Finance and Accounting

Sources of finance
Every business whether it is new or existing needs finance for different activities such as starting
a new business, expansion to production capacity, developing and marketing new products,
entering new markets, moving new premises, and to pay for the daily expenses. A source of
finance could range from short term to long term. And it could be either internal or external.
Short term: Usually taken for less than ONE year.
Medium term: Usually taken to mean between ONE and FIVE years.
Long term: Usually referring to finance OVER FIVE years.

The costs of finance

Rate of Interest
Security
Personal guarantees

Short term Finance

Retained profit or ploughed back profit
Businesses (especially limited companies) usually keep some part of the profit every year for
future use. This is also known as ploughed back profit. Over a period of time it can total up to a
huge amount which can be used for financing the business.
Advantages

No need to pay interest

Any time it can be used
Less legal formalities
No repayment
Doesnt increase liabilities

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Disadvantages
It affects shareholders dividends
All the companies may not have retained profit
Bank Loan
Some banks loans are short term and have to repay within a year. Advantages and disadvantages
of bank loans will be discussed later.

Bank Overdraft
Bank overdraft is a facility given by banks to its business customers, people having current
accounts. Through this facility the customers can overdraw their accounts to a greater value than
the balance in the account. To overdrawn amount is agreed in advance with the bank manager.
The bank assigns a limit to overdraw from the account and the business can meet its short term
liabilities by writing cheques to the extent of limit allowed.
Advantages
No need for collaterals or security.
More flexible and the overdraft amount can be adjusted every month according to needs.
Disadvantages
Interest rates are usually variable and higher than bank loans.
Cash flow problems can arise if the bank asks for the overdraft to be repaid at a short
notice.
Trade credit
Usually in business dealing supplier give a grace period to their customers to pay for the
purchases. This can range from 1 week to 90 days depending upon the type of business and
industry. By delaying the payment of bills for goods or services received, a business is, in effect,
obtaining finance which can be used for more important expenditures.
Advantages
No interest has to be paid.
Helps to solve temporary financial problems
Less legal formalities
Disadvantages
Used only for short-term purposes
Small amount
Prices of goods are high
Not available from all creditors

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Customer prepayments
Some situations customers are persuaded to pay a percentage of the total amount of the product
or services even before the goods or services are delivered. This advance money could be used
by the business for different purposes.

Invoice Factoring (Debt factoring)

It involves the business selling its bills receivable to a debt factoring company at a discounted
price. In this way the business get access to instant cash. The way factoring work is shown
below.

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The selling company X sells goods to the buying company Y on 30 days credit. (1). A copy of
invoice is sent to the factoring company, then factoring company will pay 80% of the invoice
amount to the company X. (2)
In 30 days time, Company Y (buying company) will make its payment to factoring company (3)
and not to the company X.
After receiving the payment, the factoring company will send the remaining balance of 20% of
the invoice amount to the company X after deducting the clients charges (a percentage of the
value of the invoice it has factored).
Advantages
It will boost the cash flow
there are many factoring companies, so prices are usually competitive
it assists smoother cash flow and financial planning
some customers may respect factors and pay more quickly
you will be protected from bad debts (non-recourse)
Disadvantages
The cost will mean a reduction in your profit margin on each order or service
fulfillment.
Some customers may prefer to deal directly with you.
It may be difficult to end an arrangement with a factor as you will have to pay off
any money they have advanced you on invoices if the customer has not paid them
yet.

Medium and long term financing

Shares
Investors invest their money to buy the shares to earn profit in the form of dividend
Ordinary Shares (Equity shares)
Preference Shares
New share issues
Rights Issue : shares normally issued at discount rate to existing shareholders
Bonus or Scrip Issue: free shares to existing shareholders
Advantages
Large amount of cash can be raised by issuing shares.
No need to pay interest to shareholders
The company is not obliged to pay dividends to the shareholders
It is more cheap and permanent way if raising capital especially for expansions
No repayment of share capital except redeemable shares
Disadvantages
More legal formalities
Dividend is to be paid when company makes profit
Loan note
It is an alternative to share issue. The purchase of this stock will not become shareholders, but
will be creditors. There are entitled to get interest from the company.
Debentures
A debenture is defined as a certificate of acceptance of loans which is given under the
company's stamp and carries an undertaking that the debenture holder will get a fixed return
(fixed on the basis of interest rates) and the principal amount whenever the debenture matures. It
is issued for a long periods of time.
Advantages
Large amount of cash
Money can be used for longer period
No voting rights to debenture holders

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Disadvantages
Fixed rate of interest has to be paid whether company makes profit or loss
Repayable after an agreed period

