Financial Information and Decisions

Imagine sitting in a pool of cash. Enough imagining. Now, back to reivisng!

Key Terms

Term	Definition
Finance	The money required in the business to set up, expand, and increase working capital.
Start-up Capital	The initial capital used to buy assets before trading commences.
Working Capital	The finance needed by the business to pay its day-to-day running expenses.
Capital Expenditure	The money spent on fixed assets that will last more than a year. These are long-term capital needs.
Revenue Expenditure	The money spent day-to-day on short-term assets.

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For the tables in this chapter, please scroll towards the right to view the entire table (each table has an individual scrollbar for this purpose).

Sources of Finance

There are four key types of finance that we will cover as a part of the syllabus. Each has its own advantages and disadvantages, and companies constantly make decisions with tradeoffs to raise funding to grow their businesses.

Types of Finance

Short-term Finance: Provides the working capital needed for the business.
Long-term Finance: Financing available for more than a year.
Internal sources of Finance: Obtained from within the business.
External sources of Finance: Obtained from external sources outside of the business.

Short-term Finance

a group of coins — The size of capital needed in short-term finance is typically small

If a company needs working capital to continue fulfilling its day-to-day operations, it looks to raise short-term capital. There are a number of ways in which companies raised short-term financing (please refer to the table below).

Also, the amount of money raised through short term financing is typically lower than that of long term financing.

Source	Meaning	Advantages	Disadvantages
Overdrafts	Similar to loans, but banks can spend more than what is in their bank	Flexible form of borrowing money Interest has to be paid only on the amount overdrawn Cheaper than loans in the long-term	Interest rates vary and are not fixed Banks can ask for overdraft to be paid sooner than expected
Trade Credits	Delaying paying suppliers for some time to improve cash position	No interest or repayments involved	If payments are delayed for a long period of time, suppliers may refuse to give discounts or refuse to supply at all
Debt Factoring	Please refer to the 'Debt Factoring' section in the table 'external sources of finance'

Long-term Finance

rectangular red Supreme container — The size of capital to be raised through long term finance is typically large

This is the type of financing that helps a businesses grow. Since the amount of money raised through this type of finance is typically large, businesses take more time to raise capital through these sources..

Source	Meaning	Advantages	Disadvantages
Loans	Please refer to the table 'external sources of funding' for more information
Debentures	Please refer to the table 'external sources of funding' for more information
Issue of Shares	Please refer to the table 'external sources of funding' for more information
Hire Purchase	Allowing the business to buy a fixed asset and pay for it monthly that includes interest	Firm doesn't need a large sum of cash to acquire the asset	A cash deposit has to be paid Large interest charges may be present
Leasing	Allows the business to use an asset without purchasing it. Monthly payments are made and at the end of the leasing period, the business can decide if they will buy the asset or not	Firm doesn't need a large sum of money to use the asset Care and maintenance taken care of by the leasing company	Total cost for leasing the asset may end up more than the cost of purchasing the asset

Internal Sources of Finance

a person sitting at a table with a laptop — Profitable businesses tend to have internal sources of revenue

As the name suggests, internal sources of finance include sources of finance that come from within the business. Creating internal sources of revenue take time for any business, which also helps them to be financially sustainable in the long term.

Source	Meaning	Advantages	Disadvantages
Retained Profit	The profit kept in the business that can be re-invested after owners have been given their share of profit	Does not have to be repaid No interest to be paid	Profit may be too low More profit used as capital will reduce owners' share so they may be hesitant A new business will not have retained profit
Sales of Assets	The selling of assets that are no longer needed to gain finance	Is not debt for the business Makes better use of capital tied up	Time-consuming and expected amount may not be gained New businesses may not be able to sell assets
Sales of Inventories	Sell finished or unwanted goods in inventory	Reduces cost of inventory holding	If too much is sold, when unexpected demand comes they cannot be all fulfilled
Owner's Savings	For a sole trader and partnership, any finance the owner invests from their savings	Available to the firm quickly No interest to be paid	Increased risk by the owner

External Sources of Finance

three flag of America on concrete building during daytime — NYSE (New York Stock Exchange) building

External sources of finance are a great opportunity for a business to expand its operations and grow. However, they come with strings attached.

