Topic 3: Finance

3.1 Introduction to Finance

Finance department is responsible for overseeing the firm’s financial management

Business expenditure: spend money to earn money

Two kinds of expenditure (of equal importance):

o Capital expenditure
o Revenue expenditure

Capital expenditure: – non-current assets

– capital equipment

– long-term investments in assets

– lead to gains in productivity and efficiency

– greater capital expenditure leads to growth and evolution

– includes:

o Buildings
o Tools, machinery and equipment
o Technology
o Vehicles

Revenue expenditure: – everyday spending to run daily operations

– needed to keep the firm operational

– funds come from short-term sources of finance

– includes:

o Stocks of raw materials

o Stocks of finished goods
o Delivery costs
o Utility bills
o Employee salaries

Capital Expenditure Revenue Expenditure

Long-term benefits and non-regular Short-term and regular
Adds value to non-current assets Doesn’t add value to non-current assets
Reflected in balance sheets Reflected in profit and loss accounts
Improves operational efficiency Doesn’t improve operational efficiency
Long-term benefits
Increases depreciation charges for many Short-term benefits
periods
 3.2 Sources of Finance
The ways a business gets funds

Two ways:

o Internal – inside firm; no third party involved

o External – outside firm; third party involved

External sources of finance have costs of finance

Thus, only sought when internal sources are not viable

Internal sources of finance have no costs of finance

Internal Sources of Finance

o Personal funds
o Retained profits
o Sales of assets

Personal funds
Main source of finance for sole traders and partnerships

Can be used for both capital and revenue expenditure

Advantages Disadvantages
0 costs of finance
Unless borrowed from family/friends Limited to the size of the sole trader’s savings
that expect to be paid back with May not be enough
interest

Retained profits
Money that a firm keeps to reinvest after paying taxes and dividends

Can be used for both capital and revenue expenditure

Advantages Disadvantages
If firm makes a loss, this source is unavailable
0 costs of finance (no interest charges)
If dividends are high, there may not be a lot

Sales of assets
Firms can sell unused assets, such as old machinery, buildings or vehicles

Can be used for capital and revenue expenditure

Should only be used for revenue expenditure in extreme cases when firm is facing a liquidity
crisis

Advantages Disadvantages
0 costs of finance (no interest charges) Unused assets may be obsolete
No demand, funds cannot be raised
 External Sources of Finance
o Share capital
o Loan capital
o Overdrafts
o Trade credit
o Crowdfunding
o Leasing
o Microfinance providers
o Business angels

Share Capital
Main source of finance for limited liability companies

Publicly-held can raise funds through the selling of shares on the stock market, privately-held
cannot use the stock market

Used for revenue expenditure

Advantages Disadvantages
Potential to raise a lot of money (esp. for Time consuming and expensive to launch IPO
publicly-held) No guarantee that investors will want to buy

Loan Capital
Obtained from borrowing from institutions (usually banks)

Interest is charged

Paid back in installments over agreed period of time

Include:

o Bank loans
o Mortgages
o Debentures

Used for capital expenditure

Advantages Disadvantages
Repayments by installments Cost of borrowing may be high (interest rates)
Give firms time to earn revenue and If collateral is provided, and firm fails, lender
pay back bit by bit takes possession of assets

Overdrafts
When a firm temporarily takes out more mney than it has in its bank account

Used for revenue expenditure

Advantages Disadvantages
Flexible finance for unexpected large cash High cost of borrowing (interest rates)
 outflows Next to other loan-bearing alternatives

Trade Credit
“buy now, pay later”

Business is given a time period to pay for the goods it has already received

Used for revenue expenditure

Advantages Disadvantages
Gives firms time to process materials If the payment is late, added costs can be
Sell finished goods charged
Uses revenue to pay back “overdue payment penalties”

Crowdfunding
Raises money from large number of people

Small amount of money from each person

Used for capital expenditure

Advantages Disadvantages
Feedback from potential and current investors Cost of finance
Valuable market research Funds needed to create platform
High potential, low risk Competition for funds lowers success rate
Leasing
Renting assets over period of time

Sale and leaseback: firm A sells asset to firm B and firm B rents it immediately to firm A

