3.

1 WHAT IS FINANCE
WHEN DOES A BUSINESS NEED FINANCE?
What is finance?
Money used to purchase things the business needs or want.

What is a source of finance?

It is a method of getting hold of the money you need. Most of
the time you have to pay it back and it can be expensive.

When might a business need finance?

1. When it is
starting – up.

2. When it needs to 3. When it wants to

buy equipment or expand the
premises. business.
3.1 SOURCES OF FUNDS
All businesses need money to conduct their day-to-day
operations or to expand their current production and
achieve future growth.
3.2 SOURCES OF FINANCE
SOURCES OF FINANCE
DEBT FACTORING

LONG-TERM BANK SHORT-TERM BANK

LOAN LOAN

SOURCES HIRE PURCHASE

BANK OVERDRAFT OF
FINANCE

MORTGAGE
LEASING

ADDITIONAL GRANT
CAPITAL

RETAINED PROFITS TRADE CREDIT

SOURCES OF
FINANCE
Sources of finance are classed as being either internal or external.

Internal sources:
finance from within the
business.

External sources:
finance from outside the
business.
3.1 SOURCES OF FUNDS
INTERNAL SOURCES OF FINANCE
Internal finance saves a business from borrowing from a lender and having to
pay back interest.

1.Owners Funds/Capital
The owner of the business uses
their own personal savings and
invests in the business

Easy to access, no money to pay

back, no interest to pay
The person may lose all their
savings if the business fails.
INTERNAL SOURCES OF FINANCE

2.Selling Assets
The owner decides to sell items that
they own and use the money to
invest in the business.

Money gained can be used to buy a

new asset. No money to pay
back, no interest to pay
7KH³VROG´DVVHWLVO
INTERNAL SOURCES OF FINANCE

3.Using Profit (Retained Profit)

The owner decides to use the profit
they have made and invest this
profit back into the firm.
No money to pay back, no interest to
pay
Owner cannot then have this money
for themselves
3.1 SOURCES OF FUNDS
Advantages of Internal Financing are:

Disadvantages of Internal Financing are:

HOMEWORK
3.1 SOURCES OF FUNDS
3.1 SOURCES OF FUNDS
EXTERNAL SOURCES OF FINANCE
External sources of finance come from outside a business and are more difficult
to arrange than internal sources.

1.Bank Loan/ Mortgage

Borrowing an amount of money from a bank and paying it back in
instalments. Interest is added to the loan.

Business can spread the cost of the repayments

Interest is added to the amount borrowed

External sources:
finance from outside the
business.
EXTERNAL SOURCES OF FINANCE

3.Hiring and Leasing

5DWKHUWKDQEX\LQJDQDVVHWDILU
the item.
The leasing charge is cheaper than buying the asset. Faults
will be mended by the firm leasing the asset
The asset does not belong to the firm and therefore cannot be
sold

External sources:
finance from outside the
business.
EXTERNAL SOURCES OF FINANCE

4.Selling Shares
Persuading members of the public to invest in the company by
buying shares.
No money to pay back, no interest to pay
2ZQHUVKLSRIWKHFRPSDQ\LV³VKDUHG´ ±
danger of a possible takeover

External sources:
finance from outside the
business.
EXTERNAL SOURCES OF FINANCE

5.Government or EU (European Union) Grant

Applying to the government for an amount of money to be used for
a specific purpose. It is usually a loan.

Interest on the loan is cheaper than a bank

Often only available in certain parts of the country where
unemployment is high

External sources:
finance from outside the
business.
EXTERNAL SOURCES OF FINANCE

6.Business Angels
Individuals who provide capital for small and start-up businesses in
return for a share of ownership in these companies.
No money to pay back, no interest to pay
2ZQHUVKLSRIWKHFRPSDQ\LV³VKDUHG´ ±
danger of a possible takeover

