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Accounting & Finance
Unit 5
Accounting & Finance
Topics:
1. Business Finance
2. Costs
3. Accounting Fundamentals
4. Forecasting cash flows and managing working capital
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Accounting & Finance
Topic 1: Business Finance
Finance:
Funds required by a business to operate are called finance. Finance is very important for any
organization as it enables it to meet its expenditures and expansion projects. Every organization
needs to ensure effective management of its financial resources as its shortage could lead to
business failure.
Why a business organization might be needing funds?
A business organization might be needing funds for following reasons:
• A new business would need owner's investment for initial setup e.g. purchase of equipment,
material, for cash payments etc. It may also be termed as start-up capital.
• Most of the private sector businesses set growth as their business objective, for expansion they
might be needing funds.
• Businesses need to expand size of their product mix and for this they need to produce new
products to cater new needs of consumers. For new product development they might be
needing budget for research & development.
• In order to meet day to day (revenue) expenditures business needs to have working capital. A
reasonable amount of finance would also be needed for this purpose.
• Technological environment keeps on changing rapidly. keeping this in mind co. would be
needed to upgrade technology in order to stay competitive and for this purpose it might also
be needing fund.
Expenditures:
Costs which are incurred to produce output.
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Accounting & Finance
Expenditures
Capital expenditures Revenue expenditures
Are expected to return benefit for a longer time Will return short term benefits.
period. Are incurred to ensure smooth operations. E.g.
Are normally incurred to buy fixed assets. E.g. salaries. bills etc.
building, machinery etc. They need a nominal amount of money.
Huge amount is required for them. Short term sources are more likely to be used.
Long term sources of finance are most likely to E.g. working capital.
be used for them. Are recorded in income statement.
Are recorded in balance sheet of the company. Are incurred on regular basis.
Are incurred occasionally.
Explain why different sources of finance are needed for capital expenditures:
• Require huge amount of capital which can just be provided by long term sources of finance.
E.g. share capital, long term bank loan etc.
• Payback time shall be more than a year so short term sources of finances might be suitable.
Working capital:
The amount of capital which a business needs to meet its day to day expenditures. It is the
difference between currents assets and current liabilities. Working capital is also referred as that
part of the firm's capital. which is required for financing short term or current assets such 'as-cash,
accounts receivables and inventories. It is also termed as revolving, circulating. Operating or short
term capital.
Working capital = current assets - current liabilities Positive working capital means that
business will be able to repay its short term liabilities easily, while a negative working capital
means that business does not have enough Working capital to repay its short term debts.
What is meant by the management of working capital?
The management of working capital means that business must forecast the requirement for
working capital and maintain a satisfactory amount which will enable it to pay off its day to day
expenses or short term liabilities easily. E.g. payment of salaries, wages, utility bills, loan interest,
advertising bills, taxes etc.
Importance of managing working capital?
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Accounting & Finance
A business organization needs to ensure effective management of it working capital due to
the following reasons:
• If it will have enough working capital then it will be making regular payments to its suppliers,
hence ensuring continuous supply of raw material for production.
• If business has enough working capital, then it can make prompt payments to its suppliers and
can enjoy cash discount on prompt payments.
• If business will pay off it short term debts in time, then it will lead to a strong credit rating
which encourage banks giving loans easily to business
• If business will have strong working capital, then it might be able to take benefit of market
conditions. E.g. in case of expected shortage of material in future it might be able to buy in
bulk and in the same way it might be able to entertain huge consumer order on time.
• If business will have adequate working capital, then it will have a psychological effect on
managers. This is because no obstacle arises in the day to day business operations. Creditors,
wages and all other expenses are paid on time hence it keeps the morale of managers high.
• If business will have adequate amount of working capital then it will enable it to face business
crisis in emergencies such as depression, because during such periods. generally, there is much
pressure on working capital.
Sources of Finance
Short term and long term finance
Short Term
These sources of finance provide for the working capital for day-to-day running of business
operations. These provide for less than a year.
Long term
These sources of finance provide for a long term, which is more than a year. Usually used in case
of fixed assets and finance take overs etc.
Internal Sources:
1. Sales of Excessive Fixed Assets
2. Sale and lease back option
3. Retained profit
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Accounting & Finance
4. Working capital
External Sources:
1. Bank Overdraft
2. Trade Credit
3. Debt Factoring
4. Hire purchase
5. Leasing
6. Share Capital
7. Mortgage Loan
8. Bank Loan
9. Debentures
10. Venture capital
11. Grants
12. Microfinance
13. Crowd funding
Sales of Excessive Fixed Assets:
In some situations, business might be having some excessive fixed asset. If it needs funds, then it
may decide to sell out these assets to generate funds for its financial needs. E.g. Company has three
vehicles and it has ascertained that it just needs two of them. Third vehicle be sold to generate
funds internally.
Sale and lease back option:
If company does not have any excessive fixed asset and it is not getting funds from any other
source, then it might decide to sell its asset to a leasing company and get it leased back. This will
provide funds to the business: however, it will have to bear additional fixed cost as it will have to
pay rent to the leasing company for using its asset.
Retained profit:
Out of annual profit every organization is going to save some amount which is accumulated in an
account named as retained profit. In other words, it is a saving to meet unforeseen future
expenditures. E.g. every year co. saves 10% of its profit and it is kept as retained profit. Company
has been doing this for past 5 years. If it needs funds, then it can use this amount as an internal
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Accounting & Finance
source of finance. However, this could just be available for established businesses as new
businesses might not be having any retained profit.
