Topic: Unit 5 Notes – Finance Name: Emily Baker Class/Period: 6

Cornell Notes Date: February 24, 2025

Content/Class: AICE Business
Questions: Notes:
- Analyze reasons 5.1
why business
activity requires Why business activity requires finance
finance  Start-up capital: the capital needed by an entrepreneur to set up a business
- Analyze the  Working capital: capital needed to pay for raw materials, day-to-day running costs, and credit offered to customers
importance of
working capital to a Capital and Revenue Expenditures
business and how it
is managed - Capital expenditure involves the purchase of assets that are expected to last for more than one year, such as building and
- Differentiate machinery
between capital - Revenue expenditure is spending on all costs and assets other than fixed assets and includes wages and salaries and materials
and revenue bought for stock
expenditure
- Analyze the Working Capital – Meaning and Significance
different sources of *Working capital is often described as the ‘lifeblood’ of a business. Finance is needed by every business to pay for everyday expenses, such
long-term and as the payment of wages and buying stock
short-term finance,
both internal and
Without sufficient working capital, a business will be illiquid
external
- Evaluate the  Illiquid: unable to pay its immediate or short-term debts
factors that
managers consider What happens in cases such as this?
when taking a Either the business raises the finance quickly (such as a bank loan) or it may be forced into liquidation by its creditors, the firms it owes
finance decision money to
- Recommend and Liquidity: the ability of a firm to be able to pay its short-term debts (money owed)
justify appropriate
sources of finance Liquidation: when a firm cases trading and its assets are sold for cash to pay suppliers and other creditors
for different
business needs  How Much Working Capital is Needed?
- Too low a business can become illiquid and unable to pay its debts
- Too high a level of working capital is a disadvantage
The opportunity cost of too much capital tied up in inventories, accounts receivable and idle cash is the return that money could earn
elsewhere in the business – invested in fixed assets, perhaps
- The working capital requirement for any business will depend upon the ‘length’ of this ‘working capital cycle’

Working capital = current assets – current liabilities

The simple working capital cycle – the longer this cycle takes to complete, the more working capital will be needed

Where does finance come from?

*Companies are able to raise finance from a wide range of sources…
 Internal money raised from the business’s own assets or from profits left in the business (ploughed0back or retained profits)
 External money raised from sources outside the business

 Internal sources of finance:

- Profits retained in the business
- Sale of assets
- Reductions in working capital

Profits retained in the business:

- If a company is trading profitably, some of these profits will be taken in tax by the government (corporation tax) and some is
nearly always paid out to the owners or shareholders (dividends)
- If any profit remains, this is kept/retained in the business and becomes a source of finance for future activities

External sources of finance:

 SHORT TERM:
o Bank overdrafts – bank agrees to a business borrowing up to an agreed limit as and when required
o Trade credit
o By delaying the payment of bills for goods and services received, a business is, in effect, obtaining finance
o Its suppliers or creditors are providing goods and services without receiving immediate payment and this is as good as
‘lending money’
o Debt factoring
o The selling of claims over debtors to a debt factor in exchange for immediate liquidity
o Only a proportion of the valuer of the debts will be received as cash
o Ex. A company might buy 90% of a $100,000 invoice, so you receive $90,000
o Bank loans
 LONG TERM:
o Long-term bank loans
o Loans that do not have to be repaid for at least one year
o Long-term bonds or debentures
o Bonds issued by companies to raiser debt finance, often with a fixed rate of interest
o Sale of shares – equity finance
o Equity finance is permanent finance raised by companies through the sale of shares
o Rights issue: existing shareholders are given the right to buy additional shares at a discounted price

Other long-term sources

- Grants
o Government grants are usually given to small businesses or those expanding in developing regions of the country
o Grants often come with conditions attached, such as location and the number of jobs to be created, but if these conditions
are met, grants do not have to be repaid

- Venture capital
o A risk capital invested in business start-ups or expanding small businesses that have good profit potential but do not find it
easy to gain finance from other sources

