P

age1

Finance and Accounting

Sources of finance

Every business whether it is new or existing needs finance for different activities such as starting

a new business, expansion to production capacity, developing and marketing new products,

entering new markets, moving new premises, and to pay for the daily expenses. A source of

finance could range from short term to long term. And it could be either internal or external.

Short term: Usually taken for less than ONE year.

Medium term: Usually taken to mean between ONE and FIVE years.

Long term: Usually referring to finance OVER FIVE years.

The costs of finance

Rate of Interest

Security

Personal guarantees

Short term Finance

Retained profit or ploughed back profit

Businesses (especially limited companies) usually keep some part of the profit every year for

future use. This is also known as ploughed back profit. Over a period of time it can total up to a

huge amount which can be used for financing the business.

Advantages

No need to pay interest

Any time it can be used

Less legal formalities

No repayment

Doesn’t increase liabilities

Disadvantages

It affects shareholders dividends

All the companies may not have retained profit

Bank Loan

Some banks loans are short term and have to repay within a year. Advantages and disadvantages

of bank loans will be discussed later.

P

age2

Bank Overdraft

Bank overdraft is a facility given by banks to its business customers, people having current

accounts. Through this facility the customers can overdraw their accounts to a greater value than

the balance in the account. To overdrawn amount is agreed in advance with the bank manager.

The bank assigns a limit to overdraw from the account and the business can meet its short term

liabilities by writing cheques to the extent of limit allowed.

Advantages

No need for collaterals or security.

More flexible and the overdraft amount can be adjusted every month according to needs.

Disadvantages

Interest rates are usually variable and higher than bank loans.

Cash flow problems can arise if the bank asks for the overdraft to be repaid at a short

notice.

Trade credit

Usually in business dealing supplier give a grace period to their customers to pay for the

purchases. This can range from 1 week to 90 days depending upon the type of business and

industry. By delaying the payment of bills for goods or services received, a business is, in effect,

obtaining finance which can be used for more important expenditures.

Advantages

No interest has to be paid.

Helps to solve temporary financial problems

Less legal formalities

Disadvantages

Used only for short-term purposes

Small amount

Prices of goods are high

Not available from all creditors

Customer prepayments

Some situations customers are persuaded to pay a percentage of the total amount of the product

or services even before the goods or services are delivered. This advance money could be used

by the business for different purposes.

P

age3

Invoice Factoring (Debt factoring)

It involves the business selling its bills receivable to a debt factoring company at a discounted

price. In this way the business get access to instant cash. The way factoring work is shown

below.

The selling company X sells goods to the buying company Y on 30 days credit. (1). A copy of

invoice is sent to the factoring company, then factoring company will pay 80% of the invoice

amount to the company X. (2)

In 30 days’ time, Company Y (buying company) will make its payment to factoring company (3)

and not to the company X.

After receiving the payment, the factoring company will send the remaining balance of 20% of

the invoice amount to the company X after deducting the clients charges (a percentage of the

value of the invoice it has factored).

Advantages

– It will boost the cash flow

– there are many factoring companies, so prices are usually competitive

– it assists smoother cash flow and financial planning

– some customers may respect factors and pay more quickly

– you will be protected from bad debts (non-recourse)

Disadvantages

– The cost will mean a reduction in your profit margin on each order or service

fulfillment.

– Some customers may prefer to deal directly with you.

– It may be difficult to end an arrangement with a factor as you will have to pay off

any money they have advanced you on invoices if the customer has not paid them

yet.

P

age4

Medium and long term financing

Shares

Investors invest their money to buy the shares to earn profit in the form of dividend

– Ordinary Shares (Equity shares)

– Preference Shares

– New share issues

– Rights Issue : shares normally issued at discount rate to existing shareholders

– Bonus or Scrip Issue: free shares to existing shareholders

Advantages

– Large amount of cash can be raised by issuing shares.

