BUSINESS STUDIES NOTES – (ACCOUNTING AND FINANCE)

Accounting – is a managerial tool for recoding financial transactions so that a

summary of what has happened to business money can be traced.

Finance – refers to how a business funds its activities (where it gets its money to
trade, why it chooses to use certain lenders) as well as the costs, risks and benefits
of different types of borrowing.

Sources and Uses of Finance

There are two types of lenders to the business:

 Equity Financiers – is the money borrowed from internal lenders
(investments/loans from those who own the business)
 Debt Financiers – is money borrow from external lenders (loans to a
business from those who are outside it)

The business may require lenders because it needs funds to:

• Commerce the business(start up capital)
• Cover expenses and help fund operations
• Assist in growth of the business, buying more capital

The three main sources of equity finance are:

 Owners equity – the capital contributed by the business’s owners
 Retained profit – money earned by the business activities but not distributed
to owners/shareholders in the form of dividends.
 Venture capital – money that is invested in small and sometimes struggling
businesses that have the potential to be very successful.

Owner’s Equity:
• Is referred to as owner’s equity in the case of a sole trader/partnership and
shareholder’s equity in the case of a company.
• Represents funds invested by the owners of the business and can be raised
by taking on another partner or the issuing of more shares.

Advantages Disadvantages
• Does not have to be repaid • Amount limited by ability of
(although owners expect a owners to contribute more
return on their investment) capital funds.
 • No interest payments • Increase in the number of
• Owners who have contributed owners to raise more equity
retain control over how the finance will increase the number
finance is used who share the future profit -
• Low gearing (low use of debt may result in lover returns or
finance) therefore business is at dividends.
less risk of financial difficulties.
Retained Profits:
• Money earned by the business (profit) is not disturbed to the owners. Some
profits are retained to finance future business activity and expansion.
Dividend payments to shareholders are reduced as a result.
• Cheap (no interest payment) and easily accessible
• Shareholders may require a good return on their investment and lack of
satisfactory dividend may result in the fall of the share price (affects capital
gain for shareholders) Therefore the business must only use a portion of its
profits for retained profits and distribute the remainder.

Venture Capital (seed capital):

• Associated with risky but innovative schemes, it is used in new business
ventures or to grow and develop an established business.
• Potential for high profits but business venture may also ‘go broke’. Venture
capital is equity capital because it is supplied by investors who become
shareholders.

There are many types of debt finance (external sources) such as:
 Banks, financial institutions, government suppliers, credit unions or business
lenders.

Advantages Disadvantages
• Large pool of funds available. • Regular repayments must be
Increased funds into the business made.
should generate increased profits. • Interest, bank charges and the
• Interest payments tax deduction government charges must be paid.
• No increase in number of • Increased risk to business of
owners/shareholders. Future financial difficult (high gearing)
growth in profits shared between • Lenders have first claims on any
existing shareholders. money from the business is
 bankruptcy occurs.

Types of Debt Finance: (long term and short term)

Short-Term Debt Finance – type of borrowing used to finance temporary shortages

in cash flow or finance for working capital. Examples of short term borrowing are
listed below:
• Bank Overdraft - the bank allows a business to overdraw their account up
to an agreed limit and for a specific time to help overcome a temporary cash
shortfall. They have high interest rates and are flexible. Security: when bank
gives a lower interest rate but has the security of taking the person’s house,
if they do not pay.
• Trade Credit – where the company invoiced for goods or services
purchased and repaid the supplier in a specific time period (usually 2 weeks,
30 or 90 days). There is not interest unless you don’t on time, which means
it is free. However the business must have a good credit record, reliable
income history/flow in order for it to obtain trade credit.

• Bank Bills – written, unconditional orders for a specified sum of money to

be paid on a specific date in the future. They are very safe with low interest
and the flexibility to ‘roll over’ which means the business can extend the
period of time if they haven’t collected the funds yet.