External sources:
finance from outside the
business.
 TYPES OF FINANCING IN TERMS OF
DURATION
‡Short-Term Financing: used to finance day-to-day working
capital. Its duration is less than 12 months such as overdraft,
trade credit, and debt factoring.
‡Medium-Term Financing: used to purchase fixed assets that have
a useful life between 1 and 10 years such as equipments and
vehicles.
‡Long-Term Financing: used to finance long-term assets and the
expansion of a business for a long-term duration that might
reach 30 years such as purchase a building.
FACTORS OF CHOOSING A SOURCE OF
FINANCE
‡Purpose or Use of Funds: related to matching the source of finance
to the businesses’ specific needs such as to finance day-to day
operations might be best fulfilled using an overdraft.
‡Costs: are the expenses that are incurred when choosing a source
of finance; including the opportunity costs that are the costs of
forgone sources of finance when choosing another source.
‡Status and Size: the nature and size of the company might affect
its ability to reach various sources of finance. For Example small
companies will not be able to issue shares unlike large
multinationals.
FACTORS OF CHOOSING A SOURCE OF
FINANCE
‡Amount Required: can induce the type of finance that could be
needed by organizations. For example a small amount of money
could be financing using short-term financing.
‡State of the external Environment: are the economic factors that
might influence the financing costs such as interest rates and
inflation. For example an expected rise in the interest rate might
stimulate businesses to take long term financing at the current lower
rates.
‡Gearing: is the ratio of loan to capital share inside any
organization which might affect its riskiness. High loan to capital
ratio would induce high geared level and high risk.
3.3 Costs and Revenues
Introduction
Types of Costs
Types of Costs
Homework
3.4 Final Accounts
Purpose of Final accounts to
Stakeholders
 Shareholders: need to know the financial performance of their company and
the safety of their investments.
 Managers: can compare their current performance to the previous years to
determine potential growth and then compare the company’s performance to
its competitors.
 Employees: A good financial performance would signify a sense of continuity
in this business and more possible salary raises.
Purpose of Final accounts to
Stakeholders
 Customers: they would be interested if they would still be able to buy the
company’s products and the supply of such products would be guaranteed.
 Suppliers: would use the final accounts to know if the company would be able
to pay its debts on time.
 Government: would use the final accounts to determine if the company is
paying its tax obligations.
The Main Final accounts
 The profit and Loss accounts: shows the revenues and expenditures of a
company for a certain period of time.
 It involves:
 the trading account (Sales revenues – Cost of Goods Sold = Gross Profit). COGS = Opening
stock + purchases – closing stock.
 The profit and Loss Account:
 Gross profit – Operating Expenses = Net profit before interest and tax.

 Net profit before tax = Net profit before interest and tax – interest expense.

 Net profit after interest and tax = net profit before tax – tax expense.
The Main Final accounts
 Retained profit = Net profit after interest and tax - dividends.
Statement of Financial Position
(Previously used to be Balance Sheet)

 It includes Assets, Liabilities and Equity.

 Assets are what the business owns including:
 Non-Current Assets: durable assets that lasts for more than 1 year. Ex:
equipment, vehicles, computers…
 Current Assets: are non-durable assets that last for less than 1 year such as
cash, A/R, inventory, insurance.
 Liabilities are what the business owes including:
 Current Liabilities: are debts that have a maturity of less or equal to 1 year.
 Long-term Liabilities: are debts that have a maturity of more than 1 year.
 Equity are the net worth of shareholders including:
 Share Capital: are the amount of capital invested by the owners in the business.
 Retained Profits: are accumulated profits that the company saved in the
previous years.
Working capital & Equity
Ethics of Accounting Practices

 Ethics are the set of values and conduct that should be implemented in
business behavior including the accounting practices.
 Ethics would help organizations to build their accountability and reputation
among the public.
 Accountants should comply with the code of ethics in accounting, which is
known as the Association of Chartered Certified Accountants (ACCA) code of
ethics.
ACCA Principles