– No need to pay interest to shareholders

– The company is not obliged to pay dividends to the shareholders

– It is more cheap and permanent way if raising capital especially for expansions

– No repayment of share capital except redeemable shares

Disadvantages

– More legal formalities

– Dividend is to be paid when company makes profit

Loan note

It is an alternative to share issue. The purchase of this stock will not become shareholders, but

will be creditors. There are entitled to get interest from the company.

Debentures

A debenture is defined as a certificate of acceptance of loans which is given under the

company's stamp and carries an undertaking that the debenture holder will get a fixed return

(fixed on the basis of interest rates) and the principal amount whenever the debenture matures. It

is issued for a long periods of time.

Advantages

– Large amount of cash

– Money can be used for longer period

– No voting rights to debenture holders

Disadvantages

– Fixed rate of interest has to be paid whether company makes profit or loss

– Repayable after an agreed period

P

age5

Differences between shareholders and debenture holders

SHAREHOLDERS DEBENTURE HOLDERS

Owners of the company

Creditors of the company

Dividend

Interest

Dividend is payable from profit Interest must be paid whether company makes

profit or loss

Can vote

No voting rights

Share is part of capital

Debenture is a loan

Have full power to control the company

Cannot control the company

Share may be Issued for cash or kind Debentures are only issued for cash

Leasing

Leasing involves using an asset, but the ownership does not pass to the user. Business can lease a

building or machinery and a periodic payment is made as rent, till the time the business uses the

assets. The business does not need to purchase the asset

Advantages

Saves capital expenditure: The business does not need large sums of money to

buy the use of equipment

Maintenance and repair costs are not the responsibility of the user

A leasing agreement is generally easier for a new company to obtain than other

forms of loan finance. This is because the assets remain the property of the

leasing company

Losses due to technical improvements will be reduced

Firm is eligible for tax advantages

Solves working capital problems

Disadvantages

× Rent is to be paid regularly

× Over a period of time the costs incurred from leasing might exceed the outright

purchase cost of the equipment

× The business might be tied in to excessively long contracts at rates which cannot

be renegotiated when a cheaper supplier might become available on the market

× More legal formalities

× Equipments cannot be used as securities for loans

P

age6

Commercial mortgages

Some companies own freehold of real estate premises such as factories, offices and warehouses.

These assets have a value in the company’s accounts. If the business wants to raise sum of

investments in new assets, it could take out a commercial mortgagee with a property company.

Assets sales

Business might sell off old, obsolete assets which are no longer used by the business to raise

additional cash for the business. It will be better use of capital but a new company can’t raise

finance as such since they may not have old assets to sell.

Sales and Lease back

This involves a firm selling its assets or property to an investment company and then leasing it

back over a long period of time. The business thus can use the asset without purchasing it and

can use the revenue earned from its sale for other.

Advantages

– No need to pay interest

– Large amount of money

Disadvantages

– Difficult to sell immediately

– Lease back will increase the firms expenses

Hire Purchase

Hire Purchase is a means of buying a capital asset by paying a deposit and regular installments

over a period of time. Finance Houses, which retain ownership of the equipment until the last

payment has been made, provide the funding.

Bank loans

This is borrowing from bank for a limited period of time. The business has to pay an interest on

the borrowing. This interest may be fixed or variable. Businesses taking loan will often have to

provide security or collateral for the loan.

Advantages

Money can be used for long term investments

Reasonable rate of interest

Disadvantages

× Fixed rate of interest has to be paid whether company makes profit or loss

× Repayable after an agreed period

P

age7

Government grants

Governments will provide financial support in certain circumstances. The major grants are

related to regional policy. There are usually conditions attached with the grants such as

guarantees of continued operations and creation of jobs. There are no interest charges or

repayment of capital sum.

Factors affecting the choice of right source of finance

• Amount of money required – a large amount of money is not available through some

sources and the other sources of finance may not offer enough flexibility for a smaller

amount.

