since the capital is raised from within the business.
However:
A new business will not have any retained profits.
Many small firms’ profits might be too low.
Keeping more profits in the business reduces payment to owners.
3. Selling Assets
An established business may be able to sell some unwanted assets to raise finance.
Machinery, land and buildings that are no longer required could be sold off for cash.
External Sources of Finance
Reasons for External Finance
Some businesses have seasonal trade. A farmer, for example, may need to
borrow money for a few months until revenue comes in from selling the harvest.
A manufacturer may need finance to pay for raw materials and wages to meet a
large order.
A firm might be short of money because it is waiting for a customer to pay.
A business may need to meet emergency expenditure.
Types of External Finance
1. Bank Overdraft
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A bank overdraft means a business can spend more money than it has in its
account. In other words, they go overdrawn. The bank will set an overdraft limit and
interest is only charged when the account is overdrawn.
2. Trade Payables
Businesses often buy resources and pay for them at a later date, usually within 30 to
90 days. This is called trade payables. The downsides are:
many suppliers encourage early payment by offering discounts
the cost of goods is often higher if firms buy on credit
delaying payment may upset suppliers.
3. Credit Cards
Credit cards are popular because they are convenient, flexible and avoid interest
charges if accounts are settled within the credit period. However, interest rates on
credit cards are very high if accounts are not settled within the credit period, usually
56 days.
4. Bank loans
A bank loan is a sum of money obtained from a bank which must be repaid and on
which interest is payable.
These are usually quick to arrange.
They can be for varying lengths of time.
Large companies are often offered low rates of interest by banks if they borrow
large sums.
However:
A bank loan will have to be repaid eventually and interest must be paid.
Security or collateral is usually required. This means the bank may insist that it
has the right to sell some of the property of the business if it fails to pay the
interest or does not repay the loan.
5. Unsecured bank loans
Some bank loans are unsecured. This means that the bank lends money without the
security of having a claim on your assets if you do not pay it back. Interest rates are
higher for unsecured loans compared to secured loans.
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6. Mortgages
A mortgage is a long-term loan and the borrower must use land or property as
security. This means that if the borrower fails to make the repayments, the lender
can repossess the property.
7. Debenture
Another form of loan is a debenture. Debenture holders are creditors of a company,
not owners. Debenture holders are entitled to a fixed rate of return, but have no
voting rights.
8. Hire purchase
This allows a business to buy a non-current (fixed) asset over a long period of time
with monthly payments which include an interest charge.
The business does not have to find a large cash sum to purchase the asset.
However:
A cash deposit is paid at the start of the period.
Interest payments can be quite high.
9. Leasing
Leasing an asset allows the business to use the asset without having to purchase it.
Monthly leasing payments are made.
The business does not have to find a large cash sum to purchase the asset to
start with.
The care and maintenance of the asset are carried out by the leasing company.
However:
The total cost of the leasing charges will be higher than purchasing the asset.
10. Issue of shares
This source of finance is only possible for limited companies.
This is a permanent source of capital which would not have to be repaid to
shareholders.
No interest has to be paid.
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However:
Dividends are paid after tax.
Dividends will be expected by the shareholders.
The ownership of the company could change hands if many shares are sold.
Chapter 26 | Cash Flow Forecasting
Cash inflow
flow of money into a business
Cash outflow
flow of money out of a business
❔ Opening balance is $0 on the date and month the business starts trading.
T otal Cash Inflow − T otal Cash Outflow = Net Cash Flow
Closing Balance = Opening Balance + Net Cash Flow
Why Cash Flow Forecasts are important
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1. Identifying Cash Shortages
A forecast can help to identify in advance when a business might need to borrow
cash.
2. Supporting Applications for Funding
When trying to raise finance, lenders often insist that businesses support their
applications with a cash flow forecast.
3. Help when Planning the Business
It helps to clarify aims and improve performance. Producing a cash flow forecast is a
key part of the planning process.
4. Monitoring Cash Flow
A business should compare the predicted figures in the cash flow forecast with those
that actually occur. By doing this, it can find out where problems have occurred.
Chapter 27 | Costs
Fixed costs
costs that do not vary with the level of output
Variable costs
costs that change when output levels change
Total costs
fixed costs and variable costs added together
Total revenue
money generated from the sale of output. It is price multiplied by quantity
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T otal cost = F ixed costs + Variable Costs
T otal Costs
Average Cost =
Quantity P roduced
T otal Revenue = P rice ∗ Quantity
P rofit = T otal Revenue − T otal Costs
Chapter 28 (Break-Even Analysis)
Break-even point
level of output where total costs and total revenue are exactly the same
F ixed Cost
Break even point =
Selling P rice per unit − Variable Cost P er Unit
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Benefits and Limitations of Break-even charts
Benefits
Managers can read the graph if the company expects profit or loss, and can see
how much profit/loss they will have at any level of output.
They can attempt different scenarios and see the impact it will have on the profit
or loss of the business. It lets managers try out different possibilities to find out
which one is the best.
Limitations
The TC and TR are shown as straight lines. In practice, they may not be straight
lines. For example, a business may have to offer discounts on large orders, so
total revenues fall at high outputs.
It is assumed that all output is sold and no stocks are held. Many businesses
hold stocks of finished goods to be able to cope with changes in demand.
The accuracy of the break-even chart depends on the quality and accuracy of
the data used to construct total cost and total revenue.
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Chapter 29 | Statement of Comprehensive
Income
Revenue
Revenue is the money the business receives from selling goods and services.
Cost of Sales
Cost of sales would include costs such as raw materials and the wages of factory
workers.
Gross Profit
Gross profit is calculated when the cost of sales is subtracted from the revenue.
Administrative Expenses
Administrative expenses are the general overheads or expenses of the business.
E.g. Office salaries, expenses claimed by senior staff, stationary expenses, IT
expenses, accountancy fees and telephone bills.
Other Operating Expenses
Any expenses not included in administrative expenses above may be called other
operating expenses. E.g. small irregular expenses such as subscriptions, stationary,
postage, office supplies.
Selling Expenses
A business may incur a range of expenses that are directly related to the selling of
its products. E.g. Sales commissions, advertising, distribution and promotional
expenses.
Operating Profit
If the administrative costs and other operating expenses are subtracted from gross
profit we get the operating profit.
Finance Cost
If a business borrows money it will have to pay interest to the lender. The amount
paid will be entered in the income statement as a finance cost.
Profit for the year
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If the cost of finance is subtracted from the operating profit , the profit for the year is
determined.
Profit for the year after tax
This is the amount of money that is left over after all expenses, including taxation,
have been subtracted from revenue.
How might the Statement of Comprehensive Income
be used in Decision Making?
Investment Decisions
A business might use the statement of comprehensive income to decide how much
money to invest in the business. For example, if the statement shows that profits are
rising, this might encourage decision makers to use more funds for investment. In
contrast, if the statement shows that the business is struggling, investment plans
might be postponed in the hope that the business
will pick up in the near future.
Cost Analysis
The statement of comprehensive income will show what has happened to costs
during the year. A business might decide that cheaper suppliers of raw materials
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must be found or that the wages of production workers must be brought under
control.
Basis for Future Forecasts
Most public limited companies are expected to give shareholders some idea of what
earnings to expect in the future. Businesses can therefore use the statement of
comprehensive income as a basis on which to make forecasts.
Making Comparisons
Investors may use the statement of comprehensive income when deciding where to
invest their funds.
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