Long-Term Debt Finance – relates to funds borrow for over two year periods,
usually used to finance real-estate and equipment. Examples of long-term
borrowing are listed below:
• Mortgages – is a loan secured by the property of the borrower (business)
The property mortgaged cannot be sold or used as ‘security’ for further
borrowing until the mortgage is repaid. Usually used for finance property
purchases such as new premises, a factory or office.
• Debentures – are issued by a company for a fixed rate of interest and for a
fixed period of time. It is a secured loan; the company has security over a no.
of the companies assets. Debentures are issues by large public companies in
order to raise large amounts of finance.
• Leasing – is a contract between the owner of asset and a business which
wants to use that asset, they allow businesses to use certain long term assets
(buildings, equipment, computers). There is no large capital outlay, which
 means the business can pay in repayments over a period of time. However it
cannot be canceled and it can be more expensive than buying the product.
There are two types of leasing, which are explained below:

Operating Lease Financial Lease

• Contract between the leasee • Contract between the leasee
and leasor. and leasor.
• Periodic payments made, • Periodic payments made,
usually for shorter period of usually held for the life of the
time (less than one year) asset, 3-5 yrs.
• Lease can be cancelled at any • Lease cannot be cancelled
time (without penalties) during contracted time period.
• E.g. rental car – 2 weeks Early cancelation involves
penalties (fees)
• Leased car – 3 years

• Factoring – is the selling of accounts receivable (customers who owe

money for services supplied) for a discounted price to a finance or factoring
company. The company will follow up on the debtors and call in the cash. A
business usually only considers factoring companies when they are very
desperate and there is a large cash flow decrease, because in the process they
will loose profit as the full amount will not be received for the accounts.

Financial considerations when choosing appropriate forms of finance

General rule:
• Short term funds are used for short term purposes and long term funds are
used for long term purposes. This matches the economic benefit gained from
using the finance with the economic cost of the finance.
Costs of Finance - The cost of finance must be balanced with the expected rate of
return. Set up costs and interest rates must be measured for each of the available
sources of funds, as costs fluctuate depending on market and economic conditions.
Structures of the Business – Small businesses have fewer chances to raise equity
capital than large businesses. Equity from unincorporated businesses has to be
raised from private sources or by taking on another partner. Corporate businesses
raise equity bye the issuing of shares to the public.
Flexibility – Businesses may require the funds to be flexible (e.g. when a business
has excess funds it can repay the debt more quickly, this can be done in bank
overdrafts)
Availability of Finance – A businesses credit rating will affect the availability of
funds to a business. A poor credit rating may result in difficulty in borrowing
further. Too heavy dependence on a small number of investors can increase risk if
an investor pulls out.
Level of Control – Some lenders will require an asset such as a building to be
used as collateral/security, in which a businesses ability to consider future
financing possibilities are reduced.

Comparing debt to equity financing

Debt Financing – relates to the short term and long term borrowing from external
sources by an organisation.
Equity Financing – relates to the internal sources of finance in the organisiations.
Gearing is the ratio (mix) of debt to equity that a company uses to finance its
assets. A comparison of the two is shown below:
Debt Equity
• Externally borrowed from banks • Internally received from owners
or companies or shareholders, but requires
• It is more risky, because the sufficient profits to be made so
principal must be paid as well as that the organization can continue
interest. to operate.
• Easy to get from lenders, • It is safer because owner’s

attractive to businesses because it ‘donate’ money or business can

is readily available. sell shares to get capital.
• It is contractual; legally it must be • Funds don’t have to repaid but it

paid (every month etc.) is hard to get (hard to convince

people)
• No contractual obligation.
 The more highly geared a business is, the greater risk there is but there is greater
potential for profit. It is risky because the business might not be able to pay back
the money but the company doesn’t have to distribute the profit among
shareholders.
• Highly geared = more debt than equity
• Lowly geared = more equity than debt

Solvency – refers to the ability of a business to repay debt. Insolvency means that a
business is unable to repay debt, which may lead to eventual bankruptcy. A
business that is highly geared is at greater risk at becoming insolvent.

Forecasting financial requirements for a business

Break Even analysis:

Break even analysis determines the level of sales that needs to be generated to
cover the total cost of production. Total cost (TC) of production includes fixed
costs (FC) and variable costs (VC). TC = FC + VC
Fixed costs are costs that don’t change/are fixed throughout increasing production.
(E.g. rent, wages, insurance)
Variable costs are costs that depend on the amount of sales (E.g. materials, fuel,
and packaging)
Break even point occurs when the money earned from sales (total revenue, TR)
equals total costs. There is no profit or loss. Break even point is where TR = TC

Financial Statements
There are three financial statements:
 Balance sheet (statement of financial position)
 Revenue statement (statement of financial performance)
 Cash Flow statement (liquidity statement)

The goals of financial management, which are shown in financial statements are:
 Profitability – ability to maximize profits
 Liquidity – ability to meet short-term financial commitments
 Solvency – ability to meet long-term financial commitments
  Efficiency – effective use of resources to ensure financial stability and
profitability.