• How quickly the money is needed – the longer a business can spend trying to raise the

money, normally the cheaper it is

• The cheapest option available – the cost of finance is normally measured in terms of the

extra money that needs to be paid to secure the initial amount – the typical cost is the

interest that has to be paid on the borrowed amount.

• The length of time of the requirement for finance - a good entrepreneur will judge

whether the finance needed is for a long-term project or short term and therefore decide

what type of finance they wish to use.

• The amount of risk involved in the reason for the cash – a project which has less

chance of leading to a profit is deemed more risky than one that does. Potential sources of

finance (especially external sources) take this into account and may not lend money to

higher risk business projects; unless there is some sort of guarantee that their money will

be returned.

The finance providers

Clearing banks

The clearing banks are the large high street banks. In practice, it is more useful to think them as

financial service providers. They are very large public limited companies in their own right and

have shareholders to satisfy and are in the business of selling financial services to generate

maximum profits for their shareholders

Merchant banks

These are whole sale banks which offer the following services

– Advice on takeover or merger options

– Capital restructuring of business

– Assists with share issues and loans

– Portfolio management (investment mix and policy)

P

age8

Trade suppliers

The other main suppliers of business finance are trade suppliers. It should be borne in mind that

suppliers are businesses and may be looking for finance themselves so that they can offer trade

credit to their customers.

Accounting Accounting is an information system that 1) identifies, 2) records, and 3) communicates the

economic events of an organization to interested users.

Financial statements

Accounting reports, called financial statements, provide summarized information to the owner.

• Statement of profit or loss—A summary of the revenue and expenses for a specific

period of time.

• Statement of owner’s equity—A summary of the changes in the owner’s equity that

have occurred during a specific period of time.

• Statement of financial position—A list of the assets, liabilities, and owner’s equity as of

a specific date.

• Statement of cash flows—A summary of the cash receipts and disbursements for a

specific period of time.

The purpose of statement of profit or loss

The purpose of a Profit and Loss statement is to assess the success of the management decisions

that have been made in the past and to help them to make appropriate decisions in the future. The

statement will show the annual sales, the costs of generating those sales and the resulting profit

or loss. Most companies hope to grow year on year. The Profit and Loss statement can also be

used to inform and reassure existing shareholders or to persuade prospective investors to invest

in the business. The statement would also be needed to support an application for a loan to a

bank.

The purpose of Statement of financial position

The Statement of financial position represents a valuation of the assets that a business owns and

the liabilities that it owes. In other words it identifies the net wealth of the business. Shareholders

hope to see growth in the net value of the business on an annual basis. The balance sheet also

shows how much of the capital has been borrowed and thus provides an indication of the level of

risk from interest rate changes.

Financial Accounting is concerned with reports made to those outside the organization.

Management Accounting is concerned with information for the internal use of management.

Assets are resources owned by a business. They are used in carrying out such activities as

production, consumption and exchange.

P

age9

Fixed Assets: Assets held for long term use in the business. E.g. Land & building, Furniture,

Computer equipments etc. Current assets are anything owned by a business that is likely to be

turned into cash during the year. Typical current assets are stock, debtors and cash

Liabilities are claims against assets. In other words it is something owed to somebody else. They

are existing debts and obligations. E.g. Creditors, Bank loans, Overdraft, Accrued expenses etc

Owner’s Equity is equal to total assets minus total liabilities. Owner’s Equity represents the

ownership claim on total assets. Subdivisions of Owner’s Equity are Capital or Investments by

Owner, Drawing, Revenues and Expenses.

Fixed costs are costs that do not vary in the short-term when a firm alters its level of output.

These are the costs that the businesses must pay whether the business trades or not. Examples of

fixed costs include rent, rates, insurance and depreciation and must be paid irrespective of the

level of output.

Variable costs are those expenses that change directly with the volume of output.