Differences between shareholders and debenture holders

SHAREHOLDERS
DEBENTURE HOLDERS
Owners of the company
Creditors of the company
Dividend

Interest

Dividend is payable from profit

Interest must be paid whether company makes

profit or loss

Can vote

No voting rights

Share is part of capital

Debenture is a loan

Have full power to control the company

Cannot control the company

Share may be Issued for cash or kind

Debentures are only issued for cash

Leasing
Leasing involves using an asset, but the ownership does not pass to the user. Business can lease a
building or machinery and a periodic payment is made as rent, till the time the business uses the
assets. The business does not need to purchase the asset

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Advantages
Saves capital expenditure: The business does not need large sums of money to
buy the use of equipment
Maintenance and repair costs are not the responsibility of the user
A leasing agreement is generally easier for a new company to obtain than other
forms of loan finance. This is because the assets remain the property of the
leasing company
Losses due to technical improvements will be reduced
Firm is eligible for tax advantages
Solves working capital problems
Disadvantages
Rent is to be paid regularly
Over a period of time the costs incurred from leasing might exceed the outright
purchase cost of the equipment
The business might be tied in to excessively long contracts at rates which cannot
be renegotiated when a cheaper supplier might become available on the market
More legal formalities
Equipments cannot be used as securities for loans

Commercial mortgages
Some companies own freehold of real estate premises such as factories, offices and warehouses.
These assets have a value in the companys accounts. If the business wants to raise sum of
investments in new assets, it could take out a commercial mortgagee with a property company.
Assets sales
Business might sell off old, obsolete assets which are no longer used by the business to raise
additional cash for the business. It will be better use of capital but a new company cant raise
finance as such since they may not have old assets to sell.

Sales and Lease back

This involves a firm selling its assets or property to an investment company and then leasing it
back over a long period of time. The business thus can use the asset without purchasing it and
can use the revenue earned from its sale for other.
Advantages
No need to pay interest
Large amount of money
Disadvantages
Difficult to sell immediately
Lease back will increase the firms expenses
Hire Purchase
Hire Purchase is a means of buying a capital asset by paying a deposit and regular installments
over a period of time. Finance Houses, which retain ownership of the equipment until the last
payment has been made, provide the funding.
Bank loans
This is borrowing from bank for a limited period of time. The business has to pay an interest on
the borrowing. This interest may be fixed or variable. Businesses taking loan will often have to
provide security or collateral for the loan.
Advantages

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Money can be used for long term investments

Reasonable rate of interest
Disadvantages
Fixed rate of interest has to be paid whether company makes profit or loss
Repayable after an agreed period

Government grants
Governments will provide financial support in certain circumstances. The major grants are
related to regional policy. There are usually conditions attached with the grants such as
guarantees of continued operations and creation of jobs. There are no interest charges or
repayment of capital sum.

Factors affecting the choice of right source of finance

Amount of money required a large amount of money is not available through some
sources and the other sources of finance may not offer enough flexibility for a smaller
amount.

How quickly the money is needed the longer a business can spend trying to raise the
money, normally the cheaper it is

The cheapest option available the cost of finance is normally measured in terms of the
extra money that needs to be paid to secure the initial amount the typical cost is the
interest that has to be paid on the borrowed amount.

The length of time of the requirement for finance - a good entrepreneur will judge
whether the finance needed is for a long-term project or short term and therefore decide
what type of finance they wish to use.

The amount of risk involved in the reason for the cash a project which has less
chance of leading to a profit is deemed more risky than one that does. Potential sources of
finance (especially external sources) take this into account and may not lend money to
higher risk business projects; unless there is some sort of guarantee that their money will
be returned.

The finance providers

Clearing banks
The clearing banks are the large high street banks. In practice, it is more useful to think them as
financial service providers. They are very large public limited companies in their own right and
have shareholders to satisfy and are in the business of selling financial services to generate
maximum profits for their shareholders
Merchant banks
These are whole sale banks which offer the following services
Advice on takeover or merger options

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Capital restructuring of business

Assists with share issues and loans
Portfolio management (investment mix and policy)

Trade suppliers
The other main suppliers of business finance are trade suppliers. It should be borne in mind that
suppliers are businesses and may be looking for finance themselves so that they can offer trade
credit to their customers.

