BUSINESS FINANCE
ON THIS CHAPTER
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Understand why business activity requires finance
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Recognise the difference between capital and revenue
expenditure and different needs for finance these create
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Understand the importance of working capital to a business
and how this can be managed
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Analyse the different sources of long, medium and short term
finance, both internal and external

Understand the role played by the main finance institutions
Select and justify appropriate sources of finance for different
business needs

Analyse the factors that managers consider when taking a
finance decision
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Why business activity requires finance
Start-up capital = capital needed by an entrepreneur to set up a business
Working capital = the capital needed to pay for raw materials, day-to-day
running costs and credit offered to customers. In accounting terms working
capital = current assets – current liabilities

Capital and revenue expenditure
Capital expenditure = involves the purchase of assets that are expected to last
for more than one year, such as building and machinery
Revenue expenditure = is spending on all costs and assets other than fixed
assets and includes wages and salaries and materials bought for stock

Working capital – meaning and significance
Liquidity = the ability of a firm to be able to pay its short-term debts
Liquidation = when a firm ceases trading and its assets are sold for cash to
pay suppliers and other creditors
How much capital is needed?
 Where does finance come from?

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Internal source of finance
•
Profits retained in the business
•
Sale of assets
•
Reduction in working capital
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External source of finance
•
Bank overdrafts
•
Trade credit
•
Debt factoring
Overdraft = bank agrees to a business borrowing up to an agreed limit as
and when required
Factoring = selling claims aver debtors to a debt factor in exchange for
immediate liquidity-only a proportion of the value of the debts will be
received as cash

Sources of medium-term finance
•
Hire purchase and lasing
•
Medium-term bank loan

Long-term finance
Long term loans
• Debentures, also known as loan stock or corporate bonds
Long-term loans = loans than do not have to be repaid for at least one year
Equity finance = permanent finance raised by companies through the sale of
shares
Long-term bonds or debentures = bonds issued by companies to raise debt finance,
often with a fixed rate of interest
Rights issue = existing shareholders are given the right to buy additional shares
at a discounted price
•

Other sources of long-term finance
•
Grants
Venture capital = risk capital invested in business start-ups or expanding small
business that have good profit potential but do not find it easy to gain finance
from other sources

Raising external finance – the importance of a business plan
•
Business plan = a detailed document giving evidence about a new or existing
business, and that aims to convince external lenders and investors to extend
finance to the business
o Making the finance decision
FORECASTING CASH FLOW
ON THIS CHAPTER
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Understand the importance of cash to business
Explain the difference between a firm’s cash flow and its
profit
Structure a cash-flow forecast and understand the source
of information needed for this

Evaluate the problems of cash-flow forecasting

Analyse the different causes of cash-flow problems

Evaluate
problems
different methods of solving cash-flow

The importance of cash flow
Cash flow = the sum of cash payments to a business (inflows) less then sum
of cash payments (outflows)
Liquidation = when a firm ceases trading and its assets are sold for cash to
pay suppliers and other creditors
Insolvent = when a business cannot meet its short-term debts

Cash and profit – what’s the difference?
Cash inflows = payments in cash received by a business, such as those from
customers (debtors) or from the bank, e.g. receiving a loan
Cash outflows = payments in cash made by a business, such as those to
suppliers and workers
How to forecast cash flow
 Forecasting cash inflows

Debtors = customers who have bought products an credit and will pay cash at
an agreed date in the future

Forecasting cash outflows

The structure of cash-flow forecasts
Cash-flow forecast = estimate of a firm’s future cash inflows and outflows
Net monthly cash flow = estimated difference between monthly cash inflows
and outflows
Opening cash balance = cash held by the business at the start of the month
Closing cash balance = cash held at the end of the month becomes next
month’s opening balance
What uses does this type of financial planning have?
 Cash-flow forecasting – what are the limitations?
 The causes of cash-flow problems

Credit control = monitoring of debts to ensure that credit periods are not
exceeded
Bad debt = unpaid customer’s bills that are now very unlikely to ever be
paid
Overtrading = expanding a business rapidly without obtaining all of the
necessary finance so that a cash-flow shortage develops

Ways to improve cash flow
COSTS
ON THIS CHAPTER
Explain the different classifications given to production
costs
 Understand the uses to which cost data can be put
 Analyse which costs of production are likely to vary with
output and witch will not
 Use costs of production in brak-even analisys
 Apply break-even analisys in simple business decisionmaking situations
 Evaluate the usefulness of brake-even analisys
 Understand the different costing methods
 Apply
different costing methods to operationmanagement decisions
 Evaluate the relative usefulness of these costing
methods for decision making

Who needs cost data?
 What are the costs of production?