Finance for Unincorporated Businesses

*Unincorporated businesses – sole traders and partnerships – cannot raise finance from selling shares and are most unlikely to be
successful in selling debentures and they are likely to be relatively unknown firms
 Owners of these business will have access to bank overdrafts, loans and credit from suppliers
 They may borrow from family, friends, use the savings and profits made by the owners and, if a sole trader wishes to do so, take on
partners to inject further capital or even take on more partners

Microfinance
- Providing financial services for poor and low-income customers who do not have access to banking services, such as loans and
overdrafts offered by traditional commercial banks

Finance and Shareholders

Rights Responsibilities Objectives
Shareholders  Part ownership of the company in proportion  Capital invested cannot be  To receive an annual return
to the numbers of shares owned claimed back from the on investment in shares –
 To receive dividends by the board company except when it the dividend
 To receive a share of the capital if the ceases trading  To receive capital growth
business is wound up after all debts have been through an increase in
paid share price
 Possible, to influence a
company policy through
pressure at the AGM
Banks  To receive interest payments as laid down in  To check on business  To make a profit from a
the loan or overdraft agreement viability before loan or loan
 To be repaid before shareholders if the overdraft is agreed; this is  To receive repayment of
company is wound up both a responsibility to the capital at the end of the
bank’s shareholders and to loan term,
the business – advice to  To establish a long-term
customers is an important relationship, of mutual
responsibility benefit, with the business
Creditors  To receive payment as agreed  To provide regular  To provide credit to
 To be repaid before shareholders in the event statements of account encourage the business to
of the business being wound up owning and terms of purchase stock
 To attend creditors’ meetings if the business is repayment  To establish a relationship
put into liquidation built on trust so that credit
can be offered in
confidence

Raising external finance – the importance of a business plan

- A business plan is 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
- Without some evidence that the business managers have thought about and planned for the future it is most unlikely that bankers,
venture capitalists, or potential shareholders will invest money in the business
- Include executive summary

Making the financial decision

Examples of factors that are considered before making the financing choice are:
- Cost
- Amount required
- Legal structure and desire to retain control
- Size of existing borrowing
- Flexibility

Questions 5.2 Forecasting Cash Flows

- Analyze the
importance of cash Introduction: The Importance of Cash Flow
to a business  Cash flow is always important in the short and long-term
- Explain the o Cash flow is the sum of cash payments to a business less the sum of cash payments from the business
difference between
cash flow and  If a business does not plan the timing of these payments and receipts carefully, it may run out of cash even though it is operating
profit profitably
- Analyze the  If suppliers and creditors are not paid in time, they can force business owners into liquidation of the business’s assets if it appears to be
purpose of cash- insolvent
flow forecasts
Cash Flow:
- Interpret and
(sum of cash payments to a business – INFLOWS) – (sum of cash payments – OUTFLOWS)
amend simple cash
flow forecasts Liquidation: when a firm ceases trading, and its assets are sold for cash to pay suppliers and other creditors
- Analyze the Insolvent: when a business cannot meet its short-term debts
different causes of
cash-flow problems  Cash: notes, coins, and money stored in a bank account
- - Evaluate different  Profit: the amount left over once all costs have been deducted from sales revenue
methods of Profit = sales revenue – total costs
improving cash-
 Structure of Cash-Flow Forecasts
flow problems
- A cash-flow forecast is an estimate of a firm’s future cash inflows and outflows
- The net monthly cash flow is an estimated difference between monthly cash inflows and outflows
- The opening cash balance is the cash held by the business at the start of the month
- The closing cash balance is the cash held at the end of the month becomes next month’s opening balance

There are several important advantages to cash-flow forecasting, especially for new businesses:
- By showing periods of negative cash flow, plans can be put into place to provide additional finance, for example arranging a bank
overdraft or preparing to inject more owner’s capital

- If negative cash flows appear to be too great, then plans can be made for reducing these
o Ex. By cutting down on purchase of materials or machinery or by not making sales on credit, only for cash

- A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to a cash-
flow forecast – and the assumptions that lie behind it

What are the limitations?

