Business Notes
Kira Prado
Finance and Accounts
3.1 Sources of Finance
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The role of finance for business
Sources of finance can either be internal or external.
The appropriateness of the source of finance chosen varies depending on may
factors such as:
- Size of business
- Type of business
- Time scale involved
- Purpose of the finance
The role of finance can be classified as either capital or revenue expenditure.
Capital Expenditure
Capital expenditure is finance spent on fixed assets.
- These are items of monetary value that have a long term function and can be
used repeatedly. They are not intended for immediate resale, but are used to
generate money for the business e.g. land, buildings, equipment, machinery,
vehicles etc.
Revenue Expenditure
Revenue expenditure is payment necessary for the daily running of the business
- These costs must be controlled so that a business can make a profit through its
revenue e.g. wages, raw materials, rent, electricity, insurance, advertising etc.
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Internal Sources of Finance
Internal sources of finance come from within the business and include the following:
Personal Funds
Personal funds – often the main source of finance for sole traders
and partnerships.
Retained profits
Retained profits – the value of the profits a business keeps after paying taxes and
distributing dividends, if appropriate.
- Retained profits are often used to finance capital expenditure.
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Sale of Assets
Sale of assets – e.g. selling old/out-of-date assets, or even fixed assets if having a
serious cash-flow problem.
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External Sources of Finance
External sources of finance come from outside the business and include the
following:
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Share Capital
Share capital is the money raised from selling shares in a limited liability company,
from its initial public offering (IPO) and any subsequent share issues.
- In other words: it is the part of the company that comes from the issue of shares.
This is the main source of finance for most limited liability companies, as shown in a
firm’s balance sheet.
Private limited companies cannot sell their shares to the general public whereas
public limited companies can issue their shares on a stock exchange.
Loan Capital
Loan capital refers to medium to long term sources of interest-bearing finance
obtained from commercial lenders, such as banks.
- Examples include mortgages, business development loans and debentures.
A mortgage is a secured loan for the purchase of property such as land or buildings.
- If the borrow defaults on the loan (fails to repay), then the lender can repossess
(take back) the property.
A business development loan is catered to meet the specific development needs of
the borrower.
- Businesses can use these highly flexible loans to start or expand their business,
to purchase equipment and other assets, or even to boost working capital.
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Debentures are long-term loans issued by a business whereby debenture holders
(individuals, governments and other businesses) receive interest payments even if
the business makes a loss, and before shareholders are paid any dividend.
- The interest payment can be fixed or variable depending on the type of
debenture.
Overdrafts
 Overdrafts allow a business to spend in excess of the amount in its bank account, up
to a predetermined limit. They are the most flexible form of borrowing in the shortterm.
 Overdrafts are commonly used when businesses have minor cash flow problems
Advantages
Disadvantages
Safety net – you only need to pay interest
Interest rates - While you won’t pay any
on the money you overdraw, so it could act interest on the balance of the overdraft you
as a relatively low cost safety net.
don’t actually use, you will be charged an
interest rate (generally a daily rate) on the
money you do draw upon.
Flexible term limits – you only borrow
If you have to extend your overdraft, you
what you need at the time which may make usually have to pay an arrangement fee.
it cheaper than a loan.
Cash flow - A business overdraft could
The bank has the right to ask for repayment
help you fund a range of business needs
of your overdraft amount at any time,
when you don’t have your own money on
although this is unlikely to happen unless
hand, especially if they’re unexpected
you get into financial difficulties.
expenses.
Choice of security - Lenders tend to offer Overdrafts may be secured against
both secured and unsecured business
business assets.
overdrafts.
USEFUL LINK: Bank Loans and Overdrafts
Trade Credit
 A trade credit is a business-to-business (B2B) agreement in which a customer can
purchase goods on account without paying cash up front, paying the supplier at a
later scheduled date.
- IN OTHER WORDS: It allows a business to “buy now” and “pay later”. The credit
provider does not receive any cash from the buyer until a later date.
 Organisations that offer trade credit (creditors) usually allow between 30-60 days for
their customers (debtors) to pay.