Source	Meaning	Advantages	Disadvantages
Issue of Share	Selling of shares in limited companies only	No interest Permanent source of capital	Dividends have to be paid Too many shares sold can make the founders lose control of the business
Bank Loans	Money borrowed from banks	Quick to borrow Can be for a very long time Low interest for large companies	Need to pay interest regularly It has to be repaid Need to give bank collateral security
Debenture Issues	Long-term loan certificates issued by companies that people buy and repay soon with interest	Can be used to raise money for very long-term finance	Interest has to be paid and repaid
Debt Factoring	Special agents that collect debt from debtors	Immediate cash available Business doesn't have to manage it	Debt factor will get a percent of the debts collected
Grants and Subsidies	Government or other agencies that can give a business a grant or subsidy	Doesn't have to be repaid	There are certain conditions to be fulfilled such as locating in a particular area
Microfinance	Financially lacking people get small sums of money	Guaranteed way for new businesses to earn money	Money may not be enough to start a business
Crowdfunding	Asking for small funds from a large pool of people	Voluntary; don't have to be repaid or paid a dividend	People may be hesitant/unsure if their business plan isn't convincing

Factors affecting choice of source of finance

Purpose: If fixed assets are to be bought, then leasing or hire purchase is suitable. If finance is needed to pay off expenses, then overdrafts or debt factoring will be used.
Time period: Long-term or short-term?
Amount needed: How much money is required?
Legal form and size: Issue of shares are for limited companies only.
Risk amount: If the business already has loans, then borrowing more capital can increase risks as more interest rates are to be paid.

Deciding factors affecting why Shareholders invest

An increase in the company's share price (as a result of good performance) can increase the returns of the shareholder's investment
If the company is profitable, and issues a dividend, it creates an additional source of passive income for the shareholder.
They see the potential for growth in the company's business over the long term.

Deciding factors affecting the approval of loans to businesses (from Banks)

The company's business plan shows how the money will be used, and if the company will be able to increase its revenue by doing so.
A clean track record/ financial history of the company showing consistent growth over a long time as seen through the income statement and pro-forma income statement (future income projections)
Evidence of collateral security is available, and its size. (In case the company is unable to repay its loan, the collateral can be seized by the bank).

Cash is essential as workers, suppliers, landlords, and government taxes need to be paid. The business could go into liquidation which is selling everything it owns to pay debts if it is unable to keep up with its payments.

Cash Flow

a pile of twenty dollar bills laying on top of each other — Close your eyes and think of the smell of money. Ok. Back to work now!

Cash Flow: The cash flow of a business is its cash inflows and cash outflows over a period of time, usually monthly.

Example of a Cash Flow Statement

Cash Flow Statement For the month ending December 31, 2023

Category	Inflows	Outflows	Net Cash Flow
Operating Activities
Sales Revenue	$100,000
Cost of Goods Sold		$60,000
Depreciation Expense		$10,000
Other Operating Expenses		$20,000
Net Cash Flow from Operating Activities			$10,000
Investing Activities
Purchase of Equipment		$25,000
Net Cash Flow from Investing Activities			-$25,000
Financing Activities
Borrowing from Bank	$50,000
Net Cash Flow from Financing Activities			$50,000
Net Increase (Decrease) in Cash			$35,000
Beginning Cash Balance			$10,000
Ending Cash Balance			$45,000

Cash Inflows

The sums of money received by the business over a period of time:

Sales revenue
Payment from debtors
Money borrowed from external sources
Investments

Cash Outflows

The sum of money paid out by the business over a period of time:

Purchasing goods and materials
Paying wages and other expenses
Purchasing fixed assets
Repaying loans

The Cash Flow Cycle

The business needs cash to pay for expenses such as raw materials, wages and rent.
To gain the cash, goods/services are produced and sold.
Cash is received for the goods/services sold and the expenses are paid for.