 Integrity: honesty and straightforward in all business

practices.
 Objectivity: not allowing bias or conflict of interest; besides
not compromising their professional or business judgment.
 Professional competence: maintain the required level of
knowledge and skill to deliver the desired professional
services.
 Confidentiality: do not disclose any information acquired
during professional and business relationship.
 Professional Behavior: comply with laws and regulations.
Intangible Assets
They are non-physical durable assets that include the
following:
 Patents: provide inventors with the exclusive rights to
use, sell, manufacture or control their inventions. Its
legal life is around 20 years.
 Goodwill: refers to the positive attributes related to a
business such customers’ relations, strong brand name,
highly skilled labor, and good reputation.
 Copyright laws: provide the creator with the right to
protect the production and sale of their artistic or
literary work. Its useful life is between 50 to 100 years.
 Trademarks: are symbol, word, phrase or design that is
officially registered for a product or business.
Depreciation (HL)
 It is a non-cash expense of a fixed asset over time. There are
two depreciation methods:
 Straight Line Method: spreads the cost of an asset equally
over its lifetime. It includes
 Useful life (how many years the company might use
the asset).
 Original Cost of the fixed asset.
 The residual or scrap value (its value after its useful
life)
Straight-Line Depreciation
Depreciation (HL)
 Reducing Balance Method: applies a percentage
depreciation over the useful life of the fixed asset. As a
result, higher depreciation is charged at the beginning of
the asset’s lifetime. It includes
 Useful life (how many years the company might use the asset).
 Original Cost of the fixed asset.
 The residual or scrap value (its value after its useful life)
Reducing Balance Method
3.5 Ratios Analysis
Ratios Analysis

 Theymeasure the company’s financial

performance at a specific period.
 They would influence the stakeholders such as
creditors and lenders to assess the company’s
situation to take appropriate decisions.
 They include profitability ratios, efficiency
ratios, and liquidity ratios.
Profitability Ratios

 Gross Profit Margin

 Net Profit Margin

Efficiency Ratios

 Return on Capital Employed (ROCE)

Liquidity Ratios
 Current Ratio

 Acid Test (Quick) Ratio

3.6 Efficiency Ratios
Efficiency Ratios

 They measure how the company is managing

its resources (assets and liabilities) to
generate profits at a specific period.
 They would reflect how the company is being
efficient in terms of managing its resources at
the best possible way.
 They include stock ratios, debtor days,
creditor days and gearing ratios.
Stock Ratios
 They measure how quickly a firm is selling its stock
during its fiscal year.
 Stock Turnover Ratio (in times)

Average stock = (Beginning stock + Ending stock)/2

Stock Ratios
 Stock Turnover Ratio (in days)

Average stock = (Beginning stock + Ending stock)/2

Debtor Days
 It measures how many days it takes a firm to collect
its receivables from its customers.
 Debtor Days (in days)
Creditors Days
 It measures how many days it takes a firm to pay its
payables to its suppliers.
 Creditor Days (in days)
Gearing Ratio
 It measures how much of the capital employed has
been financed from loan capital.
 Gearing Ratio
3.7 CASH FLOW
CASH FLOW

• It is the amount of cash that flows in and out of the business

over a given period.
• Cash Inflows are the money received by a business through
the sale of its inventory, or fixed assets, or through acquiring a
debt or issuing new shares for a given period.
• Cash Outflows are the money that the company pays to its
suppliers, creditors, or shareholders (dividends).
 PROFIT AND CASH FLOW
• Profit is the gain obtained from selling your inventory or
services and incurring all necessary costs to operate.
Profit = Total Sales Revenues – Total Costs
• Net Cash Flow is the difference between the cash inflows
and the cash outflows.
Net Cash Flow = Cash Inflows – Cash Outflows
• If the company has little net cash flow then the company
would be insolvent, although it might have high profits.
• The company might also be highly solvent (high net cash),
but suffers from huge losses.
 WORKING CAPITAL
• It is the amount of money needed to pay the daily costs of a
business.

Working Capital = Current Assets – Current Liabilities

• If the company suffers from low liquidity problems, it might have

to liquidate (sell) its fixed assets to finance its essential costs
(such as paying its short term debts).