Used for capital expenditure

Advantages Disadvantages
Useful for firms who can’t afford to buy assets
May be more expensive in the long run
Leasing is treated as an expense
Sum of leasing expense is greater than
Lowers firm’s profit tax
the price of the asset
Owner is responsible for repairs/maintenance

Microfinance Providers
Aimed at helping entrepreneurs from poor backgrounds

Helps to eradicate poverty

Closes wealth disparity gap by financing business ventures

Used for capital expenditure

Advantages Disadvantages
Accessibility to funds for poor entrepreneurs Limited eligibility
who could not otherwise succeed Borrowers must prove they can repay
Creates jobs Unethical lending practices
Benefits society (social welfare gain) Lenders are usually for-profit only
 Business Angels
Wealthy individuals who invest in businesses

Invest their own money

Eligible businesses need high growth potentisal

Different from venture capitalists

Venture capitalists operate as a professionally managed fund pool

Used for capital expenditure

Advantages Disadvantages
Source of finance for firms with no alternative Angels tend to take on role in firm (control loss)
Can’t secure bank loans Firms may need to buy out angels’ stakes in the
Can’t attract venture capitalists firm in the long run

Repayment Periods
Firms need to be aware of repayment periods and their implications

So that cash flow is understood

Allowing more money in than out

Two types:

o Short-term: – less than 12 months

o Long-term: – more than 12 months

3.3 Costs and Revenues

Types of Costs
Set-up costs: items of expenditure needed to set up a business

Running costs: ongoing costs of running a business

Types of costs:

o Fixed costs
o Variable costs
o Direct costs
o Indirect/overhead costs

Total costs: sum of fixed and variable costs

Fixed Costs
Business must pay these costs regardless eof how much it produced and/or sold

Even if there is no output, these costs must be paid

 Variable Costs
Change proportionally to output level

Direct Costs
Specifically related to an individual project or output of individual product

Usually variable costs

Indirect/Overhead Costs
Cannot be traced to a single specific project or product

Usually fixed costs

Revenues
Sales revenue: money coming into business from selling product

Calculated using:

sales revenue= price × quantity sold

Revenue streams: other ways money comes into firm other than sales revenues

Examples of revenue streams:

 o Advertising
o Franchise royalties
o Sponsorships
o Merchandise
o Donations
o Interest earnings

3.4 Final Accounts

Profit and loss statement

Balance sheet

Usually a legal requirement

Allows for better financial control and understanding

Ensures transparent use of funds to stakeholders

Stakeholder Interest in Final Accounts

Internal Stakeholders
Shareholders: – see where money was spent

– see how their investment performed

Employees: – assess job security

– assess likelihood of pay increments

Managers: – judge firm’s operational efficiency

– setting targets and strategic planning

External Stakeholders
Competitors: – compare rival’s financial performance

Government: – examine accounts for tax purposes

Financiers: – assess debt repayment ability

Suppliers: – decide whether trade credit should be approved

Potential investors: – guide potential investment decisions

Profit and Loss Statements

Shows net profit/loss of a firm over a trading time period

Direct and indirect costs must have brackets () around figures

Profit and Loss Account (For-Profit Entities)

Sales revenue
Cost of sales
Gross profit

Expenses
 Profit before interest and tax

Interest
Profit before tax

Tax

Profit for period

Dividends
Retained profit

For non-profits, substitute profit with surplus

Profit: – for-profit organizations

– after all expenses have been paid from gross profit

– profit distributed as:

o Rewards to shareholders
o Dividends
o Reinvesting profits back into business
o Internal source of finance: retained profits

Surplus: – non-profit organizations

– after all expenses have been paid from gross surplus

– all surplus reinvested into business

o Internal source of finance: retained surplus

Profit and Loss Account (Non-Profit Entities)

Sales revenue
Cost of sales
Gross surplus

Expenses

Surplus before interest and tax

Interest
Surplus before tax

Tax

Surplus for period

Retained profit
Worked Example:

Statement of profit or loss for (Business name), for the year ended (date)
Sales revenue 700
Cost of sales (350)
Gross profit 350

Expenses (200)

Profit before interest and tax 150

Interest (10)
Profit before tax 140

Tax (25)