Accounting
Accounting is an information system that 1) identifies, 2) records, and 3) communicates the
economic events of an organization to interested users.
Financial statements
Accounting reports, called financial statements, provide summarized information to the owner.
Statement of profit or lossA summary of the revenue and expenses for a specific
period of time.
Statement of owners equityA summary of the changes in the owners equity that
have occurred during a specific period of time.
Statement of financial positionA list of the assets, liabilities, and owners equity as of
a specific date.
Statement of cash flowsA summary of the cash receipts and disbursements for a
specific period of time.
The purpose of statement of profit or loss
The purpose of a Profit and Loss statement is to assess the success of the management decisions
that have been made in the past and to help them to make appropriate decisions in the future. The
statement will show the annual sales, the costs of generating those sales and the resulting profit
or loss. Most companies hope to grow year on year. The Profit and Loss statement can also be
used to inform and reassure existing shareholders or to persuade prospective investors to invest
in the business. The statement would also be needed to support an application for a loan to a
bank.
The purpose of Statement of financial position
The Statement of financial position represents a valuation of the assets that a business owns and
the liabilities that it owes. In other words it identifies the net wealth of the business. Shareholders
hope to see growth in the net value of the business on an annual basis. The balance sheet also
shows how much of the capital has been borrowed and thus provides an indication of the level of
risk from interest rate changes.
Financial Accounting is concerned with reports made to those outside the organization.

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Management Accounting is concerned with information for the internal use of management.
Assets are resources owned by a business. They are used in carrying out such activities as
production, consumption and exchange.

Fixed Assets: Assets held for long term use in the business. E.g. Land & building, Furniture,
Computer equipments etc. Current assets are anything owned by a business that is likely to be
turned into cash during the year. Typical current assets are stock, debtors and cash
Liabilities are claims against assets. In other words it is something owed to somebody else. They
are existing debts and obligations. E.g. Creditors, Bank loans, Overdraft, Accrued expenses etc
Owners Equity is equal to total assets minus total liabilities. Owners Equity represents the
ownership claim on total assets. Subdivisions of Owners Equity are Capital or Investments by
Owner, Drawing, Revenues and Expenses.

Fixed costs are costs that do not vary in the short-term when a firm alters its level of output.
These are the costs that the businesses must pay whether the business trades or not. Examples of
fixed costs include rent, rates, insurance and 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 fuel with miles driven or raw materials and components with production
output. These costs will depend on the level of production and sales.
Total costs are the all the cost of producing specific amount of something, including both fixed
and variable cost
Total Cost = Fixed Cost + Variable Cost
Revenue is the receipts the business receives from the sale of goods and services. This includes
total sales and other forms of revenue such as rent received, and interest received.
Total Revenue = (Average) Selling Price * Quantity Sold
Expenses are the decreases in owners equity that result from operating the business. They are
the cost of assets consumed or services used in the process of earning revenue. Examples of
expenses may be utility expense, rent expense, supplies expense, and tax expense.

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Profit is the excess of income over expenditure. Profit could be used to pay shareholders
dividend, to pay loans or to reinvest in to the business. Profit = Total Revenue Total Cost

Break-Even is reached when Sales Revenue = Total Costs. This is the point where business
makes no profit and no loss. After the survival, Break even becomes the most important
objective of the business. Break-Even could be used to calculate, with a given level of fixed costs

and cost per unit, how many goods at a specific price it needs to sell to break even. It can also be
used to calculate how many units the business needs to sell to reach its target profit. Break-Even
point could be changed with a change in fixed cost, Selling price and Variable cost.
Break Even Point = Fixed Costs/Contribution per Unit. Contribution is the amount of revenue
remaining after deducting variable costs. This the amount each item sold contributes toward
paying the other costs of the business i.e. the fixed costs. Contribution per Unit = Selling Price
Variable Cost
A budget is a financial plan (estimate of cost or revenue) for a specified future period of time,
that the business or department must try to achieve. A master budget combines the forecast
income from sales together with forecast expenditure. This can be used to determine a forecast
cash flow statement as well as a forecast profit and loss account.

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The primary purpose of budgeting is to control cost by ensuring that no department in a

business spends more than the company expects.
Budgeting can motivate managers: When managers at all levels are involved in the
budgeting process they will have a commitment to ensuring that budgets are met.
Budget is a tool of accountability, where individuals success can be measured. It
enables power to be shared within an organization, so that those people in the best
position can be responsible for the businesss money.
Budgeting ensures, or should ensure, that limited resources are used where most
effective: The budgeting process allocates resources to where they are most likely to help
achieve the firms objectives.
Improved management and financial control of the organization: Managers know
who is spending what, and why they are spending the money. Part of the budgeting
process is monitoring of expenditure and revenues. Any changes from (variances from)
budgeted amounts need to be explained and reacted too.
Budgeting is a time consuming and costly job
Budgets are not necessarily a good barometer for progress.
Budgets are based on assumptions that often turn out to be inaccurate
If the budgets are set at an unrealistic level, then it can be de-motivational, as managers
can never achieve the targets set.
If budgets are inflexible then changes in the market or other conditions may not be met
by appropriate changes in the budget.
Those excluded from the budgeting process, may not be committed to the budgets and
may feel de-motivated.
A cash flow forecast is a detailed estimate of a firms future cash inflows and outflows for the
forthcoming year. From this the firm can derive monthly cash flow balances and the annual
cumulative cash position. It is important to identify periods when the firm is cash starved and
needs extra funds and when it is cash rich. Overdraft arrangements can be arranged in order to
ensure temporary finance is available.