• Current Assets include cash, Debtors and stock or inventory,

while current liabilities include creditors and bank overdrafts.
 CASH FLOW FORECASTS
• Cash flow forecasts could be calculated through
determining the following accounts:
• Opening Cash Balance.
• Total cash inflows
• Total Cash outflows
• Calculate the net cash flow.
• Closing Cash Balance.
CASH FLOW FORECASTS
STRATEGIES TO DEAL WITH CASH FLOW PROBLEMS
• Reduce Cash Outflows
STRATEGIES TO DEAL WITH CASH FLOW PROBLEMS
• Improve Cash Inflows
STRATEGIES TO DEAL WITH CASH FLOW PROBLEMS
• Look for additional sources of finance
EXERCISE
 JUMA
January February March April May
Opening Balance 10,000 (500) (13,000) (22,000) (34,250)

Cash Inflows 2,000 4,000 5,000 5,500 6,000

Sales Revenues 2,000 4,000 5,000 5,500 6,000
Cash Outflows 12,500 16,500 14,000 17,250 14,500
Material Expense 1,000 2,000 2,500 2,750 3,000
Wages 5,000 5,000 5,000 5,000 5,000
Advertising Expense 3,000 3,000
Loan Repayment 500 500 500 500 500
Rent expense 6,000 6,000 6,000 6,000 6,000
Net Cash Flow (10,500) (12,500) (9,000) (12,250) (8,500)
Ending Balance (500) (13,000) (22,000) (34,250) (42,750)
3.8 INVESTMENT
APPRAISAL
INTRODUCTION

• Investment appraisal tools are used to assess the attractiveness of various

investments , which would enable the investors to take appropriate decisions.
• Investment appraisal tools are:
• Payback Period.
• Average Rate of Return.
• Net Present Value. (HL)
PAYBACK PERIOD
• It is the time needed for a project to pay back its initial cost.
• It is measured in years and months.
 ANNUAL RATE OF RETURN
• It measures the annual rate of return on any investment as a percentage of the
initial cost incurred on this investment.
• Example 1:
Initial cost $200,000
Annual cash flow = $50,000 for eight years.
Even cash flow
Minimum Criterion rate = 10%.
Calculate the average rate of return= ?
Average rate of return = ((Total returns – Initial costs)/number of years)/Initial Cost
x100
ARR = ((50,000x8 – 200,000)/8)/200,000 x100
= ((400,000-200,000)/8)/200,000 x 100
= 12.5%
CHOOSING BETWEEN 2 PROJECTS
• Example 2
• Project A needs $500,000 as initial investments and awards $20,000 for the first 5
years and 100,000 for the following 5 years.
• Project B needs $500,000 as initial investment and returns $50,000 for 10 years.

A) Which project should be chosen based on the payback period, if investors require
maximum 5 years to payback their initial investment.
Payback period for project A = (20,000/20,000) + (20,000/20,000) + (20,000/20,000) +
(20,000/20,000) + (20,000/20,000) + (100,000/100,000) + (100,000/100,000) +
(100,000/100,000) + (100,000/100,000) = 9 years.

Payback period for project B = Initial costs/Annual return (since it is an even cash flow)
= $500,0000 / 50,000 = 10 years.
Both projects are rejected since investors require a maximum of 5 years to get back
their initial investments, and projects A and B require more than 5 years to pay back
the initial cost.
B. Which project should be chosen based on the ARR, if investors require minimum
criterion rate of 8% on their initial investment.
CHOOSING BETWEEN 2 PROJECTS
• Example 2
• Project A needs $500,000 as initial investments and awards $20,000 for the first 5
years and 100,000 for the following 5 years.
• Project B needs $500,000 as initial investment and returns $50,000 for 10 years.