*Here are the most common limitations of using cash-flow forecasts:
 Mistakes can be made in preparing the revenue and cost-forecasts or they may be drawn up by inexperienced entrepreneurs or
staff
 Unexpected cost increases can lead to major inaccuracies in forecasts
o Fluctuations in oil prices lead to cash-flow forecasts of even major airlines being misleading
 Wrong assumptions can be made in estimating the sales of the business, perhaps based on poor market research, and this will
make the cash inflow forecasts inaccurate

Poor Credit Control

 The credit-control department of a business keeps a check on all customers’ accounts (who has paid, who is keeping to agreed credit
terms and which customers are not paying on time)
o If this credit control is inefficient and badly managed, then debtors will not be chased up for payment and potential bad debts
will not be identified
 Credit control: monitoring of debts to ensure that credit periods are not exceeded
 Bad debts: unpaid customers’ bills that are now very unlikely to ever be paid

Causes of Cash-Flow Problems

1. Expanding too rapidly:
When a business expands rapidly, it has to pay for the expansion and for increased wages and materials months before it received cash
from additional sales. This overtrading can lead to serious cash-flow shortages – even though the business is successful and expanding

Overtrading: expanding a business rapidly without obtaining all of the necessary finance so that a cash-flow shortage develops

2. Unexpected events:
A cash-flow forecast can never be guaranteed to be 100% accurate
Ex. Unforeseen increases in costs

Ways to Improve Cash Flow

 Increase cash flows
 Reduce cash outflows
***Care needs to be taken here – the aim is to improve the cash position of the business, not sales revenue or profits

Method How it works Possible drawbacks

Overdraft  Flexible loans on which the business can  Interest rates can be high – there may be
draw as necessary up to an agreed limit an overdraft arrangement fee
 Overdrafts can be withdrawn by the bank
and this often causes insolvency
Short-term Loan  A fixed amount can be borrowed for an  The interest costs haver to be repaid
agreed length of time  The loan must be repaid by the due date
Sale of Assets  Cash receipts can be obtained from selling  Selling assets quickly can result in a low
off redundant assets, which will boost cash price
inflow  The assets might be required at a later date
for expansion
 The assets could have been used as
collateral for future loans
Sale and Leaseback  Assets can be sold but the asset can be  The leasing costs add to annual overheads
leased back from the new owner  There could be a low of potential profit if
the asset rises in price
 The assets could have been used as
collateral for future loans
Reduce credit terms to customers  Cash flow can be brought forward by  Customers may purchase products from
reducing credit terms from say, two months firms that offer extended credit terms
to one month
Debt Factoring  Debt-factoring companies can buy the  Only about 90-95% of the debt will now be
customers’ bills from a business and offer paid by the debt-factoring company – this
immediate cash – this reduced risks of bad reduces profit
debts too  The customer has the debt collected by the
finance company – this could suggest that
the business is in trouble

Ways to reduce cash outflows and their possible drawbacks

Method How it works Possible drawbacks
Delay payments to suppliers (creditors)  Cash outflows will fall in the short term  Suppliers may reduce discount offered
if bills are paid after, say three months with the purchase
instead of two months  Suppliers can either demand cash on
delivery or refuse to supply at all if they
believe the risk of not being paid is too
great
Delay spending on capital equipment  By not buying equipment, cash will not  The efficiency of the business may fall
have to be paid to suppliers if outdated and inefficient equipment is
not replaced
 Expansion becomes very difficult

Managing Working Capital

1. Debtors
Can be managed in many different ways, including:
- Not extending credit to customers – or extending it for shorter time periods
- Selling claims on debtors to specialist financial institutions acting as debt factors
- By being careful to discover whether new customers are credit worthy
- By offering a discount to clients who pay promptly

2. Credit
Creditors: suppliers who have agreed to supply products on credit and who have not yet been paid
*Can be managed by:
- Increasing the range of goods and services brought on credit
- Extend the period of time taken to pay

3. Inventory
Inventory can be managed by:
- Keeping smaller inventory levels
- Using computer systems to record sales and therefore inventory levels, and ordering as required
- Efficient inventory control, inventory use and inventory handling as to reduces losses through damage wastage and shrinkage
- Just-in-time inventory ordering --- by reducing inventory holdings using this technique, and by only producing when orders have
been received, working capital tied up in inventories will be minimized. Getting goods to customers as quickly as possible will speed
up the eventual payment received for these products

