BUSINESS ACCOUNTING AND FINANCE - Chapter 6

Fixed costs are cost that do not vary with output in the short-term when the firm alters its level of output.
Examples are fixed costs are rent, insurance, depreciation and must be paid irrespective of the level of output.

Variable costs are those expenses that change directly with the volume of output. Examples might include raw
materials and labour. These costs will depend on the level of production and sales.
Examples are :
OI~
The cost of nails for a building contractor. (More houses sold = more nails bought).
The cost of paper for a printing company. (More jobs printed = more paper used)

Sales Revenue is the total amount of money the business earned from sales of goods and services during a
given period.

The formula is:

Sales Revenue = Volume of goods sold X Average Selling Price
e.g if sold 1,000 units at RM1.50 per unit
Sales Revenue - 100 X RM1.50 = RM1,500.00

Working Capital is the finance needed by the firm for the day-to-day running of the business. The control of
working capital is important to ensure it has enough finance to meet its needs and to make sure that there is
enough cash to meet future orders.

The formula is:

Current Assets - Current Liabilities = Working Capital

Budget
A budget is a target for costs or revenue that a firm or department must aim to achieve in a time period. It is a
list of planned revenues and expenses. The purpose of budgeting is to ensure that no department in a
business spends more than the company expects. A budget is used for providing information for supporting
management's decisions.

Profit is the gain from investment or business operations after subtracting all expenses. It is used to pay
shareholders in the form of dividends or to reinvest into the business to purchase property and machinery.

Profit earned from the business can be used to measure the level of success of the company or investment.

The formula is:

Profit = Sales Revenue - Total Costs

Retained Profits are profits earned which are kept in the business (i.e. not distributed to the owners via
dividends or other payments). A

Net Profit is the difference between a firm's sales revenue and all costs and tax by the government . The costs
include operating costs such as materials and labour and indirect costs such as insurance, rent, advertising and
tax on profit.
Sales Revenue - Total Operating Costs- Taxes = Net Profit

Gross Profit is the difference the revenue and the cost of making the product or service. It is important as it
indicates how efficient the company uses its raw materials and labour in the production process.
The formula is:
Sales Revenue - Cost of the Goods sold = Gross Profit

Ref: TSK Oct-2011 1/5

 BUSINESS ACCOUNTING AND FINANCE - Chapter 6
Breakeven is the where the firm's revenue equals to the total costs (Fixed costs and variable costs). There is
neither a profit or loss. For newly established companies , breakeven is one of its first goal.
The formula is:
Breakeven Sales Revenue = Total Costs

Current ratio = Current Assets / current Liabilities

Current ratio (or liquidity ratio) measures the company's ability to meets its short-term debts. The bank will be
looking for a ratio of approximately 2 to 1 i.e. twice as many currents assets to meet its current liabilities.

Current Assets are anything owned by an organisation that is likely to be turned into cash within one year.
Examples of current assets are stocks, debtors and cash.

Current Liabilities are short terms debts of the business. These include all payments due within one year.
Examples are overdraft, creditors, dividends due and unpaid tax.

Gearing ratio = Long term liability / Total capital employed x 100%

The gearing ratio measures the proportion of the company's capital is consist of long term loans. The higher
the ratio , the more likely the company be be affected by the rising interest rates and therefore the greater the
risk. A high ratio means a large proportion of the capital is long-term loans; hence banks will choose not to
lend to the company due to the high risk factor. Bank would be looking for a low gearing ratio

Return on capital employed (ROCE) = Operating Profit / Total capital employed x 100%
The ROCE measures the return on the capital employed in the business. It is a measure of the profitability and
efficiency of the investment. Bank would be looking for a high ROCE as this means the company would be able
to pay back the loan.
ROCE tells us how much profit we earn from the investments the shareholders have made in their company.

Debenture is another form of loan; a loan contract taken out with a lender (example , a bank) . The lender is
not an owner but a creditor and you undertake to pay interest on a regular basis and to repay the loan at an
agreed time. Debentures are usually secured on the assets of the business which means the debenture
holders have first call on those assets should the company not be able pay meet its obligations to pay interest
or repay the loan.

A leasing company can provide a business with new assets such as machinery and vehicles without having to
buy them outright. The leasing company rents the assets to the business for an agreed monthly payment. At
the end of the leasing period, the assets are returned to the leasing company. The Company can start to lease
again for the more modern versions of machinery. This allows the business to renew its vehicles and
equipment without having to find large amounts of capital.

Question : - When do you use leasing?

Leasing is used when the business is not willing to commit large capital to buy assets and is used when the
business is uncertain. It is also used because of rapid technology changes and the business needs to update its
equipment regularly. Leasing can also have tax advantage as leasing amount paid is an expense.
At the end of the leasing period, you can have an option to end the lease or buy back the asset. If you buy
back the asset then is is called lease/purchase.

A Hire Purchase is a means of buying capital assets by paying a deposit and regular instalments over a period
of time. Finance houses, retain ownership of the equipment until the last payment has been made.

Ref: TSK Oct-2011 2/5

 BUSINESS ACCOUNTING AND FINANCE - Chapter 6

A factoring company provides finance to bridge the gap between the issue of invoices by a company and the
receipt of the payment i.e. the period of credit. Usually the factoring company will provide 80% of the invoices
value as soon as the invoice is issued to the customer. At the end of the credit period, the factoring company
will collect the total due from the customer. It will send the balance of 20% minus its own charges to the firm.
The business benefits by receiving the bulk of its money at the time of the sales and hence can use the fund
first to fund its business. The customer still retains the same credit period and the factoring company earns a
percentage of the invoice total for extending credit/fund to the business.

