Business unit 3

3.1.1 - The role of finance (What do companies spend their money on?)

Capital expenditure – spending on a firms fixed assets.

Revenue expenditure – spending on a firms general operational costs (day – to – day) e.g.
paying wages, utilities, debts & tax.
Insolvency – If a firm cannot pay its revenue expenditure it will go out of business rapidly

3.1.2 - Internal sources of finance

Term – long, short, medium & all

Internal sources of finance – money that is raised for a business’s existing assets (within a
business). The main sources are:
- Personal funds – money invested by the owners of a company
- Retained profit – money a firm has left at the end of the trading year after paying all
costs, expenses, dividends and taxes
- The sale of assets – An asset is something a company owns. Fixed assets are items a
company keeps for a period greater than one year, and can be used over and over
again

3.1.3 - External sources of finance

External sources of finance – money that come from outside the business. The main ones
are:
 Equity finance – in return for offering equity finance, the provider will demand
ownership of part of the company. Equity finance does not have to be repaid, and no
interest is charged.
- Business angels – people who invest their money into a new business that has high
growth potential (risk their money)
- Venture capital – companies that use the money from their clients to fund
investments (help companies grow so they can later sell their stake for an increased
price)
- Share capital – money raised by shareholders through the sale of ordinary shares 

 Debt finance – the money that is borrowed from a bank or other financial institution
- Interest – the cost of borrowing
- Loan capital – money that is required to run a business which is raised form loans
rather than shares
- Overdraft – facility that will allow you to withdraw more money from your account
than is available

 Financial aid – money that is invested in a business with almost no opportunity cost.
It does not need to be repaid and there is no loss of ownership
- Subsidies – designed to increase production of goods that are deemed beneficial to
society
 - Grant – fixed amount of money usually awarded by the government

3.1.4 - Short, medium and long term finance

Short term – repaid within 12 months

Medium term – lasts longer than one year but less than 5 years
Long term – lasts longer than 5 years

3.2.1 - Classification of costs

Variable costs – costs that change with output e.g. materials, packaging, delivery
Fixed costs – costs that don’t change with output e.g. salaries, rent and mortgage,
machinery
Direct costs – these costs such as raw materials, can be linked to a product e.g. staffing,
utilities, material costs
Indirect costs – these costs such as rent, cannot be linked directly to a product e.g.
advertising, salaries

3.2.2 - Revenue and revenue streams

Revenue – income earned by a business over a period of time

Revenue = price x quantity
Total revenue = selling price x output
Revenue streams – different ways to make income

3.3.1 - Calculating break even point

Break-even analysis – a tool that businesses can use to determine how many sales are
needed to cover all their costs.
Break-even point – the level of output that generates sufficient revenue to cover total costs
without any profit left.
Selling price – the average price paid by the customer for one unit of a product or service.
Contribution per unit – how much a product contributes to covering the fixed costs of a
business.
Total contribution – how much the whole product line (all the products/services produced
by the business) contributes to covering the fixed costs.
Margin of safety – The difference between the break-even point and the current level of
output. It shows how far output can fall with the business still achieving break-even. 

Contribution per unit = selling price - variable cost per unit

Total contribution = contribution per unit x output
Break even point = fixed cost / contribution per unit
Margin of safety = Current level of output - Break-even point
Predicted profit = output x contribution per unit - fixed costs
Fixed costs = total cost of production – variable cost x number of units
3.3.2 - Break even charts

Variable costs per unit = cost per unit x total number of units
Total costs = fixed costs + variable costs
Revenue = selling price x output
Profit = total cost - revenue
Total variable costs = variable cost per unit x output
Target profit output = fixed costs + profit target / contribution

Y - axis – revenue and costs

X - axis – output

Example break even chart :

3.3.3 - Changes in price and cost

Increased selling price – Break even point – lower, profit – higher, margin of safety – higher
Increased fixed costs – break even point – higher, profit – lower, margin or safety – lower
Increased variable costs - break even point – higher, profit – lower, margin or safety – lower

+
 Allows businesses to set targets
 Can see how changes in output effect profit levels
 It is fast and easy

 Unrealistic assumptions e.g all units are sold

 Forecasts are unreliable
 Most businesses sell more than one product, so break-even for the business
becomes harder to calculate
3.4.1 - The purpose of final accounts to different stakeholders

Internal stakeholders – people within the business that are interested in the final accounts.
Some examples are:
- Management
- Shareholders and owners
- Employees

External stakeholders – parties outside the business that are interested in the final accounts
of a business.
- Government
- Competitors
- Financers
- Suppliers

3.4.2 - The principles and ethics of accounting practice

- Ethics
- Integrity
- Objectivity
- Professional competence and due care
- Confidentiality
- Professional behaviour

3.4.3 - Final accounts: profit and loss account

Profit and loss account – the profit and loss account ultimately shows the profit or loss that
is generated by a business from the company's trading activities.