Examples might include fuel with miles driven or raw materials and components with production

output. These costs will depend on the level of production and sales.

Total costs are the all the cost of producing specific amount of something, including both fixed

and variable cost

Total Cost = Fixed Cost + Variable Cost

Revenue is the receipts the business receives from the sale of goods and services. This includes

total sales and other forms of revenue such as rent received, and interest received.

Total Revenue = (Average) Selling Price * Quantity Sold

Expenses are the decreases in owner’s equity that result from operating the business. They are

the cost of assets consumed or services used in the process of earning revenue. Examples of

expenses may be utility expense, rent expense, supplies expense, and tax expense.

Profit is the excess of income over expenditure. Profit could be used to pay shareholders’

dividend, to pay loans or to reinvest in to the business. Profit = Total Revenue – Total Cost

Break-Even is reached when Sales Revenue = Total Costs. This is the point where business

makes no profit and no loss. After the survival, Break even becomes the most important

objective of the business. Break-Even could be used to calculate, with a given level of fixed costs

P

age1

0

and cost per unit, how many goods at a specific price it needs to sell to break even. It can also be

used to calculate how many units the business needs to sell to reach its target profit. Break-Even

point could be changed with a change in fixed cost, Selling price and Variable cost.

Break Even Point = Fixed Costs/Contribution per Unit. Contribution is the amount of revenue

remaining after deducting variable costs. This the amount each item sold contributes toward

paying the other costs of the business i.e. the fixed costs. Contribution per Unit = Selling Price

– Variable Cost

A budget is a financial plan (estimate of cost or revenue) for a specified future period of time,

that the business or department must try to achieve. A master budget combines the forecast

income from sales together with forecast expenditure. This can be used to determine a forecast

cash flow statement as well as a forecast profit and loss account.

The primary purpose of budgeting is to control cost by ensuring that no department in a

business spends more than the company expects.

Budgeting can motivate managers: When managers at all levels are involved in the

budgeting process they will have a commitment to ensuring that budgets are met.

Budget is a tool of accountability, where individual’s success can be measured. It

enables power to be shared within an organization, so that those people in the best

position can be responsible for the business’s money.

Budgeting ensures, or should ensure, that limited resources are used where most

effective: The budgeting process allocates resources to where they are most likely to help

achieve the firm’s objectives.

Improved management and financial control of the organization: Managers know

who is spending what, and why they are spending the money. Part of the budgeting

process is monitoring of expenditure and revenues. Any changes from (variances from)

budgeted amounts need to be explained and reacted too.

× Budgeting is a time consuming and costly job

× Budgets are not necessarily a good barometer for progress.

× Budgets are based on assumptions that often turn out to be inaccurate

× If the budgets are set at an unrealistic level, then it can be de-motivational, as managers

can never achieve the targets set.

× If budgets are inflexible then changes in the market or other conditions may not be met

by appropriate changes in the budget.

× Those excluded from the budgeting process, may not be committed to the budgets and

may feel de-motivated.

A cash flow forecast is a detailed estimate of a firm’s future cash inflows and outflows for the

forthcoming year. From this the firm can derive monthly cash flow balances and the annual

cumulative cash position. It is important to identify periods when the firm is cash starved and

needs extra funds and when it is cash rich. Overdraft arrangements can be arranged in order to

ensure temporary finance is available.

P

age1

1

Businesses must continually review its cash flow position against their forecasts. The primary

purpose of the cash flow budget is to predict the sources and uses of cash and to identify your

cash position for a specific time period (daily, weekly, monthly etc.). Cash flow forecast allows a

firm to get a clear idea of how the business is doing - and how it is likely to perform in the

future. It also allows managers to be able to specify times when the business may need additional

funding, such as when cash outflow exceeds inflow.

Possible advantages include:

• Identification of the timing of cash shortages and surpluses.

• Supporting applications for funding.

• Enhancing the planning process.