Advantages
Disadvantages
Increased sales – A customer will buy
Negative Effect on Cash Flow - The most
more of a supplier's products if they don't
immediate effect of trade credit is that
have to pay cash immediately for their
purchases.
Help startup businesses get up-andrunning – Trade credit can be useful for
new businesses unable to raise funding or
secure business loans, yet need stock
quickly.
sellers do not receive cash immediately for
sales.
Must Investigate Creditworthiness of
Customers
Competitive Advantage - A seller who is
able to offer trade credit to buyers has an
advantage over his competitors, if they are
not able to offer credit terms.
Possibility of Bad Debts – Inevitably, the
extension of trade credit will lead to some
buyers not paying their debts. When this
happens, an employee needs to spend
time making collection calls to the late
payers, and, eventually, the seller may
need to write off the unpaid receivables and
take a loss.
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Grants
Grants refer to financial gifts (non-repayable funds) to support business activities.
Grants are usually offered to businesses as one-off payments and do not need to be
repaid.
This might be for small business start-ups or to help stimulate economic activity.
Subsidies
Subsidies are funded by the government to lower a firm’s production costs as output
provides extended benefits to society.
- For example, farmers are often provided with subsidies to stabilise food prices.
Subsidies do not cut into profit margins.
Debt Factoring
Debt factoring is a financial service whereby a factor (such as a bank) collects debt
on behalf of other businesses, in return for a fee.
Businesses use debt factoring as an alternative to tapping out their overdraft when
they need to reduce temporary cash flow problems. It also protects against bad
debts since the debt factoring company is taking on the task of collections and the
risk that the customer will not pay.
How does it work?
- First it approaches the ‘factor’, a financial institution or lender who specialises in
accounts receivable finance.
- The factor assesses the level of risk by looking primarily at the financial health
and reliability of the companies owing the invoices.
- Based on this analysis they then make a quote regarding what percentage of the
invoices they can factor (up to 90%), and the terms are drawn up.
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Once the agreement is signed, the lender advances most of the money straight
away with a small proportion held back until the invoice has been paid.
Advantages
Disadvantages
Receivables (amounts owed by customers) Higher interest rates than traditional bank
are turned into cash quickly.
loans.
Saves time and administrative resources.
The facility is practically limitless and
therefore suits a fast-growing business.
There is no security required – unlike a
loan or overdraft.
Business can focus on selling rather than
collecting debts.
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May damage confidence in your business
as your clients become aware of the
factoring.
Unless specifically arranged, factoring is
with ‘recourse’ which means you will be
liable to cover any invoices which aren’t
paid.
Won’t work if your clients have adverse
credit history.
The slower your customers pay the higher
the factoring fees.
Leasing
Leasing is a form of hiring whereby a
contract is agreed between a leasing
company (the lessor) and the
customer (the lessee).
A lease is a contract outlining the
terms under which one party agrees
to rent property owned by another
party.
- It guarantees the lessee, also
known as the tenant, use of an
asset and guarantees the lessor,
the property owner or landlord, regular payments for a specified period in
exchange.
It can be cheaper to lease assets such as machinery, equipment, vehicles and
buildings, especially in the short to medium term.
- Hence, leasing is suitable for business customers who do not have the initial
capital to buy such assets.
Sale-and-leaseback involves a business selling a particular fixed asset (to raise
finance) and immediately leasing the property back.
- In essence, the business transfers ownership although the asset does not
physically leave the business.
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Short, Medium and Long-Term Finance
Effective managers need to ensure that cash coming into the business covers the
cash going out.
Managers must consider different forms of finance to deal with short, medium and
long-term needs.
Short term refers to the current fiscal (tax) year (e.g. repaid to creditors within next
12 months).
Medium term refers to the time period of more than twelve months but less than 5
years (e.g. commercial loans).
Long term refers to any period of five years or longer (e.g. mortgages, debentures).
3.2 Costs and Revenues
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Types of Cost
Cost refers to the sum of money incurred by a business in the production process.
- Set up costs are the items of expenditure needed to start a business e.g.
obtaining premises, purchase of machinery and equipment and deposits to
utilities companies.