4. Cash
Cash can be managed by:
- Use of cash-flow forecasts – these can help the management of cash flows and working capital
- Wise use of investment of excess cash
- Planning for periods when there might be too little cash and arranging for overdraft facilities from the banks to avoid a liquidity
crisis
Objectives: Chapter 5.3
- Analyze the need for
cost information The Need for Accurate Cost Information
 Effective business decisions would not be possible without cost data.
- Analyze types of Here are some of the business uses of cost information:
costs: fixed, variable, o Calculation of profit or loss
direct, and indirect
o Pricing decisions
o Measuring performance
- Analyze the
o Setting budgets
difference between
o Resource use
full costing and
contribution costing o Making choices

- Apply and evaluate Calculation of Profit & Loss

the technique of *To calculate profit and loss, accurate cost information is required
contributing costing
Measuring Performance
- Appy contributing - Cost information allows comparison to be made with past periods of time. Efficiency or profitability is measured over time
costing to
accept/reject special Setting Budgets
orders decisions - Budgets can act as targets for departments to work towards. Actual costs can then be compared with the budget

- Draw and interpret Capital vs. Labor

breakeven charts and **Resource use: comparing cost data can help decide resource use
calculate the
breakeven point Making Choices
- Calculating and comparing costs of different options can assist with decision making
o Ex. Production machinery vs. alternative location
- Apply and evaluate
break even analysis
> Types of COST
in simple decision-
*Before cost information can be used to make a business decision, you must understand cost classifications:
making situations
 direct costs
 indirect costs
 fixed costs
 variable costs

Problems in Classifying Costs

It may not be easy to classify into categories…
- Labor costs are often variable and indirect costs
- Wages can become fixed costs

Important costing concepts

- Cost centers
- Profit center
- Overheads
- Average cost

*The benefit of using cost and profit center

o Should have a positive impact on motivation because of reasonable goals
o Identify well performing areas vs. opportunity areas

Average Costs: the average cost of producing each unit of output (aka Unit Costs)

Average cost =

Overheads: indirect expenses and usually classified into 4 groups

 Production overhead: factory rent and rates
 Selling and distribution overhead: warehouse, packing, and distribution costs
 Administration overhead: office rent, clerical salaries
 Finance overhead: interest on loans

Break-Even Point: when sales revenue equals total costs

- At this point, no profit or loss is incurred
- The firm merely covers its total costs
- Break-even point can be shown in graph form or by use of formulae

Total Costs
- Simply fixed costs and variable costs added together
- As total costs include some of the variable costs, then total costs will also change with any changes in output/sale

Total costs = fixed costs + variable costs

 Break-Even Analysis
We must firstly calculate how much income from each cupcake (item) can go towards covering the fixed costs

Unit contribution = selling price – variable costs

- Ex. SP – VC ------- $2.00 - $0.50 = $1.50
- For every item sold, $1.50 can go towards covering fixed costs

Break Even Formula = total cost / unit contribution

 Limiting Factors:
- Under normal circumstances, the best paying product is which shows the highest contribution per pound/$ of sales
- Certain circumstances make this inappropriate
o Ex. A factory producing a particular range of products may depend on a highly skilled labor force

- If skilled labor is in short supply in the locality of the factory, then labor is termed a limiting, or key, factor

The most important criterion now will be the optimum use of labor
- This is expressed by the contribution per labor hour
- Direct labor is only one example of a limiting factor
Other examples could be:
- Direct materials
- Machine hours
- Factory capacity

Assumptions of break-even analysis

- All fixed and variable costs can be identified
- Variable costs are assumed to vary directly with output
- Fixed costs will remain constant
- Selling price are assumed to remain constant for all levels of output

- The sales mix of products will remain constant – break even charts cannot handle multi-product situations
- It is assumed that all production will be sold
- The volume of activity is the only relevant factor which will affect costs

Limitations of Break-Even Analysis

- Some costs cannot be identified as precisely fixed or variable
- Semi-variable costs cannot be easily accommodated in break-even analysis
- Costs and revenues tend not to be constant
- With fixed costs the assumption that they are constant over the whole range of output from zero to maximum capacity is
unrealistic