It is divided into three parts :

1. The trading account
2. Profit and loss account
3. Appropriation account

The trading account – records the results of the core business activity of selling goods or
services and enables the firm to calculate its gross profit
Gross profit – the profit made by a company, calculated by deducting the Cost of Goods Sold
from the revenue generated from the sale of the goods or services.
Opening stock – the quantity of goods produced/owned by the business that are unsold in
the previous accounting period and therefore available for sale at the beginning of the
current accounting period.
Closing stock – the quantity of goods produced/owned by the business after sales at the
close of the accounting period such as a year.
Purchases – the quantity of goods bought by the business for resale during the accounting
period.
Retained profit – the proportion of profits not paid out as dividends but left in reserve
usually to be reinvested in the business or to increase its financial stability.
Net profit = gross profit - Expenses
The Cost of Goods Sold (COGS) = Opening stock + Purchases – closing stock
Gross profit = Sales revenue – COGS
Revenue = Price x Quantity

In order to increase its gross profit, a company must either raise its revenue by increasing
either price or quantity, or reduce its COGS.

Order :
Profit and loss account for __________ year ended __________ $ $

Sales revenue
Cost of goods sold
Gross profit
Expenses
Net profit before interest and tax
Interest
Net profit before tax
Tax
Net profit after interest and tax
Dividends
Retained profit

3.4.4 - Final accounts: balance sheet

Balance sheet – statement of the financial position of a business in terms of assets, liabilities

and owner's equity at a particular point in time such as at the end of a financial year.
Assets – items of value that are owned by the firm, such as cash or buildings.
Liabilities – funds owed by the company to financial and other institutions, such as banks
and suppliers respectively.
Equity – funds invested in a business by the shareholders plus retained profits.
Current assets - items of value owned by the company that can be converted into cash in
the short term
Fixed assets – long-term tangible items of value owned by the company. They have a
lifespan of over 12 months or are not sold within a year.

Owner equity = Assets – Liabilities

Assets = Liabilities + Owners equity
Net current assets = current assets - current liabilities
Order :
__________ Balance sheet for __________ $ $

Assets
Fixed assets
Net fixed assets
Current assets
Total current assets
Net assets
Net current assets (working capital)
Current liabilities
Total current liabilities
long-term liabilities
Share capital
Retained profit
Equity

3.4.5 – Depreciation

Depreciation - the loss in the value of a fixed asset over time.

Causes of depreciation :

- Wear and tear – when machinery / equipment is used in production, its working
parts will either deteriorate or get damaged.
- Obsolescence –when new inventions replace the machinery currently in use (more
efficient)

Annual provision for depreciation = purchase price – residual value / estimated useful life

Book value table example:

3.5.1 – Profitability and liquidity ratios

Profitability or performance ratios are indicators of the extent to which the firm's effective
use of its resources enables it to create an excess of revenue over the cost incurred to
produce and sell its goods/services. 

Gross profit margin = Gross profit / sales revenue x 100

Sales revenue = price x quantity

The GPM can be increased by either increasing sales revenue and/or reducing the cost of
goods sold. Different strategies to raise revenue :

 Change the price

 Reduce the price by establishing economies of scale, such as bulk buying economies 
 Reduce the price by finding cheaper suppliers

Lowering the cost of goods sold can help the firm by either by lowering the price (which
thus may lead to an increased quantity sold) or by increasing the contribution to profit and
fixed costs.
 This could be done by finding cheaper suppliers of the product or using cheaper
materials to produce the goods or services in question.
 Manufacturing firms could reduce the direct labour costs either by hiring fewer
workers or by using non-financial motivation strategies to improve productivity and
consequently reduce costs.

Net profit margin shows the net profit as a percentage of sales revenue.

Net profit margin = net profit before interest and tax / sales revenue x 100

Ways to improve the NPM

 Increase sales revenue
 Lower the COGS
 Reduce operating expenses (rent, electricity, stationary, entertainment,
administrative expenses)

Return on capital employed is a profitability ratio that measures how efficiently a company
can generate profits from its capital employed.
ROCE = Net profit before interest and tax / capital employed x 100
Capital employed = Long-term liabilities + Share capital + Retained profits

Ways to improve the ROCE

 Increase EBIT
 Reduce long-term liabilities
 Reduce equity and retained profit
3.5.2 – Liquidity ratios

There are two liquidity ratios: the current ratio and the acid test ratio (or quick ratio). These
show how well a firm can pay off (settle) its short term liabilities without the need to sell off
any long-term assets (capital).

Current ratio is a firm's ability to pay off its short-term debts using its current assets.
Current ratio = current assets / current liabilities

Ways to improve the current ratio

 Reduce current liabilities
 Improve the business' credit control system
 Sale of unused fixed assets
 Negotiate longer payment terms with suppliers
 Decrease overheads
 Monitor owner's draw: cash drain

Acid test ratio, or quick ratio, is a more immediate and severe indicator of the firm's ability
to pay off its short-term debt.
Acid test ratio = current assets – stock / current liabilities

Ways to improve the acid test ratio

 Increase sales
 Reduce current liabilities.
 Reduce drawings
 Sale of unused assets