Cash Flow vs. Profit

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Cashflow and Profit are NOT the same.

Profit is defined as the revenue after expenses have been paid, while cash flow is cash that flows in and out of the business.
Profit indicates the major indicator of the business success, where cash is needed to keep and operate the business successfully.
Profit is the payments received or paid or not yet received while cash flow considers elements paid by cash only.

Cash Flow Forecast

Cash flow forecast is an estimate of future cash inflows and outflows. This helps the manager:

Tell how much cash is available for paying expenses.
Tell how much cash the bank will need to lend to the business.
Tell whether the business has too much cash that can be put to a profitable use.

Important notes:

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Net Cash Flow = Total Cash Inflow – Total Cash Outflow.

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Closing balance = Opening Balance + Net Cash Flow.

The opening cash/bank balance is the amount of cash held by the business at the start of the month.
The closing bank balance of a month is the opening balance of the next month.
Net Cash Flow is the Cash Inflow – Cash Outflow.
Figures that are negative are placed in between brackets.

Factors Affecting Cash Flow Forecast

Forecasted cash flow may change because of external events such as:

Increased interest rates, which causes more cash outflow.
Weather, which will change the number of goods sold to the customer.
Inflation, which increases costs of goods which reduces customers.
Competition, which attracts customers away.

Uses of Cash Flow Forecasts

When setting up a business so managers can know how much cash is required to set up such as rent, wages and advertising etc.
Required by bank managers when applying for a loan, so the bank will decide on a suitable amount to lend and when it needs to be paid back.
Managing cash flow, such as if a negative value is given. The business can then plan ahead and apply for an overdraft to avoid a negative balance. If too much cash is available, loans may be paid off as well as suppliers to maintain a healthy relationship.

How to Overcome Cash Flow Problems

Increase bank loans, even though interest payments have to be paid.
Delay payment to suppliers which decreases cash outflow. However, this can affect the relationship.
Ask debtors to pay more quickly, which increases cash inflow. The debts include credit customers who will be asked to pay by cash on the spot rather than credit sales.
Delay purchases of capital equipment, which reduces cash outflow significantly. However, efficiency is lost as old technology is used rather than new.

Long-term solutions to improve cash flow

Expand product offerings and diversify sources of revenue
Increase operational efficiency by reducing waste and cutting costs where possible
Optimally price products in a way where the price dynamically meets the changes in supply and demand.
In businesses with inventory, improve demand forecasting, reduce holding costs, and increase inventory turnover.

Working Capital

person preparing cooked dish — Most restaurants need working capital to keep their doors open.

Working capital is all the liquid assets of the business that can be quickly converted to cash to pay off short-term day-to-day expenses such as debts. It can be in the form of:

Cash is needed to pay expenses.
Cash due from debtors, which is when they are asked to pay quickly.
Cash in the form of inventory, which is when finished goods are quickly sold to reduce high inventory costs/storage.

Restaurants are typically very working capital intensive since money for purchasing ingredients, pay workers, pay leasing costs, and utilities need to be paid in advance to be able to serve guests.

Accounts and Profit

Accounts are the financial records of a firm's transactions. Final Accounts are prepared at the end of the financial year and give details of the profit or loss made.

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Profit = Sales Revenue – Total Cost

When the total costs exceed the sales revenue, a loss is made. To increase profit:

Increase sales revenue- this can be done by increasing the price of products/services or by increasing the quantity of products/services sold.
Double down on profitable products or services and discontinue unprofitable sources of revenue.
Increase productivity of the employees.
Reduce costs (these include cost of goods sold, operating costs, etc).

Importance of Profit

Profit is important to a business because:

It is a reward for the enterprise. Entrepreneurs start a business to make a profit.
It is a reward for risk-taking. Entrepreneurs take considerable risks when investing capital and profits are compensation/reward to them for taking these risks.
It is a source of finance. After payments to owners, the money left is retained profit, which can be reinvested back into the business.
It is an indicator of success. More profits indicate to investors that the business is worth their time and money, making them more likely to invest.

