Chapter 3: Finance Abiel Zewolday Gloria Evstatieva

Peter Dolittle Gabriela Perdomo

3.1Sources of Finance

Time to Finance

•Short-Term:

–One year or less

•Medium-Term:

–One to five years

•Long-Term:

–More than five years

Sources of Financing

•Internal:–Money raised by the business’s own assets or profits

retained by the business.

•External:–Sources of capital from outside the business.

Internal Financing

•Profits retained by the business

•Sale of assets

•Reductions in working capital

•Lease option

External Financing

•Trade credit

–Delaying payments to vendors

•Bank overdrafts

–Line of credit

•Debt factoring

–Selling accounts receivable

•Venture Capitalists/Loans

3.2 Management Accounting

Payback

•This measures the time it takes to recover enough cash to cover an initial investment or outlay

•Example: A new machine for a mental pressings business will cost $100,000 and generate $25,000 extra sales revenue each year

Formula: initial investment/ annual cash flow from investment

The Average Rate of Return (ARR)

•This measures the profitability or accounting of a project over its useful time

•It considers all data and not just cash flows up to the point of payback

Formula: net return (profit) per annum/ capital outlay (cost) x 100 = %

Working Capital •Money needed by a business for its day-to-day or

immediate needs

•Businesses try to squeeze working capital by making it move quickly toward cash

•The working capital cycle will help you appreciate how cash is used by the business and how it moves from one stage to another

•Working capital is used to buy raw materials, which are turned into finished goods and then sold to customers via invoice

Working Capital Continued

•The customer or debtor, on paying the invoice, returns cash to the business

•This cash is then recycled into raw materials and some of it is also used to pay suppliers’ invoices and maybe even reduce the bank overdraft

•Controlling the working capital cycle links closely with an accountant’s role to manage cash and forecast cash flow needs

Strategies to Improve Cash Flow

•Offer prompt payment discounts to its customers

•Delay paying its suppliers by asking for an extended credit period

•Negotiate better interest rates on loans

•Possibly sell off some of its non-core assets

•Spread or smooth out quarterly rental or utility bills to avoid sudden rises in overdraft position; cut back on wages, etc

3.3 Financial

Accounts and Ratio Analysis

Final Accounts

• Are financial statements that inform stakeholders about the financial profile and performance of the business. o one group of statements covers the years

trading, its profit or loss, and how that profit/loss was distributed at the end of the financial year.

o The other is the balance sheet, which discloses what the business owns (assets); owes other people (liabilities); and how it has funded (the capital employed) its net assets (assets less liabilities)

The Trading & Profit and Loss Account

• The trading or manufacturing account looks at the costs of production.

• The profit and loss account presents the sales revenue of the company for a given period of time. o it also shows the related costs in making that

sales revenue and finally it shows how the resulting profit is used.

Balance Sheet

http://www.investopedia.com/video/play/introduction-balance-sheet/

How are accounts used by Stakeholders?

• Shareholderso accounts inform shareholders of how efficient

the organization is at investing their capital and making a good return, how safe their investment is, or if the business is likely to fail, and generally whether the directors are performing on their behalf or need to be replaced or possibly re-incentivized.

• Directors, Managers, and Employeeso accounts inform these people about the

financial viability of their employer and it may be useful to them or their trade unions to have profit figures when negotiating salary changes.

How are accounts used by Stakeholders? Continued

• Suppliers o Assess whether the business is secure and liquid

enough to pay off its debtso Assess whether the business is a good credit risko Decide whether to press for early repayment of

outstanding debts

• Customers o Assess whether a business is secureo Determine whether they will be assured of future

supplies of the good they are purchasingo 3. Establish whether there will be security of spare

parts and service facilities

How are accounts used by Stakeholders? Continued

Citizens

• can use this information to better understand the financial strength or weakness of a local business.

Competitors

• Business will use published accounts to try and see how well their competitors are doing.

Ratio Analysis

• Is a management tool for analysing and judging the financial performance of a business. This is done by calculating financial ratios from a firm's final accounts (namely the balance sheet and profit and loss account).

Liquidity & Liquidation

• 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.

Profitability

Gross Profit/ Sales revenue X 100

• This indicates what the return is after we take variable costs like production wages and materials from our sales revenue.

Net Profit Margin

• Net Profit/Sales Revenue X 100o Profit left after all costs, both

variable and fixed.

Stock Turnover Ratios

Cost of sales/Average Stock = Number of times

Investor Ratios

• Gearing: Long-term loan capital/total capital employed X 100

Working Capital (Cycle)

Working Capital

• The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.

• Without working capital, a business will not be able to pay its immediate (or short-term) debts.

Working Capital=Current Assets – Current Liabilities

Cash Flow

• The timing of payments to workers and suppliers and receipts from customers.

• The sum of cash payments to a business (inflows) less the sum of cash payments made by it (outflows).

How to Increase Cash FlowMethod How it Works Evaluation

Overdraft (Credit Line)

Flexible loans in which businesses can draw at any time.

Interest rates can be highCan be rescinded by the bank

Short-Term Loan A fixed amount can be borrowed at any time.

Interest must be paidThe loan must be repaid

Sale of Assets Cash can be raised by selling redundant assets.

Selling assets quickly can result in a low sales priceThe assets might be needed laterThe assets could be used as collateral for future loans

Sale and Leaseback Assets can be sold and leased back at a reduced price.

Leasing costs add to overheadCould be loss of profit on sale of assetThe asses could be used as collateral for future loans

Reduce Credit terms to customers

Cash flow can be brought forward from reducing terms from 60 days to 30 days.

Customers may change to different firm for their purchases

Debt Factoring Sell Accounts Receivable to raise cash.

The debt purchases company will not pay full value for the A/RCustomer may perceive the company is in financial trouble

How to Reduce Cash FlowMethod How it Works Evaluation

Delay payments to suppliers (creditors)

Cash outlays will fall in short term if bills are paid in 2 months instead of 1 month

Suppliers may reduce discounts offeredSuppliers may demand cash on delivery or refuse to supply if they feel the risk of not being paid is too high

Delay spending on capital equipment

By not buying equipment cash will not have to be paid

Business may become inefficient if outdated equipment is not replacedExpansion becomes difficult

Use leasing not outright purchase of equipment

No large cash outlay is required

The asset is not owned by the businessLeasing charges are added to overhead

Cut overhead spending that does not affect output – like advertising

Costs will not reduce production capacity or sales but cash payments will be reduced

Future demand may be reduced by failing to promote your product effectively.