B. Which project should be chosen based on the ARR, if investors require minimum
criterion rate of 8% on their initial investment.
ARR = ((Total Returns – Initial cost)/number of years)/Initial cost x 100
ARR for project A = ((( 20,000x 5 + 100,000x5) – 500,000)/10)/500,000) x 100
ARR for project A = 2%

ARR for project B = ((50,000 x 10) – 500,000)/10) / 500,000) x100

ARR for project B = 0%

Therefore, Projects A & B are rejected since they award a return less than 8% that is
the minimum criterion rate imposed by the investors.
NET PRESENT VALUE (HL)

• It is a method to assess the attractiveness of an investment based on identifying its

net value through subtracting its initial costs from the value of its future cash flows
today.
• The act of determining the value of future cash flows today is called discounting. It
is represented by the discounting factors that take into account various interest
rates and years.
NPV EXERCISE

• Example NPV
An investment needs 50,000 as an initial cost and provides annual cash flows as
follows: 10,000 first 2 years, 20,000 for the following 3 years.
Based on the NPV, should the investor accept this project if the discount rate is
8%.
NPV = Present value of cash flows – Initial cost
Present value of cash flows = (10,000 x 0.9259 + 10,000 x 0.8573 + 20,000 x
0.7938 + 20,000 x 0.7350 + 20,000 x 0.6806
Present value of Cash flows = ……………………….
NPV = …………………… - 50,000 = > 0 accept the project, <0 reject the project.
SOLUTION
DECISIONS BASED ON NPV

• If NPV > 0 => Accept the project.

• If NPV = 0 => Assess the project.

• If NPV <0 => Decline the project.

SOLUTION

a) Straight line method:

Strength: it is a simple and quick method to calculate the depreciation.
Weakness: It is not suitable for expensive assets.

b)
Years Option A Option B
0 (20,000) (40,000)
1 9,500 0
2 11,500 (200)
3 16,500 21,800
4 19,500 26,000
 Years Option A Option B
0 (20,000) (40,000)
1 9,500 0
2 11,500 (200)
3 16,500 21,800
4 19,500 26,000

• Payback period A = 9,500/9500 + 10,500/11,500 = 1 + 0.91 = 1.91 years.

• Payback Period B = 0 + (200)/(200) + 21,800/21,800 +18,400/26,000
• = 1+ 1+ 1+ 0.71 = 3.71 years.
 Years Option A Option B
0 (20,000) (40,000)
1 9,500 0
2 11,500 (200)
3 16,500 21,800
4 19,500 26,000

c) ARR = ((Total Returns – Initial costs)/ years of usage)/ initial cost x 100
ARR for A = (57,000 – 20,000)/4 /20,000 x 100 = 46.25%
ARR for B = (47,600 – 40,000)/4 /40,000 x 100 = 4.75%
 Years Option A Option B
0 (20,000) (40,000)
1 9,500 0
2 11,500 (200)
3 16,500 21,800
4 19,500 26,000

d) Net Present Value = Present value of cash flows – Initial cost

NPV for A = (9,500x0.9615 + 11,500x0.9246 + 16,500x0.8890 +19,500x0.8548) – 20,000
NPV for A = $31,105.25
NPV for B = (0x0.9615 + (-200)x0.9246 + 21800x0.8890 +26,000x0.8548) – 40,000
NPV for B = $1,420.08
• e)
• Advantage: It takes into consideration the current discount rate which matches the
investors’ required rate of return.
• Disadvantage: it is on a discount rate that may be subjective to different investors’
perception.

f) Option B has many benefits such as:

- It repays its initial costs in 3.91 years and has a positive NPV.
- It’s a new project based on new technology that would give the business a competitive
advantage over the existing rivals.
It also has many limitations such as:
- It has high initial costs as compared to project A.
- It has lower ARR and NPV and higher payback period as compared to project A.

Therefore, Maia’s choice of option B may be suitable based on the applied investment
appraisal tool that favor option A since it shows better indicators.
3.9 BUDGETS (HL)
 INTRODUCTION

• A BUDGET IS A FINANCIAL PLAN THAT FORECASTS REVENUE AND EXPENDITURE OVER A SPECIFIED
PERIOD OF TIME.

• THE BUDGET HOLDER IS THE PERSON WHO ESTIMATES THE FINANCIAL PLAN AND MAKES SURE THAT
THE SPECIFIED BUDGET ALLOCATION ARE BEING MET.

