FINANCE

5.1 – Business Finance: Needs

and Sources
Finance is the money required in the business. Finance is needed
to set up the business, expand it and increase working capital (the
day-to-day running expenses).
Start-up capital is the initial capital used in the business to buy
fixed and current assets before it can start trading.
Working Capital finance needed by a business to pay ti’s day-to-
day running expenses
Capital expenditure is the money spent on fixed assets (assets
that will last for more than a year). Eg: vehicles, machinery,
buildings etc.
Revenue Expenditure, similar to working capital, is the money
spent on day-to-day expenses which does not involve the purchase
of long-term assets. Eg: wages, rent
Sources of Finance
Internal finance is obtained from within the business itself.
 Retained Profit: profit kept in the business after owners have
been given their share of the profit. Firms can invest this profit
back in the businesses.
Advantages:
– Does not have to be repaid, unlike, a loan.
– No interest has to be paid
Disadvantages:
– A new business will not have retained profit
– Profits may be too low to finance
– Keeping more profits to be used as capital will reduce owner’s
share of profit and they may resist the decision.
 Sale of existing assets: assets that the business doesn’t
need anymore, for example, unused buildings or spare equipment
can be sold to raise finance
Advantages:
– Makes better use of capital tied up in the business
 – Does not become debt for the business, unlike a loan.
Disadvantages:
– Surplus assets will not be available with new businesses
– Takes time to sell the asset and the expected amount may not
be gained for the asset
 Sale of inventories: sell of finished goods or unwanted
components in inventory.
Advantage:
– Reduces costs of inventory holding
Disadvantage:
– If not enough inventory is kept, unexpected increase demand
form customers cannot be fulfilled
 Owner’s savings: For a sole trader and partnership, since
they’re unincorporated (owners and business is not separate), any
finance the owner directly invests from hos own saving will be
internal finance.
Advantages:
– Will be available to the firm quickly
– No interest has to be paid.
Disadvantages:
– Increases the risk taken by the owners.

External finance is obtained from sources outside of the business.

 Issue of share: only for limited companies.
Advantages:
– A permanent source of capital, no need to repay the money to
shareholders
no interest has to be paid
Disadvantages:
– Dividends have to be paid to the shareholders
– If many shares are bought, the ownership of the business will
change hands. (The ownership is decided by who has the highest
percentage of shares in the company).
 Bank loans: money borrowed from banks
Advantages:
– Quick to arrange a loan
– – Can be for varying lengths of time
Large companies can get very low rates of interest on their loans
Disadvantages:
 – Need to pay interest on the loan periodically
– It has to be repaid after a specified length of time
– Need to give the bank a collateral security (the bank will ask for
some valued asset, usually some part of the business, as a
security they can use if at all the business cannot repay the loan in
the future. For a sole trader, his house might be collateral. So
there is a risk of losing highly valuable assets)
 Debenture issues: debentures are long-term loan certificates
issued by companies. Like shares, debentures will be issued,
people will buy them and the business can raise money. But this
finance acts as a loan- it will have to be repaid after a specified
period of time and interest will have to be paid for it as well.
Advantages:
– Can be used to raise very long-term finance, for example, 25
years
Disadvantage:
– Interest has to be paid and it has to be repaid
 Debt factoring: a debtor is a person who owns the business
money for the goods they have bought from the business. Debt
factors are specialist agents that can collect all the business’ debts
from debtors.
Advantages:
– Immediate cash is available to the business
– Business doesn’t have to handle the debt collecting
Disadvantage:
– The debt factor will get a percent of the debts collected as
reward. Thus, the business doesn’t get all of their debts
 Grants and subsidies: government agencies and other
external sources can give the business a grant or subsidy
Advantage:
– Do not have to be repaid, is free
Disadvantage:
– There are usually certain conditions to fulfill to get a grant.
Example, to locate in a particular under-developed area.
 Micro-finance: special institutes are set up in poorly-
developed countries where financially-lacking people looking to
start or expand small businesses can get small sums of money.
They provide all sorts of financial services.
 Short-term finance provides the working capital a business needs
for its day-to-day operations.
 Overdrafts: similar to loans, the bank can arrange overdrafts
by allowing businesses to spend more than what is in their bank
account. The overdraft will vary with each month, based on how
much extra money the business needs.
Advantages:
– Flexible form of borrowing since overdrawn amounts can be
varied each month
– Interest has to be paid only on the amount overdrawn
– Overdrafts are generally cheaper than loans in the long-term
Disadvantages:
– Interest rates can vary periodically, unlike loans which have a
fixed interest rate.
– The bank can ask for the overdraft to be repaid at a short-notice.
 Trade Credits: this is when a business delays paying suppliers
for some time, improving their cash position
Advantage:
– No interests, repayments involved
Disadvantage:
– If the payments are not made quickly, suppliers may refuse to
give discounts in the future or refuse to supply at all.
 Debt Factoring: (see above)