In social enterprises, profit is not the main objective. However, they will still try to make some profit by reinvesting in the business to help it grow.

Income Statements

An income statement is a financial document of the business that records all income generated by the business as well as the costs over the financial year. It is also known as a profit and loss account.

Now, there's going to be a lot of light bulbs going off. Brace yourself 😄

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Gross Profit = Sales – Cost of Sales

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Cost of Sales = Total Variable cost of Production + (Opening inventory of finished goods – Closing inventory of finished goods)

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Net Profit = Gross Profit – Overhead Expenses

Overhead expenses are all the fixed costs.

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Profit after Tax = Net Profit – Tax

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Retained Profit = Profit after Tax – Dividends

Dividends are a share of profit given to shareholders

Purpose of Income Statements

Know the profit/loss made by the business.
Compare performance with previous years and with competitors. If profit is lower, they can find why it fell and how to correct the issue. If it's lower than competitors, they can find out how to be more profitable and competitive.
Know the profitability of products by preparing separate income statements for each product. They can then stop manufacturing products that are making little to no profit.
Help decide which products to launch by preparing forecast income statements. Whichever product has a higher forecast will be chosen.

Example of an Income Statement

Income Statement For the year ended December 31, 2023

Item	Amount
Revenue
Sales Revenue	$1,000,000
Other Income	$50,000
Total Revenue	$1,050,000
Cost of Goods Sold
Beginning Inventory	$100,000
Purchases	$800,000
Less: Ending Inventory	$120,000
Cost of Goods Sold	$780,000
Gross Profit	$270,000
Operating Expenses
Selling Expenses	$100,000
Administrative Expenses	$50,000
Depreciation Expense	$30,000
Total Operating Expenses	$180,000
Operating Income	$90,000
Other Income and Expenses
Interest Income	$10,000
Interest Expense	$20,000
Net Other Income (Expense)	-$10,000
Income Before Taxes	$80,000
Income Tax Expense	$24,000
Net Income	$56,000

Balance Sheet

A balance sheet for a business is prepared at the end of every financial year. They show the:

Company's financial position at a specific point in time
Assets and Liabilities of the business - what the company owns and what it owes.

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Helpful Note: A balance sheet is also known as a Statement of Financial Position

Assets

Assets are items that are owned by the business.

Fixed/Non-Current Assets: Assets that remain in the business for more than a year. Their value falls over time in a process called depreciation. E.g., Buildings, Vehicles, Equipment, etc.
Short-Term/Current Assets: Assets that are owned only for a very short time. E.g., Inventory and debts from customers.
Intangible non-current assets: Assets that cannot be touched or felt. They include copyrights and patents.

Liabilities

Liabilities are debts owed by the business to its creditors.

Non-Current Liabilities: Liabilities that do not have to be repaid within a year. E.g., loans, debentures, etc.
Current Liabilities: Liabilities that need to be repaid within a year. E.g. overdrafts, trade payables etc.

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Working Capital = Current Assets – Current Liabilities

Shareholders' Equity: The total amount of money invested in the company by shareholders. This includes the share capital and reserves. Shareholders can see if their stake in the business has risen or fallen by looking at the total equity.

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Shareholders Equity = Total Assets – Total Liabilities

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Total assets = total liabilities + shareholders' equity

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Capital employed = shareholders' equity + non-current liabilities

Note: you can access all these formulas in one place on our IGCSE Business Studies Formulas page.