Direct costs = these costs can be clearly identified with each unit of production
and can be allocated to a cost centre
Indirect costs = costs that cannot be identified with a unit of production or
allocated accurately to a cost centre

How are costs affected by the level of output?
Fixed costs = costs that do not vary with output in the short run
Variable costs = costs that wary with output
Marginal cost = the extra cost of producing one more unit of output
Problems in classifying costs
 Margin of safety

Margin safety = the amount by which the sales level exceeds the break-even
level of output
Contribution per unit = selling price less variable cost per unit

Evaluation of break-even analysis

Introduction to cost methods
Cost centre = a section of a business, such as a department, to which costs can
be allocated or charged
Profit centre = a section of a business to which both costs and revenues can be
allocated – so profit can be calculated

Full – or absorption – costing technique
Full/absorption costing = a method of costing in which all fixed and variable
costs are allocated to products or services

Marginal-costing or contribution-costing approach
Marginal-costing or contribution-costing = costing method that allocates only
direct costs to cost/profit centers not overhead costs
Should a firm stop making a product?
 Contribution costing
 Evaluation of the costing approaches

ACCOUNTING
FUNDAMENTALS
ON THIS CHAPTER
Understand why keeping business accounts is so
important
 Analyse the main users and uses of business-accounting
records
 Identify and understand the main components of an
income statement (profit and loss account)
 Identify and understand the main components of a
balance sheet
 Analyse business accounts by using ratio analisys –
liquidity and profit-margin ratios
 Evaluate the limitations of ratio analisys and of
published accounts

Why keep accounting records?
 Internal and external users of accounting information
 Limitations of published accounts
 Are the published accounts really accurate?

Window dressing = presenting the company accounts in a favorable light – to
flatter the business performance
Management and financial accounting
 Foundations of accounting – accounting concepts and
conventions
 The main business accounts

Income statement = records the revenue, costs and profit (or loss) of a
business over a given period of time
Gross profit = equal to sales revenue less cost of sales
Sales revenue (or sales turnover) = the total value of sales made during the
trading period = selling price * quantity sold
Cost of sales (or cost of goods sold) = this is in the direct cost of purchasing the
goods that were sold during the financial year
Net profit (operating profit) = gross profit minus overhead expenses
Profit after tax = operating profit minus interest costs and corporation tax
Dividends = the share of the profits paid to shareholders as a return for investing
in the company
Retained profit = the profit left after all deductions, including dividends, have
been made. This is ‘ploughed back’ into the company as a source of finance
Low-quality profit = one-off profit that cannot easily be repeated or sustained
High-quality profit = profit that can be repeated and sustained

The balance sheet – what it shows about a business
Non-current assets = assets to be kept and used by the business for more than one
year. Used to be referred to as ‘fixed assets’
Intangible assets = items of value that do not have a physical presence, such as
patents and trademarks
Current assets = assets that are likely to be turned into cash before the next
balance-sheet date
Inventories = stocks held by the business in the form of materials, work in
progress and finished goods
Accounts receivables (debtors) = the value of payments to be received from
customers who have bought goods on credit. Also known as ‘trade receivables’

Balance-sheet formats
Accounts receivables (debtors) = the value of payments to be received from
customers who have bought goods on credit. Also known as ‘trade
receivables’
Current liabilities = debts of the business that will usually have to be paid
within one year
Accounts payable (creditors) = value of debts for goods bought on credit
payable to suppliers. Also known as ‘trade payables’
Non-current liabilities = value of debts of the business that will be payable
after more than one year

Balance-sheet formats

Non-current or fixed assets
Goodwill = arises when a business is valued at or sold for more than the
balance-sheet value of its assets
Cash-flow statement = record of the cash received by a business over a period
of time and the cash outflows from the business

Profit margin ratios
Gross profit margin (%) = gross profit / sales revenue * 100
Net profit margin (%) = net profit / sales revenue *100
Liquidity = the ability of a firm to pay its short-term debts
Current ratio = current assets / current liabilities

Acid-test ratio
Acid test ratio = liquid assets / current liabilities
Liquid assets = current assets – inventories (stocks) = liquid assets

Limitations of ratio analysis
BUDGETS
ON THIS CHAPTER
Understand why financial planning is important
 Analyse the advantages of setting budgets – or financial
plans
 Examine the importance of a system of delegated
budgeting
 Analyse the potential limitations of budgeting
 Use variance analysis to assess adverse and favorable
variances from budgets

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Advantages of setting budgets
Budget = a detailed financial for the future
Budget holder = individual responsible for the initial setting and achievement
of a budget
Variance analisys = calculate differences between budgets and actual
performance, and analysing reasons for such differences

Key feature of budgeting
Delegated budgets = giving some delegated authority over the setting and
achievement of budgets to junior managers
The stages of preparing budgets
 Setting budgets