Profit for period 115

Dividends (35)
Retained profit 80

Improving Gross Profit

Increasing sales revenue through

o Increase selling price

o Sell greater quantities
o Undertake marketing strategies

Reducing sales costs

o Use cheaper suppliers

o Buy in bulk
o Discounts

Improving Gross Surplus

Increasing sales revenue through

o Increase selling price

o Sell greater quantities
o Undertake marketing strategies

Reducing sales costs

o Use cheaper suppliers

o Buy in bulk
o Discounts

Increase funding

o Find corporate sponsors

 o Fundraising strategies

Improving Profit Before Tax and Interest

Reduce expenses

o Reduce rent
o Move to cheaper location
o Use energy efficient machinery
o Find cost effective suppliers for insurance
o Reduce ATL promotion
o Increase BTL promotion

Improving Surplus Before Interest

Reduce expenses

o Reduce staffing costs

o Seek volunteers
o Reduce rent
o Move to cheaper location
o Use energy efficient machinery
o Find cost effective suppliers for insurance
o Reduce ATL promotion
o Increase BTL promotion

Balance Sheets
Snapshot of a firm’s value at a point in time

Legal requirement for all firms for auditing purposes

Statement of Financial Position for (company name) as at (date)

Non-Current Assets:
Individual values here
Accumulated depreciation ()
Non-current assets NCA-AC

Current Assets:
Individual values here
Current assets Sum of all individual values

Total assets Sum of all assets

Current Liabilities:
Individual values here
 Current liabilities Sum of all individual values

Non-Current Liabilities:
Individual values here
Non-current liabilities Sum of individual values

Total liabilities Sum of all liabilities

Net Assets Assets-Liabilities

Equity:
Individual values here
Total equity Sum of individual values

Assets
Items of monetary value owned by a firm

Two types:

o Non-current assets
o Current assets

Non-current assets: – assets used for business operations

– used for more than 12 months

Current assets: – assets likely to be converted into cash within 12 months

– three main types:

o Cash
o Debtors
o People who have received goods and will pay later
o Stock

Liabilities
Firm has legal obligation to repay its lenders/suppliers later on

Two types:

o Current liabilities
o Non-current liabilities

Current liabilities: – debts due to be repaid within 12 months

Non-current liabilities: – debts due to be repaid after 12 months

Equity
Value of firm that belongs to the owners

For a non-profit: equity comes solely from retained earnings

Firm’s financial objective is to reinvest all surplus

Two items:

o Share capital
o Retained earnings

Share capital: – amount of money earned through the sale of shares

Retained earnings: – amount of profit per period that has been reinvested into the firm

– reinvested earnings come from profit and loss statement

– balance sheet always made after profit and loss statement for this
reason

Intangible Assets
Non-physical and non-current assets

Earn revenue for the firm

Can be a big portion of the firm’s asset value

Difficult to place an accurate monetary value on them

Provide legal protection for intellectual property (IP)

Types:

o Brands: – legally registered names for firm’s trading activities

o Patents: – legal protection for the inventor’s design
o Copyrights: – legal protection for IP
o Goodwill: – firm’s established reputation
o Registered trademarks: – legal protection for the firm’s logos

Depreciation
When non-current assets lose their value

Most non-current assets lose value over time

Not applicable to lands and/or buildings

Reasons for depreciation:

o Wear and tear

o Obsolescence

Key terms of depreciation:

o Lifespan: – estimated useful life of asset

o Residual value: – estimated disposal value at the end of lifespan
o Accumulated depreciation: – annual depreciation × number of years in use
o Net book value: – original purchase cost minus accumulated depreciation

2 methods to calculate depreciation:

o Straight line method

o Units of production method
Straight line depreciation formula :

purchase cost−residual value

annual depreciation=
lifespan
Straight Line Depreciation
Advantages Disadvantages
Simple to calculate Not realistic that assets will depreciate by the
Simple to understand same amount every year

Units of production formula:

depreciation expense=depreciation per unit ×number of units produced

purchase cost−residual value
depreciation per unit=
units
expected number of
lifespan
Units of Production
Advantages Disadvantages
Better insights
Harder to calculate
Real depreciation of non-current assets

3.5 Profitability and Liquidity Ratio Analysis

Analyze financial performance

Ratios are compared in two different ways:

o Historically
o Same ratio at two different time periods
o Inter-firm
o Ratios of different firms in the same industry