• MOST COMMON TYPES OF BUDGET ARE REVENUE BUDGETS AND COST BUDGETS.
 WHY BUDGETS ARE IMPORTANT?
BUDGETS WOULD HELP MANAGERS IN:
• PLANNING: BUDGETS HELP MANAGERS TO REACH THEIR TARGETS
THROUGH PROVIDING A SENSE OF DIRECTION.
• MOTIVATION: STAFF INVOLVED IN SETTING THE BUDGETS FEEL THAT
THEY ARE PART OF THE DECISION MAKING PROCESS.
• RESOURCES ALLOCATION: HOW TO ALLOCATE THE FINANCIAL
RESOURCES BASED ON THE PRIORITY AND AVAILABILITY OF THE
OTHER RESOURCES.
• COORDINATION: BUDGETS INCREASE THE COORDINATION
AMONG EMPLOYEES FROM DIFFERENT DEPARTMENTS FOR A
COMMON PURPOSE.
• CONTROL: BUDGETS WOULD ENABLE THE COMPANY TO LIMIT ITS
COSTS AND AVOID DEBT PROBLEMS.
 COSTS AND PROFITS CENTERS

COST CENTERS: WHERE THE COST OF EACH UNIT IS RECORDED SEPARATELY. IT COULD BE IN THE
FORM OF:

• BY DEPARTMENT: EACH DEPARTMENT WILL HANDLE ITS OWN COSTS; I.E. EACH DEPARTMENT IS A
COST CENTER.
• BY PRODUCT: EACH PRODUCT WOULD INCLUDE ITS COSTS SEPARATELY; I.E. EACH PRODUCT IS A
COST CENTER.
• BY GEOGRAPHIC LOCATION: EACH AREA HAS ITS OWN COSTS SEPARATELY; I.E. EACH AREA IS A
COST CENTER.
 COSTS AND PROFITS CENTERS

• PROFIT CENTERS: WHERE THE PROFIT OF EACH UNIT IS RECORDED THROUGH INCLUDING
REVENUES AND COSTS FOR EACH UNIT.
• THEY HELP MANAGERS TO ASSESS AND COMPARE THE PROFITABILITY OF EACH CENTER.
• THEY COULD BE ALSO DIVIDED INTO PRODUCT, DEPARTMENT, AND GEOGRAPHIC CENTERS.
• FOR EXAMPLE A CAR MANUFACTURER SUCH AS TOYOTA COULD ASSESS THE PROFITABILITY OF
DIFFERENT CAR MODELS.
 ROLE OF COSTS AND PROFITS CENTERS

• HELPING MANAGERS IN THEIR DECISION MAKING PROCESS THROUGH PROVIDING THE FINANCIAL
PERFORMANCE OF EACH CENTER.
• ENHANCING THE ACCOUNTABILITY OF EACH CENTER THROUGH GIVING QUANTIFIABLE INFORMATION
FOR EACH CENTER.
• TRACKING PROBLEM AREAS WHERE IN CERTAIN CENTERS TO BE DETECTED AND TO BE SOLVED
IMMEDIATELY.
• INCREASING MOTIVATION AMONG DIFFERENT CENTERS TO PERFORM BEST AND MEET THE ASSIGNED
TARGETS.
• BENCHMARKING THE BEST CENTERS AND COMPARE THEM TO OTHER CENTERS THAT MIGHT HAVE LOWER
EFFICIENCY.
 VARIANCE ANALYSIS

• VARIANCE IS THE DIFFERENCE BETWEEN THE BUDGETED AND ACTUAL FIGURES.

• VARIANCE ANALYSIS COULD BE FAVORABLE OR ADVERSE.
• FAVORABLE VARIANCE WHEN THE DIFFERENCE BETWEEN ACTUAL AND BUDGETED FIGURES IS
POSITIVE, I.E. BENEFICIAL FOR THE COMPANY.
• ADVERSE VARIANCE WHEN THE DIFFERENCE BETWEEN ACTUAL AND BUDGETED FIGURES IS
NEGATIVE, I.E. FINANCIALLY COSTLY FOR THE COMPANY.