- Running costs are the ongoing costs of operating the business e.g. wages and
salaries, insurance premiums and the cost of purchasing stock.
Price is the amount the product is sold for, which is paid by the consumer.
There are many other types of cost that businesses need to consider e.g. fixed,
variable, semi-variable, direct and indirect/overhead costs.
Fixed costs
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Fixed costs are the costs that the
business has to pay regardless of how
much it produces or sells i.e. fixed costs
do not vary with output.
Examples include:
- Rent on leased premises
- Interest payment on bank loans
- Advertising expenditure
- Market research
- Management salaries
- Stationery
- Security
- Professional accountancy fees
Variable costs
Variable costs are the costs of production that change in proportion with the level of
output or sales.
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As output increases, so do total variable costs.
Examples include:
- Sales commissions
- Direct labour costs
- Cost of raw materials
- Utility costs
Semi-variable costs
Semi-variable costs contain an element of both fixed and variable costs. They tend
to change only once a certain level of output has been reached.
- E.g. mobile phone plans often include both a fixed monthly fee, as well as excess
charges should the data or call limit be exceeded.
Direct cost
Direct costs are specifically related to an individual project or the output of a
particular product – without which the cost would not be incurred.
They may be fixed or variable costs and may relate back to a product or cost centre.
- E.g. direct costs of purchasing a property may include the solicitor’s fee, bank
charges, postage etc.
Indirect cost
Indirect costs (overheads) are those that cannot be clearly traced to the production
or sale of any single product.
They are associated with all areas of the business rather than being attributed to any
one project or product. Indirect costs are often fixed costs.
- E.g. rent, electricity
Calculating cost
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Where:
- AVC is the Average Variable Costs of production
- AFC is the Average Fixed Costs of production
- Q is the Quantity produced
Revenue
Revenue refers to the money coming into a business, usually from the sale of goods
and/or services.
Sales revenue = price x quantity sold (SR = P x Q)
Revenue streams
Revenue does not only come from the sale of goods and services.
Other sources of income for a business are known as revenue streams.
Examples include:
Advertising revenue
Advertising revenue is the monetary income that
individuals and businesses earn from displaying paid
advertisements on their websites, social media channels,
or other platforms surrounding their internet-based
content.
Companies such as Google, Twitter and Facebook rely
heavily on advertising revenue as a revenue stream.
Transaction fees
 A transaction fee is an expense a business must pay each time
it processes an electronic payment for a customer transaction.
 Ryanair, for example, charges customers who pay by American
Express credit card €7 ($9.50) and 2% commission.
Franchise costs and royalties
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Franchisees pay a fee to the franchisor to purchase the right to
use its brand name, logos and trademarks.
The franchisee also pays a royalty payment based on the sales
revenue of the franchised business.
- Royalties are also received by the holder of patents and
copyrights from others who are granted the use of their
inventions and creations.
Sponsorship revenue
Sponsorship is a form of below-the-line promotion whereby the
sponsor financially supports an organisation in return for prominent
promotional display of the donor’s brand trademark.
Subscription fees
 Subscription fees are imposed on customers who use or access
a good or service, based on a formal agreement.
 For example, fitness and leisure clubs charge yearly
membership fees.
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Merchandise
Merchandising is the promotion of goods and/or services
that are available for retail sale.
Service providers rely on in the entertainment industry (such
as cinemas, concerts, theatres and theme parks) rely on
selling merchandise (such as food, drink, souvenirs and
memorabilia) in addition to admissions charges.
Dividends
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Dividends are a share of the net profits distributed to
shareholders at the end of the tax year.
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Being a shareholder of other companies entitles a business to
payments of any declared dividends.
Donations
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Donations are financial gifts from individuals or other organisations
to a business.
Charities and non-profit organisations such as schools, hospitals and
universities rely heavily on donations as a regular revenue stream.
There are usually no direct benefits to the donor.
Interest earnings
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If a business deposits money in a bank, interest is the money
that the business earns as a percentage of their deposit.
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For highly cash-rich businesses, this can be an important
revenue stream.