A bank overdraft is a flexible loan facility provided by a bank. The advantage is that the business can withdraw
money it its account up to an agreed limit and only pay interest for the amount use . It is a simple and quick
form of short-term loan. The disadvantage is that it can be expensive as banks normally charge higher interest
for overdraft plus an arrangement fee. Another disadvantage is that it can be recalled at any time.

A bank loan is a formalised agreement between the borrower and the lender, normally a bank. The capital
borrowed must be repaid over a stated period together with interest in regular instalments. Examples of such
loan are as car loan or a house loan.

Trade credit is an arrangement between businesses to buy goods or services on account, that is, without
making immediate cash payment i.e. buy now and pay later . The supplier typically provides the customer with
an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should
pay. Example 30 days or 60 days credit. Business can now use money to buy more stocks or for other business
purpose.

Question : - For the following situation, explain what is the most suitable source of finance :- A
Company with a cash flow problem that is having difficulty collecting its debts.

This is a short-term problem that results in business short of cash to fund their current operations. The short-
term sources are designed for less than one year are as follows:-

1 Approaching a bank for an overdraft. Interest is only paid on the amount used and is useful source for extra
cash.

Negotiating for longer trade credit. This will allow the firm to receive goods and materials for an agreed period
2 without payment i.e. buy first and pay later. The aim is to collect money from debtors before payment to
creditors.

Where debtors are reliable it is possible to use factoring to solve the problem . The factoring company will
3 pay the invoice value of up to 80% to the firm upon receipt of the invoice. Upon payment of this invoice from
customer , the factoring company will then pay balance of 20% minus their charges to the firm. This method
allows the firm to use the cash first instead of waiting until the credit term is due.

Question : - A firm wishes to borrow £1 m to invest in new machinery. Explain why a bank would
need to analyse each of the following financial statements of the firm before approving such a loan.
i) Profit and Loss Account ii) Balance Sheet and iii) Cash flow Statement

The purpose of a Profit and Loss Statement is to determine if the business has made a profit or a loss. This will
show how successful the business is. The statement will show in detail the sales revenue and the operating
costs and the profit. This statement can be used to inform and reassure the bank and other shareholders on
the profitability of the company. As for the bank, it can use it as a tool to see whether the firm can afford to
pay if the bank gives a loan to the firm.

Ref: TSK Oct-2011 3/5

 BUSINESS ACCOUNTING AND FINANCE - Chapter 6

The Balance sheet shows the assets and liabilities of a business ; i.e. net wealth of the business. Shareholders
wish to see growth in the net value of the business The balance sheet also shows how much capital is funded
by shareholders and how much the capital in the business has been borrowed. The bank would be interested
to see if the business had enough assets to act as collateral to guarantee repayment of the loan.

A Cash flow Statement is concerned with the cash in and cash out of the business. It shows the source and
use of money by the firm over the financial year. The statement shows the firms' liquidity position at the
beginning and end of the year. This enables the bank to assess the firm's ability to meet its short-term
liabilities.

Medium and Long Term finance - FOR FUTHER DETAILS REFERT Page 107 & 109

1 Shares Issues - offer new shares to public to raise capital

2 Loan Stock - issue loan stock . Purchasers of loan stock become creditors and not shareholders

3 Debentures - a loan contract taken out with the lender(for example a bank) ; business borrow money and
pay interest on a regular basis and repay loan at agreed period.

4 Leasing - a form of hire used for purchasing fixed assets such as computer , vehicle and machineries

5 Commercial mortgages - raise capital using commercial mortgages of premises (60 - 70 % of property value)
as security.

6 Assets sales - raise capital by selling surplus assets (assets no longer in use) and convert to cash and to be
used to purchase new assets or repay debts.

7 Sale and leaseback - The business owns premises and needs funds; it may sell the premises and arrange to
lease back. This type is also suitable for large machinery.

8 Bank Loans - The business has to pay back a fixed rate of interest and a monthly repayment of loan
throughout the agreed loan period.

Grants - This is a support by the government to business under certain circumstances; some regions have a
9 high unemployment rate and living standards or the predominant business decline. The main attraction of
this loan is free finance and there is no interest charges or repayment of capital.

Types of shares - refer Page 114 & 115 - Ordinary shares, Preference shares & Rights issues

Working Capital - Management of stocks, Management of Debtors and Management of Cash - Page 117-119

Ref: TSK Oct-2011 4/5

 SALE AND LEASEBACK

Arrangement in which one party sells a property to a buyer and the buyer immediately leases the
property back to the seller.

With a sale and leaseback you can continue to use your equipment, so productivity never slows
down, and your revenue should remain constant. The extra capital you get can be applied to
expanding your business and increasing revenue as it can be used for any purpose.

At the end of the lease period, you can return your assets and acquire (buy) new technology to
avoid technology obsolescence (no longer wanted) . Another advantage , the selleer gets tax
advantage.

Debentures and bonds are similar, but bonds are more secure than debentures. In the case of
both, the company pays you a guaranteed interest that does not change in value irrespective of
the fortunes of the company. However, bonds are more secure than debentures, and carry a
lower interest rate. In the case of bonds, the company provides collateral for the loan. Moreover,
in case of liquidation, bondholders will be paid off before debenture holders.

Ref: TSK Oct-2011