Example of a Balance Sheet

Example Balance Sheet

Assets		Liabilities and Equity
Current Assets		Current Liabilities
Cash	$50,000	Accounts Payable	$30,000
Accounts Receivable	$80,000	Salaries Payable	$10,000
Inventory	$120,000	Notes Payable (due within a year)	$20,000
Prepaid Expenses	$10,000	Total Current Liabilities	$60,000
Total Current Assets	$260,000	Long-term Liabilities
Property, Plant, and Equipment		Notes Payable (due after a year)	$50,000
Land	$100,000	Total Long-term Liabilities	$50,000
Building	$200,000	Total Liabilities	$110,000
Equipment	$50,000	Equity
Less: Accumulated Depreciation	$50,000	Common Stock	$100,000
Net Property, Plant, and Equipment	$300,000	Retained Earnings	$150,000
Total Assets	$560,000	Total Liabilities and Equity	$560,000

Uses of Balance Sheet

To check if the business is liquid. This is done by comparing current assets with current liabilities.
Debt-equity ratio. This is comparing the total liabilities to the total assets.
To see if the firm will be able to pay back its debt. This is done using the Debt to Equity Ratio.
Investors can check if the dividends paid to them are suitable.
Any assets that can be potentially sold off can be checked.

Financial Ratios

person wearing suit reading business newspaper

Profitability Ratios

Profitability is the ability of a company to use its resources to generate revenues in excess of its expenses. These ratios are used to see how profitable the business has been in the year.

ROCE (Return on Capital Employed): Calculates the net profit earned on each unit of capital employed. The higher the ROCE, the better.

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ROCE = (Net Profit / Capital Employed) × 100%

Gross profit margin: This calculates the percentage of gross profit made on each unit of sales revenue. The higher the GPM, the better. If this increases this means that prices have increased and cost of goods have decreased.

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Gross profit margin = (Gross Profit / Sales Revenue) × 100%

Net profit margin: This calculates the net profit generated on each unit of sales revenue. The higher the NPM, the better. If this increases, this means the gross profit increased and overhead expenses decreased.

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Net profit Margin = (Net Profit / Sales Revenue) × 100%

Liquidity Ratios

Liquidity is the ability of the company to pay back its short-term debts. If the working capital is low, it will go illiquid meaning it will be forced to sell assets.

Current Ratio: The ratio that calculates the proportion of current assets to every current liability. A value above 1 is good, with 1.5-2 being ideal. The higher the better but too high indicates that too much money is invested in assets which is risky. A number lower than one means the business has cash flow problems.

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Current Ratio = Current Assets / Current Liabilities

Acid Test Ratio/ Liquidity Ratio: This ratio doesn't consider inventories to be a liquid asset as it takes time to convert it to cash. A high inventory can cause a big difference between the current and liquid ratio. A value of 1 means the company is just able to pay off their short-term debts. A value below 1 means the managers have to take action as this is worrying, such as reducing the level of inventories.

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Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities

Uses and Users of Accounts

Managers

Use them to help keep control over the performance of each product since they can see which product is profitably performing.
Better decisions can be made, such as cutting expenses.
Ratios can be compared with other firms, to ensure they are still in the market and are doing better than rivals.

Shareholders

It is a legal requirement that they be presented with the company's financial account information.
It helps them decide whether they should invest by buying shares. Higher profitability means higher dividends.
Ratios can be compared with other companies and the highest ratio is the company they will invest in.

Creditors

The position and debts of the business can be determined. They will be ready to supply the business if they will be able to pay them.
If there are liquidity problems, they will be hesitant to supply them.

Workers and Trade Unions

Helps them see if the business is secure, by checking if workers will lose their jobs or not.

Banks

They will look at how risky it is to lend to a business. They'll only lend to profitable and liquid firms.

Governments

Helps determine a fixed tax rate and to see if the business is profitable and liquid to continue operating which will ensure job security.

Other Businesses

Helps them compare performance and decide on takeovers.

Limitations of Using Accounts and Ratio Analysis

Ratios are based on old data, meaning the forecasts may not be accurate.
External users may not get the full picture about the business as managers only publish required documents. Some documents are kept within the business.
Data comparison over the years leads to misleading assumptions as inflation affects the prices.
Different companies use different accounting methods, making comparisons unreliable.

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