Balance Sheet:
The purpose of a balance sheet is:
• To help owners keep watch on their debt and equity levels
• Compare their overall financial position, gives a snap shot of the financial
situation
• Assist with the process of financial decisions
• Shows overall stability of the business

A balance sheet is divided into two parts – assets and liabilities.

 Assets are items of value to the organisation that can be given a monetary
value.
• Current assets are items whose value is expected to be used up, or
turned over, within 12 months. E.g. bank savings, cash on hand,
inventories (stock)
• Non-current assets are those items that have an expected life of three
to five years or longer. These include large physical items such as
buildings, land or machinery.
• Intangible items are things of worth that have no physical substance
such as goodwill (reputation), brand name, copyright and patents.

 Liabilities are items of debt owed to outside parties and or other

organisiations, such as loads, mortgages or credit card debt.
• Current liabilities are those in which the debt is expected to be repaid
in the short term (less than a year) and include bank overdrafts,,
accrued expenses.
• Non current liabilities are long term debt items such as mortgages,
leases, debentures and retirement benefits’ funds (they can last up to
30 years).

Owners Equity is where the owner gives the business money in order for it to
acquire resources and being operating (the money is known as capital). Owner’s
equity is considers a liability from the point o view of the business because it is a
type of debt the business carries. However, unlike liabilities, owner’s equity is a
debt owed to owners because of the risk they took in investing in the business.

Balance sheet or Accounting Equation:

A (assets) = L (liabilities) + OE (Owners Equity)

Revenue Statement:
• A revenue statement is a summary of the income earned and the expenses
incurred over a period of trading. It shows how much money has come into
the business as revenue. How much has gone out as expenditure and how
much has been derived as profit.
• Profit – refers to money earned by a business in the course of operating that
is in excess of costs (money left after expenses are covered).
• Revenue – refers to money received in normal trading or operating (income
from sales).

There are five main parts to a revenue statement:

 Heading – name of the business, states the period of time over which the
statement is reporting on.
 Revenue – total income of the business (price x quantity)
 Costs of Goods Sold (COGS) - only effects businesses that purchase stock.
• Opening stock + purchases – closing stock
• COGS are not included as an expense because it is used to work out
gross profit.

 Gross Profit – tells the business how much its mark up of goods sold is.
• Gross profit = sales – COGS
 Expenses – are simply costs. They are the costs incurred in the process of
acquiring or manufacturing a good or service to sell, as well as the costs
associated with managing all aspects of the sales of that good or service.
There are operating and non operating expenses:
• Operating expenses – means occurring in the normal course of trading
and refers to predictable and recurring items. E.g. payment of wages,
insurances and rates.
 • Non-operating expenses – refers to unusual, unexpected and
unpredictable items that affect income either favorable or
unfavorably. E.g. loss due to burglary.

Cash Flow Statement:

• Are vital for the business to assess whether money inflows can match money
outflows. It gives information on timing for payment and receipt of income.
• Liquidity – refers to the amount of cash the business has access to and how
readily it can convert its assets into cash so that debt can be paid (shows if
the business has good or adequate cash flow)
• They show the need of the business to match the desire for cash with the
customer’s ability to pay. They summaries all cash flows that have occurred
throughout the past year.

Cash Inflows Cash Outflows

• Cash sales • Payment for stock
• Credit sales when paid • Payment for expenses (wages and
• Other income e.g. interest from insurance)
investments. • Payment for non-operating
expenses

The cash inflow and outflows are divided into three categories:
 Cash from operating activities – related to the main business operations
and prime function.
 Cash from investing activities – related to the sale and purchases of assets
such as land and buildings.
 Cash from financing activities – related to the acquisition of and
repayment of both debt and equity finance.

Cash flow report/budget– are a planning tool that will help a business to prepare
a cash flow budget to determine the timing of cash payments and receipts.
However reports are broader than budgets because they are used as summaries of
past information.
Budgets - provide in information in quantitative terms (facts and figures) about
requirements to achieve a particular purpose. They are statements anticipated
financial flows (estimated)
• Resource Budgets – included estimates on use of raw materials, labour, land
and buildings.
• Output Budgets - are estimates on sales, financial position, solvency and
liquidity.