• Can reduce the risk of a business going bust.

Possible disadvantages include:

• Sales might be higher or lower than expected.

• Suppliers might increase their prices.

• Bank interest rates may rise or fall.

• Production problems may mean you have delays in meeting deadlines.

Cash flow problem (poor cash flow)

As cash flow is not profit, and it is the cash which is most important for the business to prevent

its failure. As such businesses must ensure that there is sufficient money inflow in to the

business. If a business do not have sufficient cash (poor cash flow) to pay its bills could serious

affect a firm’s reputation and impact upon its ability to gain future credit and supplies. It could

also affect the day to day running of the business as well. A cash flow problem could arise as a

result of one or more of the following reasons.

There might be a sudden fall in sales whereas the expenses may not come down in the

same proportion.

Any unforeseen expenses may lead to high cash outflow as compared to cash inflow in

that particular period.

Debtors’ payback period is too long.

Cash flow problems could be overcome by adopting number of techniques.

– Arranging a bank loan or an overdraft.

– Reducing or delaying some planned expenditure.

– Delay payments to creditors.

– Offering discounts to customers for early payment.

– Factoring

– Leasing equipment rather than purchasing it.

– Improving credit control function as such by reminding debtors continuously about

payments that are due.

P

age1

2

Gearing measures the proportion of capital employed that is provided by long term lenders. The

gearing ratio is given by the equation:

Gearing = Long term liabilities/Capital employed *100

A company with high gearing could be in a volatile and risky position as it has to pay large

amount of money as interest payment whether company makes profit or not.

Working capital is the day-to-day finance required to run a business. It is the finance required to

pay for raw materials, running costs, labor and to finance credit offered to customers. Working

capital can be calculated using the equation:

Working capital = Current assets – Current liabilities

Working capital management

These are Decisions relating to working capital and short term financing. These involve

managing the relationship between a firm's short term assets and short term Liabilities. This is

extremely important function in the business as it is mainly a balancing process between the cost

of holding current assets and the risks associated with very small or zero amount of them. The

goal of working capital management is to ensure that the firm is able to continue its operations

and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming

operational expenses

Management of stock

This includes stock of raw materials, work in progress and finished goods. We have to consider

the cost of holding and not holding stock.

• The cost of holding stocks:

– Financing cost

– Storage cost

– Insurance cost

– Cost of losses as result of theft, damage etc

– Obsolescence and deterioration cost

• The cost of holding low stock:

– Cost of loss of customer good will

– Ordering cost – low stock levels usually associated with higher ordering cost than

bulk purchase

– Cost of production hold-ups owing to insufficient stock

The organization normally will set the balance which achieves the minimum total cost, and

arrive at optimal stock level.

P

age1

3

Management of debtors

This requires identification and balancing of following costs:

• Cost of allowing credit:

– Financing cost

– Cost of maintaining debtors’ accounting records

– Cost of collecting the debts

– Cost of bad debts written off

– Cost of obtaining credit reference

– Inflation cost

• Cost of refusing credit

– Loss of customer good will

– Security costs owing to increased cash collection

– Loss of sales

Management of cash

This also requires identifying and balancing of following:

• Cost of holding cash

– Loss of interest if cash were invested

– Loss of purchasing power during times of high inflation

– Security and insurance cost

• Cost of not holding cash

– Cost of inability to meet bills as they fall due

– Cost of lost opportunities for special offer purchase

– Cost of borrowing to obtain cash to meet unexpected demands

Failure to have sufficient working capital could result in the following problems.

Difficulty paying its suppliers on time. The knock on effect of this is that the firm may

lose favourable credit terms or be refused credit in the future

It may need to borrow additional monies from the bank, thereby incurring additional

interest payments, which will reduce the profits of the business and increase current

liabilities.

It may ‘lose’ out on being able to take advantage of purchasing economies of scale by not

being able to buy in sufficient quantities to secure the maximum discounts.