Incremental budgeting = uses last year’s budget as a basis and an
adjustment is made for the coming year
Zero budgeting = setting budgets to zero each year and budget holders
have to argue their case to receive any finance
Flexible budgeting = cost budgeting for each expense are allowed to vary if
sales or production vary from budgeting levels
Potential limitations of budgeting
 Budgetary control – variance analysis
 Responding to variance analysis results
 Budgets and budgetary control – an evaluation

Adverse variance = exists when the difference between the budgeted and
actual figure leads to a lower – than – expected profit
Favourable variance = exists when the difference between the budgeted and
actual figure leads to a higher – than – expected profit
CONTENTS OF PUBLISHED
ACCOUNTS
ON THIS CHAPTER
Make simple amendments to balance sheets and profit
and loss accounts from given data
 Understand the importance of accounting for the
depreciation of fixed assets and apply the strength-line
method to simple problems
 Draw up balance sheets and profit and loss accounts
from given data
 Explain the significance of goodwill, net realisable value
of stock and depreciation to the final accounts of a
business

Amending income statements
 Amending balance sheets further amendments for
published accounts

Goodwill = arises when a business is valued at or sold for more than the
balance-sheet value of its assets
Intellectual property = an intangible asset that has been developed from
human ideas and knowledge
Market value = the estimated total value of a company if it were taken over
Capital expenditure = any item bought by a business and retained for more
than one year, that is the purchase of fixed or non-current assets
Revenue expenditure = any expenditure on costs other than non-current
assets expenditure
Depreciation = the decline in the estimated value of a non-current asset over
time

How depreciation is calculated
Straight-line depreciation = a constant amount of depreciation is subtracted
from the value of the asset each year
= (original cost of asset – expected residual value) / expected useful life of
asset (years)
Net book value = the current balance-sheet value of a non-current asset
= original cost – accumulated depreciation
Net realisable value = the amount for witch an asset (usually an inventory)
can de sold minus the cost of selling it. It is used on balance sheet when
NRV is estimated to be below historical cost
ANALYSIS OF PUBLISHED
ACCOUNTS
ON THIS CHAPTER
Calculate the return on capital employed ratio
 Calculate the gearing ratio, the financial efficiency
rations and investment ratios
 Analyse ratio results and evaluate ways in which these
results could be improved
 Assess the practical use of ratio analysis


Interpreting company performance
Return on capital employed (%) = net or operating profit / capital employed *
100
Capital employed = the total value of all long-term finance invested in the
business. It is equal to (non-current assets + current assets) – current
liabilities or non-current liabilities + shareholders’ equity
Inventory (stock) turnover ratio = cost of goods sold / value of inventories
Days’ sales in receivables ratio = accounts receivable * 356 / sales turnover
Dividend = the share of the company profits paid to shareholders
Share price = the quoted price of one share on the stock exchange
Dividend yield ratio (%) = dividend per share * 100 / current share price
Dividend per share = total annual dividends / total number of issued shares
Dividend cover ratio = profit after tax interest / annual dividends
Price/earnings ratio = current share price / earnings per share
Earnings per share = profit after tax / total number of shares
This is the amount of profit earned per share
Gearing ratio (%) = long-term loans / capital employed * 100

Ratio analysis of accounts – an evaluation
INVESTMENT APPRAISAL
ON THIS CHAPTER
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Understand what investment means and why appraising
investment project is essential
Recognise the information needed to allow for quantitative
investment appraisal
Assess the reasons why forecasting future cash flows contributes a
considerable element of uncertainty to investment appraisal
Understand and apply the payback method of investment appraisal
and evaluate its usefulness
Understand and apply the average rate of return method of
investment appraisal and evaluate its usefulness
Analyse the importance of qualitative or non-numerical factors in
many investment decisions
Understand and apply the net present method of investment
appraisal and discounted playback and evaluate their usefulness
Understand and apply the internal rate of return method of
investment appraisal and evaluate its usefulness.

What is meant by investment?
Investment appraisal = evaluating the profitability or desirability of an
investment project
Quantitative investment appraisal –what information is
necessary?
 Forecasting cash flows in an uncertain environment

Annual forecasted net cash flow = is forecast cash inflows – forecast cash out
flows

Quantitative techniques of investment appraisal
Payback period = length of time it takes for the net cash inflows to pay back
the original capital cost of the investment
Average rate of return = measures the annual profitability of an investment
as a percentage of the initial investment
ARR (%) = annual profit (net cash flow) / initial capital cost * 100

Discounting future cash flows

Discounting – how is it done?
Net present value (NPV) = today’s value of the estimated cash flows resulting
from an investment
Internal rate of return (IRR) = the rate of discount that yields a net present
value of zero – the higher the IRR, the more profitable the investment
project is
Criterion rates or levels = the minimum levels (maximum for payback period)
set by management for investment – appraisal results for a project to be
accepted

Qualitative factors – investment decisions are not just
about profit