Long-term finance is the finance that is available for more than a

year.
 Loans: from banks or private individuals.
 Debentures
 Issue of Shares
 Hire Purchase: allows the business to buy a fixed asset and
pay for it in monthly installments that include interest charges.
This is not a method to raise capital but gives the business time to
raise the capital.
Advantage:
– The firms doesn’t need a large sum of cash to acquire the asset
Disadvantage:
– A cash deposit has to be paid in the beginning
– Can carry large interest charges.
 Leasing: this allows a business to use an asset without
purchasing it. Monthly leasing payments are instead made to the
owner of the asset. The business can decide to buy the asset at
 the end of the leasing period. Some firms sell their assets for cash
and then lease them back from a leasing company. This is called
sale and leaseback.
Advantages:
– The firm doesn’t need a large sum of money to use the asset
– The care and maintenance of the asset is done by the leasing
company
Disadvantage:
The total costs of leasing the asset could finally end up being more
than the cost of purchasing the asset!

Factors that affect choice of source of finance

 Purpose: if a fixed asset is to be bought, hire purchase or
leasing will be appropriate, but if finance is needed to pay off rents
and wages, debt factoring, overdrafts will be used.
 Time-period: for long-term uses of finance, loans, debenture
and share issues are used, but for a short period, overdrafts are
more suitable.
 Amount needed: for large amounts, loans and share issues
can be used. For smaller amounts, overdrafts, sale of assets, debt
factoring will be used.
 Legal form and size: only a limited company can issue
shares and debentures. Small firms have limited sourced of
finances available to choose from
 Control: if limited companies issue too many shares, the
current owners may lose control of the business. They need to
decide whether they would risk losing control for business
expansion.
 Risk- gearing: if business has existing loans, borrowing more
capital can increase gearing- risk of the business- as high interests
have to be paid even when there is no profit, loans and
debentures need to be repaid etc. Banks and shareholders will be
reluctant to invest in risky businesses.

Finance from banks and shareholders

Chances of a bank willing to lend a business finance is higher when:
 A cash flow forecast is presented detailing why finance is
needed and how it will be used
 An income statement from the last trading year and the
forecast income statement for the next year, to see how much
profit the business makes and will make.
 Details of existing loans and sources of finance being used
 Evidence that a security/collateral is available with the
business to reduce the bank’s risk of lending
 A business plan is presented to explain clearly what the
business hopes to achieve in the future and why finance is
important to these plans
Chances of a shareholder willing to invest in a business is higher
when:
 the company’s share prices are increasing- this is a good
indicator of improving perforance
 dividends and profits are high
 the company has a good reputations and future growth plans
5.2 – Cash Flow Forecasting and
Working Capital
Cash Flow
Why is cash important?
If it doesn’t have any cash to pay it’s workers, suppliers, landlord and
government, the business could go into liquidation– selling up everything it
owns to pay it’s debts. The business needs to have an adequate amount of
cash to be able to pay all it’s short-term payments.
The cash flow of a businesses is its cash inflows and cash outflows over a
period of time.
Cash inflows are the sums of money received by the business over a
period of time. Eg:
 sales revenue from sale of products
 payment from debtors– debtors are customers who have
already purchased goods from the business but didn’t pay for
them at that time
 money borrowed from external sources, like loans
 the money from the sale of business assets
 investors putting more money into the business
Cash outflows are the sums of money paid out by the business over a
period of time. Eg:
 purchasing goods and materials for cash
 paying wages, salaries and other expenses in cash
 purchasing fixed assets
 repaying loans (cash is going out of the business)
 by paying creditors of the business- creditors are suppliers
who supplied items to the business but were not paid at the time
of supply.
The cash flow cycle:

Cash flow is not the same as profit! Profit is the surplus amount
after total costs have been deducted from sales. It includes all income and
payments incurred in the year, whether already received or paid or to not yet
received or paid respectfully. In a cash flow, only those elements paid by cash
are considered.
Cash Flow Forecasts
A cash flow forecast is an estimate of future cash inflows and outflows of a
business, usually on a month-by-month basis. This then shows the expected
cash balance at the end of each month. It can help tell the manager:

 how much cash is available for paying bills, purchasing fixed

assets or repaying loans
 how much cash the bank will need to lend to the business to
avoid insolvency (running out of liquid cash)
 whether the business has too much cash that can be put to a
profitable use in the business
Example of a cash flow forecast for the four months:
The cash inflows are listed first and then the cash outflows. The total inflows
and outflows have to be calculated after each section.

The opening cash balance is the amount of cash held by the business at
the start of the month
Net Cash Flow =
Total Cash Inflow – Total Cash Outflow
The net cash flow is added to opening cash balance to find the closing
cash balance– the amount of cash held by the business at the end of the
month
 Uses of cash flow forecasts:

 when setting up the business the manager needs to know

how much cash is required to set up the business. The cash flow
forecast helps calculate the cash outflows such as rent, purchase
of assets, advertising etc.
 A statement of cash flow forecast is required by bank
managers when the business applies for a loan. The bank
manager will need to know how much to lend to the business for
its operations, when the loan is needed, for how long it is needed
and when it can be repaid.
 Managing cash flow– if the cash flow forecast gives a
negative cash flow for a month(s), then the business will need to
plan ahead and apply for an overdraft so that the negative balance
is avoided (as cash come in and the inflow exceeds the outflow). If
there is too much cash, the business may decide to repay loans
(so that interest payment in the future will be low) or pay off
creditors/suppliers (to maintain healthy relationship with
suppliers).

How can cash flow problems be overcome?

When a negative cash flow is forecast (lack of cash) the following methods
can be used to correct it:
 In the long-term, to improve cash flow, the business will need to attract
more investors, cut costs by increasing efficiency, develop more
products to attract customers and increase inflows.
Working Capital
Working capital the capital required by the business to pay its short-term day-
to-day expenses. Working capital is all of the liquid assets of the
business– the assets that can be quickly converted to cash to pay off the
business’ debts. Working capital can be in the form of:
 cash needed to pay expenses
 cash due from debtors – debtors/credit customers can be
asked to quickly pay off what they owe to the business in order for
the business to raise cash
 cash in the form of inventory – Inventory of finished goods can
be quickly sold off to build cash inflows. Too much inventory
 results in high costs, too low inventory may cause production to
stop.

5.3 – Income Statements

Accounts are the financial records of a firm’s transactions.
Final Accounts are prepared at the end of the financial year and
give details of the profit or loss made as well as the worth of the
business.
Profit
Profit = Sales Revenue – Total cost
When the total costs exceed the sales revenue, then a loss is made.

How to increase profit?

 Increase sales revenue
 Cut costs
Why is profit important to a business?
For social enterprises, profit is not one of their primary objectives,
but welfare of the society is. However, they will also strive to make
some profit to reinvest it back into the business and help it grow.