Businesses must continually review its cash flow position against their forecasts. The primary
purpose of the cash flow budget is to predict the sources and uses of cash and to identify your
cash position for a specific time period (daily, weekly, monthly etc.). Cash flow forecast allows a
firm to get a clear idea of how the business is doing - and how it is likely to perform in the
future. It also allows managers to be able to specify times when the business may need additional
funding, such as when cash outflow exceeds inflow.
Possible advantages include:
Identification of the timing of cash shortages and surpluses.
Supporting applications for funding.
Enhancing the planning process.
Can reduce the risk of a business going bust.
Possible disadvantages include:
Sales might be higher or lower than expected.
Suppliers might increase their prices.
Bank interest rates may rise or fall.
Production problems may mean you have delays in meeting deadlines.

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Cash flow problem (poor cash flow)

As cash flow is not profit, and it is the cash which is most important for the business to prevent
its failure. As such businesses must ensure that there is sufficient money inflow in to the
business. If a business do not have sufficient cash (poor cash flow) to pay its bills could serious
affect a firms reputation and impact upon its ability to gain future credit and supplies. It could
also affect the day to day running of the business as well. A cash flow problem could arise as a
result of one or more of the following reasons.
There might be a sudden fall in sales whereas the expenses may not come down in the
same proportion.
Any unforeseen expenses may lead to high cash outflow as compared to cash inflow in
that particular period.
Debtors payback period is too long.
Cash flow problems could be overcome by adopting number of techniques.
Arranging a bank loan or an overdraft.
Reducing or delaying some planned expenditure.
Delay payments to creditors.
Offering discounts to customers for early payment.
Factoring
Leasing equipment rather than purchasing it.
Improving credit control function as such by reminding debtors continuously about
payments that are due.

Gearing measures the proportion of capital employed that is provided by long term lenders. The
gearing ratio is given by the equation:
Gearing = Long term liabilities/Capital employed *100
A company with high gearing could be in a volatile and risky position as it has to pay large
amount of money as interest payment whether company makes profit or not.
Working capital is the day-to-day finance required to run a business. It is the finance required to
pay for raw materials, running costs, labor and to finance credit offered to customers. Working
capital can be calculated using the equation:
Working capital = Current assets Current liabilities

Working capital management

These are Decisions relating to working capital and short term financing. These involve
managing the relationship between a firm's short term assets and short term Liabilities. This is
extremely important function in the business as it is mainly a balancing process between the cost
of holding current assets and the risks associated with very small or zero amount of them. The
goal of working capital management is to ensure that the firm is able to continue its operations
and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses

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Management of stock
This includes stock of raw materials, work in progress and finished goods. We have to consider
the cost of holding and not holding stock.
The cost of holding stocks:
Financing cost
Storage cost
Insurance cost
Cost of losses as result of theft, damage etc
Obsolescence and deterioration cost
The cost of holding low stock:
Cost of loss of customer good will
Ordering cost low stock levels usually associated with higher ordering cost than
bulk purchase
Cost of production hold-ups owing to insufficient stock
The organization normally will set the balance which achieves the minimum total cost, and
arrive at optimal stock level.

Management of debtors
This requires identification and balancing of following costs:
Cost of allowing credit:
Financing cost
Cost of maintaining debtors accounting records
Cost of collecting the debts
Cost of bad debts written off
Cost of obtaining credit reference
Inflation cost
Cost of refusing credit
Loss of customer good will
Security costs owing to increased cash collection
Loss of sales
Management of cash
This also requires identifying and balancing of following:
Cost of holding cash
Loss of interest if cash were invested
Loss of purchasing power during times of high inflation
Security and insurance cost
Cost of not holding cash
Cost of inability to meet bills as they fall due
Cost of lost opportunities for special offer purchase
Cost of borrowing to obtain cash to meet unexpected demands
Failure to have sufficient working capital could result in the following problems.

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Difficulty paying its suppliers on time. The knock on effect of this is that the firm may
lose favourable credit terms or be refused credit in the future
It may need to borrow additional monies from the bank, thereby incurring additional
interest payments, which will reduce the profits of the business and increase current
liabilities.
It may lose out on being able to take advantage of purchasing economies of scale by not
being able to buy in sufficient quantities to secure the maximum discounts.