Working capital:
It is the amount which needed by a business to meet its day to day expenditures, pay for raw
material and credits offered to debtors. If a business needs funds, then it can reduce its working
capital to release funds. However, it may lead to liquidity problems as business might not be left
with enough working capital to meet its day to day expenditures.
• External sources:
• Short term sources of finance:
• Bank overdraft:
A facility which is provided by a commercial bank to its current account holders
(Businesses), According to this bank allows business to withdraw more amount as
compared to its available balance. E.g. Business has a bank balance of $50,000 and it issued
a cheque of $55,000 to a creditor. Bank pays this cheque; it means overdraft amount is
$5,000. Overdraft amount shall be agreed in advance between bank and business. It is
normally used by business to improve its cash flow position. Interest rate is comparatively
high as compared to bank loan. Overdrawn amount has to be repaid as soon as possible and
interest will be charged on the overdrawn amount.
• Trade credit:
A facility according to which business will get raw material supplies from its suppliers but
payment shall be made after some time. E.g. 3 months. This will serve the purpose of source
of finance as business will get supplies without instant payments. This is normally without
any extra payment; however, business might have to sacrifice cash discount for instant
payment or trade discount for bulk buying.
• Debt factoring:
As a trading practice business will have to sell goods to its customers on credit. Credit
customers are then termed as 'debtors'. Selling constantly on credit basis could lead to cash
flow problems as cash inflows will be reduced. In order to overcome this problem business
has an option of selling its debtors to a credit loan firm, who is later termed as a 'factor'. In
order to explain this let's take an example: Mr. A sold good to Mr. B worth $5,000 on credit
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Accounting & Finance
and payment is due in November in July Mr. A needs funds so he goes to a factor (credit
loan firm) and requests it to pay him in July and collect payment for Mr. in November.
Factor pays $4500 to Mr. A. Factor will later on collect full payment of $5,000 from Mr.
and $500 shall be his profit.
• Hire purchase:
This is medium term finance. Business might use it to acquire some fixed assets. This could
also be termed as installment buying. The use of this method might prevent business
making huge payments to buy fixed assets and leading to cash flow problems.
• Leasing:
In this business will acquire a fixed asset e.g. a construction co might acquire a machine
from a leasing company on rental basis. It will continue to make a rental payment to leasing
company till it wants to use machine. Benefit of this will be that business will not have to
incur a capital expenditure to buy it. Repair & maintenance asset shall be the responsibility
of the leasing company and business will keep getting latest technology from leasing
company. At the end it will not be compulsory for business to buy ownership of asset.
• Long term sources of finance:
• Share capital:
Private limited company can raise capital by selling shares to its friends and family where
as a public limited company raise funds by selling shares to through stock exchange. These
shareholders will share profit and loss of the company.
• Mortgage loans:
This is a form of secured bank loan. In this borrower will have to pledge some of its
property with the bank as a security against loan. Borrower can get huge amount of loans
and interest rate is comparatively low as compared to un-secured loans. This type of loan
is available for a very long period of time. E.g. 20 years.
• Long term bank loan:
It is form of un-secured loan. Borrower might not be needed to pledge any property as
security for loan. This type of loan can provide a reasonable amount of money to borrower.
Interest rate might be comparatively high as compared to secured loans.
• Debentures:
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Accounting & Finance
It is only available for a public limited company. It is a long term loan given by the general
public to a public limited company. As a proof of loan plc issues a certificate known as
debenture. Debenture holders will earn a fixed %age of interest every year on their
investment and they will be recorded as a long term liability in balance sheet of the co. they
will not be concerned with the profitability of the company. Interest is going to be a must
payment for the co. In some countries they are also known as bonds, loan stock or note.
Sometime Govt. might also issue these bonds in order to secure capital.
• Venture capital:
There are going to be companies (venture capital firms) who might provide finance to
business who are either at the initial stage or if they want funds for expansion. This could
also be provided to businesses with high potential, high risk growth start-up companies.
Venture capital is a form of 'risk capital'. In other words, capital that is invested in a project
(a business) where there is a substantial element of risk relating to the future creation of
profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and
investor requires a higher "rate of return" to compensate him for his risk. Venture capitalists
assume by investing in smaller and less mature companies, venture capitalists usually- get
significant control over company decisions. Venture capital firms usually invest for
between three and seven years or more The duration/term of investment is often linked to
the growth and profile of the business.
• Government Grants:
Federal and state governments often have financial assistance in the form of grants and/ or
tax credits for start-up or expanding businesses. Objective could be to speed up rate of
economic growth or to increase employment opportunities in the country.
• Microfinance:
Providing financial services for poor and low-income customers who do not have access
to banking services, such as loans and overdrafts offered by traditional commercial banks.
• Crowd funding
the use of small amounts of capital from a large number of individuals to finance a new
business venture. This is usually on an on-line platform.
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Accounting & Finance
• Factors to be considered while selecting source of finance:
factor in consideration Explanation
Time factor If business needs it for less than a year then
short term source of finance might be used, but
if it needs for more than a year then medium or
long term source might be used.
Type of business Loan from friends and family can be used by
businesses such as sole trader or partnership
and in the same way debentures are just
available for public limited companies.
Amount required If business needs a nominal amount of money
then it might use internal or external short term
sources, but in case of huge amount it will have
to use external long term sources of finance.
Gearing ratio If business is highly geared (more loans) then
it will prefer to sell share to raise more capital
to decrease its gearing or vice versa.
Risk factor For high risk projects co. might use share or
venture capital instead of using loan capital.
Cost factor Business will obviously select a source of
finance with lower/reasonable cost. E.g. rate of
divided or interest rate.
Financing requirements If bank requires any collateral security and
business cannot provide then in this case
business will have to use un-secured loan or
share capital.