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Subventions
Subventions are subsidies offered from the government to
certain businesses to help reduce their costs of production.
They are usually given to organisations that generate
benefits to society, such as private schools and hospitals.
3.3 Break-even Analysis
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Contribution
Contribution refers to the sum of money that remains after all direct/variable costs
have been taken away from the sales revenue i.e. the amount available to contribute
towards paying fixed costs of production.
Formulas:
Contribution per unit = P – AVC
Total Contribution = (P – AVC) x Q
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Contribution analysis can help a business to identify products that are relatively
profitable and ones that might need more attention.
Once variable costs have been taken away from the price the unit is sold at, the
contribution represents the amount each unit sold ‘contributes’ to the payment of the
firm’s fixed costs, and then the profits.
Profits = Total contribution – TFC
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Contribution analysis can also be used for the following:
Pricing strategy
Contribution analysis helps a business to set
prices for each of its products to ensure there
is contribution being made towards payment
of fixed and indirect costs.
Product portfolio management
The analysis can help managers to decide
which products should be given investment
priority.
Allocation of overheads to cost and
The analysis can ensure the cost allocation is
profit centres
done in a fair manner.
Make or buy decisions
The analysis can help a business decide
whether it should produce the products or
purchase them.
Special order decisions
These occur when a customer places an
order at a price that differs from the normal
price charged by the business.
Break-even analysis
A business breaks even when neither a profit
or loss is made.
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Break-even analysis
All firms are concerned with the difference between revenue and costs, however,
start-up firms in particular will be concerned with the number of sales that must be
made in order to earn a profit. This point is known as the break-even point, and can
be calculated through break-even analysis.
- IN OTHER WORDS: A business breaks even when neither a profit or loss is
made.
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In financial terms, a business can be in one
of the following situations at any point in
time:
- Loss: when costs of production exceed
the revenues of the business.
- Break-even: when the revenues of the
business equal the costs of production.
- Profit: when revenues exceed costs of
production.
A break-even analysis may inform
managers of the following:
- Whether it is financially worthwhile to
produce or launch a product.
- The expected level of profits if all goes to
plan.
Calculating the break-even quantity
This can be done in the following ways:
1. Using the TR = TC rule (e.g. P x Q = TFC + TVC)
2. Using the contribution per unit rule (e.g. Break even = Fixed Costs/Contributions per
unit, Break even = TFC/(P – AVC)
3. Interpretation from a break-even chart
Margin of safety
 The margin of safety refers to the difference
between a firm’s sales volume (i.e the current
level of sales of quantity demanded), and the
quantity needed to break even.
Margin of safety = Level of Demand – Breakeven quantity
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Target Profits and Revenue
If profits can be calculated by P = TR – TC, we can also calculate target profit and
how to achieve this:
Target Profit (TP) = Target Revenue – Total Costs
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Depending on the variables, it is therefore also possible to calculate:
- Target price, to achieve certain profits.
- Target quantity to sell, to achieve certain profits.
Changes in Break-Even
Actual break-even quantities, profits and/or losses are likely to be different from
those predicted by the break-even analysis for a number of reasons:
- The difference between short-term and long-term profits.
- The level of demand is subject to change.
- Profit depends on the level of risk involved.
- Innovation and the introduction of new technologies.
- External influences.
Benefits and Limitations of Break-Even Analysis
Benefits
 Break-even analysis is a useful decision-making tool for managers.
 It is a more accurate way to make predictions regarding price, costs and
profits/losses, rather than relying on guesswork.
 It is particularly beneficial if a business:
- Sells a single, standardised product.
- Operates in a single market.
- Can assume that all their output will be sold (e.g. makes to order/Just In Time).
Limitations
 It assumes cost and sales revenue functions are linear
 It assumes that a business sells all of its output
 It is a static model – does not react to immediate changes in the external
environment (e.g. fluctuating exchange rates).
 If the input data is inaccurate, the model will reflect these inaccuracies.
 It ignores other qualitative factors (e.g. staff working under increased pressure may
be less productive).
 It is difficult to apply to diversified firms with a wide product range.
Pros and cons of break even