Income Statement
An income statement is a financial document of the business that
records all income generated by the business as well as the costs
incurred by the business and thus the profit or loss made over the
financial year. Also known as profit and loss account.

This is a
summarized Income statement
Sales Revenue = total sales
Cost of Sales = total variable cost of production + (opening
inventory of finished goods – closing inventory of finished goods)
Gross Profit = Sales Revenue – Cost of Sales
Expenses: all overheads/fixed costs
Net Profit = Gross Profit – Expenses

Profit after Tax = Net Profit – Tax

Dividends: share of profit given to shareholders; return on shares
Retained Profit for the year = Profit after Tax – Dividends. This
retained earnings is then kept aside for use in the business.
 Only a very small portion of the sales revenue ends up being the retained profit. All
costs, taxes and dividends have to be deducted from sales.

Uses of Income Statement

Income statements are used by managers to:

 know the profit/loss made by the business

 compare their performance with that of previous years’ and
with that of competitors’. If profit is lower than that of last year’s
why is it falling and what can they do to correct the issue? If it is
lower than that of competitors’ what can they do to be more
profitable and be competitive in the market?
 know the profitability of individual products by preparing
separate income statement for each product. They may decide to
stop production of products that are making losses.
 help decide what products to launch by preparing forecast
income statement for the first few years. Whichever product is
forecast to have a higher profit, the business will choose to launch
that product
5.4 – Balance Sheets
The balance sheet, along with the income statement is prepared at
the end of the financial year. It shows the value of a business’
assets and liabilities at a particular time. It is also known as
‘statement of financial position’.
Assets are those items of value owned by the business.
Fixed/non-current assets (buildings, vehicles, equipment etc) are
assets that remain in the business for more than a year – their
values fall over time in a process called depreciation every year.
Short-term/current assets (inventory, trade receivables (debts
from customers), cash etc) are owned only for a very short time.
There can also intangible (cannot be touched or felt) non-current
assets like copyrights and patents that add value to the business.
Liabilities are the debts owed by the business to its creditors.
Long-term/non-current liabilities (loans, debentures etc)- they do
not have to be repaid within a year.
Short-term/current liabilities (trade payables (to suppliers),
overdraft etc)- these need to be repaid within a year.
CURRENT ASSETS – CURRENT LIABILITIES = WORKING
CAPITAL
This is because the the liquid cash a company has with them will be
the liquid (short-term) assets they own less the short-term debts
they have to pay.
Shareholder’s Equity is the total amount of money invested in the
company by shareholders. This will include both the share capital
(invested directly by shareholders) and reserves (retained earnings
reserve, general reserve etc).
Shareholders can see if their stake in the business has risen or fallen
by looking at the total equity figure on the balance sheet.
 Che
ck to see if the equations mentioned on the right are satisfied on this balance sheet

SHAREHOLDERS EQUITY = TOTAL ASSETS – TOTAL

LIABILITIES
TOTAL ASSETS = TOTAL LIABILITIES + SHAREHOLDERS
EQUITY
CAPITAL EMPLOYED = SHAREHOLDERS EQUITY + NON-
CURRENT LIABILITIES
 This is because non-current liabilities like loans are also used for
permanent investment in the company.

5.5 – Analysis of Accounts

The data contained in the financial statements are used to make some
useful observations about the performance and financial
strength of the business. This is the analysis of accounts of a business. To
do so, ratio analysis is employed.
Ratio Analysis
 Profitability Ratios: these ratios are used to see how
profitable the business has been in the year ended.
 Return on Capital Employed (ROCE): this calculates the
return (net profit) in terms of the capital invested in the
business (shareholder’s equity+non-current liabilities) i.e. the
% of net profit earned on each unit of capital employed. The
higher the ROCE the better the profitability is. The formula is:

 Gross Profit Margin: this calculates the gross profit (sales

– cost of production) in terms of the sales, or in other words,
the % of gross profit made on each unit of sales revenue. The
higher the GPM, the better. The formula is:

 Net profit Margin: this calculates the net profit (gross

profit-expenses) in terms of the sales, i.e. the % of net profit
generated on each unit of sales revenue. The higher the NPM,
 the better. The formual is:

 Liquidity Ratios: liquidity is the ability of the company to pay

back it’s short-term debts. It if it doesn’t have the necessary
working capital to do so, it will go illiquid (forced to pay off it’s
debts by selling assets). In the previous topic, we said that,
working capital = current assets – current liabilities. So a business
needs current assets to be able to pay off it’s current liabilities.
The two liquidity ratios shown below, use this concept.
 Current Ratio: this is the basic liquidity ratio that
calculates how many current assets are there in proportion to
every current liability, so the higher the current ratio the better
(a value above 1 is favourable). the formula is:

 Liquid Ratio/ Acid Test Ratio: this is very similar to

current ratio but this ratio doesn’t consider inventory to be a
liquid asset, since it will take time for it to be sold and made
into cash. A high level of inventory in a business can thus cause
a big difference between it’s current and liquidity ratios. So
there is a slight difference in the formula:

Uses and users of accounts

 Managers: they will use the accounts to help them keep
control over the performance of each product or each division
since they can see which products are profitably performing and
which are not.
 This will allow them to take better decisions. If for
example, product A has a good gross profit margin of 35% but
it’s net profit margin is only 5%, this means that the business
has very high expenses that is causing the huge difference
 between the two ratios. They will try to reduce expenses in the
coming year. In the case of liquidity, if both ratios are very low,
they will try to pay off current liabilities to improve the ratios.
 Ratios can be compared with other firms in the
industry/competitors and also with previous years to see how
they’re doing. Businesses will definitely want to perform better
than their rivals to attract shareholders to invest in their
business and to stay competitive in the market. Businesses will
also try to improve their profitability and liquidity positions
each year.
 Shareholders: since they are the owners of a limited
company, it is a legal requirement that they be presented with the
financial accounts of the company. From the income statements
and the profitability ratios, especially the ROCE, existing
shareholders and potential investors can see whether they
should invest in the business by buying shares. A higher
profitability, the higher the chance of getting dividends. They will
also compare the ratios with other companies and with
previous years to take the most profitable decision. The balance
sheet will tell shareholders whether the business was worth more
at the end of the year than at the beginning of the year, and the
liquidity ratios will be used to ascertain how risky it will be to
invest in the company- they won’t want to invest in businesses
with serious liquidity problems.
 Creditors: The balance sheet and liquidity ratios will tell
creditors (suppliers) the cash position and debts of the business.
They will only be ready to supply to the business if they will be
able to pay them If there are liquidity problems, they won’t
supply the business as it is risky for them.
 Banks: Similar to how suppliers use accounts, they will look
at how risky it is to lend to the business. They will only lend to
profitable and liquid firms.
 Government: the government and tax officials will look at the
profits of the company to fix a tax rate and to see if the business is
profitable and liquid enough to continue operations and thus if the
worker’s jobs will be protected.
 Workers and trade unions: they will want to see if the
business’ future is secure or not. If the business is continuously
running a loss and is in risk of insolvency (not being liquid), it may
shut down operations and workers will lose their jobs!
 Other businesses: managers of competing companies may
want to compare their performance too or may want to take over
the business and wants to see if the takeover will be beneficial.

Limitations of using accounts and

ratio analysis
 Ratios are based on past accounting data and will not
indicate how the business will perform in the future
 Managers will have all accounts, but the external users will
only have those published accounts that contain only the data
required by law- they may not get the ‘full-picture’ about the
business’ performance.
 Comparing accounting data over the years can lead to
misleading assumptions since the data will be affected by
inflation (rising prices)
 Different companies may use different accounting
methods and so will have different ratio results, making
comparisons between companies unreliable.