Benchmark for Ratios

Ratio Benchmark
GPM The higher, the better
PM The higher, the better
ROCE The higher, the better
Current ratio 1.5:1 to 2:1
Quick ratio 1:1

Profitability Ratios
Analyze profit vs another variable

Relevant for for-profit organizations, not non-profits

3 types:

o Gross profit margin (GPM)

o Profit margin (PM)
 o Return on capital employed (ROCE)

Gross Profit Margin (GPM)

Value of gross profit as a percentage of sales revenue

Gross profit is calculated after subtracting direct costs (costs of sales)

gross profit
GPM = ×100
sales revenue
Higher GPM is better

Improving GPM:

o Increase revenue
o Increase sales price for goods with few substitutes
o Decrease selling price for goods with many substitutes
o Marketing strategies
o Produce/sell goods with higher GPM
o Find alternative revenue streams
o Reduce costs of sales
o Source alternative cheaper raw materials
o Find new suppliers
o Reduce direct costs

Profit Margin (PM)

Value of profit as a percentage of sales revenue

Profitability after deducting direct and indirect costs from sales revenue

profit before interest ∧tax

PM = ×100
sales revenue
Higher PM is better

Control expenses to improve PM

Return On Capital Employed (ROCE)

Firm’s financial performance based on capital investment

profit before interest ∧tax

ROCE= × 100
capital employed
capital employed =non current liabilities +equity
Higher ROCE is better

Efficient at generating profit from available funds

Control expenses to improve ROCE

Liquidity Ratios
Firm’s ability to repay its current liabilities

Reveal the level of working capital

2 types:

o Current ratio
o Acid test (quick) ratio

Improving liquidity ratios:

o Raise value of current assets

o Reduce value of current liabilities

Not good to exceed ratios

Implications of exceeding ratios:

o Cash balance is too high

o Firm is wasting opportunity to use surplus to grow
o Debtor balance too high
o Too many late customer payments increase firm’s risk of facing debt
o Stock balance too high
o Unsold items may never be converted into cash
o Unsold items may become:
 Perishable
 Unfashionable
 Obsolete

Current Ratio
Whether a firm can use its current assets to cover current liabilities

current assets
current ratio=
current liabilities
Should be between 1.5:1 to 2:1

Acid Test (Quick) Ratio

Same as current ratio but ignores stock

current assets−stock
quick ratio=
current liabilities
Should be 1:1

3.6 Efficiency Ratios

Types:

o Inventory/stock turnover
o Debtor days
o Creditor days
o Gearing ratio

Benchmark for Ratios

Ratio Benchmark
Inventory/stock turnover (times) The higher, the better
Inventory/stock turnover (days) The lower, the better
 Debtor days 30-60 days
Creditor days 30-60 days
Gearing ratio Lower is better

Inventory/Stock Turnover
Speed at which firms replenish their stock

Number of times within a period that a firm sells out its stock

Usually a year

Measured based on times a year, or days

cost of sales
stock turnover ( ¿ ) =
average stock
average stock
stock turnover ( days )= × 100
cost of sales
Faster stock turnover is better

Improving stock turnover:

o Holding lower stock levels

o Divestment of unpopular items
o Slow to sell items
o Reduce range of product offerings
o Keep only the best selling

Debtor Days
Average number of days taken to collect payments from debtors

debtors
debtor days= ×365
sales revenue
Lower debtor days is better (improves cash flow), why:

o Too long: may cause liquidity issues

o Too short: customers may seek alternatives with better credit terms

Improving debtor days:

o Impose charges on late payers

o Discounts for customers who pay earlier
o Threaten legal action
o Refuse further business until payment is made

Creditor Days
Average number of days taken for firm to pay back trade creditor

creditors
creditor days= ×100
cost of sales
Lower creditor days are better

Firm avoids late payment penalties

High creditor days free up money to use elsewhere in business

Improving creditor days:

o Negotiating better trade credit terms if firms struggle to meet payment deadlines
o Improving debtor days

Gearing Ratio
Assess long-term liquidity

non−current liabilities
gearing ratio= × 100
capital employed
capital employed =non current liabilities +equity
Acceptable levels depend on:

o Size and status of firm

o Interest rates
o Potential profitability

Lower is better

Improve overall efficiency ratios to improve gearing ratio